Certain principles are the basis for the preparation of financial statements. They form the framework that allows analysis and comparison of the information in financial statements. Without this common framework, it would be extremely tough for investors, lenders or anyone else to analyze or even trust the information presented in financial statements. Without them financial information can be distorted.
Keep the following three principles in mind and you’ll be on the right track.
- Useful Financial Information
The accounting information you record must be useful to users.
In order to be useful, accounting information should be relevant and reliable.
Relevant information allows the person looking at a financial statement to judge a company’s value and performance. For instance, gender ratios of employees are not relevant, while employee wages are relevant information. Similarly type of equipment or office supplies is not relevant, while the original cost of such equipment and office supplies is pertinent.
Reliable information is information that can be verified independently and more than once. Judging reliability is the primary reason for auditing companies. Once information is proven reliable, it can be used for financial decision-making.
- Understandable to Users
Great you’re recording all relevant financial information, but can you understand the information recorded or is it a disjointed mess? Consistency is one aspect of ensuring that your financial information is understandable. Stay consistent with past reports of your company and other companies in your industry. The second aspect of understandable information is classification. This brings us to the chart of accounts.
Chart of Accounts
The chart of accounts is an organizational tool that lists and categorizes every financial transaction of your business. Creating a proper chart of accounts is the foundation of your business accounting system. Without a proper chart of accounts, chaos could ensue leaving you lost in a quagmire of unclassified transactions that leave you scratching your head.
The five main types of accounts are:
- Owner’s Equity
Any financial transaction of your business will fall into one of these categories. In your chart of accounts, create an account for each of these categories and record transactions appropriately. A software like QuickBooks can create a chart of accounts for you and also take care of the debits and credits for you. You can easily modify the chart as needed. Think of it as a virtual filing cabinet with a different drawer for each category. Keeping things nice and tidy ensures that at any moment in time you know where your business stands.
- Communicate through Financial Statements
The main purpose of financial statements is to record and communicate useful financial information. In other words, they “Show you the money”. They also let you assess the health of your business. The statements that do this are:
This statement shows the financial position of a company based on what it owns and owes at a certain point in time.
An income statement shows the revenue earned and expenses incurred by a company during a certain time frame, usually a year or portion of the year. It shows whether your company generated a profit or loss.
Cash Flow Statement
This statement records your company’s cash inflows and outflows. It is important as it shows the company’s cash on hand. It breaks down cash inflows and outflows across three areas: operating activities, investing activities and financial activities. When you have greater cash inflows from operating activities, your company has high liquidity and is doing well.
With these 3 principles to guide you, you have a good idea of what information your business accounts should record and how to go about the basics of business accounting.