For small business owners, accounting can be both a headache and an indispensable tool. Understanding the role of accounting in business can help you develop a friendlier relationship with the process, which is both a legal requirement and a source of objective feedback about your company's financial performance and overall viability.
TL;DR (Too Long; Didn't Read)
The functions of accounting give business owners the information they need to report to outside parties, such as banks and revenue agencies. They also provide data that allow you to evaluate success and make strategic adjustments.
The Importance of Accounting
Some people start businesses because they are interested in marketing, financial ratios and long-term planning. Many other small business owners come to the world of entrepreneurship because they have a skill or a passion, or they want more autonomy over their schedules and work lives. Business owners who are more interested in their craft than their balance sheet still need to perform basic accounting tasks to stay legal and solvent.
Accounting is a system of tracking and documenting business activities. Your system can be simple or complex, homegrown or standardized by a software company, but it must be reasonably current and accurate, or your company could run into practical and even legal difficulties. A well-maintained accounting system doesn't just keep you out of trouble. It also provides information that will help make your company into a better business.
The importance of accounting lies in its capacity to shed light on short-term and long-term activities. Accounting is sometimes referred to as the "language of business" because it connects the dots in meaningful ways, expressing observations in terms that are consistent and structured. Not all accounting information follows traditional formats, but these methods do give you a leg up in organizing your data to extract answers to questions that are common to all businesses, such as whether you are losing or making money.
Functions of Accounting
- Recording. Accounting processes document business expenditures, allowing you to see and compile the many pieces of information that describe your business processes. These include outgoing expenditures for operations and infrastructure, incoming revenue from sales of products or services and other sources, such as interest you accrue.
- Generating reports. Accounting information is typically compiled into statements using streamlined and widely understood formats such as profit and loss statements, balance sheets and cash flow statements. These reports summarize financial activity, providing a broader perspective than you'd get by simply looking over a list of transactions.
- Auditing. Accounting information should be double checked to verify its consistency and accuracy. By doing periodic audits, you can have a backup system to flag dishonesty, carelessness or faulty systems that provide questionable results. An audit can be as intensive as hiring an outside company to evaluate your work, or it can be as simple as another staff member looking through your accounting information with a fresh set of eyes.
- Projecting. Although you'll never be able to predict future sales and expenses with complete accuracy, it is still useful to forecast future business activity based on past and present patterns. These projections can show you when you may need to borrow money to cover shortfalls or when you'll have extra cash to invest in capital improvements.
Objectives of Accounting
- Accuracy. Your accounting system should faithfully reflect your business activity for both legal and practical reasons. Tax reporting requires that you provide information that is accurate to the best of your knowledge. If your accounting is sloppy, and your numbers don't correspond with the flow of money in and out of your bank account, this can be a red flag for a tax auditor. Accuracy is important for internal purposes as well because better information helps you to make better strategic decisions.
- Completeness. An accounting system that is missing key pieces of information will be neither accurate nor useful. To ensure completeness, your system should have solid systems in place for receiving information about all transactions from your staff, your vendors and your bank accounts. You should also have regular internal methods for double checking whether all of your revenue and expenditures have been entered.
- Relevance. If your accounting staff devotes a disproportionate share of its attention to tracking down negligible inaccuracies from previous years at the expense of entering information from the current year, you may lose sight of truly useful information by neglecting the big picture. It is important to prioritize tasks that keep your information relevant so you can complete your tax forms on time and understand your company's current financial picture.
- Usefulness. Aside from being used for tax forms, loan applications and reports for investors, your accounting system should also yield information that your company can use for planning and evaluating. This may include data about production efficiency and sales reports by month, region or sales representative. The usefulness of different types of accounting information varies from business to business and even within the same business over time.
Financial Accounting vs. Management Accounting
Accounting processes can be broken down in terms of the roles of accounting information for your business. Financial accounting concerns itself with compiling the reports and forms that your company uses to report to outside entities, such as tax agencies, banks and investors. The formats and processes it uses tend to be standardized, and your business should follow generally accepted accounting principles when preparing this information.
In contrast, management accounting works with information that will be useful for internal purposes, such as evaluating profitability and planning future ventures. Management accounting need not follow any traditional format, although the information collected in financial accounting reports is often useful for management accounting as well. In addition to assessing profit and loss, management accounting also looks at cost accounting for different products, overall margins and profitability and sales figures relative to a range of variables.
Financial Accounting Reports
Most agencies and investors who review your financial accounting information will expect to see three basic reports:
- Profit and loss statement. This financial report tracks your company's earnings and expenditures over a specific period of time, such as a month or a year. It shows your cost of goods sold, or the amount spent on direct costs such as materials and production labor. It also calculates your gross profit, or the amount left over after subtracting these direct costs from your gross revenue, and your net profit, or the amount left over after also subtracting generalized infrastructure expenditures, such as rent and utilities.
- Balance sheet. Your balance sheet provides a snapshot of how much your business owns and owes at a particular point in time. It lists assets such as cash on hand, inventory and real property such as real estate. It also breaks down liabilities into categories such as long-term loans, credit card debt and accounts payable to vendors. In addition to showing the sums your company owns and owes, your balance sheet also shows how these amounts are distributed and whether your assets are sufficiently liquid to finance business activities.
- Cash flow statement. This accounting report shows how funds are flowing in and out of your business and whether you will have money available to meet your current financial obligations. It is not required for tax reporting, but it is extremely important to lenders and investors who need to evaluate whether you will be able to meet loan payments and whether you will have the capital you need to operate and expand.
Management Accounting and Financial Planning
While financial accounting is used to keep your business in good standing with outside stakeholders, management accounting provides essential information for making strategic decisions.
Management accounting may include data about the profitability of each of your products and services and a more detailed and nuanced accounting than the generalized cost of goods sold figure that appears on your profit and loss statement. By identifying the products that earn the highest margins and those that are easiest to produce, your business can focus its manufacturing and marketing resources in areas that will yield the highest returns.
Management accounting can also help you plan for upcoming product launches and equipment investments by creating cash flow projections. The information on a cash flow pro forma can't be completely accurate because there's no way to precisely foretell the future, but you can use past accounting numbers to forecast future patterns.
This information can tell you whether you can expect a cash flow shortfall at a particular time and, if so, approximately how much you'll be short. It can also give you a sense of whether you can afford a new project you're contemplating and, if not, how much you'll need to borrow to make it happen.
Accounting Processes and Software
Business advisers often refer disparagingly to an approach to bookkeeping called "shoebox accounting", which involves keeping all of your receipts in a shoebox and periodically going through them and entering them into your system or giving them to your accountant to do the work. While there's no question that it's better to do your bookkeeping sooner rather than later, shoebox accounting can still be a useful approach because it does keep all of your information in one place for easy access.
Before desktop computers came into widespread usage, accountants and bookkeepers mostly compiled accounting information by hand in ledgers. Some business owners still do their accounting manually, and the process certainly takes more time than entering information into a spreadsheet that automatically does the math. However, this approach does offer some advantages, such as circumventing the need for computer backups and the risk of losing all your information in a power outage.
Your business can use a software program such as QuickBooks to track accounting information and generate reports, or you can create custom spreadsheets that organize the information you find most useful. Software programs save you the work of programming, but they aren't especially flexible, so they're most useful for standardized financial accounting reports. Customized spreadsheets require extra work, but they offer the advantage of allowing you to tailor them to reflect the specific information that interests you most.
The Role of Accounting in Society
In addition to its usefulness for individual businesses, the field of accounting has been instrumental in creating standards and protocols that facilitate communication about financial matters.
The fact that the vast majority of businesses use comparable formats for balance sheets and profit and loss statements allows stakeholders to understand the information in these reports through filters that zero in on answers to questions that are particularly urgent, such as whether the company in question has the resources and the track record to pay its bills.
Although standardized accounting practices make it easier to grasp an overview of a company's financial situation, they certainly lend themselves to abuse and fraud. In addition, the institution of accounting practices makes it easy to overlook idiosyncrasies that may make a company especially resilient, such as a resourceful and tenacious manager. When evaluating accounting information, it's important to keep in mind both the discipline's strengths and its limitations.