Monday, 20 May 2013

Accounting Statements: Introduction

In the past two articles, we’ve looked at what records we need to keep in our small business; records both of income and of expenditure. Now we’re going to start looking at why we need to keep those records and what we need to do with the data we collect.

There are two main reasons for keeping financial records. Firstly, it is a legal requirement. The law says if we earn money, we have to pay tax. I know that’s a very broad statement and there are all sorts of things to consider, such as whether a particular income type is tax-free; or whether our earnings exceed our tax allowance level; but in general terms, if we earn, we pay tax. And yes, before you ask, that does apply “even if it’s only a hobby”. Although why we would be thinking about hobbies when we are supposed to be running a business, I have no idea.

Incidentally, although I am writing about systems in the UK, I think I’m safe in saying the rule “if we earn, we pay tax” applies in most other countries as well.

But frankly, there is a much more important reason why we keep financial records: we need to know whether our business is successful or not. Remember the quote from Mr Micawber: “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” (David Copperfield by Charles Dickens). Now, I’m not actually saying that profitability is the only measure of success; but we are running a business here. We need to know whether we’ve made a profit or not; whether our cash flow is going to be sufficient to pay the mortgage next month and so on. As always, we should try to keep the systems as simple as possible, so they are effective, tell us what we need to know, with as little effort as possible, so we can concentrate on what we really want to be doing: writing.

There are three main accounting statements. I’m going to introduce all three in this article, then go on to talk about the two key ones in the next couple of articles. The statements are: profit and loss; balance sheet; and cash flow.

Profit and Loss

The profit and loss statement is an historical picture of how the business has performed over a given time period. We’ve already talked about the profit and loss equation in earlier articles:

I (total income) - E (total expenditure) = profit (if I is bigger than E)
or loss (if E is bigger than I)

We’ll look at this in more detail next time. The P&L statement is usually calculated annually; it will certainly form part of our closing accounts. However, it may also be useful to monitor it on a monthly basis. If we are going to do that, it’s certainly easier to do with an accounts package (software).

Balance Sheet

The balance sheet provides a snapshot in time; what is the business worth today? It compares the total assets (what we own in terms of equipment; money in the bank; stock waiting to be sold; and money owed to us) with the total liabilities (what we owe in long-term or short-term debts) and also looks at how the business is funded. This statement is more appropriate to limited companies and is not a requirement for a sole trader in the UK. It can be calculated manually, but is much easier to prepare at the press of a button via a software package. I’m not going to cover balance sheets in nay more detail than this.

Cash Flow Statement

This is arguably the most important statement for any business; it is a forward-looking document, used to plan the flow of money over time. It is particularly important if we are going to incur high expenses (for example, if we are self-publishing a hard-copy book) or if there will be a delay before receiving payments.

In most businesses, there is a time-lag between incurring expenditure and bringing in income. Even cash businesses like shops often have to pay upfront for their stock, but only get income in return when the stock is sold. As writers, we may be lucky enough to have an advance against a commissioned book (although that’s becoming rarer these days) but even that will then to be a relatively small amount of income. If we have to wait for publication, for sales to grow and for the first royalty statement to be issued (which can be six or twelve months after publication), our investment (in time, in electricity, in printing costs etc) will occur quite a bit in advance of the expected income. We need to know if and when our cash flow is likely to be negative (more going out than coming in) so that we can plan our funding appropriately. This is particularly important in a start-up business and applies equally to sole traders or limited companies. We will look at cash flow in more detail in a couple of weeks’ time.

As always, note that I am not an accountant or a lawyer, just a long-term business owner, talking about my own experience. If you are unsure about anything, always take advice from an appropriate professional.

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