Every Accounting 101 course begins with an instructor telling you how important accounting is - and that it’s known as the “language of business”. But what does that really mean? And why should accounting matter to you as a small business owner?
An Easy Definition of “Accounting”
Accounting is considered the language of business because it essentially tells the (true) story of how a company is doing from a financial perspective. You’ll find this language in your:
accounting reports, and
You can also think of accounting as a system where the results of all your business activities are recorded, organized, and analyzed. Those results can then be reported to various decision-makers, including yourself.
What an Accountant Can Do for Your Business
The main reason why understanding accounting is so important is that, as the language of business, it can easily be converted to the language of finance. And understanding your company financially means taking data from your accounting documents, and using it to make better business decisions.
Accountants are fluent in the language of business, but they also speak your language.
That means they can help you translate accounting terminology into information that makes sense to you, and can help you apply that information to steering your business in the most financially rewarding direction. Working with an accountant also gives you access to tax deductions, exemptions, and credits you may not have otherwise known about – ultimately making your business more profitable.
Different Types of Accounting
Similar to the way your family doctor or general practitioner (GP) knows a little about everything, some Chartered Professional Accountants (CPAs) are generalists. Like law and medicine, however, there are specializations inside the accounting profession that may help you run your business more effectively.
Some of these specializations include:
Financial Accounting – The summary, analysis, and reporting of financial transactions related to a business.
Management Accounting – The assistance of companies through financial planning, forecasting, budgeting, management of cost and revenue, and measurement of business performance.
Tax Accounting – The completion of tax returns, in compliance with Canada Revenue Agency (CRA) regulations, with the intention of minimizing the impact of paying taxes in Canada.
Audit Accounting – The comprehensive and independent examination of a company’s financial records and internal controls to determine their fairness and accuracy. The Canadian Public Accountability Board (CPAB) is Canada’s recognized source for promoting accountability in auditing.
All CPAs, regardless of their area of expertise, work to Canada’s Generally Accepted Accounting Principles (GAAP). Whether your company is public or private, these Principles or Standards form a framework of accounting guidelines, rules, and procedures that every business must follow.
Exploring the Accounting Cycle
The accounting cycle begins the moment a business transaction (activity) occurs, and ends when that transaction gets represented on your company’s financial statements. As the only activities that enter your accounting system, transactions are recorded as journal entries in an accounting journal.
Let’s say you buy a Widget from your supplier on credit for $150.00. The transaction would be recorded in your journal, like so:
Date: Sept 7
Accounts Payable $150
All the journal entries in your journal feed into your company’s accounting ledger. And the ledger is where all transactions of the same type get grouped together and summarized.
If, for example, you had $300 of Widgets in your ledger before the transaction above, your new balance of Widgets after the transaction would be $450. If you had a ledger balance of $500 in your Accounts Payable, your new balance would be $650.
All the amounts in your accounting ledger eventually form your financial statements. So, if you had 1000 sales of $40 each during a given year, those 1000 transactions would show on your Income Statement as $40,000 in revenues.
It’s a bookkeeper’s job to ensure every business transaction is recorded and summarized. And that makes accurate bookkeeping the first step in an important process that leads to accurate financial statements.
Different Methods of Accounting
Transactions in accounting can be recorded on either a cash basis or an accrual basis. Cash accounting records transactions in the period in which they occur. Accrual accounting records transactions in the period to which they’re related.
Confused? Let’s look at an example.
Let’s say your company paid its April Utilities bill on May 10. Under the cash accounting method, the Utility expense would show as a May transaction because that’s when the transfer of cash actually occurred. Under the accrual method, however, the Utility expense would show as an April transaction because the Utilities were attributed or related to the month of April, regardless of when they were paid.
What Your Financial Statements Can Tell You
Your company’s financial statements are reports that get created from your business activities. Depending on which financial statement you look at, however, you can view your company’s accounting “story” as either a snapshot or a movie. Let’s find out how.
The most frequently used financial statements in accounting are:
the Balance Sheet,
the Income Statement (also known as the Profit and Loss Statement), and
the Statement of Cash Flows
Your Balance Sheet tells you what your business owns, and what it owes, at a specific date. In other words, it acts like a snapshot of your business on that day. For example, your Balance Sheet can tell you how much cash you had, or how much cash you owed, on the last day of your annual accounting period (usually December 31).
Your Income Statement and Statement of Cash Flows, on the other hand, behave like movies in the sense that they contain information recorded over a period of time.
The Income Statement shows all your revenues and expenses during a given period, as well as the corresponding profit or loss. The Statement of Cash Flows, meanwhile, shows you how much cash came into and went out of your business, also during a given period. Because both statements provide a summary of all the transactions that occurred during a specific accounting period, they can tell you things like how much your payroll expenses or revenues were from January 1 to December 31.
Using Financial Statements to Analyze Your Business Performance
Because Certified Bookkeepers are consistent in the way they prepare your financial statements, you can use those statements as benchmarks to analyze your business performance. For example, you can compare how your business performed financially during the current period against how it performed during a prior month, year, or quarter.
You can also use the figures on your financial statements to see how profitable your business is. One way to do this is with the help of simple mathematical formulas known as financial ratios.
For small business owners, three of the most useful ratios include:
Gross Margin – This calculation tells you the percentage of gross profit (Revenue – Cost of Good Sold) from selling your goods or services. The formula looks like this:
( Revenue – Cost of Goods Sold ) ÷ Revenue x 100 = Gross Margin
Net Profit Margin – This calculation tells you the percentage of net profit you’re earning from selling your goods or services. The formula looks like this:
Net Income* ÷ Revenue x 100 = Net Profit Margin
*Net Income = Revenue – COGS – Operating Expenses – Interest – Taxes)
Return on Equity (ROE) – This calculation tells you how effectively you’re using company net assets to generate profits. The formula looks like this:
Net Income ÷ Shareholder Equity* = ROE
*Shareholder Equity = Assets – Liabilities
With the vast amount of information that’s available online, you can also use performance analysis to make business-to-business comparisons based on estimates or research. You can find out how your company stacks up against its competitors, for example, by examining the cost of your product, how much your competitor is selling that same product for, and comparing your margin to theirs.
The Role of Internal Controls
Internal controls are rules and procedures your business establishes to ensure its accounting and financial information remains accurate and truthful. These procedures are meant to promote accountability in the workplace and to help prevent things like fraud and embezzlement.
Some of the most important internal controls involve policies for handling cash. As your most liquid asset, cash can be easily hidden, moved, or transferred between parties. Opting for cloud-based accounting and bookkeeping systems is one way to improve your internal controls.
When transactions are conducted in the cloud:
contact with cash is reduced,
oversight - in terms of easily tracking the flow of money - is increased, and
access to financial systems is restricted to appropriate personnel
Because they alert you to cash discrepancies between your accounting records and your bank account balances, bank reconciliations are also important internal controls. Performing regular reconciliations is yet another area where a good bookkeeping process will benefit your business.
Why Accounting is So Important for Your Business
It’s clear that accounting is extremely important when it comes to running a successful business. As we’ve already seen, understanding the language of business helps you:
better plan your business activities,
conduct valuable performance analyses,
improve your internal controls, and
determine how your business is doing overall
But there are many other areas where accounting records play a key role, including:
the preparation of various budgets and forecasts,
your ability to secure a loan or line of credit, and
eventually selling your business
Accurate, organized, and timely record keeping is crucial during every stage of your company’s life cycle. Seeking professional help – and taking advantage of cloud-based software – can save your business time and money, and will help keep you compliant with tax laws and other accounting regulations.
About Saulo Ferreira
Saulo is the founder of Databooks. Before becoming an accountant and working at a Big 4, he founded two successful small businesses. Saulo is passionate about empowering businesses through better bookkeeping services and technology.
This article was written for informational purposes only and is not intended to substitute for professional accounting, legal, or business advice. The reader is advised to consult with their accountant, attorney, or business advisor before taking action based on article content.