Introduction to accounting

Introduction to accounting

Intro and Fundamentals

This course explains accounting fundamentals such as defining assets, liabilities, and other types of accounts; the profit and loss statement; the balance sheet; and the basics of double-entry bookkeeping. In this introduction, we’ll cover the building blocks of accounting: the monetary principle and accounts.

The Monetary Principle

When we track things in accounting, they always have a dollar value associated with them for our accounting purposes.

For example, inventory, while not being actual money, is valued in terms of dollars. This puts everything on an even playing field and allows you to compare apples with apples—even if you are talking about pears and oranges. Sure, this is obvious, but it’s still got a fancy name: the monetary principle.

Accounts

In day-to-day life, when the word “accounts” is used, it usually refers to bank accounts, but in the accounting context, accounts has a much wider meaning. It can mean any area of business we want to track in order to see where money is going to or coming from—in other words, what we spend money on, where money comes in from, whom we owe money to, and who owes money to us.

Examples of accounts are inventory, accounts receivable (people owe you money), bank accounts, advertising expenses, revenue/income, vehicles, accounts payable (you owe money), loans, and equity, just to name a few. Accounts are relevant at home too. A house would fit into an account, as would the mortgage, the gas bill, and salary. Anywhere that money comes in from, or gets spent to, is an account.

Groups of Accounts

All these accounts will fall into one of six groups. Which one they fit into is important when we come to reporting the account.

Assets: Assets are stores of money or things that can be turned into money reasonably easily, such as things that can be sold. Examples of assets are cash, positive bank accounts, vehicles, TVs, computers, buildings, and accounts receivable.

Expenses: Expenses are things you spend your money on while running your business and trying to earn an income. Examples of expenses are phone, gas, marketing, rent, and electricity. An expense is money paid on something that is used up almost immediately. The money spent on buying assets is not classed as an expense, because there is something valuable that could be sold again.

Drawings: Distributions made to business owners—e.g., when an owner takes money out of their business for themselves—are known as drawings.

Liabilities: This is when a company or person owes money or some other asset to another company or person. Examples of liabilities include loans, mortgages, and accounts payable.

Equity: This is the share in the business that the owners have. When assets outweigh liabilities, the balancing figure is the equity. What this means is that if the business was closed and all assets were sold and all debts settled, whatever is left would be given to the owners. This figure is equity. The idea can also be applied at home. If you sold all your worldly possessions and paid all you owe, then the figure left at the end is your equity. If the figure is negative, then there are not enough assets to cover your liabilities.

Revenue: Any money that comes into the business for services rendered or goods sold is called revenue or income.

Up next, we’ll cover the profit and loss statement, which tracks revenue and expenses.

The Profit and Loss Statement

Above, we covered the main types of accounts, and now, we’ll look at how to track two of them—revenue and expenses—with the profit and loss statement. The official name for the profit and loss statement is the statement of financial performance. It is also known as the income statement, or the P&L.

The profit and loss is the financial summary of the operations of a company over a set time frame, usually a year. It is designed to show how much money came in as revenue, how much went out as expenses, and finally, the resulting profit at the end of the year. Below is the layout of a typical company profit and loss.

Statement of Financial Position for the Period Ended 31 March 2018

Revenue (Sales)100,000 
Cost of Sales40,000 
Gross Profit 60,000
Less: Expenses  
Administration Expenses10,000 
Selling Expenses10,000 
Earnings Before Interest and Tax (EBIT) 40,000
Interest5,000 
Tax12,000 
Net Profit After Tax (NPAT) 23,000

Heading. The first thing to notice is the part of the title that says, “for the period ended …” This means that the statement is for a period of time, as opposed to a snapshot at a certain moment in time. This means the figures shown are the result of an accumulation over time. Almost always, this period of time is a financial year. A financial year is twelve months, like a calendar year, except that it can start and end at arbitrary times. In this example, the period begins on 1 April 2017 and ends on 31 March 2018. That means that all the figures in the statement are a summary of what happened for the company during the period between 1 April 2017 and 31 March 2018.

The revenue line. The first line is the revenue line. It is a summary of all the transactions that have impacted the revenue account during the period. In other words, this line shows how much money the company received over the period. Let’s say this company makes rocking horses. Here, the company has received R100,000 in sales of their rocking horses.

Cost of sales. The next line shows how much it cost the company to make that revenue; in this case, it cost R40,000. That money is the costs directly associated with the items that were sold. For example, the timber that went into the horses and the labour of the people who built the horses would be included in that cost, because it is possible to say that a specific piece of wood or labour went directly into the products. The cost of sales is the cost of getting the goods to a point where they could be sold. It does not include the infrastructure or overhead costs like administration because it is not simple to say exactly how the administration contributed to a specific product. So, the overhead costs come later.

Gross profit. Revenue minus cost of sales gives the gross profit, or gross margin. This is the first indication of the profitability of the business. This line shows whether the sales of the goods or services at the company are covering the cost of producing those goods or services and by how much.

Note that cost of sales and gross profit are only relevant to manufacturing or retail companies. Services companies do not have direct costs the way manufacturing and retail do because there are no physical products.

Expenses. Following the gross profit line are the other expenses, or overheads. These are expenses not directly required in the manufacture of the goods of services. Examples of this are things like management staff, telephone charges, and postage.

EBIT. EBIT, or earnings before interest and taxation, is the gross profit less overhead expenses, but before interest or tax expenses are paid.

NPAT. NPAT stands for net profit after tax, also known as profit available for distribution. NPAT is EBIT less interest and tax expenses. This is the number that will get paid to owners or reinvested in the business.

Up next, we will look at the statement that tracks the remaining groups of accounts, the balance sheet.

The Balance Sheet: Part 1

Previously, we covered revenue and expenses. In this section, we’ll start talking about the balance sheet.

The official name for the balance sheet is the statement of financial position. It shows what the assets of the business are and how they have been funded—either by borrowing (liabilities) or through owner-introduced funds and profits (equity).

This lesson will recap what assets, equity, and liability are, but going a little deeper than before.

Assets

An asset is money or something that can be changed into money reasonably quickly. To be more precise, it is an item that the company has made or purchased in a previous arm’s length transaction and is likely to produce future tangible benefits to the company.

An arm’s length transaction is simply a normal business transaction where a fair value is paid. “Mate’s rates” would not qualify as an arm’s length transaction because the value paid is probably less than the asset is actually worth.

Future tangible benefits means that because of this asset, there is likely to be income generated at a later date. This income may be generated either by selling the asset, creating revenue by using this asset, or both.

For example, a company may own a truck, which means they are able to go out and deliver the products they sell, thus helping to earn revenue. Or they may sell the truck. Either way, it will make the company money at some point in the future.

Liabilities

A liability is the opposite of an asset. It is an obligation to pay money to another party in the future. To be more precise, it is a contractual obligation resulting from a previous arm’s length transaction, which necessitates a payout of money or equivalent to a third party at or by a specified future date.

For example, if a homeowner has a mortgage with the bank, then they are obligated to pay them back in the future. Or if a company bought wood on credit, then they must pay their supplier in the future.

Equity

Equity is the balancing item on the balance sheet. If all assets were sold and all debts paid, then equity is what would—theoretically—be left. The term “proprietorship” can also used in sole trader organizations or very small companies. It gets this name because all the equity belongs to the proprietor, who is the sole owner in these organizations. In larger companies, it is spread much further among a variety of shareholders and gets its more common name: equity.

It is also the balancing item in another respect: When cash is first invested in the business, it goes to two accounts—to bank and to equity—as the balancing item. The reason for this will become more obvious in a future lesson, when we discuss double-entries and debits and credits.

NPAT in the Balance Sheet

The net profit after tax (NPAT) line that we first saw in the profit and loss statement makes another appearance in the balance sheet. The reason is that while a profit and loss is for a given period of time, the balance sheet gives a snapshot of an evolving and continuing set of accounts.

The balance sheet gives an overall idea of the health of a business. A profit and loss tracks revenue and expenses for one year, then it is closed and another one begins. However, the result of that year’s profit and loss contributes to the business’s overall strength or weakness. So, that result gets assimilated into the balance sheet, and it will continue to be a part of the business results for as long as the business exists.

It goes into the equity section because it is one of the sources of funding for buying the assets or paying off the liabilities in the business. It contributes to the business’s “net worth.”

Up next, we’ll dive into an example balance sheet and look at the components we’ve discussed in this section.

The Balance Sheet: Part 2

Up until now, we learned more about the groups of accounts covered in the balance sheet, also known as the statement of financial position. The account groups were assets, liabilities, and equity. Net profit also came over from the profit and loss. Let’s look at the balance sheet in more detail.

Balance Sheet

Here’s the example of a balance sheet:

Statement of Financial Position as at 31 March 2018

Current Assets  
Cash5,000 
Accounts Receivable10,000 
Inventory20,000 
  35,000
Non-current (Fixed) Assets  
Buildings100,000 
Vehicles50,000 
Land150,000 
  300,000
TOTAL ASSETS 335,000
   
Current Liabilities  
Overdraft20,000 
Accounts payable10,000 
  30,000
Non-Current Liabilities  
Mortgage100,000 
Loan75,000 
  175,000
TOTAL LIABILITIES 205,000
   
Equity  
Equity at Start of Period102,000 
NPAT for 201823,000 
Equity at End of Period 125,000
   
TOTAL LIABILITIES AND EQUITY335,000

Heading. The first thing to notice is, again, the time frame, which states “as at.” The balance sheet is a snapshot. It details what the assets and liabilities of a company are at a given point in time, not over a period of time, like the profit and loss statement.

Assets. The first set of accounts is the current assets. These are the assets that are likely to be gone, or turned over, in a year’s time. That does not mean there will be zero cash, inventory, or accounts receivable in a year’s time, but there will be different cash, inventory, and accounts receivable in a year. The cash in the bank now will be spent, and there will be other cash there instead.

The second set of accounts is non-current assets. These are the assets that are likely to remain constant for at least a year.

Current and noncurrent assets add up to give total assets. This is the total for the top half of the balance sheet.

Liabilities. Current and non-current liabilities are similar to their asset counterparts. Current liabilities should have turned over by this time next year, and non-current liabilities probably have not, though they may have changed in value—for example, the loan may have been partially paid down.

Equity. Equity is the difference between the assets and liabilities. It is not a cash reserve. This is a common misconception because people talk about taking equity out of the business or putting it in, which they usually do by moving cash. The difference should become clear when we discuss debits and credits in the next lesson.

Equity shows how much of the assets in the business are funded by the owners and the business itself. It can be compared with the liabilities on the balance sheet. If equity is greater than the liabilities, then the company is primarily funded by investors and its own profits, rather than debt.

It Balances

Note that the total assets figure is the same as the total liabilities plus the total equity figure. This is where the name “balance sheet” comes from. The company’s assets balance to the two sources of finance: liabilities and equity.

Liabilities and equity show how the assets were funded. For the assets listed on the top half of your statement, the bottom half will tell you how much was bought by borrowing money from other people (liabilities) and how much was bought with company funds, such as investor funding and reinvested company profits (equity).

Up next, we will start look at double-entry bookkeeping: debits and credits.

Debits and Credits: Part 1

In the next two sections, we are going to get into the nuts and bolts of accounting: debits and credits, also known as double-entry bookkeeping.

The Accounting Equation

Together, the six groups of accounts mentioned in the first lesson are the core of accounting, and they make up the accounting equation, which is the focus of this lesson, as it underpins the double-entry bookkeeping system. The accounting equation says:

Assets + Expenses + Drawings = Liabilities + Equity + Revenue

This and the next sections go into some detail in order to show how the concepts of double-entry work, but bear in mind that the aim is only to understand the concepts, not remember all the details.

Debits and Credits

For every action, there is an equal and opposite reaction. This statement is taken from physics, but it applies equally in accounting. For any change that is made in one account, there must be an equal change made in another. This necessity gives rise to debits and credits, also known by their abbreviations, Dr and Cr, and the “double-entry” bookkeeping system.

The kernel of why double-entry accounting exists is held in the proverb, “Money doesn’t grow on trees.” Money has to come from somewhere. For example, if a parent gives their child some money, then the parent has less cash themselves.

If Sally buys a car, then her assets—the car—goes up. On the other side, either her bank balance goes down because she paid cash or the amount she owes goes up because she used vehicle finance or a loan. Money is moving from one place to another.

When a mortgage payment is made, the value of the mortgage owed decreases and so does the bank account from which the money was paid. Again, money is moving from one place to another.

Where it gets a little more complicated in accounting is that the concepts of “increase” and “decrease” do not map directly to “debit” and “credit.” The type of account dictates whether an increase or decrease is a debit or credit. This is shown in the table below. Note how it fits in directly with the accounting equation from the beginning of the chapter. This table, and the accounting equation, is the key to debits and credits. You may find it useful to refer back to when working through the examples.

IncreaseDecrease
Assets, expenses, drawingsDebitCredit
Liabilities, equity, revenueCreditDebit

If the transaction increases an asset, expense, or drawing, then that account is debited. If they decrease, then the account is credited. Conversely, if a transaction increases a liability, equity, or revenue account, then it is a credit. If any of these three decrease, then the account is debited.

Credit Is in the Eye of the Beholder

You will find in the example ,in the next section, that an increase in the bank account is noted there as a debit because it is an asset. But on a bank statement, if there is cash in the bank, then the account holder is said to be “in credit.” This appears to be a contradiction, but it is actually a matter of perspective. A positive bank account is an asset to the account holder, but to the bank, it is a liability because they have to pay it back. Hence, the bank will talk about the account being in credit because they owe the account holder money.

The bank has a contractual obligation to pay the account holder the money in their bank account at some point in the future. As noted earlier, that is the definition of a liability, which is why the bank will refer to that account as being in credit. Therefore, debits and credits in accounting terms can take some time to get used to because it necessitates unlearning many years of experience with bank statements.

Up next, we’ll look at a few examples of debits and credits in action and how the transactions they record eventually sum up into the profit and loss and balance sheet statements we’ve already covered.

Debits and Credits: Part 2

Previously, we looked at the theory of debits and credits. In this section, we’ll go through examples.

Tom’s Rocking Horse Business

Tom is starting a rocking horse business. He decides to put R7,000 into his new company. The double-entry for this transaction is:

DrBank (an asset going up)R7,000
CrEquity (equity going up)R7,000

The bank account has increased, which means an asset going up, so the debit side of the transaction goes there. On the credit side, equity was earlier defined as the balancing figure of assets minus liabilities. If Tom put the money in the bank and wound up the company straight away, then he would get the value of the equity back, which is the amount of money he just put in the bank. It is the balancing entry for money provided by the owner.

Sometimes the double-entry is a triple (or more) entry. The key point is that the total debits equal the total credits regardless of how many accounts are affected.

For example, Tom wants to buy a car for his business. The car is worth R10,000, but he only uses R5,000 from the bank account and gets a loan for the remaining R5,000. The result looks like this:

DrVehicle (an asset going up)R10,000
CrLoan (a liability going up)R5,000
CrBank (an asset going down)R5,000

Tom sells R5,000 worth of horses, which cost R3,000 to make. This means two double-entries:

DrBank (asset going up)R5,000
CrRevenue (revenue going up)R5,000
DrCost of sales (expense going up)R3,000
CrInventory (asset going down)R3,000

Tom decides to pay back the vehicle loan:

DrLoan (liability going down)R5,000
CrBank (asset going down)R5,000

Tom gives himself a pat on the back and takes out R500:

DrDrawings (drawings going up)R500
CrBank (asset going down)R500

Drawings are like the opposite of equity. Money is being taken out of the business with no benefit to the business—the opposite of what happens when equity goes up. In fact, it is common to just ignore drawings and use equity for money going in or out from or to the owner.

Trial Balance

The trial balance is a summary of all the transactions that have occurred in the accounts over a period of time. Let’s take the examples above. The bank account has been involved in five transactions: two debits (increases) totalling R12,000 and three credits (decreases) totaling R10,500. The net result is the debits outweighing the credits by R1,500. If the other transactions are summarized in a similar fashion, we end up with a complete (albeit small) trial balance:

AccountDrCr
BankR1,500 
VehicleR10,000 
Loan (repaid)
Equity R7,000
Cost of SalesR3,000 
Revenue R5,000
Inventory R3,000
DrawingsR500 
TotalR15,000R15,000

The trial balance is not an end in itself; the trial balance is used to build the profit and loss and the balance sheet.

All the accounts that fit into the categories of revenue or expenses go into the profit and loss to tell us what our profit is. These accounts are then wiped clean and reset to zero in anticipation of the new financial year.

As we saw in the last chapter, the profit and loss’s resulting figure of profit is sent off to the balance sheet, along with assets, drawings, liabilities, and equity. These four sets of accounts are not reset to zero. They roll over to the next period.

So, the overall process looks as follows:

  • Transactions occur throughout the year and are recorded in the format we have seen above: Dr one account, Cr another.
  • All the transactions are summed up to give a net figure for each account. This summary is known as the trial balance.
  • The trial balance is then used to build the profit and loss statement and balance sheet.

Transactions => Accounts => Trial Balance

Trial Balance => Profit and Loss and Balance Sheet

Up next, we’ll look at the cash flow statement which, as the name suggests, tracks where all the cash goes.

Cash Flow Statement

Coming up, we’ll talk about the cash flow statement. The cash flow statement doesn’t get much attention but deserves it. A large percentage of new businesses go out of business in the first few years—not because they are unprofitable, but because they are not generating enough cash coming into their business in order to cover their cash going out.

When investing in a new business, it is essential to get a handle on the concepts that this statement brings to the fore. This is the most important statement when working out budgets; the profit and loss comes second.

The previous section explained that the profit and loss and balance sheet statements result from the trial balance. The cash flow statement does not.

The cash flow statement focuses solely on the bank account and details the inflow and outflow of cash. It is a summary of how the bank account went from its balance at the beginning of the year to the closing balance at the end of the year.

There are three areas where cash moves: operating activities, investment activities, and financing activities. Operating activities relates to the day-to-day running of the business. Investment activities relate to the purchase and sale of assets. Financing activities relate to funding, like loans and share floats (the liabilities and equity from our statement of financial position).

Here’s an example.

Statement of Cash Flows for the Period Ended 31 March 2018

Cash Flow from Operating Activities
Cash was provided from (i.e., cash in)
Receipts from customers70,000 
Interest received5,000 
Cash was disbursed to (i.e., cash spent)
Payments to suppliers and employees(40,000) 
Interest paid(3,000) 
Taxes paid(7,000) 
Net cash flow from operating activities 25,000
   
Cash Flow from Investment Activities
Cash was provided from
Sale of fixed assets20,000 
Loan payments received5,000 
Cash was applied to
Purchase of plant(30,000) 
Purchase of subsidiaries  
Net cash flow from investment activities (5,000)
   
Cash Flow from Financing Activities
Cash was provided from
New loans  
Share float10,000 
   
Cash was applied to
Payment of loans(20,000) 
Payment of dividends(1,000) 
Net cash flow from financing activities (11,000)
   
Net increase (decrease) in cash held 9,000
   
Opening cash held (1,000)
Closing cash held 8,000

So, in the cash flow from operating activities section, it details how the business generated and spent cash through its normal day-to-day operations. The cash flow from investment activities section explains how the change in asset structure affected the cash book: buying and selling assets. The cash flow from financing activities explains how debt and equity—our two sources of external finance—affected the cash flow. Finally, it summarizes this information and shows the net effect on cash.

This statement is critical when it comes to understanding the viability of a business. In fact, when starting up a business, it is a good idea to have a budgeted cash flow statement for every one of the first 24 months.

For a start-up business, one of the main reasons the cash flow statement will differ from the profit and loss is that the purchase of assets needed to start up the business requires cash, but these purchases do not hit the P&L because they are not an expense. This is why a business can appear profitable from the P&L but be losing cash and ultimately becoming non-viable.

Up next, we’ll look into how we deal with assets losing value over time, more commonly known as depreciation.

Depreciation

Previously, we covered the cash flow statement. Up next, you’ll learn what depreciation is.

Let’s start with an example. Imagine a car was purchased in 2009 for R20,000, driven for eight years, and then sold in 2017. It was sold for only R8,000—considerably less than the original purchase price. The reason it sold for much less is that it is simply worth less than it was before. This is because the use of the car consumed R12,000 worth of value. This is called depreciation, which is a type of expense. We need to recognize this expense over the eight years that the car has been in use. There are two common ways of doing this.

Straight Line Depreciation

The first and most common way of accounting for depreciation is called “straight line depreciation.” As the name suggests, it deals with depreciation in a linear fashion by spreading the cost equally over the relevant period of time. The calculation is:

(Historical cost of the asset – Salvage value) / Expected lifetime of the asset

Historical cost is the price that was paid for the asset. The salvage value is what is expected to be recovered when the asset is sold at the end of its useful life. This is often zero. The expected lifetime of the asset is how long the asset is expected to be used before it is disposed of.

In the car example, the depreciation calculation is (R20,000 – R8,000) / 8 = R1,500 depreciation per year.

Diminishing Value Depreciation

The other common method of depreciation is diminishing value. This method recognizes that assets often lose the majority of their value in the early stage of their ownership, especially items like mobile phones, laptops, and tablets.

It is calculated as a percentage of the asset’s current book value. Book value is the historical cost less any depreciation that has already been attributed to the asset. For example, book value at the end of year two is historical cost, less depreciation in years one and two. Book value will reduce every year that depreciation is applied.

If the previously mentioned car was depreciated using the diminishing value method at 12.25% p.a., the depreciation table would look like this:

Book ValueDepreciation
120,0002,450
217,5502,150
315,4001,886
413,5141,655
511,8581,453
610,4061,275
79,1311,119
88,012982

Note that when using diminishing value, there is quite a big difference between the depreciation cost in the first year (R2,450) and the last year (R982). Over the course of the eight years, the two different methods arrive at a similar book value; however, the depreciation cost for each year differs.

Matching Principle

The whole point of depreciation is to spread the cost of an asset over its time with the business, rather than as one big expense when it is bought.

To get a little more technical, the reason for spreading the cost is something called the “Matching Principle.” This principle says that revenue should be matched—i.e., recorded at the same time—with the costs incurred in generating that revenue.

The asset value changed over each of the eight years because it was generating revenue for the company, and so that cost should be matched with that revenue and recorded in the same period.

The depreciation method chosen can also depend on what depreciation is primarily viewed as. If it is seen as a way to spread the cost of the asset, then the straight-line method is more appropriate and is in accordance with the matching principle. If it is viewed more as an indication of the value of an asset, then diminishing value may be more appropriate.

Since depreciation is not a cash expense, it does not appear in the cash flow statement. Because it is still an expense, it does appear on the profit and loss statement.

Up next, we’ll look at three ways that a business can be structured.

Business Structures

Business structures can vary around the world, particularly in tax treatment and liability law. The next section’s’s lesson covers these structures at a general information level.

There are three main types of business structure: sole trader, partnership, and company. The main differences between them are the number of people who can be involved in each structure and the level of risk the parties involved in the structure are exposed to.

Sole Trader

A sole trader is also known as a sole proprietorship. People may start up their own business and not bother with any of the legalities. This means they fit into the sole trader category. It is extremely easy to get into this category—there is no need to do anything.

In this structure, there is a single person at the head of the firm. Such a person is deemed to be the business, so anything that happens is not seen to be done by a company or business, they are deemed to be done by the person.

The bad news is that this means that if anything goes wrong, the owner is liable as a person. If something goes wrong and the owner is taken to court, then they may lose their personal possessions, as well as their business possessions.

Partnership

A partnership is much like sole trading, except there will be more than one person involved in the business. Like a sole trader, everything done is deemed to be done by those people, not by the business, because they are not legally separate.

Again, if something goes wrong, a partner is personally liable for damages. And if one partner or any employee does something wrong, then all the partners are jointly liable. Local tax laws can vary on how much each partner is liable.

Partnerships usually have a partnership agreement that sets out things like how a new partnership will be formed if one partner leaves and how profits and losses will be distributed among the partners.

Companies/Corporations

Limited liability companies, also known as corporations or LLCs, are a very different structure from partnerships and sole trading. Companies are separate legal entities in their own right. When talking about a partnership or a sole trader, it is possible to use the names of the people and the name of the business interchangeably, as they are legally one and the same. In the case of a company, there is no person or people that the business revolves around. It is an entity entirely on its own, separate from people altogether.

A company is also owned in a different way from the other structures. The owners in the other structures are the people who run the business. The owners of a company, on the other hand, are the shareholders, also known as stockholders. They buy shares in the business and own a little piece of the company.

The shareholders’ liability—that is, what they will lose if the company is sued or liquidated—is limited to the amount of money they have invested in the shares. This means that if anything goes wrong, there is no person that can be pursued for damages, as only the company can be pursued, and the amount of damages that can be recovered is limited to the assets of the company. This is why they are called “limited liability” companies.

There are two types of company: public and private. A public company trades on the stock exchange, which means anyone can buy their shares. Private companies are not traded on the stock exchange, but shares can be sold to friends and family. Private companies are the structure of choice for most small businesses.

If you are thinking about starting a business, talk to your accountant about the best type of structure for you.

Up next, we’ll finish off by looking at a couple of variations in accounting.

Types of Accounting

In our final section, we’ll talk about variations in accounting.

Accrual vs Cash Accounting

There are two possible times to record a sale as having occurred. The first is when the buyer and seller both agreed to make a deal. The second is when cash is exchanged. Therein lies the difference between accrual and cash accounting.

Cash accounting is interested in when cash actually changes hands. It will not recognize a sale until money has been transferred. Accrual accounting, on the other hand, recognizes the sale when both parties have agreed on a contract for transfer of money, which is usually when the money is earned.

Accrual accounting is the generally accepted accounting principle (GAAP) used by most countries and usually required by the tax department. This is because legally, a sale is complete when both parties have agreed to make a deal.

Cash accounting often makes sense for small businesses because it means the bank account can be used as the main source of accounting records, which simplifies record keeping.

Cash vs accrual accounting does not apply only to sales; it applies equally to purchases, debt, liabilities, or any other transactions.

Choosing the date when an income is earned can be quite tricky. A project may last several months or even years, and payments might be made throughout the project. In this scenario, the usual practice is to recognize the income when the job is completed. If payments are made in installments while the project is being carried out, then the money should debit the bank account and be credited against the liability account, “unearned revenue.” It is only recognized as true revenue when the job is completed.

Management vs Financial Accounting

There are two separate disciplines within the world of accounting. Financial accounting is primarily concerned with presenting financial information through reports, such as the statements we have already seen: the statements of financial performance, financial position, and cash flows. There are a number of standards and procedures to follow in financial accounting, and their work is often used by people outside the organization that they are reporting on.

Financial accountants are great for reporting and for analyzing a company when all that is available is an annual report or set of accounts. They like to interpret and show numbers, but they tend not to have too much influence over the business behind the numbers.

Management accountants are more involved in day-to-day running and analysis of business. They spend the majority of their time looking at their business, where costs are going to, where revenues are coming from, and how to better streamline the business.

If you want to report your business, then talk to someone with specialized financial accounting knowledge. If you want an accountant who will help you run your business better, reduce costs, and improve profitability, then talk to a management accountant. Usually, accountants who specialize in small business do both, and this is fine because the legal requirements for the financial reports are not so stringent for small businesses.

We’ve covered a lot of ground in ten sections. We learned about the six main types of account groups, then saw two of them—revenue and expenses—go into the profit and loss statement. The final profit from that, plus the rest of the account groups—assets, drawings, liabilities, and equity—went into the balance sheet. We’ve gone over debits and credits, which can be summed up as “money goes from one place to another.” The cash flow statement allowed us to track where cash came from and went to. We saw two different ways of accounting for depreciation, then three different ways of structuring a business. Finally in this section, we saw a few different ways of looking at accounting.