5 MIN READ
Take a step back and remember your younger self in high school or even college. Get out your notes because this is your first day of accounting class! But don’t stress—today’s class will be an easy introduction to accounting. We are going to break it down to the basics today so you can better understand the importance of accounting and all the considerations you will face as a small business owner.
Let’s get started.
Introduction to accounting
First, what is accounting? Accounting is the language of business. Accounting for much of the business world is the heart of all decision making. But what type of decisions would you and I make? Well, it depends! That is where the two types of accounting come into play.
- Financial accounting is the most familiar type of accounting centered around providing financial statements for external users.
- This is when people within the company make decisions within the company. For example, a grocery store would figure out using managerial accounting if they should keep the deli in the store open.
Accrual vs. cash basis of accounting
One of the most important things to take away from this post is the difference between accrual and cash basis accounting.
Cash basis accounting
Sometimes when a business makes money, the business doesn't receive the cash right away (the technical term for this is selling on account). For example, let’s look at a “sign then drive” car leasing event. The dealership does not get a check for $30,000 from you to walk away with a new Civic, right? Do they wait to record the sale of the car until they get the money from you six months from now or right away, even though they haven’t received any cash? The answer depends on if they use the cash or accrual basis of accounting. The cash basis of accounting states revenue or expenses that are recorded only when cash is received or paid out. So, let’s say you pay for the car six months from now, and with cash basis accounting, the dealership won’t record a sale until they get the $30,000 check from you.
But ask yourself, is this an accurate representation of how the company is doing? If all sales were like that, how can you make informed decisions without knowing of a sale?
That is where accrual accounting comes into play. Accrual accounting recognizes expenses and income when it incurs, not when cash is exchanged. Could it happen at the same time? Yes, and that makes our life easy, but not always. In our car example, the dealership would record the income immediately after the sale.
Financial statements are the whole reason why we have financial accounting. These statements help people make decisions like whether or not to invest in a company. There are dozens of statements, but we will focus on three main ones: the balance sheet, income statement, and statement of cash flows.
The balance sheet gives us a snapshot in time of how our business doing. The balance sheet tells us what the business owns versus what it owes. More specifically, it goes over the accounting equation: assets (what the business owns) = liabilities (what the business owes) + owners equity (net assets).
Next, the income statement tells us how the business is making money. More specifically, how is the business making money through its primary activities? Or is it getting by because it is selling a lot of assets? "The bottom line" is a term often used to describe the net income of a company, but you might see another term called gross profit. Although they sound similar, gross profit is the net between revenues and expenses, while your net income is your gross profit less taxes.
Statement of cash flows
Lastly, the statement of cash flows tells us all of our cash expenses. One of the potentially most confusing aspects of bookkeeping is that not all expenses are cash expenses. For example, your car depreciates in value over time, but do you pay the car manufacturer for the car decreasing in value? No, but we do record the depreciation on paper, so we have to subtract the depreciation expense from our net income to see the actual flow of cash. This is important because it tells us how well a company is managing cash.
Credits and debits
The last concept we'll cover is credits and debits. Another good way to look at accounting is to analyze where money is coming from and where it is going. We want to know where our money is going because we want to keep track of it and produce statements to analyze.
Typically, credits represent the source, and debits are the destination of the money (this is sometimes not true, but that’s a different conversation for a different day). Let’s say I invoice a client for a service I performed. I will credit my income account because the money is coming from the customer, and debit cash as the client’s money is going to my bank account. This is important because credits and debits are the foundation of journal entries and the chart of accounts.
Accounting can be an intimidating task for firm owners. Starting with the basics and understanding each type of accounting, types of costs, and different financial statements makes the execution of your everyday bookkeeping tasks far more manageable.
Another way to make your life easier? Work with the Bean Team to handle all your accounting. Get more information and join our waitlist here.
About the Author
Milan Chokshi is a Bookkeeping Intern with XY Bean Counters. His favorite part about his job is that it’s more than just a paper filing internship—he loves the fact that he’s encouraged to learn and ask questions freely, and the emphasis on growth has paid off; Milan has seen growth within himself in the short time he’s been here. When he’s not making his case for “World’s Best Bookkeeping Intern,” Milan loves skiing and dancing (he’s a competitive dancer!).