Key Financial Statements

To effectively manage and grow your business, there are three financial reports you should complete and review on at least a monthly basis.

  1. Balance Sheet
  2. Income Statement (AKA Profit & Loss Statement or P&L)
  3. Statement of Cash Flows

(For corporations, there’s also the Statement of Stockholders’ Equity or Shareholders’ Equity, which I won’t cover here.)

The balance sheet summarizes the company’s financial position as of the end of a specified time period. It is often used by potential creditors to determine what a company owns as well as what it owes. Investors, management, suppliers, some customers, competitors, government agencies, and labor unions can also be interested in the balance sheet.

Unlike the balance sheet, the income statement covers a span of time. While the balance sheet is a snapshot of one date in time, the income statement covers a time span or interval. It summarizes the company’s profitability during the specified time interval. Revenues, expenses, gains, and losses are included on the income statement, but not cash receipts or disbursements.

Finally, the statement of cash flows also covers a specific time interval. It summarizes cash received and disbursed in these categories:

  1. Operating activities
  2. Investing activities
  3. Financing activities
  4. Supplemental information

A good accountant or bookkeeper will prepare and interpret these reports for you, enabling you to effectively plan for revenue growth and maximum profitability.

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Cash or Accrual – WTHeck?

headacheIn regards to bookkeeping, businesses have a choice between two accounting methods: Cash or Accrual. Under Generally Accepted Accounting Principles (GAAP), the accrual basis should be used. Essentially, in a nutshell, this is the difference between these two accounting methods:

  1. Under the cash basis, revenues and expenses are reported on the income statement based on the date cash is received from customers, and for expenses, the date cash is paid out.
  2. In contrast, the accrual basis reports revenues when they are earned, and expenses when they are incurred (but not necessarily paid).

Businesses are required to use the accrual basis when they have sales of more than $5 million per year, or if they stock inventory for resale to the public and gross receipts are more than $1 million. The accrual method also shows the ebb and flow of business income and debts more accurately on financial statements. Here is additional information on the differences between these two methods.

  • Receivables are reported as assets under the accrual basis, but not the cash basis.
  • Revenues are reported when they are earned (accrual basis), or when they are received (cash basis).
  • Payables are reported as liabilities with the accrual basis, but not reported with the cash basis.
  • Expenses are reported when they are incurred (accrual basis), or when they are paid (cash basis).
  • The balance sheet is more complete with the accrual basis, because under the cash basis some assets and liabilities are not included. Equity also changes depending on whether you’re using the accrual or cash basis.

The accrual method has a distinct tax advantage if expenses incurred (but not paid) in 2016 (for example) can be deducted on your 2016 taxes. And income received but not earned (a customer payment in 2016 for goods to be delivered in 2017) can be reported on your 2017 return.

For guidance, contact a professional bookkeeper or CPA.

Free Report Bookkeeping Myths: Common Mistakes Small Businesses Make

GAAP (No Not GAP)

femaleAccountantEthical bookkeepers and accountants strive to maintain strict compliance with the Generally Accepted Accounting Principles as defined by the Financial Accounting Standards Board. Here’s a more in-depth explanation from AccountingCoach.com.

There are general rules and concepts that govern the field of accounting. These general rules–referred to as basic accounting principles and guidelines–form the groundwork on which more detailed, complicated, and legalistic accounting rules are based. For example, the Financial Accounting Standards Board (FASB) uses the basic accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and standards.

The phrase “generally accepted accounting principles” (or “GAAP”) consists of three important sets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and standards issued by FASB and its predecessor the Accounting Principles Board (APB), and (3) the generally accepted industry practices.

If a company distributes its financial statements to the public, it is required to follow generally accepted accounting principles in the preparation of those statements. Further, if a company’s stock is publicly traded, federal law requires the company’s financial statements be audited by independent public accountants. Both the company’s management and the independent accountants must certify that the financial statements and the related notes to the financial statements have been prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and methods. Because of generally accepted accounting principles we are able to assume that there is consistency from year to year in the methods used to prepare a company’s financial statements. And although variations may exist, we can make reasonably confident conclusions when comparing one company to another, or comparing one company’s financial statistics to the statistics for its industry. Over the years the generally accepted accounting principles have become more complex because financial transactions have become more complex.

While smaller companies may not feel GAAP compliance is a necessity, it can greatly enable audit survival.

Take the Money and Draw

One of the most common mistakes small business owners make is in how they record personal withdrawals of money from their business. One incorrect approach is to include their personal bank account in their business books, and when they take money out of the business, they record it as a transfer to their personal bank account.

Such withdrawals should actually be recorded as a draw, and should be posted to an Equity account. (You should have one of the following on your Chart of Accounts in your accounting application):

  • Owners Draw (Sole Proprietorship)
  • Members Draw (LLC)
  • Shareholder Distribution (S Corp)

This approach requires a bit more work, but it brings you into compliance with Generally Accepted Accounting Principles (GAAP).

Current vs. Long-Term

Have you ever looked at your Chart of Accounts (COA) in your accounting application? Did you notice that some assets and liabilities are classified as current, while others are classified as long-term? Why is that? Well, this is standard accounting practice.

Quoting the Investopedia.com definition, “Current assets are balance sheet accounts that represent the value of all assets that can reasonably expect to be converted into cash within one year.” Conversely, as AccountingCoach.com explains, “A long-term asset is an asset that will not turn into cash or be consumed within one year of the date shown in the heading of the balance sheet.”

As for current liabilities, again turning to Investopedia.com, “Current liabilities are a company’s debts or obligations that are due within one year, appearing on the company’s balance sheet and include short term debt, accounts payable, accrued liabilities and other debts. Essentially, these are bills that are due to creditors and suppliers within a short period of time.” Long-term liabilities “form part of a section of the balance sheet that lists obligations of the company that become due more than one year into the future. Long-term liabilities include items like debentures, loans, deferred tax liabilities and pension obligations.

And there you have it!

Chart of Accounts

Whether you’re using QuickBooks Online (QBO) or Xero, or some other accounting application, when first setting up your books you’ll need to establish a Chart of Accounts, or COA. Usually accounting apps come with a predefined Chart of Accounts, which you can then customize to fit your needs. Below is a general list of the types of accounts you need to have on your COA.

  1. Asset
  2. Liability
  3. Equity
  4. Revenue
  5. Cost of Goods Sold
  6. Expense
  7. Other Income
  8. Other Expense (typically depreciation and interest expense)

(The first three types make up the Balance Sheet, and types 4 through 8 make up the Income Statement.)

If you wish, in both QBO and Xero you can assign account numbers to the accounts on your COA. These typically begin with the same numbers from the list above, and can be two, three, four, five, or more digits in length. (Because I’m a numbers person, I like to use account numbers. After I work with a COA for awhile, I start remembering the account numbers. When I’m posting a transaction to a specific account, I just have to type in the account number to find it. Yes, I’m weird that way.)