Accounting Overview

Accounting: Overview for Small Business Owners

January 29, 2007

Accounting: Overview for Small Business Owners

The opportunity to present information to small business owners with no accounting or finance knowledge certainly presents an immediate challenge. The material included herein will identify the audiences, purposes and natures of financial statements and managerial reports. In addition to this, the scope of the paper will explain the use of financial accounting information in making informed and ethical business decisions.

Financial Statements

"Accounting is sometimes said to be the language of finance because it provides financial data through income statements, balance sheets, and the statement of cash flows" (Block & Hirt, 2005). Financial statements are at their most basic level a summary of the monetary position of any organization. The most common financial statements include the income statement, the balance sheet, and the statement of cash flows (formerly referred to as the statement of changes of financial position). These statements are used by management, labor force, investors (present and prospective), creditors and government regulatory agencies. Financial statements can be available for individuals, non-profit organizations, retailers, wholesalers, manufacturers and service industries. The nature of the organization involved dramatically affects the kind of data available in the financial statements. The purpose of the user dramatically affects the data he or she will seek.

To pursue the inner workings of accounting through these financial statements, a basic appreciation for each must be obtained. The three financial statements described are a required element of the Statement of Financial Accounting Standards (SFAS, No. 95), detailed by the Financial Accounting Standards Board (FASB). "The mission of the FSAB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information" (FSAB, 2007).

Income Statement

"The income statement is the major device for measuring the profitability of a firm over a period of time" (Block & Hirt, 2005). Any income statement is a representation of a defined period of time. The income statement may contain information for one month, three months, or a year. The layout of the statement is in a stair-step fashion so as to enable the examination of profit or loss after each type of expense item is deducted. Quite basically, the income statement maintains the basic ability to show the profitability of a firm through some defined period.

There are certain limitations to the income statement from an accounting viewpoint. Accounting principles allow the use of actual transactions only. However, some analysts can evaluate certain economic gains to a firm's worth based on real estate gains, etc. The income statement does not allocate perceived value increases outside of actual transactions, and therefore the increased valuation can not be included in the income statement.

Balance Sheet

"The balance sheet indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest. Together with the income statement, these statements are intended to answer two questions: How much did the firm make or lose, and what is a measure of its worth" (Block & Hirt, 2005). A balance sheet is basically a picture of the firm at some point in time. Unlike the income statement which covers a broader time period, the balance sheet "...is a cumulative chronicle of all transactions that have affected the corporation since its inception" (Block & Hirt, 2005).

The limitations of a balance sheet are that most of the values which are included are stated at the original, historical costs. The impact of this is realized as equipment may be worth two or three times the original amount and conversely require several times the original value to replace.

Statement of Cash Flows

The purpose of the statement of cash flows is to emphasize the critical nature of cash flow to the operations of the firm. The term cash flow represents cash or cash equivalent items that can easily be converted into cash within 90 days. In relative terms, income statements and balance sheets are normally based on the accrual method of accounting, in which revenues and expenses are recognized as they occur, rather than when cash actually changes hands per the statement of cash flow. "It translates the information on the income statement and balance sheet that was prepared on an accrual accounting basis to a cash basis" (Block & Hirt, 2005).

In addition to the three required statements, managerial reports can also augment the data to make it more applicable, or provide key financial action items.

Budget

A budget is more than a financial plan showing expected income versus past and planned expenses. Once created, the budget becomes a tool to monitor current operating