Introduction
As a manager, you may be asked to produce or contribute towards an income statement for your own business unit. This provides senior management with an indication of how your business unit is performing against its targets over a specific period, for example, quarterly. In addition, you will usually be expected to understand simple financial reports and communicate effectively with financial people in your own organization.
This chapter I explain all of the basic accounting concepts and terminologies you will need to understand the three primary financial statements that appear in every organization’s annual report and most internal monthly reports as well.
These are:
- The Income Statement—An accounting of revenue, expenses, and profit for a given period. This can also be an internal document that can be used to make management decisions about almost any activity where you have a record of the money spent and the associated return
- The Balance Sheet—An itemized statement that summarizes the assets and liabilities of the business at a given date.
- The Statement of Cash Flow— A report that shows the effect of all transactions that involved or influenced cash but did not appear on the income statement.
If you work in a nonprofit sector then do not be put off by words like business’ and ‘profit.’ Even if your organization is not a business that exists to make a profit, it is still important to understand the basic principles of finance and management reporting so that you can monitor efficiency and control your budget effectively.
Your organization may not be concerned with sales and profit as such, but there will be some metrics for measuring the service delivered and the costs incurred in delivering it.
Financial reporting requires an understanding of: basic financial terms, the differences between cash-based and accrual accounting, and an appreciation of when revenue and costs are recognized. All of these topics are dealt with in this eBook, which is an ideal introduction to basic accounting principles
KEY POINT
’ You should make sure that you know the basic concepts and terminology needed to understand income statements, balance sheets, and statements of cash flow as these are widely used, even by nonprofit organizations.
Basic Accounting Concepts
The basic principles of accounting are best understood by considering some simple businesses and how they might document their financial activities.
An Income Statement
This is a financial statement that measures an organization’s financial performance over a specific accounting period by giving a summary of how it incurs its revenues and expenses. It also shows the net profit or loss incurred over that period and is often referred to as a ‘Profit and Loss’ or ‘Revenue and Expenses’ statement.
An income statement consists of two sections: operating and non-operating activities.
- The operating section details the revenue and expenses directly associated with business operations, for example the purchase of raw materials.
- The non-operating section details revenue and expenses that result from activities outside of normal business operations, for example the sale of an office or land.
This division of revenue and expenses into ‘operating’ and ‘non-operating’ is particular to each organization and is dealt with in detail in the eBook ‘Understanding Income Statements,’ which you can download from www.pscclass.blogspot.com.
For the moment we will use a ‘simple’ income statement to illustrate the financial principles you need to be familiar with, since this type of income statement does not distinguish between ‘operating’ and ‘non-operating’ revenues and expenses.
A Sample Simple In come Statement
This sample simple income statement covers a twelve-month period for ‘Lamichhane Group,’ a one-person business that designs signage It details the amount of revenue and expense that comes in and goes out of the organization without distinguishing between operating
and non-operating items.
The income statement uses three terms that can be defined as:
- Revenue—incoming assets in return for sold goods or services.
- Expenses—outgoing assets or liabilities incurred.
- Net Income—the difference between Revenue and Expenses. This shows whether you are generating a profit or you are operating at a loss.
In our example, Lamichhane runs him own design agency called Lamichhane Group. He works from his home office and offers a design service for customers who need a sign for their business premises. The design is done according to a brief supplied by the customer.
Once the design has been approved, Lamichhane obtains quotes for its manufacture from three suppliers. He then sends the design and the quotes to the customer including his in voice for the total number of hours spent on this design, based on an hourly rate of $45.
The following table gives you an example of what a simple income statement would look like for Lamichhane Group, on 1st Jan to 31st Dec.
The net profit or loss is the difference between the income received and all of the costs paid out. In this case Lamichhane has made a profit for the year of $7,215.
He may need this information to give to the tax authorities or he could use it to compare this year’s performance to last year’s, or even to his expectations at the beginning of the year.
As simple as this document is, there are some practical issues that it raises. For example:
- Lamichhane sends out an invoice in December, but it has not been paid by 31 December.
- What does he do?
- Should the invoice amount appear on the statement or not, and does it matter?
The answer to this question depends on the type of accounting that Lamichhane is using. There are two types, known as ‘cash accounting’ and ‘accrual accounting.’
The practical implications of each type for your organization are explained in the next sections using our example of Lamichhane Group.
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