Unless you are already a qualified accountant who has just bought a business, as the owner, you would not be expected to have detailed knowledge of accounting principles. Most owners have only a passing understanding of how their accounts are generated. They rely on professional help from external accountants like Charter Partners or if the business is large enough, by experienced staff.
However, there are some accounting terms and principles that every business owner should understand if they are to give the enterprise the best chance of succeeding. Many fledgling businesses fail to last beyond the first year because the owner/operator, for example, does not keep business and private expenses separate.
What is Double-Entry Bookkeeping?
The best place to start is with one of the founding principles, established in the 14th century, and one of the first things a trainee bookkeeper learns. It is extraordinary that after all this time, double-entry bookkeeping is still practiced all over the world. “For every debit, there must be a corresponding credit” is seared into the consciousness of every bookkeeping student.
Why is this important? Every transaction must be entered into two different accounts which, at a point in time, must balance. When all the transactions in a timeframe are entered, usually by the end of the month, the value of all the debits should equal the value of all the credits. When this occurs, we say that the accounts are in balance. When it doesn’t, there is an error somewhere that must be found and corrected.
A credit entry increases liabilities while a debit entry increases assets. Traditionally, a credit entry is posted to the right side of the ledger while a debit entry is posted to the left side of the ledger.
The Role of the Ledger
Let’s look now at the term “ledger”. Originally, the ledger was a large book with ruled columns in which all the entries pertaining to a business were written by hand. Later these entries were processed by ledger machines onto cards for each account. Now computer software does this efficiently, and from this information managers run financial reports to check the position of the business.
Understanding Assets and Liabilities
An asset is something that is owned and a liability is something that is owed. The business owner may own a home, a car and other personal possessions as well as office equipment and work vehicles. If all these assets have been acquired by taking out loans, then these loans are liabilities.
Where Equity Fits In
The gap between the value of the assets and the value of the liabilities is called equity. If the value of the assets increases while the owner is making regular loan payments, eventually the assets will be valued at much more than the outstanding balance of the loans. This is a healthy position to be in as opposed to the opposite. In fact, if the owner’s overall equity is less than zero, the business is in deficit.
Balance Sheet, Income Statement, Cash Flow Statement
These are the major reports that show the state of the business. The balance sheet is often described as a snapshot at a single point in time of the assets, liabilities and owner’s equity. It describes the result if the business had to be liquidated at that moment. The income statement records all the income and expenses in various categories or accounts. The result is recorded at the bottom of the statement as either a profit or a loss for that trading period. The cash flow statement records where all the cash came from and how it was spent.
A General Understanding is Enough for Now
If all this information is making your head spin, fear not. Remember that your role as the owner is to grow the business. You are probably good at selling yourself and your product to customers, making connections and networking with the right people. Keep doing that, but also take the time to absorb as much as you can about these accounting basics. It is important for the future of your business that you develop enough of an understanding to have meaningful discussions with your external accountants.
Accounting firms like Charter Partners offer business mentoring services to help owners understand what their accounting figures mean, so they can take corrective action when necessary.