The reasons companies create and maintain accounting systems
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Running a business successfully requires the business owner many skills. One of the necessary skills is the knowledge about the accounting system. The accounting always plays an important role in the financial management of business. Many different accounting aspects affect the business success, so the more the business owners acknowledge the accounting systems, the more chances they get to succeed.
There is an old saying in business, "you cannot manage what you cannot measure." Therefore, without the accounting system, the business owners cannot find out the most suitable way to run their businesses as successfully as they expect. Without the accounting system, the business owners cannot know the business is really making a profit or a loss. Also, they cannot predict cash flow shortages, and worst of all, they cannot accurately keep track of those slow paying customers.
The accounting systems bring many benefits to the business management:: accurate reporting of business transactions, easy access to financial statements, up to date reports in accounting pay and fee, excellent management tool, and minimize problems with IRS and other tax authorities
The basic structures of assets, liabilities, and stockholders' equity
Assets are something valuable that an entity owns, benefits from, or has use of, in generating income; especially that which could be converted to cash. Assets are recorded in the balance sheet. From the accounting perspective, assets are divided into the following categories: current assets (cash, account receivable, and other liquid items), long-term assets (real estate, plant, equipment), prepaid and deferred assets (expenditures for future costs, such as insurance, rent, interest), and intangible assets (trademarks, patents, copyrights, goodwill).
Liabilities are obligations that legally bind an individual or company to settle a debt for the future payment of assets or the future performance of services that result from past transactions. Liabilities are recorded in the balance sheet. There are two perspectives of liabilities:
Current liabilities: expected to be satisfied within one year or the normal operating cycle, whichever is longer
Long-term liabilities: due beyond one year or beyond the normal operating cycle.
Stockholders' equity represents the claims by the owners of a business to the assets of the business. Stockholders' equity is residual equity that remains after deducting liabilities from assets. Stockholders' equity could be paid in capital, donated capital or retained earnings ( not yet paid out by the company).
Relationships of assets, liabilities, stockholders' equity
Assets = Liabilities + Stockholders' equity
The above formula describes the relationships of three major parts of accounting. Total of liabilities and stockholders' equity is assets.
The four basic financial statements
The income statement reports the success or failure of the company's operations for a period of time. Financial users are interested in net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about the company's future performance. Creditors also use income statement to predict future earnings. The net income equals to the revenues subtract the expenses: Net income = Revenues - Expenses. In addition, amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses.
Retain earnings statement
The retain earnings statement shows the amounts and causes of changes in retain earnings during the period. The time period is the same with the period of income statement. The first line in retain earnings statement is the beginning retain earnings amount, then the company adds net income and subtracts dividends to have the retain earnings at the end of period.
The balance sheet reports assets and claims of assets (liabilities and stockholders' equity). According to the basic accounting equation:
Assets = Liabilities + Stockholders' equity
Assets must balance with the claims of assets.
Statement of cash flows
This statement provides the financial information about the cash receipt and cash payments of a business for a specific period of time. It reports the cash effects of a company's operating, investing, and financing activities to help financial users. The financial users are interested in the statement of cash flows because they want to know what is happening to a company's most important resources.
The difference between net income and cash flow statements
Many things that affect the cash flow of a business are not directly related to its income statement. For example, a company buys a new truck; the cash outlay affects the cash flow statement, but the truck is considered as an asset in the balance sheet. It will start to hit the income statement in small pieces when the company depreciates it.
Moreover, the income statement is updated with any sales made or revenues earned as soon as the deal is done, and payments for such sales may be actually received much later. Therefore, though the income statement shows profits and the entrepreneur has made money, it is not yet available as cash flow and cannot be spent.
At the end of accounting period, the balances is temporary accounts are transferred to an income statement and retain earnings statement, thereby resetting the balance of the temporary accounts to zero to begin the next accounting period. Accountants close temporary accounts to permanent accounts because permanent accounts (assets, liabilities, and the owner's capital account) always the starting balance in the subsequent accounting period. When an accountant closes an account, the account balance returns to zero. Starting with zero balances in the temporary accounts each year makes it easier to track revenues, expenses and to compare from one year to the next.