2 6-2 What Is Accounting? The American Accounting Association defines accounting as “the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.” Accounting practices are essential to business confidence. –The purpose is to keep track of items of value, in their current state and in their flow or change over time and to make reports that are useful in management decisions. –Accounting is based on the concept of a financial transaction.
4 The Accounting Equation The accounting equation indicates a company’s financial position at any point in time. On its framework rests the entire accounting process. Any business transaction can be analyzed in terms of its effect on the accounting equation. According to the accounting equation, a company’s assets equal its liabilities plus owners’ equity, as shown: Assets = liabilities + owners’ equity Assets: Anything of value owned by the business and used in conducting its operations. Liabilities: Debts owed by the business to its creditors, including obligations to perform services in the future. Equity: The claims of the owners, partners, and shareholders against the firm’s assets. Revenues: Inflows of assets resulting from the ongoing operation of a business. Expenses: Costs incurred to produce revenues. o Revenues result in an increase in owners’ equity, whereas expenses result in a decrease. o Net income, is the excess of revenues over expenses.
5 6-4 The Accounting Cycle Accounting cycle: The sequence of steps that are used to keep track of what has happened in the business and to report the financial effect of those events. –Accountants first analyze the business transactions to determine which should be recorded and at what amount. –Transactions are recorded chronologically in a journal—general journal or specialized journals. –Data entered into journals originates from various source documents. –Entrepreneurs may need to know the balances of the various accounting equation elements.
6 Exhibit 6-2 The Accounting Cycle
7 Exhibit 6-3 General Journal Entries
8 6-4a Accounts Receivable One of the ledgers subsidiary to the general ledger is the accounts receivable ledger, or AR. –A cash sale results in a debit or deposit to the bank account and a credit to the proper sales revenue account. –A credit sale is posted as a debit or increase in the asset AR account and a credit to the sales revenue account. –The profit or loss, which is the sum of revenues and expenses, is carried into the balance sheet as current earnings.
9 6-4a Accounts Receivable (cont.) The AR accounting system requires the identification of a customer or vendor for the transaction. –The AR system generates three primary reports: A ledger or report for a single customer An aged accounts report Statement or bill to customers The accounting system also charges a customer’s or vendor’s account for amounts not paid on a timely basis.
10 6-4b Accounts Payable The accounts payable ledger, or AP, is the mirror image of the AR ledger. Accounts payable: For products or services that have been acquired and have flowed into inventory but have not yet been paid for. –AP accounts carry a credit balance or a liability balance. –AP accounts are liabilities. –AP system produces checks to pay to suppliers. –AP system also generates a detailed ledger for each supplier and an aged accounts report.
11 6-4d Inventory Control Inventory control ledger: Account for each item or type of item in inventory and to enable the entrepreneur to know: –How much of each item is being sold and at what times of the year. –How much of each item is in stock. –How much of each item should be reordered and when. Inventory control accounting is more difficult and takes more attention to detail than do other accounting subsystems.
Cash Management The entrepreneur must manage the venture’s cash and develop projections that provide advance warning when cash is running low. –Cash flow: The movement of money into and out of the business. It flow consists of: Inflows: The movement of money into the venture. Outflows: The movement of money out of the business. –Entrepreneurs need to understand cash flow to plan growth and to repay debts. The first step in managing cash effectively is to understand the venture’s cash flow cycle. –The cash flow statement records how and when cash flows into and out of the venture.
13 Exhibit 6-5 The Cash Flow Cycle
14 6-5a Budgets One ways for an organization to achieve strategic objectives is by preparing budgets and then monitoring actual performance against them.
15 6-5a Budgets –Budget: A plan set out in monetary terms, prepared and approved prior to a defined period of time, and usually showing either or both the planned income to be generated and the expenditure to be incurred during that time period. –There are various methodologies for budgeting: Incremental budgeting Zero-based budgeting –Successful budgeting results from the careful development and evaluation of all aspects of the budgeting process.
16 Zero-Based Budgeting (not from text) The process of preparing an operating plan or budget that starts with no authorized funds. In a zero-based budget, each activity to be funded must be justified every time a new budget is prepared.
17 6-5a Budgets (cont.) –A cash budget is prepared specifically to manage the cash flowing into and out of the venture. –There are four steps in preparing a cash budget: –Determine an adequate minimum cash balance for the venture. –Forecast cash receipts. –Forecast cash disbursements. –Determine the end-of-month cash balance. –The rule of thumb for cash budget is to underestimate future sales rather than overestimate them. –It is safer for an entrepreneur to assume that the venture’s cash flow cycle will be similar to whatever is standard in the industry. Entrepreneurs can estimate cash disbursements by using the pro forma cash flow statement.
18 Cash Management Strategies (i.e. three ways to increase cash-flow without necessarily increasing cash sales) 1.Progress Billing 2.Retainers 3.Invoices
19 6-5b Cash Management Strategies An Invoice is a standard business form that informs purchasers of how much they owe, when they need to make payment to avoid penalty, and where payment should be sent. The most important technique that entrepreneurs can use to improve cash flow is to have a systematic procedure for issuing invoices. –A new venture that is not diligent about invoicing can expect its cash flow to be affected. –Mid-size and large corporate customers are likely to have internal purchasing and payment cycles.
20 6-5b Cash Management Strategies (cont.) –Aging: Factor that companies consider in deciding who gets paid first; the older an invoice, the less likely it is to be paid. –Factoring: Firms will purchase a venture’s receivables at a discount.
Working with Accountants Many entrepreneurs choose to work with professional accountants to manage the financial records of their ventures. –The entrepreneur contacts the lead accountant with any questions about accounting, taxes, or financial statements. –An entrepreneur hires consultants precisely because they are expert at what they do, allowing the entrepreneur to focus on other issues. Proper management of the external accountant, then, requires a balance between strict oversight and complete disinterest. Entrepreneurs should never completely turn over the reins of accounting and financial decision making to outside consultants.
Working with Accountants (cont.) When selecting an accounting firm, entrepreneurs should: –Look at the number of the firm’s CPAs who are accredited by the American Institute of Certified Public Accountants (AICPA). –Look at references provided or ask for references. – Look for the following qualities: Reputation Professionalism Ethics Reliability