Friday, February 21, 2014

ABC of Financial Statements

The Small Business Administration (SBA) reports that two-thirds of new businesses survive for at least two years and only 44 percent last four years. Allbusiness.com a D&B company, reports that the main reasons small businesses fail are because of poor capital structure, overspending when starting a business, lack of cash reserves, and poor accounting controls. On the face of it, these are startling facts and every entrepreneur may be worried. “Will it happen to me?” is a question that may keep popping up in their mind. You may have also noticed that many of the major reasons for failure are directly or indirectly tied to accounting.
Strong and robust accounting may be the difference between creating a successful business and filing for bankruptcy. It is as simple as that. Small business accounting may seem very complicated and may be intimidating for some. It doesn’t really have to be that way.
The accounting system in a nutshell keeps a track of all the money that you received or likely to receive and the payment made or likely to be made. This is essential to assess the profit or loss of your business. Most of the accounting software used by small business owners these days assists in tracking this data.
In all my years dealing with small businesses, I realized that some of the frequently used accounting jargons or terminologies are not necessarily understood by the small business owner. Through this blog I am hoping to explain some of commonly used terminologies. We hope this may help you gain a better understanding of the basic concepts that go to make a Financial Statement.
Accounting Method
One of the early accounting decisions you may need to make for your business is the accounting method to choose from. There are two accounting methods namely cash basis and accrual (also known as mercantile) basis of accounting. In the cash basis of accounting, revenue or income is recorded in the books of accounts only when payment is received from the customer while expenses are recorded only when the payment is actually made to the vendor. In case of accrual basis the revenue or income is recorded when the sale is completed irrespective of whether money has been received or not while expenses are recorded when a bill is received from a vendor even if payment is not made.  It is generally believed that the accrual basis of accounting presents a more accurate picture of the company’s financial condition.
General Ledger
General Ledger or “GL” as it is commonly called, is a sum total of all transactions that affect the accounting system. This is the base document that is used to prepare Financial Statements such as Income Statement, Balance Sheet and Cash Flow Statement. General Ledger like a bank statement shows the income received and expenses paid. In the General Ledger each of these transactions are either associated with a specific customer (who has paid) and an income type (such as Sales, Interest Income etc.) or with a specific vendor (to whom payment was made) and an expense type (on account of say rent, utilities, taxes etc.). In addition a General Ledger also includes transactions which are non-cash transactions such as depreciation, provision for accrued expenses (which will be discussed in the following paragraph).
Income Statement, Balance Sheet and Cash Flow
All these statements are subsets of General Ledger. An Income Statement also known as Profit & Loss account or “P&L” describes the sales made to customers and the various expenses incurred by the business in order to execute the sale. The net amount is either a Profit or Loss and this determines how your business is performing.
Balance Sheet consists of the assets in your business such as Cash and Bank balance, Accounts Receivable, Investments, Fixed Assets and the liabilities that you owe such as Accounts Payable, Taxes Payable, Loan and Advances payable. The difference between the Assets and Liabilities is what is commonly referred to as the Equity section. This typically consists of Common Stock and Retained earnings.

Current Assets
Also known as “CA”, includes Cash and Bank Balance, Accounts Receivable, Prepaid expenses, Short term investments and Inventory. Some of these assets are self-explanatory. Accounts Receivable or “AR” as it is known, are amounts owed by customers for goods and services that you allowed the customer to purchase on credit. While an example of a prepaid expense is an insurance policy payment, since the money is paid upfront to cover the risk of a possible damaging event occurring in the future. Prepaid expenses are expensed over time as the goods or services are received. Short term Investments are usually for a period less than 12 months.
Current Liabilities
Also known as “CL”, includes Accounts payable and Short term debt. Accounts payable or “AP” are debts resulting from purchasing assets or receiving goods or services on credit.
Equity
Refers to the Retained Earnings and Common Stock (also known as Equity). Retained Earnings as the name indicates is retained by the business over the years and not distributed to the shareholders or owners of the business. At the end of the every year, the net income or loss is added or subtracted from the Retained Earnings. Common Stock is the seed capital that was invested by the owner while starting the company.
Cash Flow Statement
This statement indicates the receipts and payments made by the business. The cash flow statement doesn't show whether the business will be profitable, but it does show the cash position of the business at any given point in time by measuring revenue against outlays.
This concludes the outline of the major terminologies that a small business owner should be aware of while they manage their business. I firmly believe that understanding these terminologies will enable a business owner in having a more informed idea about their business and help in the discussions with outsiders. If you have any questions regarding this article or need further clarifications please feel free to get in touch with me.
This article is written by Prakash Iyer CPA, President, VXL SERVICES INC., a Business Consulting Services Company based in New Jersey. You can reach him at (732) 983 - 4150 or at prakash@vxlservices.com.

VXL is recognized for its comprehensive service offerings that support end-to-end functions in an Accounting department. VXL helps enterprises by leveraging their deep finance and accounting expertise. Our offering includes Accounting, Payroll, HR Advisory, Taxation, CFO/Controller and Consulting Services to start ups, small and medium sized companies across US.