Simple roads to accurate accounting
There are two ways to look at your business; a static snapshot known as a balance sheet and a more dynamic view of performance
over time, the Profit and Loss (or Income) Statement. An owner/manager uses both reports for information but more than likely relies
on the latter for monitoring their business operations on their way to some objective or “destination” described in their mission
statement. Net Profit, the gasoline that remains in the fuel tank after a “day’s” run, is what powers the engine up the next hill. A skilled
driver takes great pains to trim back RPMs whenever possible, find short-cuts to locations, and shed as much weight as possible to
minimize demands on the engine. So too, the manager monitors costs associated with generating sales, keeps expenses as low as
possible, and shuns short/long-term debt to avoid the burden of heavy carrying charges.
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.
