It can be very scary to take on reading your financial statements particularly if you don’t really understand business accounts and what they actually mean. But it is essential for business health to be able to interpret them and to use the data to make future plans. So here’s a rundown of what they are about and if you read this a couple of times and compare the information to last year’s statements then hopefully you can improve your planning for this year and seem much more knowledgeable when you talk to your accountant later this year.
Some basic terminology
Let’s start with the words assets, liabilities and equity. When you start a business you start by using some money to pay for basic requirements. This is usually your personal funds at first and you might also include some personal pieces of equipment or a vehicle that you will use for the business. This amount is your equity or the value of your ownership of the business. You might put in more money during the time of owning the business, which will increase the equity you have. And at the end of the financial year if you make a profit this will also increase your equity in the business. So equity just means the value of your ownership of the business and it goes up with capital (money or equipment) that you put in to the business and profit that the business makes (after tax is paid).
Assets are the things your business owns. Most assets are tangible – we can touch them. These include money in the bank, equipment, vehicles, computers, furniture and stock which you sell in your business (which is also called inventory). Some assets are intangible – you can’t touch them. An example of this is your website and also any intellectual property that belongs to your business.
Liabilities are what your business owes. This could be invoices for goods or services which your business has received but not yet paid for (we call these accounts payable) or it could be the overdraft on your business bank account, a loan, vehicle financing and even tax or GST which you have worked out but is not yet due to be paid.
These 3 categories are the basic building blocks that help you to understand business accounts and they are brought together in the accounting equation.
The Accounting Equation
To ensure that everything is accounted for correctly and that it is balanced accountants use the formula; assets = liabilities + equity.
And it makes sense because you only get business assets by using your own money or borrowing it from another person or business.
If you buy all your assets from money you have contributed to the business then the value of the assets will be equal to the value of your equity. If you have used some savings and borrowed to buy the rest (and borrowing means you have to pay it back) then the value of your assets will be equal to your liabilities (money owed) and your equity.
The equation is usually shortened to A=L+OE where OE means owner’s equity. This equation must balance as I have explained and this is where we get the name Balance Sheet from. It just means a numerical recording of the values of all the business’ assets, liabilities and owner’s equity.
So now you have a really basic understanding of business accounts and the first of the financial statements that are often prepared by accountants.
Of course to be able to make up the Balance Sheet at the end of the financial year you have to know the profit that the business has made and this is done by using a record of all the transactions which have occurred during the financial year. The recording of these transactions is called bookkeeping and nowadays it is usually done digitally using spreadsheets or even better, with accounting software.
Bookkeeping – this is just recording transactions
Transactions come about through selling products or services, buying products or services, paying bills, paying staff, paying yourself, repaying loans and paying tax. Every time money changes hands then a transaction is completed and it needs to be recorded.
To do this we need to use double-entry bookkeeping. This was invented a very, very long time ago even before the first book was written about it (by an Italian mathematician Fra Luca Pacioli and his close friend Leonardo da Vinci) and this was published in 1494 – so maybe I should have included more “verys”.
Double-entry bookkeeping just means that you need to show that a transaction affects at least 2 business accounts rather than just 1 and hopefully these examples will explain it better.
Let’s use the example of a café which is already in business. On a Monday they get a delivery of ingredients which they use to make their yummy cabinet and plated items costing $500. If they pay cash for the delivery then the 2 accounts affected will be the bank account (an asset) which will go down by $500 and the raw materials account which shows the value of what they have waiting to be made into food (also an asset) which will go up by $500.
If instead of paying cash they have an account with a supplier then the raw materials account (asset) will go up by $500 and the accounts payable (liability) will also go up by $500 as they record the invoice which will be paid later.
If we put these into the original equation
Assets = Liabilities + Owner’s Equity
Bank ↓ $500 remain same + remain same
Raw materials ↑$500
This equation is still balanced.
For the second example,
Assets = Liabilities + Owner’s Equity
Raw materials ↑$500 Accounts Payable + remain same
Again the equation is still balanced.
Hopefully you now understand business accounts a bit better but I am sure you still have lots of questions such as “am I making money?”
Let’s check out the profit before we go any further
At the end of the financial year we need to know if we have made a profit so we use the final figures in a number of our business accounts to work this out.
We start with revenue – this is just the sales the business has made as well as any other income earned from any other source. Say, for example, you rented a space for your business but it was more than you needed. You decided to rent out some of the space to another small business. You then got on with selling whatever you are selling. Your revenue would be your sales plus the rental income paid by the other business.
For lots of us our only revenue is our sales so that’s the only figure we need to worry about.
Now we need to total up our business expenses. When you have a business you don’t pay tax on the total sales you make but you get to deduct the costs involved in making your products or services available to your customers. These costs will vary depending on your business but may include the following;
- Raw materials
- Stock items which you resell
- Vehicle costs including petrol and servicing
- Internet and phone
- Delivery costs
- Interest paid on business loans
- Accountancy costs
- Rent / Rates
They will all be recorded in your bookkeeping.
So to work out your profit you just use the following equation;
Revenue – Expenses = Net profit before tax
Let’s say your business has sold $120,000 of products or services this financial year. The expenses that have made this possible add up to $83,000. This means your business has made a profit before tax of $37,000 and you will need to pay tax on this amount only.
Once you have worked out (or had your accountant work it out) the tax payable the rest of the profit is yours to keep. We record this as an increase in the Equity part of the Accounting Equation.
So, our equation is now written this way. A = L + (OE + R – E) where R means revenue and E means expenses and OE + R – E represents the change in equity when we add in the profit made (hopefully you reach the end of the year with a profit) that increases your equity or ownership of the business.
This equation is called the expanded accounting equation and it sums up everything about the movement of money in your business.
There’s just one small hiccup that makes this a little bit more complicated. You see, accountants are not fond of negatives such as –E so they rewrite the equation so it is all positive – which is a pretty good way to think of your business finances really.
When we have a negative on one side of an equation it becomes a positive on the other side of the equation. If you don’t love maths you will need to trust me on this which hopefully you are prepared to do. Now our equation reads;
A + E = L + OE + R
Assets + Expenses = Liabilities + Owner’s Equity + Revenue
Once you have got your head around this then you have cracked the code for understanding business accounts and financial reports. It honestly doesn’t get any more complicated than this, well, until we get further into debits and credits that is.
When we do our business bookkeeping everything fits into one of these 5 categories. Nothing we do financially is outside of these categories. We buy assets for our business or pay for things to run our business which are expenses. We have liabilities which are our debts we must pay and we have our ownership of the business along with the revenue or income we make from selling our ideas, services, products or stuff that we source from other people.
If you understand these categories and this basic equation then everything in the accounts for your business is covered – including how much tax you have to pay.
I mentioned a slight further complication didn’t I?
You see, accountants have words they use instead of the arrows I used earlier to show how accounts went up or down when some basic transactions were recorded. This is because it would be very messy to do your accounts with loads of arrows going up and down so instead we use the words debits and credits to describe these actions. And to make it even easier to see what is happening we list the debits in a left hand column and the credits on the right.
To make sure everyone uses these debits and credits in an identical way there are rules which accountants and business owners use to make everyone’s financial statements easy to compare.
Let’s go back to the equation
A + E = L + OE + R
On the left hand side of the equation (that’s A + E) increases to an account are shown as debits (written in the left-hand column) and decreases are shown as credits (written in the right-hand column).
So if your bank account increases because a customer pays for their purchase it is shown as a debit but if your bank account goes down because you pay your power bill then it is recorded as a credit.
On the other side of the equation (L + OE + R) it is the opposite. If an account increases it is shown as a credit – say you record some more bills that come in (increase in liabilities) – but if it decreases you show it as a debit (when you pay the bills and liabilities decrease)
The transactions we complete actually affect more than 1 account so we need to use both a debit and a credit for them all.
Let’s use the example of a customer paying for their purchase into your bank account. The bank account increases so we show this as a debit but the accounts receivable (an asset) goes down because they don’t owe you this money now so that’s the matching credit.
To explain it a bit further, when we sell our products or services we usually send the customer an invoice. We record these as an asset because it is money which will be paid to us. The account is called accounts receivable because it is money we are going to receive.
The other example of paying the power bill works across the equation. The power bill would have been recorded as a liability (an account payable) so when we pay it our bank account goes down – a credit – but accounts payable will decrease because we owe less money so that’s recorded as a debit.
Thankfully, when we use accounting software this matching of debits and credits is done for us – and if we do it wrong the software simply won’t record the transaction and will tell us what we have done wrong.
So now you have the key components to understand business accounts.
Hopefully you are now ready for some more key words
Our everyday transactions are recorded either manually or in an accounting programme by using journals. The first of these is a list of money going in to the bank account and money going out of the bank account and they are called Cash Receipts and Cash Payments. We also have a Sales Journal, a Purchases journal and a General journal. The sales journal is where we record the invoices sent to customers (this is our accounts receivable – an asset mentioned earlier). The Purchases journal is where you record the things you have received but not yet paid for (this is accounts payable – a liability). The General journal is for everything else that doesn’t fit into any of the other journals including payroll deductions.
We don’t want to just have a huge list of transactions though because it would be hard to look up information about money owed by a particular customer or to work out how our vehicle expenses compare to last month.
We therefore set up another list of accounts called ledgers which group similar accounts together. We would have a ledger for each customer, for each type of expense and any other useful groupings such as equipment or inventory.
Using these ledger totals makes it easy to summarise the total revenue and expenses at the end of the financial year to work out our profit (or loss). The best thing about this system is that when you use accounting software it automatically records the transactions in all the correct accounts making it easy to check on how your business is doing whenever you wish to know.
Understanding how business accounts become financial statements
All small businesses in New Zealand have a financial year which runs from 1 April to 31 March. This is a legal requirement. If you start a new business during this time period you still have to end your financial year on March 31st even though it will only be a partial year.
The first financial statement prepared at the end of the financial year is the Income Statement (also called the Profit and Loss) which shows the revenue earned during the year minus the expenses incurred to earn this money. The result is your profit (or loss) which you pay tax on.
R – E = Profit before tax
Now that looks really familiar doesn’t it?
Once you work out the tax you need to pay the balance of the profit is yours to keep or to reinvest into your business. Regardless of what you decide to do this profit increases your equity or ownership of the business. This is recorded in the second document – the Balance Sheet.
Once we know our profit after tax (and our tax to be paid) we now record a snapshot of our business as at the 31st of March. We use the equation A = L + OE
So our balance sheet is just a list of the value of our business assets followed by our liabilities and our equity including our profit after tax. These two lists must add up to the same number so our equation is correct and our sheet is balanced.
If you are using accounting software you can simply get it to prepare these reports for you but most small businesses also like to use an accountant to ensure that everything that should be included is and that the correct amount of tax to be paid (not a cent more, not a cent less) is worked out. This is because there are penalties imposed by IRD if you underpay your tax and you will certainly kick yourself if you pay too much.
To really understand your business accounts comparing the real thing to the examples in this article will make a big difference. I recommend you read and reread if necessary until you can look at your financial statements and immediately put everything into the correct categories.
And for those of you who have just ignored your accounts up to now hoping that somehow they will sort themselves out – don’t panic – start today with last week’s transactions and gradually work backwards until everything is recorded for this financial year. It may take some dedication but think of how much easier it will be next year when you start correctly right from the 1st of April.
And of course, we have loads of qualified accountants available who understand business accounts and can help you to ensure you are paying the correct tax. Seeking help from an expert is likely to be some of the best money you ever spent.
© Robyn Forryan
The Biz Coach NZ