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Chapter Twelve
Small Business Accounting:
Projecting and Evaluating Performance

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Education.
 Why Accounting Is Important for Small Business Success

There are several reasons.

• You must provide specific accounting information in order for investors
to consider funding your concept.
• Bankers require formal financial statements for any type of loan.
• You cannot fully know your business without accounting information.
• Planning and controlling require accounting information.
There are three types of accounting you will need in your business.
• Financial accounting is formal, rule-based accounting principles.
• Managerial accounting is intended for planning, directing, and
controlling a business.
• Tax accounting is based on governmental requirements.

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 Financial Accounting

Financial accounting is based on a set of rules called generally

accepted accounting principles (GAAP) and reports:
• How profitable the business is.
• The value of the firm’s assets and who has claim to that value.
• How much and from where money was received and how much and
to whom money was paid.
These three financial reports are called the: Financial
• Income statement. accounting does
• Balance sheet. not have a lot of
value for running
• Statement of cash flows. the day-to-day
Each report contains information on things that activities of a
have already happened. business.

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 Managerial Accounting

Managerial accounting is forward-looking where financial accounting is

concerned only with the past.
• There are no formal rules with the only issue being what is valuable.
• One of the most valuable functions of managerial accounting is
planning for future business activities.
• This is done through standard budgeting or profit planning.
• This method of organizing and formatting business planning is called
pro forma financial statements.
• The result is a detailed plan for future operations and is the standard
against which actual results are compared to assess performance.

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 Tax Accounting

Tax accounting follows the tax laws and regulations.

• The final product is a set of returns, forms, and schedules.
There are many different business taxes including:
• Federal income tax.
• State income tax.
• Employment taxes.
• Inventory tax.
• Excise taxes.
• Various use taxes including sales tax and, in some countries, value-
added tax.
The primary value of tax accounting is to avoid penalties for non-
compliance and to legally minimize tax payments.

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 The Accounting Equation

Assets = Liabilities + Owners’ equity

If a business is an entity existing apart from its owners, then the value of
the business is the sum of the values of everything the business owns.
• The name for what a business owns is asset.
• Owners do not own the assets, the business itself owns them.
• The owners have a claim on the assets of the business and this claim
is called owner’s equity.

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 The Balance Sheet

The balance sheet entry to

report the equity transaction
between the owner and Red Jett
Sweets would look like this.

Liabilities are legally enforceable

future obligations.

Total assets ($73,000) is exactly

equal to the sum of the claims of
the creditors and the owners.
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 Cost, Revenues, and Expenses

Red Jett purchases raw

materials for $2,040 on
account, then bakes
and sells 3,000
cupcakes at $2.75 each
on account.
No cash changes hands.
Red Jett incurred an
expense, called cost of
goods sold of $2,040
and realized a revenue
of $8,250.
The difference between
the revenue and the
expense is a profit of
$6,210, reported on the
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balance sheet as
retained earnings.
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 Red Jett Sweets – February Balance Sheet

Red Jett collects the

invoice due and pays
the bill it owes.
Imagine a year’s
worth of such
transactions.
Rather than enter this
on the balance sheet,
create an account.
Permanent
accounts are those
other than revenue
and expense
accounts.

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 Why Do Accounting?

To produce information useful for managing the business.

• The information must be accurate and relevant to be useful.
• Improve accuracy by using an accounting program.
• Relevance must be evaluated for each decision as it is made.

To meet legal or contractual requirements.

• You own a buffalo wings restaurant and wish to purchase a $25,000
high-capacity fryer.
• You may save $1,000 a month on your lowered electricity bill and
lowered insurance premiums.
• You also consider the increased number of people you could serve.
• Your accountant would depreciate the fryer using the MACRS rate,
allowing you to claim a depreciation expense each year.

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 Accounting Systems for Small Business

There are many software solutions

but the chosen system should
• Produce statements in
perform the following tasks.
approved formats.
• User-friendly interface.
• Produce multiple-year
• A thorough help function. comparisons.
• Produce an income statement • Provide custom reports.
using appropriate categories.
• Export data in a form
• Produce a classified balance acceptable to tax programs.
sheet clearly showing position.
• Maintain an internal “audit trail.”
• Help develop a cash budget.
• Enforce security measures.
• Help develop operating, and
• Allow for growth of the
investment budgets.
business.

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 Setting Up an Accounting System

One essential element of an accounting system is cash accounting that is

accurate, easy to use, and tracks all checks and all deposits.
These accounting functions will become important as your firm grows.
• Accounts receivable if you provide credit to customers.
• Accounts payable tracks what you owe.
• Payroll records to ensure taxes are kept current.
• Fixed asset accounting calculates and accumulates depreciation.
• Inventory accounting maintains and aids inventory levels.
• Credit card sales tracks discounts and chargebacks.
• Insurance register keeps insurance coverage current and in force.
• Investment records if you invest surplus cash in securities.
• Leasehold records if your have leased property or equipment.
Setting up your system can be outsourced to consultants.
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 Financial Reports

There are six common financial statements.

• Income statement – records debits/withdrawals, like your debit card.
• Statement of comprehensive income – if you have financial derivatives.
• Statement of retained earnings – incorporated into balance sheet.
• Statement of owner’s equity – incorporated into balance sheet.
• Balance sheet – what you own and its worth, and what you owe others.
• Cash flow statement – the exact amount of cash right now.
Your monthly bank statement parallels the retained earnings statement.
The important thing about these financial statements is that they
articulate information flows from the income statement through the
balance sheet to the cash flow statement.

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 Income Statement

The income statement is the primary source of information about a

business’s profitability.
Revenues – Expenses = Net Income
• There are two formats – a single-step and a The income
multiple-step format. statement is used
Two difficulties in understanding the statement. to analyze the
• First, what is reported as revenue. effectiveness of
business
• Second, when to recognize revenues. operations.
Similar problems arise in the timing of gains, Operating income
losses, and expenses. is the most used
• Yet the income statement reliably reports how item on the
well a business is producing profits. statement.

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 Figure 12.4A and Figure 12.4B

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 Balance Sheet

The balance sheet presents a “snapshot” of financial holdings and

liabilities on a specified date.
• Usefulness is determined by the detail it includes.
Balance sheet information is used to determine liquidity, financial
flexibility, and financial strength of the business.
• Liquidity measures the time before an asset can be converted to
cash, and the expected time before a liability must be paid.
• The most common ratio to estimate liquidity is the current ratio or
dividing the value of current assets by the value of current liabilities.
• Financial flexibility indicates a firm’s ability to manage cash flows.
• A firm’s financial strength is a matter of informed judgment.

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 Figure 12.6: Typical Balance Sheet

Problems interpreting balance

sheet information.
• All values are historical so the
cost is less than current value.
• Every balance sheet contains
estimated amounts, which may
be wrong.
• Certain assets and liabilities
are omitted.
Despite there problems, the
balance sheet supplies essential
information for outside investors.

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 Cash Flow Statement

Cash flow statements are either direct or indirect statements.

• A direct statement is developed solely from the cash records.
• The indirect statement of cash flows starts with net income and
adjusts accruals and deferrals to easily reconcile to other statements.
There are six items that must be reported in the statement of cash flows.
• Cash flows from operating activities.
• Cash flows from investing activities.
• Cash flows from financing activities.
• Net effect of foreign exchange rates.
• Net change in cash balance during the period.
• Noncash investing and financing activities.

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 Red Jett Sweets – Statement of Cash Flows

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 Uses of Financial Accounting

Reporting to outsiders.
• Absentee owners, creditors and lenders, unions, and taxing and
regulatory agencies have an interest in the conduct of your business.
Record keeping.
• Criteria: simplicity, accuracy, timeliness, understandability, security.
Taxation.
• Employers withhold: FICA, Medicare, FUTA and disperse W2s.
Control of receivables.
• The key is to have account receivables aged.
Analysis of business operations.
• Items that appear unrealistic should be carefully examined.

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 Uses of Managerial Accounting

Managerial accounting is based on understanding how costs change as

a result of business changes.
• External (cost) factors are aspects outside the business that could
cause the business costs to change.
• Internal (cost) factors are those aspects or choices within the
business that could cause the business’s costs to change.

There are two managerial accounting procedures that depend on being

able to forecast future revenue and expenses.
• Cost-volume-profit analysis.
• The budget cycle process.

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 The Sales Budget

The first step

in preparing a
master budget
is to prepare a
sales budget.
All the
numbers, both
in an initial
business plan
and in later
budgets, are
based on
estimates.

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 The Purchases Budget

Once sales
are projected,
the next step
is to plan for
inventory
purchases.

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 The Cost of Goods Sold Budget

The business plan states that all unsold cupcakes are donated at the end of the day.
The budget is simply the number of cupcakes to be made multiplied by variable cost
per cupcake.
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 The Selling, General, and Administrative Expense Budget

It is common to combine all costs of selling into a single SG&A budget.

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 Budgeted Income Statement

The budgets
completed to this
point can be
combined into a pro
forma budgeted
income statement.
During the year,
comparisons of actual
results are made to
the budgeted items. ‘
If the budget is met,
the projected profit is
realized.

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