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An Introduction to Accounting and the major components of Financial Statements

Table of Contents

Accounting: An Introduction

Accounting is a language of numbers. The process of accounting attempts to explain each business transaction using a common measurement – Rupees. When you put a rupee value on each transaction, you can compare diverse business activities such as advertising, banking and inventory purchases. This gives you information about what happened in your business in the past and clues about what will happen in the future if things remain the same. The language of accounting also allows others to better understand what you do within your business. These other readers of your information (bankers, suppliers and investors) need a summary picture of what took place and how well you are doing.

The process of accounting is designed in such a way that every monetary transaction that takes place is recorded by the accounting process. The ideal scenario would be a customer walking in; the owner recording that particular sale and then depositing the receipt. Another example: you purchase a new fixture (an asset) for the store, the accounting process will adjust the bank account by the amount of money paid for the fixture, and the fixture asset account is increased by the same amount.

This process of recording transactions achieves three main goals: ensuring that transactions are accurate, that they are complete, and that they are authorized. This aspect of accounting is called “internal control”. It is designed to assist, not replace, the owner in the control of his business.

Financial statements are the products of accounting. You will often use these statements when making decisions about running your business. The major purpose of financial statements is to show the result of every decision you have made in the past so that you can make decisions about the future. Secondary roles of financial statements are for filing income tax returns, seeking additional funding from your lender, and eventually attracting a buyer or investor for your business. The financial statements are composed of three different statements, each with its own purpose.

The Income Statement (Profit and Loss Account)

The major financial statement sometimes called the Profit and Loss Statement (P&L) or Statement of Operations. This product of accounting summarizes the results of business operations for a given period of time. First, it will show the gross sales or revenue for that period of time, which represents your customers coming into your place of business and accepting what you have to sell. Second, it will show the associated costs to provide those products to your customers. These costs can be divided into direct costs, such as staff wages, inventory purchases, and supplies, and into indirect or overhead expenses. These are usually expenses that will occur in the business regardless of whether you have sales or not. While direct costs will vary with the volume of sales, indirect costs reflect the mere fact that you opened for business. Examples of indirect costs are rent, interest expense, depreciation expense and utilities. We will discuss these expenses in a later article.

The net income or loss is calculated by subtracting the different types of expenses from the total sales income. The net income or loss represents how well you have used the money and other assets available to you, and represents how likely it is that you will remain in business. The final benefit of this statement is comparing the trend in the net income over a period of time. In business it is not where you have been, but where you are going.

The Balance Sheet (Statement of Financial Position)

The second major financial product from the process of accounting. This is a snapshot of the financial position of the company at a point in time. At the end of a period (month, quarter, year), the accounting process should allow you to examine the business’s exact position in terms of what you have in the company, what you owe to outsiders and what you own yourself. The Assets section will show you the original value of the assets you have purchased and still have on hand. Some examples of this are furniture and fixtures; inventory; money in the bank; and monies owed to you by outsiders. This is offset by the Liabilities Section. These are the company’s obligations to outsiders. Examples of liabilities are; trade payables for goods and services received but not paid for; debt to outsiders such as your bank; and amounts due to various government agencies, such as payroll taxes and GST/VAT payable.

The final section of the balance sheet is the Equity Section. This area of the statement shows your original investment and the sum of net income/losses earned in previous periods, less any dividends paid out (for incorporated companies). We use this statement periodically to examine the growth of the company’s assets and to better understand what resources are available to the company in order to conduct business. Typically, bankers, creditors and investors are interested in this statement to help them understand the tangible worth of a business.

The Cash Flow Statement

This is often called the Statement of Changes in Financials shows how the company took in cash and how it spent it. This is a statement of true cash inflows and outflows from business operations. If you paid down some debt, this would be shown as a use of funds. If you reduced your inventory from the prior period, this is shown as a source of funds (selling inventory creates cash inflow). If you, the owner, contributed funds, this would be shown as a source, and conversely, if you withdrew funds it would be shown as a use of funds. The cash flow statement effectively ties together the Income Statement and the Balance Sheet and expresses it in terms of the change in your cash position. A bank statement will tell you how much your cash position changed, but it will not tell you the how’s and the why’s of the change.

What we have discussed is the basics of accounting and its products. We realize that you need more information and that you are going to have to rely at least partially on outside experts. Some of you are relying upon other means to understand your financial position. This is too dangerous for your major investment. The purpose of this article, and ones that will follow in the future, are to make you more aware of accounting, and how to use it to make your business successful.
Submitted By: Bikash Adhikari

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