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Simple roads to accurate accounting

In order to build a financial report such as a balance sheet or P&L statement, reconcile your financial records with some third party source like a bank. The bank statement reconciliation is nothing more than a test or proof of accuracy between your “reporting system” and the records of an outside, disinterested party. If your “books” reconcile with your bank’s reporting system, you know ALL your “transactions” have been added or subtracted correctly. Reconciliation proves nothing more than that all credits/deposits have been added and all debits/charges have been subtracted! Remember the driving analogy above; think of bank reconciliations as 3,000 mile maintenance checks confirming fluid levels and the proper running of a properly managed engine. Notice how “hidden” bank service fees inevitably find their way to the surface here too! Think about the importance of changing your oil and replacing air filters on a regular basis.

Balance your accounting and bank statements to the exact penny; it is a test for 100% agreement and accuracy. A penny difference does NOT really mean JUST a penny difference but rather that INFORMATION is either incorrectly recorded or MISSING. Don’t be surprised when this “failure to agree” returns to haunt you some time in the future. Engines that occasionally misfire or make a squealing sound when you brake while, most likely, continue to run… FOR NOW! Avoid pressing the Forced Reconciliation button on your accounting software screen that adjusts the balance and posts the difference under Reconciliation Discrepancies. It records and isolates the accounting fault but does NOT resolve the underlying issue!

Once your arithmetic is in agreement with the bank, you can proceed with the fundamental activity of categorization; record incoming flows of money generated from your business as Sales or Income. Record incoming flows of money NOT generated directly from your business (such as Earned Interest) as Other Income. Whenever possible, separate bank deposits of your Income from your Other Income to provide a simple audit trail and tool; the time, date, and amount will show on the period bank statement. A check register, journal, or bank deposit receipt with detailed listings of deposits is a critical tool WHEN you need to “prove” balances or reconstruct a string of related transactions at some future time. If you anticipate issues with one particular deposit (for example, a check drawn against potentially insufficient funds, a small insurance premium refund from an old policy, or a reimbursement of overpayment to a vendor), deposit the item as a separate transaction rather than consolidate it along with other deposits in one lump sum. USE your bank as a third-party “assistant” that helps you verify the accuracy of your own recorded business transactions.

The opposite of “incoming” income is “outgoing” costs and expenses. Money flows out from your business concern to either directly pay for the creation of a product or service as a cost, or indirectly pay for support of the enterprise as an expense. Cost is directly associated with units of production; expenses do not directly relate to goods or services sold but are, instead typically monthly recurring “bills”. An example of automobile costs is gasoline; an expense is auto insurance premiums. Both will decrease your “bank account” but need different classifications in order for your P&L Statement to make sense. Once you reconcile with your bank statement, you need to correctly labeling or classify how the outgoing flows of money were disbursed or spent. Costs of sale rise and fall with levels of production. Cost of equipment used in production is typically lopsided; you spend a large sum of money or expend capital NOW to lower production costs from now into THE FUTURE. Similarly, you typically replace ALL four of your tires at 30,000 miles; you pay about $1,100 now but actually “spend” it over the course of the next two to five years depending on how much you travel. To “level” or adjust the large, one-time capital expenditure, you “average” and “cost out” the capital expenditure over time, thus bringing the one capital investment into better agreement with many subsequent “unit” costs over the lifetime of the equipment. Finally, you pay rent/utilities/service fees (think auto insurance) in a recurring fashion every period; these are expenses regardless of how much or little you produce (think travel).

If you know your arithmetic is correct and you assign categories of income, costs, and expenses according to good, acceptable accounting practices, you can combine these various components into a picture of financial performance over some period of time called a Profit & Loss or Income Statement. Incoming flows of money (sales and other income) are revenue; line of business sales is gross profit. Costs of sales, equipment and expense “outflows” are deducted from revenue and are called net profit. The positive or negative difference between inflows and outflows of money is called retained earnings; it is carried over to the next fiscal period. You fill your fuel tank with gasoline and travel to some destination of choice. If you planned well and have driven efficiently, you arrive on time, in good spirits, and with a little gas surplus left over for the ride home. Otherwise, you sit back and hope you have not exceeded the credit limit on your gasoline credit card! Good luck on the road.

Note: This article was reprinted with either private license rights or permission from the author.

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