Basic Finance for Non-Financial Managers

Understanding Accounts By Mohammed Mahrous

Introduction
 Financial management is a crucial aspect of any thriving business.  Profit maximization, or stockholder wealth maximization, are two real concerns for any     

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organization – and they depend on solid financial decisions. To make good decisions, management needs good information. that information comes from the accounting system. From the accounting system come the financial statements. These statements contain important information about the organization's operating results. This information is important for effective management, and financial control. As a manager, or any other person with financial responsibility, you have to be able to interpret this information yourself. Financial statements contain important information about your company's operating results and financial position. The relationship between certain items of financial data can be used to identify areas where your firm excels and, more importantly, where there are opportunities for improvement. Using, understanding, and interpreting these statements will help you make much better business decisions.

The Basic Financial Statements
 Balance Sheet (also known as a Statement of Financial Position,

or a Statement of Financial Condition.  Income Statement (Statement of Profit and Loss, Statement of Earnings, Statement of Operations).  Cash Flow Statement.

The Bookkeeping Process
 Every time your organization conducts a business transaction, the

status of the accounts changes.  In a retail company, for example, when a sale is made, the cash account increases, and the inventory decreases.  The bookkeeping process keeps track of these changes in various ledgers and journals.  The financial statements are then prepared using this information.

Continued
 Accounting is based on the fundamental accounting equation:
 Total Assets = Total Liabilities + Equity

 This essentially means that the difference between what the

business owns and what it owes represents the equity the company's owners have.  To keep this equation in balance means that, with each transaction, at least two accounts – and the balances in those accounts – will change.  Accounting is the process of keeping track of those changes, and recording and then reporting them.

Example

Transaction Example: On August 2, 2008, Mahrous's Pharmacy purchased a computer for $1500 with $500 cash deposit, and the remainder on a store credit program. There are three accounts affected:  The asset account 'Equipment.  The asset account 'Cash.  The liability account 'Accounts Payable. These specific accounts can be found in what is called the Chart of Accounts The titles Equipment, Cash, and Accounts Payable are not random; these are specific accounts that were identified as relevant to the company before it began operating as a business. The Chart of Accounts is a list of all the accounts used by a company to record financial transactions.

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The accounts are grouped according to type, and then numbered using the following conventions:

Asset 101-199. Liability 200-299. Equity 300-399. Revenue 400-499. Expense 500-599 (some systems use 600s).

 

To keep track of transactions efficiently, a General Journal (Original Book of Entry) is used. The journal records what happened, the accounts affected, and the dollar amounts. Once you've identified the accounts that are involved, you need to apply the rules of what accountants call 'transaction analysis.' This involves the following:
 

Asset and Expense accounts are increased by a debit, and decreased by a credit. Liabilities, Equity, and Revenue accounts are increased by a credit, and decreased by a debit

Continued

Balance Sheet
 A Balance Sheet indicates the financial position of a business at one point in

time;  it shows what the business owns and owes.  The general journal captures day-to-day account balances.  At the end of an accounting period, a Balance Sheet is prepared.  The Balance Sheet has three sections:  Assets – the things of value that the company owns. Liabilities – obligations to pay or provide goods or services at some later date. Equity – the amount of net assets (assets - liabilities) owing to the owners of the business.  The Balance Sheet is named as such because the total of the assets must equal the total of the liabilities and equity.  What a company owns equals what it owes to its creditors and owners

Assets
Cash 5,500

Mahrous's Pharmacy Balance Sheet As at July 31, 2008 Liabilities Bank Loan 5,000

Inventory
Accounts Receivable

8,000
3,500

Accounts Payable
Total Liabilities

1,000
6,000

Equipment

2,500
Equity Paid in Capital Retained Earnings Total Equity 10,000 3,500 13,500 19,500

Total Assets

19,500

Total Liabilities & Equity

Income Statement
 At certain points during the year, each business wants to     

know how well it is doing. Is it earning a profit? Is it losing money? Just how well is it doing compared to other firms? Is it likely to be able to earn a profit in the future? To answer these questions, it uses an Income Statement.

Continued
 The Income Statement communicates the inflow of revenue, and  

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the outflow of expenses, over a given period of time. Revenue is the inflow of assets (i.e. cash or accounts receivable) to a company in return for services performed, or goods sold. Expenses are the outflow or consumption of assets (i.e. cash, inventory, supplies), or obligations incurred (i.e. accounts payable, taxes payable) while generating revenue. The difference between these two is the Net Income. An Income Statement therefore shows the operating profit (or loss) of a business.

Mahrous's Pharmacy
Income Statement For the month ended August 31, 2008 Revenue

Sales Revenue
Repair Revenue Total Revenue Expenses Rent Wages Inventory Depreciation

7,000
3,000 10,000

550 2,300 4,000 200

Total Expenses
Net Income

7,050
2,950

 Many people are inclined to think that, because Tom's Plumbing

had a net income of $2950, the cash account increased by $2950.  As you can see, this is not the case:
 cash increased by only $550.

 The reason for this is because income can be accounted for in

ways other than cash;
 and activities other than operations, like financing and investment,

can affect cash.  To get an accurate picture of the actual cash generated by a business in a period you must prepare a Cash Flow Statement (Statement of Changes in Financial Position).

Cash Flow Statement
 The Cash Flow Statement records inflows and outflows of cash during a


period of time, and is divided into cash flow from operations, financing, and investing activities. To prepare a statement of cash flow you must convert net income from accrual-based accounting to cash You therefore have to add and subtract changes in non-cash accounts that have accrued during the period. For instance, you need to add back depreciation amounts, because although depreciation expense decreases net income, it has no bearing on actual cash. Likewise, you have to deduct any decreases in accounts payable because that is a use of cash that was not accounted for on the Income Statement. The following table outlines the major sources and uses of cash:

Sources of Cash Operations New loans New stock issues or owner investment

Uses of Cash Cash Dividends Repayment of loans Repurchase of stock

Sale of property, plant, or equipment

Purchase of property, plant, or equipment

Sale of other non-current asset

Purchase of other non-current asset

• The $550 dollar increase in cash has been explained by converting accrued amounts into actual cash value. • Understanding the interrelatedness of the financial statements is very important when reading and interpreting them. • Understanding where the numbers come from, and what they actually mean, is extremely important when evaluating your own performance, or comparing your performance to others.

Financial Statement Interpretation Armed with some knowledge of accounts, it's important to understand what the statements actually tell you.

What an Income Statement says
 The Income Statement reports the main and any secondary sources of income.

For example, Fees Earned would be the primary revenue in a dental office. If they had bonds, a secondary source of revenue would be Interest Earned from Bond Investment.

 The terms used to describe the revenue will provide a clue about the nature of

the organization. For example, Fees Earned implies a service company; Commissions Earned implies a brokerage; while Sales Revenue implies a retail or wholesale firm.

 The items listed as expenses are expired, meaning they have no useful value left.  The result of matching the revenues and expenses yields the Net Income or Net

Earnings if the statement is called the Earnings Statement. The term 'net' implies that the revenues and expenses have been matched, and therefore there is not an over or under statement of the income (loss).

What an Income Statement does not say:

An Income Statement does not predict the future net income for any accounting period. Since the future is full of uncertainty, a reader of a historical Income Statement can't rely on the reported results of any single period for an indication of future results.

An Income Statement, no matter how well prepared, does not provide an exact measurement of net income for the accounting period. No matter how hard you try, it is impossible to get an exact match. Consider, for example, an advertising expense. If management spent $1,000 in December on advertising, and achieved $5,000 sales revenue for December, that does not mean that the advertising brought in exactly $5,000 revenue. There may also be revenue generated in January that can be attributed to the December advertising. When it is difficult to measure, the expense is accounted for in the period it was incurred. An Income Statement does not report True Profit, which is the difference between total funds invested over the life of the company and funds realized from the sale of the company. To calculate this, you would have to calculate the difference between assets invested during the lifetime of the business, and the amount finally received from remaining assets after winding up the business.You would also have to deduct any personal withdrawals because these were actually paid out of the 'profits.'
Net Income does not mean cash! Always keep in mind that net income is the excess revenue over related expenses for a specific accounting period. Cash has very little to do with determining net income. True, revenue refers to an inflow of cash and expense to an outflow, but often the inflow of cash is used for further investment. Additionally, revenues and expenses are recorded at the time of occurrence, not when cash changes hands. What about the case of depreciation expense which does not represent an outflow of cash at all?

What a Balance Sheet says:
 A Balance Sheet gives readers a detailed summary of the assets and claims

against those assets, as at a particular date.  A Balance Sheet provides the reader with information about the financial position of the firm with regard to its ability to pay current debts. By comparing the current assets to the current liabilities, the reader can assess whether the company is in a position to meet to meet its shortterm financial obligations.  A Balance Sheet gives the reader a view of the firm's financial position to carry on its business operations. The fixed-asset section indicates how many resources the company has working for it to assist in revenue generation.  Finally, a Balance Sheet reveals the strength of the owner's claim against the assets. Remember, however, that this claim is residual, or the remaining claim after the creditors'

What a Balance Sheet does not say
 A Balance Sheet does not report the details of how the profits were made. That

information comes from the Income Statement.

 A Balance Sheet does not show the claims of the creditors and the owner(s)

against a specific asset. The claims are against the assets in general.

 The word 'Capital' under owner's equity must not be interpreted as cash. The

investment can come in many forms – cash being just one of them. The owner's original cash investment may have gone primarily to purchase fixed assets in order to assist revenue generation. Capital means investment not cash. business. Many readers believe the total assets represent a bundle of future cash reserves. This is not true because fixed assets are reported at historical cost, and their purpose is to assist revenue generation. They are not intended for sale to enhance cash flow.

 A Balance Sheet does not report the market value, current value, or worth of a

Key Points:
 Accounting is a language unto itself.  To become perfectly fluent takes a great deal of training and experience.  Thankfully, non-financial managers, and other employees with financial    

responsibility, can learn to be conversant with the key terminology. The bookkeeping process is how day-to-day transactions are recorded. Balances in the various accounts are tracked and summarized in the financial statements. The financial statements bring the cycle full circle as they reflect the changes that happened during the accounting period. By understanding this cycle, you have a much better appreciation for the numbers on the financial statements, and you can use them to make sound managerial decisions.

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