As a business owner, you should have at least a basic understanding of accounting...in particular you should know how to read your financial statements to better understand your business’ performance, at the high-level.
Financial statements are used by creditors and investors in determining if they’re going to provide you with capital. Also, comparing one year’s financial statements to another year can be useful in judging the overall trajectory of your business.
I’m Gabriel Velez, partner at Tehrani & Velez, LLP, and we’re a tax accounting firm based out of Irvine, California. In this 3 part video, I’m going to explain the two most common bases for preparing financial statements (a basis of accounting is the rule under which transactions are recorded). I will also be explaining what goes on each of the three financial statements and give some insight on how to read them.
So let’s get into it!
Accrual vs. Cash Basis Accounting - Intro
There are two primary bases of accounting.
The first is the accrual basis of accounting that records revenue when earned (like a service being rendered or a product being delivered) and records expenses when incurred (when a service or product is received).
The second basis of accounting is the cash basis of accounting, that records revenues when cash is actually received and expenses when a disbursement is made.
True cash basis accounting isn’t very common for a business because there are times when it’s not appropriate to expense an item, such as when you buy a piece of equipment or real estate that will provide benefit to your business for multiple years, or when you’re making retirement contribution after a tax year has closed. More common is a Modified Cash Basis accounting, that uses Cash Basis rules for most items, but allows us to use the Accrual Basis of accounting for certain items or accounts.
There are three basic financial statements and they can sometimes go by varying names, but those financial statements are:
The balance sheet, which is a representation of your business at a point in time. For instance, you might have a December thirty-first (31st), two thousand and eighteen (2018) balance sheet.
The next financial statement is the income statement (sometimes referred to as the Profit & Loss, or P&L for short) which is a representation of your business over a period of time. An income statement, related to the balance sheet I just mentioned, would be dated January first (1st), two thousand and eighteen (2018) THROUGH December thirty-first (31st), two thousand and eighteen (2018). This income statement spans one year’s time.
Finally, the Statement of Cash Flows is similar to the Income Statement in that it spans a period of time, but instead of judging the performance of a business, it shows us where cash is coming from (inflow) and where cash is going (outflow). The Statement of Cash Flows can sometimes be difficult for non-accountants to read or grasp, but it’s important nevertheless. I’ll go into more detail in part 3.