Like an anxious parent, you will constantly check the health of your business. Financial statements will turn you from anxious parent into effective doctor. They will tell you not only if but why your business is healthy or sick. With that knowledge, you can fix a problem or reinforce a strength.
The Foundation of Your Financial Statements – Your “Chart of Accounts “
The emphasis is on the “your”. Good entrepreneurs design their own chart of accounts. They do not leave it to a bookkeeper or accountant.
Each account is a financial record of an important element of your business.
• Revenue accounts track revenues by customer and product or service.
• Expense accounts record expenses by category e.g. wages and rent.
• Asset accounts measure what you have invested in assets used in the business e.g. equipment, supplies, amounts owed by customers.
• Liability accounts record amounts you owe, usually to banks and suppliers.
• Equity accounts track what you and other owners have invested in the business, including profits you have earned but kept in the business.
You Record Every Transaction You Do in Your Chart of Accounts
Each time you sell a product, receive a payment, pay an expense, buy supplies or borrow or repay a loan, you record the transaction in your “Journal” as both
• a “debit” – an increase in an asset or expense account or a decrease in a liability, equity or income account and
• a “credit” – an increase in a liability, equity or revenue account, or a decrease in asset or an expense account.
For example, you will record
• payment of a bill by a customer as a debit to your cash account and a credit to your customer receivables account and
• purchase of a computer as a debit to your equipment account and a credit to your cash account.
At the end of every month, you total all the entries in your Journal that month for each account and “post” the net increase or decrease to the balance for that account at the beginning of the month. The cumulative effect of all the transactions posted from your Journal is reflected in the new balances for these accounts at the end of the month.
Financial Statements Flow Almost Automatically from Your Chart of Accounts
These accounts “feed” your financial statements.
• Your Income or Profit and Loss Statement is created by your revenue and expense accounts for the period.
• Your Cash Flow Statement is created by the changes in your asset, liability and equity accounts during the period.
• Your Balance Sheet is created by the effect of the changes in your asset, liability and equity accounts during the period on the asset, liability and equity account balances at the end of the last period.
Once you design a good chart of accounts, your bookkeeper will do the rest. In the early days in a simple business, you can be your own bookkeeper! All you have to do to understand your business in detail is to read the statements that are produced almost automatically every month by this system.
