Understanding accounting will enable you to add value to your team says Adam Wilkinson
Accounting is all around us. From having finance meetings, to managing our own personal finances, the language and relevance of accounting can always be felt. But most people don’t like accounting. It can seem impenetrable because it feels complicated, dull, and full of jargon.
However, understanding accounting is the platform to understanding how any business works. Having a good grasp of numbers is key to having a strong business sense and will help you get ahead in your company. If you understand accounting, it will enable you to add value to your team and get noticed by helping to make the best decisions for your business.
The good news is that accounting is easy to grasp when it’s explained well. The fundamental building blocks of accounting are simple and logical, it’s just that accountants have a unique set of logic.
So, here are five key tips and insights into how accounting works, in order to help you understand this world a whole lot better.
1. Accounting is just organising
Underneath all the jargon and the complicated spreadsheets, all accountants are really doing is organising. They are the organisers of the finance world, monitoring and tracking how a business is performing financially. All you need to understand is HOW they organise things.
We all understand how to organise various things in our lives. For example, think about the books on your bookshelves: you probably have a way you like to organise them. It could be a functional approach (by author or title) or it might be a visual system (books according to size or colour). When you know how these things are organised, it makes it easy to find what you need. But if you looked at someone else’s book collection, if you didn’t know how they organised things, it would be much more difficult to find the book that you want.
It’s exactly the same thing with accounting; it’s just that accountants are organising numbers. They may be organising thousands of transactions, even millions of pounds worth of information, but they are just organising that information in a particular way.
This method of organising data has become ingrained in them, over years of training and practice, so that it is second nature. But it’s not natural at all – in fact it’s pretty abstract, which is why accounting can be very confusing. But at its heart it is actually very simple.
2. The accounting duality
If I hold a phone up and ask you “What have I got in my hand?” you will quickly identify that it’s an iPhone. The interesting thing is that there is more to the question than meets the eye. If I press on and ask you “So what makes this phone unique?” you will work out that it is of course MY phone. On the face of it this is a very minor leap of logic, but it’s fundamentally important to how accounting works. Here’s why.
There are two things going on: there is the tangible world of the object that we can see, the phone, and there is an invisible world of ownership, the world of rights and claims over those objects. There is an inherent duality: WHAT something is, and WHOSE it is. And almost everything in the world exists within this duality because almost everything is owned by someone: a person, a company, or the state.
The trick is that accounting takes place WITHIN this duality. Accountants are recording what things are, and whose those things are, and therefore there is always a duality in accounting too. This means there are always two impacts in the accounting system when they are organising the number. It’s even why a balance sheet balances in the first place.
3. The Balance Sheet: what’s going on?
Most people find a balance sheet a mystery, but the fundamental principle of a balance sheet is very simple.
Imagine a butterfly with two wings spread out in front of you. The wing on the left represents Assets, and the wing on the right represents Liabilities and Equity. These are the three categories of information accountants use on a balance sheet.
Now, if you own your house, the left wing of the butterfly represents the house. Let’s say it’s worth £250,000. The right wing represents how you funded your house, for example a £200,000 mortgage, and £50,000 of your own investment. Your mortgage and your equity HAVE to add up to the value of the house, the £250,000, because they describe the value of the house, just in a different way. The left wing is the value of the asset, and the right wing is how you have funded the asset. Over time, as the value of your house goes up, the value of your equity in the house will go up too, so the values always remain in balance.
It’s the same with the balance sheet of every company. It’s describing the value of the assets of the business, and how those assets have been funded, so the value is the same by definition, and a balance sheet will always balance.
4. Income is not cash!
Borrowing money, and getting investment, are two of the ways any business can source funds. But there is a third way – going out and earning it. There are two main ways that this happens, selling goods or providing services.
But, the definition of income may not be what you think it is. I always ask people “What the is the sound of income?”. Invariably the answer comes back as “Ka- Ching!” as this is the sound that we all associate with the word income. The problem is that, in accounting, this association is entirely false!
Why? Well, the Ka-Ching sound is the cash hitting the till, its having money in the bank, and this is an asset that you own. Assets live on the balance sheet, and this is separate from the concept of income. The income is the value of the work we have done that has given rise to the payment. Income is the reason for the payment, not the payment itself.
The trick is that the work, and the payment for the work, can happen at the same time, or at different times. Either way, when you do the work, that is when it is income as far as the accountants, and therefore your business is concerned. If you do the work and don’t get paid, well, it is still income, but the asset you have is not cash, it’s a receivable, as your customers now owe you money. And these receivables are another very important asset for your business.
It’s income when the sale happens, not when the cash comes in, and this is precisely why businesses put as much emphasis on cash flow as they do profits.
5. Tying it all together
Accountants have five categories of information into which everything gets grouped: Assets, Liabilities, Equity, (on the Balance Sheet), Income or Expenses (on the Profit & Loss or Income Statement). These two reports tell us two very different things.
The Balance Sheet is an overview of all the things that a business owns, its assets and their values, and how it has funded them, i.e. how much is owed to other people as its liabilities, or how much the business has funded itself. It is a statement of possessions at a particular point in time.
The P&L or income statement is entirely different: it shows all the activities of a business over a period of time. It shows how much value those activities generate from sales, and how much value it costs to make those sales and run the company. The net result of the income statement, the profit or loss for the year, feeds into the Equity section of the Balance Sheet to make it balance, and it is this link that ties the two reports together and makes the entire system of accounting work.
When you understand what these reports show you, you can engage with finance properly. You can understand how your business is performing and what the needs of your business are, so that you can add value in team meetings and help make the right financial decisions for your businesses.
