Understanding accounting is a very useful skill to have when it comes to managing a small business. The better a manager understands financial data, the easier it is for them to make a decision. In this post, we will discuss some basic accounting terms as well as accounting methods that are relevant to small businesses.
Understanding Accounting Basics
Accounting is an information system that records, identifies, and communicates the economic events of an organization or business to interested users. Accounting is very important for a business to stay organized, and for managers to make decisions. The ultimate purpose of financial information is to provide data to users for decision making.
Users of accounting can be internal users or external users. Internal users include managers, directors, officers, and supervisors. External users are investors, customers, creditors, suppliers, and taxing authorities. The best accounting practices lie in selecting the correct accounting method and financial statement to use in order to best display information for the selected users. For example, a manager may want to know the liquidity of the business in order to see how much working capital the business has. A specific type of ratio (the Current Ratio) is best used in this situation.
Accounting is fundamental to the success of any business and it’s important that users filling out financial information do so in a legal and ethical way.
There are many different forms and financial statements that can be used to record economic events in a business. There are also ratios and formulas that can be used to check the financial health and the current status of a business or organization. We will discuss these ratios and formulas in later lessons in this tutorial. However you should be aware of some basic terminology.
In accounting, we use the terms assets, liabilities, and stockholder’s equity to describe different economic events and transactions that need to be recorded. An asset is any resource owned by a business. Assets can take the form of buildings, land, vehicles, and cash. A liability is any amount owed to creditors in the form of debt and other obligations. Liabilities can be notes payable, bonds payable, or stock. Stockholder’s Equity is the owner’s claim to the assets (sometimes called owner’s equity).
In the basic accounting equation, the amount of assets must equal a company’s liabilities + the stockholder’s equity (or claim to the assets).
Assets= Liabilities + Stockholder’s Equity
This equation is important because assets must always balance with the claims to assets (liabilities and stockholder’s equity).
For example, if an individual asset is increased, then
- another asset must decrease, or
- a liability must increase, or
- An increase in stockholder’s equity.
This concept of balancing both sides of an equation or financial statement is essential to reporting accounting transactions.
For example, if XYZ Inc purchased an asset, another asset must decrease. Let’s say XYZ purchased office supplies for $400 with cash. This would mean that the “supplies account” would increase $400, while the “cash account” would decrease $400.
Other economic events may mean that assets increase while liabilities increase. For example, if XYZ Inc borrowed $1,000 from the bank, a liability would increase while an asset (let’s say cash for example) would increase as well. If XYZ then purchased supplies with that money, another economic event would occur, prompting XYZ to have an increase in the “supply” account and a decrease in the “cash” account.
Besides companies using different financial statements to show users different types of information, there are also two separate types of accounting systems in general. These accounting systems help the company determine when to make entries (or record financial/economic events.) These two systems are called the cash system, and the accrual system. The accrual basis system of accounting means that companies will record financial actions in the period in which the events occur. Cash basis accounting means that companies record economic events when they receive payment.
* For more information on this topic and other accounting topics, refer to our Accounting Tutorial.