Why Do We Need Accounting?

Accountings Importance to Business So why do we need accounting? Asking that question of an accountant is like asking a farmer why we need rain. We need accounting because its the only way for business to grow and flourish. Accounting is the backbone of the business financial world. After all, accounting was created in response to the development of trade and commerce during the medieval times.

Italy is our first recorded source for accounting entries, and the first published accounting work in 1494 was by a Venetian monk. So you see accounting as an organized method for record-keeping has been around almost as long as the trade and business industries. Another interesting fact is the knowledge and principles upon which the first accounting practices were established, have changed very little in the many hundreds of years that accounting has been in use. The concepts of assets, liabilities, and income and the need to reconcile these areas is still the basis for all accounting functions today. The process for recording those transactions, and the many reports generated by the compilation of that information has evolved over the last two hundred years. Thanks to the creation of computers, many of the bookkeeping functions that are vital to accounting, but somewhat repetitive are performed by data entry clerks, and the reports generated come from the IS Department. The end result is still the same: accounting gives us the financial snapshot we need in order to make solid business decisions about the current status or projected future health of our businesses. There are two basic categories of accounting: financial accounting and managerial accounting. Financial accounting is comprised of information that companies make available to the general public: stockholders, creditors, customers, suppliers, and regulatory commissions. Managerial accounting deals with information that is not made public. Information such as salary costs, Cost of goods produced, profit targets, and material control information. The knowledge supplied by managerial accounting is for the use of department heads, division managers, and supervisors to help them make better decisions about the day-to-day operations of the business. Now, what about the accountability part of the accounting process? Why do we need that and how do we enforce it? Businesses need to be held accountable for the methods they use to run a business because the potential for greed, theft, and dishonesty exist in every business. You have only to read the current events section of the newspaper to realize how rampant corporate abuse is in business today. We have Enron, HealthSouth, and Martha Stewart examples to show us just how extensive the problem has become. There are specialized areas of accounting, that when correctly enforced, eliminate the possibility for fraud. Auditing and income taxation, when used correctly, force business to account for all business income, transactions, and transfers, and then to pay their fair share of the tax burden. The catch here is that the principles must be correctly enforced. Accounting is the conscious of the business world. When handled with care and with respect, it performs as expected. When abuse occurs, and the system is circumvented or overridden because of dishonesty and greed, it doesnt work correctly. Accounting is much like all other systems in place, they are only as good as the people using them.

What Are Debits and Credits?

Understanding Accounting Basics Debits and credits in accounting are often confused. So where did debits and credits come from, and what do they mean?

The double-entry accounting system was developed and in use during the 1400s in Italy. We know this because there are recorded documents that use the double-entry method. The double-entry accounting system operates on the basis of the fact that every transaction has two components: a debit and a credit. Debits must always equal credits. This is the basis of a true accounting system. Debits are a component of an accounting transaction that will increase assets and decrease liabilities and equity. Credits are a component of an accounting transaction that will increase liabilities and equity and decrease assets. By now, you should have progressed past confusion. It can be thoroughly vexing to try to remember what goes where. But there is no simple way to remember if it is a debit or credit to the account. You simply must gain an understanding of what constitutes a debit or a credit, and then make your journal entry accordingly. Any item of financial impact that increases your assets, such as your bank balance, equipment, or accounts receivables, is recorded as a debit to the respective asset account; at that moment, you will have created a credit transaction that must be recorded. Now, Im going to put this into a language that anyone should be able to grasp. Its Friday afternoon, and your car payment is due. Your car is an asset. The loan against it is a liability. You make a payment on the loan. That payment has two components: a debit and a credit. After you make the payment you will own a larger portion of the value of the car. You have increased the value of an asset (your car) as it applies to your financial net worth, and you have decreased the value of a liability (the loan). The increase in asset value is a debit to the asset account entitled CAR and the decrease in liability value is a credit to the liability account entitled CAR LOAN. Now, that is an example everyone should be able to relate to, since 99 out of 100 individuals own cars, and owe for them. Even if you never formally study accounting, you will be a part of the accounting process in every transaction that you complete with an exchange of currency. Every time you buy groceries, shop at Wal-Mart, or buy gas, there is an exchange of account values. There is a debit and a credit. Most of you will never even think about the cause and effect created by purchases, monetary exchanges, or trips to the grocery store. But for the accounting professionals, every day is a debit or credit, an exchange of value between assets and liabilities.

Your Accounting Statement of Cash Flows

No, it is not an overdraft notice from the bank. Your statement of cash flows is a business tool used by many smart businesses to determine their flexibility when preparing budgets, making decisions about asset purchases, and to monitor their level of profitability in relation to cash availability.

What is a statement of cash flows, and what purpose does it serve? A statement of cash flows is a summary of all the cash receipts and cash payments of a business, for a specific period of time, such as a month or a year. Now, why would you want to watch this information, or monitor any changes? The purpose of the statement of cash flows is to provide an entry for the cash balance shown on your balance sheet. But, in essence, the statement of cash flows provides a business with so much more. An examination of the statement of cash flows will show you exactly where your cash surplus or deficit is coming from. The statement of cash flows is divided into three specific areas: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Lets take a quick look at each, hopefully you will then be able to differentiate which area your will tell you the most about the health of your business, or if just one area can provide that much information. The area of cash flows from operating activities is the meat and potatoes of the statement of cash flows. This area will show you if your sales, your cash receipts, and inventory and your accounts receivables are experiencing any dramatic changes, if your sales are to a great extent credit sales, and if your inventory is shrinking. A good manager or business owner will watch this area closely for suspicious changes, or abrupt changes. The area of cash flows from investing activities will provide you with a quick reference for any changes in permanent assets. Any sales or purchases of equipment, even bonds, will show up here. The monitoring of investment activities, when used with your operating activities, will tell you when moments of opportunity and need are presenting themselves. The area of cash flows from financing activities refers to any activity of investing, borrowing, cash withdrawals by the owners, and changes in stock levels. The statement of cash flows is meant to serve as a bridge between the minute detail of the profit and loss sheet, and the sketchy details of the balance sheet. When properly used, the statement of cash flows will fill in many gaps left in the reporting of information from one level of detail to the next. What other wonderful piece of information can be gleaned from the statement of cash flows? Your ability to review last months or last years cash balances against current totals for cash on hand. If you business has been operated efficiently, and the correct investment and purchasing decisions were made, you will see an increase in cash balances, from one time period to the next.

What is a Profit and Loss Report?

Understanding Accounting Basics The Profit and Loss report generated by your manual record keeping, your computer software, or the accountant youve previously hired, is also known as an Income Statement. This is perhaps one of the easier reports to compile, but one of extreme importance. Why? Because the businesses net income or loss is the result shown on the Income statement. Net income information is transferred directly onto your Balance sheet, and is used by business owners, lending institutions, and prospective investors to assess the financial health of your business.

In general, business owners will examine the Profit and Loss statement to determine profit ratios, to examine selling prices and costs, to compare wage expense from month to month, and to set advertising, purchasing and inventory budgets. Not every business owner utilizes the wealth of information available in the Profit and Loss report, sometimes simply due to a lack of understanding about the benefits gained by evaluating the report. Not utilizing this report, however, can be compared to neglecting some part of your health. If you realize there is a problem internally, but see no obvious outward sign of ill health, do you just ignore what is happening? No, most people would seek the advice of a physician to help them correct the internal problem. That is what a Profit and Loss statement does for your business. It helps business owners take a look at the internal workings of their business. Outwardly, sales may be great; you see no obvious sign of ill health. But your cash account balances indicate a problem. Examination of the Profit and Loss reports for several months should be the equivalent of seeking professional advice concerning your health. You should be able to pinpoint problem areas, and seek solutions. The other, sometimes crucial reason for maintaining accurate accounting information, especially as it pertains to profit and loss is to accurately report income and earnings for preparing tax returns. The IRS requires that business owners comply with some very specific rules about net income, depreciation, and inventory value. Intelligent business owners use the Profit and Loss report throughout the year to track the financial health of their business, but also to help them prepare and plan for the tax year. There are many options for businesses to protect their net income from Uncle Sams clutches, but only if they plan and prepare during the tax year. The Profit and Loss provides you with the information you need to most efficiently utilize your available resources and keep a larger portion of the net profit. If youre among the growing number of small businesses who choose to purchase software and do their own bookkeeping, generation of the Profit and Loss and Balance Sheet will be tremendously helpful at year end. Most businesses, while able to perform the bookkeeping requirements, are often not equipped to handle tax returns or the monthly reporting of sales tax, use tax, or payroll tax that is often required by the federal government. Accurate record keeping, and reports that can be provided to an accountant, make end of year tax issues much easier to resolve, and your accounting bill much smaller. After all, youve done the leg work, all the accountant now has to do is put the information together on the return. You can see, again, the benefit of using your Profit and Loss report.

Understanding Accounting: Accounts Payable Function

The accounts payable function of accounting is an area that requires close monitoring and accurate record keeping, unless you d like to pay for things you dont receive. Everything that you purchase in the course of operating your business is termed an account payable. How you choose to pay for that merchandise, may vary. Some small items are paid for as they are purchased, and listed in an area known as miscellaneous expense. Some of the more expensive pieces of equipment youll need in order to operate your business, will be set up as long-term liabilities, not as a true accounts payable.

The accounts payable that we are referring to in this article, are the items that you purchase in sufficient quantity to warrant a purchase order, an invoice, and a net due term on your account. Most often, your purchases that will go to an accounts payable area are the items you need to create your product or service. If you sell widgets, and the widgets are made from blodgets and blocks, you would purchase blodgets and blocks by the hundreds. These purchases would occur on a regular basis, on set intervals. When the items arrive, they are shipped with a pack list that will be checked, attached to a receiver, and sent to the accounting department for future payment. This is a true accounts payable item. At some point during the process, you will receive an invoice from the manufacturer of the items, and it will detail what you were shipped on a particular day; all this should match the pack list and receiver you have in your accounts payable for that manufacturer. In a perfect world, it matches every time, in reality, it will only match maybe 65% of the time. Noted somewhere on that invoice, will be the terms of payment. Some of the invoices you receive will say Net 7 or Net 30; this simply means payment is due within 7 or 30 days. With the use of computerized recordkeeping, it is often quite easy to set up timers that alert you to an approaching payment due date, based on the Net due information on the invoice. Once you have matched your invoice and receiver, you will generate a payment to that manufacturer that will reference the invoice, and quite often the receiver. All you need now are an envelope and a stamp. One of the most important lessons to be absorbed here, is not only the balancing and checking of the receiver and invoice, but the timely processing of the invoice to a payment. Many times, poor record keeping and a lack of discipline in your bookkeeping records will allow for missed payment deadlines or lost invoices. This does not enhance your reputation with the vendor to whom you owe monies, nor does it help your position should you need to ask a favor of that vendor. Timely payments, correct payments, and accurate recordkeeping help you to establish a good relationship with a vendor, or supplier, and goodwill is one of the best friends you can have in the business world.

Accounting Trial Balance Example and Financial Statement Preparation

The last two steps in the accounting process are preparing a trial balance and then preparing the balance sheet and income statement. This information is provided in order to communicate the financial position of the entity to interested parties. TRIAL BALANCE A trial balance is a list and total of all the debit and credit accounts for an entity for a given period usually a month. The format of the trial balance is a two-column schedule with all the debit balances listed in one column and all the credit balances listed in the other. The trial balance is prepared after all the transactions for the period have been journalized and posted to the General Ledger. Key to preparing a trial balance is making sure that all the account balances are listed under the correct column. The appropriate columns are as follows: Assets = Debit balance Liabilities = Credit balance Expenses = Debit Balance Equity = Credit balance Revenue = Credit balance Should an account have a negative balance, it is represented as a negative number in the appropriate column. For example, if the company is $500 into the overdraft in the checking account the balance would be entered as -$500 or ($500) in the debit column. The $500 negative balance is NOT listed in the credit column. Example Trial Balance:

The trial balance ensures that the debits equal the credits. It is important to note that just because the trial balance balances, does not mean that the accounts are correct or that mistakes did not occur. There might have been transactions missed or items entered in the wrong account for example increasing the wrong asset account when a purchase is made or the wrong expense account when a payment is made. Another potential error is that a transaction was entered twice. Nevertheless, once the trial balance is prepared and the debits and credits balance, the next step is to prepare the financial statements.

Income Statement The income statement is prepared using the revenue and expense accounts from the trial balance. If an income statement is prepared before an entitys year-end or before adjusting entries (discussed in future lessons) it is called an interim income statement. The income statement needs to be prepared before the balance sheet because the net income amount is needed in order to fill-out the equity section of the balance sheet. The net income relates to the increase (or in the case of a net loss, the decrease) in owners equity.

Now that the net income for the period has been calculated, the balance sheet can be prepared using the asset and liability accounts and by including the net income with the other equity accounts.

When preparing balance sheets there are two formats you can use. The format above is called the Report form and the Account form lists assets on the left side and liabilities and equity on the right side.