Accounting Principles
Simply stated, accounting is the measurement of economic activity. Its goal is to report financial information to the user so that (s)he can make informed decisions. There are two important reports used by more than 99% of all business operations to determine the status of the business operation. These are the income statement and the balance sheet.
Income Statement
The most common report or most important report is the income statement. It has several different names – Income Statement (this is technically the most common name)
- Profit and Loss (more commonly used in the past but the world of professional accounting prefers the Income Statement)
- Statement of Activities (used in the nonprofit environment)
- Revenues in Excess of Expenses (rarely used but the name speaks for itself)
This report is designed to report sales (revenues) and the associated expenses. It is generally a measurement of performance over an extended period of time (at least 30 days). The most common time period is a quarter of a year, but in the small business world, monthly reports are the standard.
It is broken out into three major sections. The Revenue Section includes sales, returns, and adjustments provided to the customer. The next area of the report identifies the costs associated with those respective sales. This includes direct costs of materials, labor, equipment issues, and other production costs. This section is commonly referred to as Cost of Goods Sold, Costs of Services Provided, or Direct Costs. The final and 3rd area of the report paints the picture of the overhead costs. These include facilities (rent, utilities, maintenance etc.), office operations (supplies, office labor, postage, and communications), insurance, and marketing costs.
The direct costs or costs of goods and services provided are subtracted from the revenue to give the margin for the company. From the margin, is subtracted the general operating expenses and you derive the Net Profit or Loss.
The goal of this report is point the business owner/entrepreneur to the primary source of why we make a profit or generate a loss.
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Balance Sheet
The second most commonly used report is the balance sheet. Other names include:
- Statement of Financial Position
- Assets, Liabilities, and Owner’s Equity
It is often referred to as a picture at some given moment. Just as a video consists of thousands of pictures taken in sequence, the balance sheet is just one of those pictures. It is constantly changing from moment to moment depending on the transactions occurring in the company.
The balance sheet weighs the existing assets of cash, receivables, fixed assets, and other assets against the source of their existence. The other half of the balance sheet includes current liabilities such as payables, employee payables, credit utilization (credit cards, lines of credit, or short-term notes), and other long-term notes. The remaining area of the balance sheet includes the Owner’s Equity section and this is primarily the contributed capital and the earnings to date less any distributions (disbursements) to the owners (shareholders). Both halves of the balance should equal each other.
With these two primary reports, a reader of this information can determine the overall financial status of the company.
It is important to note that for this to work well, the information loaded into the accounting system must be accurate and timely (within a reasonable period of time from the actual transaction). The old adage of good information into the system maximizes the ability to generate good information out in the form of reports. This in turn allows the owner the best chance to make good decisions based on the information he reviews.
The primary goal of accounting is to measure the economic activity of the business. Transactions are entered into the accounting software and information is collected, collated, organized, and then reported in reports for the owner. From there, the owner has the best opportunity to make good decisions to improve the success of the business. Act on Knowledge.