Accounting for first Time Founders: The Principles of Accounting
Why Accounting is Important for Founders
In the times of AI, accounting might seem like a tedious obligation, often associated with taxes and financial regulations. But understanding the principles of accounting is crucial for founders. Accounting is far more valuable than just a means to fulfill tax requirements; it’s a comprehensive tool for tracking and analyzing a business's financial health and being able to do so properly will allow you to run a much better business.
Thinking through the accounting structure of your business allows you to analyze it's strengths and weaknesses in a clear-eyed way.
The Value of Accounting
Accounting enables businesses to determine critical metrics, including:
- Assets and Receivables: What the business owns and expects to receive.
- Liabilities: What the business owes to vendors and customers.
- Shareholder Equity: What is owed to the shareholders.
- Income and Expenses: What the business has earned and spent.
By accurately recording and analyzing these metrics, accounting reveals where value is stored and how it flows through a business, providing insights that inspire confidence and enable informed decision-making.
What is Accounting?
At its core, accounting is a method of tracking the movement of value through a system of accounts. The fundamental rule of accounting, known as the accounting equation, states that:
Assets = Liabilities + Equity
This means that what the business owns and is owed must always equal what it owes to others. This principle maintains a strict separation of concerns, ensuring that every transaction is accurately reflected in the financial records.
Double Entry Accounting: Debits and Credits
In double-entry accounting, every transaction affects at least two accounts, maintaining the balance of the accounting equation. The terms debit and credit can be confusing due to their use in everyday financial products. However, in accounting:
- Debit (Dr): Represents an increase in asset accounts or a decrease in liability and equity accounts.
- Credit (Cr): Represents a decrease in asset accounts or an increase in liability and equity accounts.
Each transaction must balance, meaning the sum of debits must equal the sum of credits.
Understanding Accounts
Accounts are categorized into two basic types: those with a debit normal balance and those with a credit normal balance. Adding a debit to a debit normal account increases its value, while adding a credit decreases it, and vice versa for credit normal accounts. These accounts can represent various aspects of the business, from bank accounts to inventory and expenses.
The Concept of Balance
Balance in accounting refers to ensuring that the sum of debits and credits for each transaction and account is equal. Accountants strive for balanced books, similar to how developers aim for consistent data. An account balance is derived from the sum of all debits and credits to that point in time, with the net balance being the difference between the two sums.
Journal Entries
Journal entries are the means by which transactions are recorded in the accounts. Each entry must include a debit and a credit to maintain the balance. For instance, if you borrow $5 from a friend, the journal entry would debit cash (increasing it) and credit a liability account (indicating the amount owed).
Reports and the Chart of Accounts
Accounting reports, such as the balance sheet, income statement, and statement of cash flows, provide detailed insights into the financial state of a business. These reports aggregate individual account balances and are structured hierarchically. The chart of accounts organizes these accounts and aids in tracking financial performance.
The Balance Sheet
The balance sheet is a comprehensive report that shows the financial position of the company at a specific moment in time. It visualizes the accounting equation:
Assets = Liabilities + Equity
This structure ensures that every asset is balanced by a corresponding liability or equity, maintaining the overall financial integrity.
Income Statement and Profit/Loss
The income statement, also known as the profit and loss statement, tracks income and expenses over a period. It determines whether a business operates at a profit (more credit than debit) or a loss (more debit than credit). Understanding this report is essential for assessing the financial performance of a business.
Cash vs. Accrual Basis and The Matching Principle
There are two primary accounting methods: cash basis and accrual basis. Cash basis records transactions when cash changes hands, while accrual basis records income and expenses when they are earned or incurred, regardless of cash movement. The matching principle in accrual accounting ensures that revenues and expenses are recorded in the same period, providing a more accurate financial picture.
The Accounting Cycle
The accounting cycle involves recording transactions, preparing financial statements, and closing the books at the end of a period. This process ensures that financial records are accurate and up-to-date, allowing for meaningful historical comparisons and informed decision-making.
Accounting Standards
There are three major accounting standards:
- IFRS: Followed by most countries except the US and Japan.
- US GAAP: Used in the United States.
- Japanese GAAP: Used in Japan.
While these standards have some differences, they aim to provide a consistent framework for financial reporting.
Conclusion
For founders, understanding accounting principles is not just about fulfilling financial obligations but about leveraging a powerful tool for business management. Accurate accounting records provide valuable insights into a business's financial health, enabling better decision-making and fostering trust with stakeholders. Embracing these principles can transform the way founders build and manage financial systems, ultimately contributing to the success of their projects and businesses.
Next we have written about how you should actually set up and manage your startups accounting.