Basic Accounting Concepts and Financial Statements

The basic principles of accounting are best understood by considering some simple businesses and how they might document their financial activities. This Accounting Terminology Checklist outlines the terminology, concepts and conventions that are accepted within the accounting profession.

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.

Income 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 this website.

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 Income Statement
This sample simple income statement covers a twelve-month period for 'Suzy's Signs,' 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.

Revenue, expenses and net income

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, Suzy runs her own design agency called Suzy's Signs. She works from her 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, Suzy obtains quotes for its manufacture from three suppliers. She then sends the design and the quotes to the customer including her invoice 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 Suzy Sign's.

An example income statement

The net profit or loss is the difference between the income received and all of the costs paid out. In this case Suzy has made a profit for the year of $7,215.

Calculating net profit

She may need this information to give to the tax authorities or she could use it to compare this year's performance to last year's, or even to her expectations at the beginning of the year.

As simple as this document is, there are some practical issues that it raises. For example: Suzy sends out an invoice in December, but it has not been paid by 31 December.

What does she 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 Suzy is using.

There are two types, known as 'cash accounting' and 'accrual accounting.'

Accrual and cash based accounting

The practical implications of each type for your organization are explained in the next sections using our example of Suzy's Signs.

Cash Accounting

This is an accounting method where receipts are recorded on the date they are received, and the expenses on the date that they are actually paid. As a small business, Suzy has the option of 'cash accounting,' which means that she only needs to record transactions at the point of payment. In other words when the money leaves or is paid into her bank account.

Cash accounting

So referring back to Suzy's query:
If her December invoice is not paid until the following January, then she does not need to enter it on the income statement for this period.

Similarly, if she received a bill in December (for example a phone bill) but she does not pay it until January, then that amount will not appear either.

Accounting rules stipulate that, with few exceptions, businesses should not use this method but should prepare their accounts on the 'accrual' basis. However, it is acceptable for very small companies to use the cash accounting method. In Suzy's case, cash accounting confers two advantages.

1. It reflects exactly what she has in her bank account.
2. It helps her cash flow.

Whilst the first point is obvious, the second point needs some explanation.
In November and December Suzy raised invoices for $2,500 worth of work, which she is awaiting payment for.

Under the cash accounting rules, she does not have to declare this income during the period and she will not have to pay any tax due on it until the end of the next accounting period (the period when the money will actually be paid into her account).

This is counterbalanced by the fact that she cannot include any expenses. For example, her December telephone bill cannot be included until she has actually paid it, irrespective of the date on the invoice.

Suzy's business has relatively low expenses and because her clients can be slow to pay, cash accounting is probably the best option for her to use. By using cash accounting, she will only be paying tax on money she has actually received. It is also straightforward: if she uses a tax adviser, she could simply give him her checkbook and bank statements and he could calculate her tax liability from those two things alone.

You may also be interested in:
Accounting Concepts and Conventions | Basic Accounting Concepts and Financial Statements | Cash Accounting | Accrual Accounting | Basic Accounting Terms | Revenue Recognition Principle | Matching Principle | Example Income Statement.

Key Points

  • Under cash accounting rules, transactions are recorded at the point of payment.
  • Very small businesses and traders can use cash accounting.
  • It reflects exactly what the business has in its bank account and can help with cash flow.
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