The purpose of this article is to give you an introduction to the basic accounting concepts.

Essentially what you sell, less what you buy equals your profit.

Single entry or ‘cash’ accounting

The smallest and most simple business may be accounting on a ‘cash basis’ which means cash in (income) less cash out (expenditure) equals profit.

Income is cash or payment received that is immediately recognised as income.

Expenditures are payments made for goods or services and are immediately recognised as spends in the expenditure statement.

If a cash accounting business receives an invoice for £100 of goods before the end of the year, but pays for them next year – they will account for them when the invoice is paid. Not when the invoice is received.

Sole Traders and not-for-profit clubs often work on this basis, as what’s important to them is the cash balance in the bank.

The key report for cash accounting will be the income and expenditure statement. It will look something like this.

Basic Accounting Concepts

Of course, it’s not quite as simple as that, and more sophisticated businesses and budding entrepreneurs need more sophisticated bookkeeping, accounting and reporting to help them understand if the business is profitable, sustainable and has the potential for growth. If there is trouble ahead – we need to know about it so we can plan for it and take action if we need to.

Basic cash accounting does not take into account all of those things that happen in your business that might impact your cash flow or your profitability, nor does it take into account the timing effect of transactions:

  • You may have put cash into the business to finance it
  • You may be buying stock now that will be sold later
  • You may be buying assets now that will be used in your business to generate sales for months or years ahead
  • Assets would depreciate over time but you won’t spend any more money on them unless they need maintaining or upgrading
  • You may be buying goods on credit that you will pay for later
  • You may have paid an annual insurance policy where even though you pay for it now, the insurance covers your business for the next year
  • You may be selling goods on credit that will be paid for later

These transactions do create sales and purchases but they also create assets and liabilities with future implications. You may buy or sell now, but the cash payment or receipt happens later. This is double entry accounting, not only are we accounting for the income less expenditure but we now need to consider assets and liabilities.

Double entry or ‘accrual’ accounting

Double entry or accrual accounting considers the impact of timing on its transactions and accounts for the assets and liabilities in the accounts.

If an accrual accounting business receives an invoice for £100 of goods before the end of the year, but pays for them next year – it will account for the purchase in the year that the invoice was received and show the liability owing to the supplier at the year-end. It will show the cash payment to the supplier in the following year when payment leaves the bank.

A business working on the accrual basis will record assets and liabilities on its balance sheet.

A balance sheet is a statement of assets and liabilities and will be made up of the following types of account:

Assets – An asset is something that your business owns. It has a value and could be converted to cash:

  • Computer equipment
  • Office equipment
  • Motor vehicles
  • Debtors (customers who have not paid yet)
  • Stock and work in progress
  • Cash

Liabilities – A liability is something that your business owes:

  • Creditors (suppliers who you have not paid yet)
  • Bank loans and overdrafts
  • Lease liabilities
  • PAYE and VAT to HMRC
  • money owed to the business owners

ALCIE

A useful acronym to help you remember the different account types is ALCIE (pronounced al-ki):

Assets and expenses (the beginning and end of ALCIE) – will always be debit accounts, whereas liabilities, capital , and income will be credit accounts.

 

ALCIE - Basic Accounting Concepts

The balance sheet is made up of assets less liabilities and the profit and loss account is made up of income less expenditure.

ALCIE Basic Accounting Concepts

We will talk about double entry accounting in more detail in the next article.

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