It has been said that the only thing that’s constant is change, and if you’ve been in business for any length of time, you know how true this is. If there’s one thing that sets companies that have been successful over the long haul-think IBM, General Electric, Wal-Mart or Microsoft, for example-apart from all the others, it’s their positive reaction to change.
Adapting to change impacts a company’s ability to capture and hold onto its market, grow its business and profitably sell its products and services. However, every small business owner or manager must learn to differentiate between those business processes that must evolve and those that should remain stable.
When Change Is Destructive
While evolving in order to meet changing consumer demands and an ever-shifting technological environment is essential, there are some business processes where change and evolution are counter-productive, even destructive. Financial accounting is one of these.
The accounting scandals that brought down several large corporations in the early 2000s illustrated the destructive potential of getting too “creative” when it comes to financial accounting. While the government passed legislation that attempted to tamp down such accounting irregularities, it’s still primarily the responsibility of business owners and their accounting professionals to create and provide financial information that is what I call ARTistic: Accurate, Relevant and Timely.
Accounting rules can and do change over time to reflect changing business models and new types of business transactions. However, financial accounting as a business process should remain stable, evolving only after careful thought is given to the potential implications of reporting transactions differently.
A complete overview of the basics of financial accounting is way beyond the scope of this article. However, by sharing a few standard accounting concepts with you, I hope I’ll motivate you to perhaps take a little bit closer look at the financial statements your CPA slides across your desk next month.
The Chart of Accounts
Let’s start at the beginning: with the financial data recording system that’s known as the chart of accounts. This is a systematic listing of all ledger account names and associated numbers used by your company, arranged in the order in which they will appear in your financial statements (more on them in a minute): usually Assets, Liabilities, Owner’s or Stockholder’s Equity, Revenue and Expenses.
A chart of accounts allows the orderly reporting and summary of all of your company’s financial transactions. For example, you can go back and look at all vendor invoices paid during a specific time frame to determine exactly what work was done, why it was done and what organization benefited from the expenditures.
Think of the chart of accounts as a collection of buckets, each with a particular kind of data inside. There might be a bucket for each asset your company owns, each debt you owe, each product or service you sell, and each type of expense you incur to sell products and services.
The chart of accounts is an organized, comprehensive list of all these buckets. The buckets, in turn, are labeled with the appropriate account number and arranged by the kind of data they hold. They can be rearranged during the accounting process as their contents are counted and checked (usually monthly) so reports can be produced that summarize the data they contain.
The General Ledger
No, this isn’t the person who secretly runs the accounting department and issues all those reports nobody can read! The general ledger is the place where all accounting transactions ultimately come to rest, and the data source for your financial statements.
Think of the general ledger as a large, old-fashioned scale that is always kept in balance by adding and subtracting an equal and offsetting amount of weight to each side. All of the buckets that appear in the chart of accounts are arranged in one or the other of the trays. As transactions occur, you add to each bucket the appropriate data that represents the financial effect of that transaction.
When something is added to a bucket on the Asset side, for example, something else of equal value either must be taken away from the Asset side (such as the cash paid to acquire the asset) or added to the Liability side (such as a loan taken out to pay for it). This way, the scale always remains in balance and your company has a self-checking system to ensure that the entire transaction has been recorded properly.
The Financial Statements
These are the real “meat and potatoes” of small business accounting. There are three primary financial statement formats that appear in annual reports and most business’ internal monthly financial reports:
o Balance Sheet: This shows the financial condition of the company as of a particular date, usually the end of a month, quarter or year. It lists all of your company’s assets on one side and all of your liabilities on the other. The difference between the carrying value of the assets and liabilities is equal to the equity interest accruing to the owners.
o Income Statement: Also commonly referred to as the Profit and Loss Statement, or the P&L, this recaps all of the company activities that were intended to produce a profit. It lists the amount of sales, all the costs incurred in making those sales (or the cost of goods sold), and the overhead costs incurred in running your company’s operations (e.g., salaries, rent, utilities, etc.).
o Statement of Cash Flow: This shows the effect of all the transactions that involved or influenced cash but didn’t appear on the income statement. For example, if you borrow money and deposit it in your checking account for use later, no income or expenses have been created, so this activity can’t be reflected on the income statement. Instead, it would go on the statement of cash flow. Every transaction that occurs in your company between any two balance sheet dates will be reflected in either the income statement or the statement of cash flow, and from those two reports the summarized results appear in your balance sheet in the form of net changes to balances.
Make Better Business Decisions
The key to sound decision-making will be your ability to understand and use these critically important business reports. They are the condensed result of every financial transaction your company has undertaken, and the result needs to be accurate, relevant, timely and understood.
This is a role that cannot be delegated. Don’t shy away from asking your accounting department or CPA to explain any aspect of these reports until you really understand them. The success of your business depends on it.