Accounting and bookkeeping concepts can be difficult to understand – especially without a background in accounting or finance!
There are, however, a few key concepts that all business owners and managers should be able to get their head around.
Whether you own or manage a small or medium sized business or a large multinational in the Philippines, it is crucial that you understand the basics of accounting and bookkeeping. Just like you would with any other element of your business!
Here at CloudCfo, we believe it is necessary to educate our clients on the accounting and bookkeeping function so they can get fully up to speed on important financial information.
So in that case, here are 7 key accounting concepts and why they matter for your business.
1. The Accounting Equation
If you understand the basic accounting equation, you are already on the right track to understanding your Books of Accounts and financial statements.
The basic accounting equation is:
ASSETS = LIABILITIES + EQUITY
What does it mean? Simply, the total value of the company’s ASSETS should be equal to the value of the company’s LIABILITIES plus shareholder ownership (EQUITY).
And what do these terms mean?
Assets – All tangible and intangible resources owned by a business. Examples are cash, inventories, receivables, furniture, equipment, plant and machinery.
Liabilities – All the financial obligations that a business owes. Examples include bank loans, liabilities to suppliers (accounts payable/creditors) or rent payable.
Equity – A portion of total assets which is owned by the owners. It represents the balance between total assets and total liabilities.
The accounting equation is relevant and important whether you are a small business operating in the Philippines or a large public corporation with a HQ in Singapore.
So when you look at your company’s overall financial status (see section on Balance Sheet below), you need to make sure that the company’s total Assets equal the total value of the Liabilities added to the Equity.
If this equation does not balance out, your accounting and bookkeeping processes might have real issues and must be examined! Our recent article highlighted some of the issues that can arise if you don’t properly manage your accounting processes!
2. Accrual Accounting vs. Cash Accounting
Accrual based accounting and Cash based accounting are two different methods a business can use for recognizing income and expenses.
Accrual Accounting – This is where income is recognized when committed/earned (i.e not received) and expenses are recorded when incurred (i.e. not paid).
Cash Accounting – Income is recognized when cash is received and expenses are recorded when cash is paid out.
Here are 2 examples:
A landlord rents out apartments as her primary business. Her tenant (client) pays rent in April to cover the month of May. In which month should the landlord recognize income?
If she is using accrual accounting, the landlord will record the income in May because it is when she earns the rent. If she is using the cash basis, she will record the income in April because it is when she received the payment.
You receive and pay a utilities bill in November which relates to electricity charges during October. When should you recognize the expense?
Under the accrual accounting method, you will record the expense in October because that is when you used the electricity. Under the cash accounting method, you will record the expense in the November books – the month you paid the bill.
It is crucial for a company to use just one method. If both methods are used simultaneously, it will be difficult to understand the true financial status of a company at a point in time.
So which type of accounting method to use?
Cash accounting seems simpler in practice as your financial transactions would simply follow movements in the company’s bank accounts. However, accrual accounting is essential if you truly want to understand your business’ financial performance during a given period.
Recognizing a liability when it arises in your books of accounts allows you to monitor how much you owe to various suppliers – this would not be available in the case of cash accounting.
Finally, it should be noted that under the Philippine Financial Reporting Standards, or PFRS, an entity is required to prepare its financial statements on an accrual basis except for information on cash flow.
3. Accounting Period
It is best practice for companies to divide the calendar year into financial periods. This enables managers and owners to monitor their finances at regular intervals during the year.
The periods that companies generally divide their financial year into are called Accounting Periods.
Standard accounting periods for companies are generally monthly, quarterly or annual.
It can also be a requirement from a compliance and regulatory perspective. For example, unless subject to an exemption, taxpayers and corporations are obliged to submit an annual Income Tax Return, or ITR, and an Annual Financial Statement, or AFS, on an annual basis. Our article on Audit Season in the Philippines explains how a company’s mandatory filing obligations depends on the period of a company’s financial year.
Usually, the title of company income statements (see section on Income Statements below) will include wording such as: “For the period of __”. This is the accounting period relevant to that report/statement.
For example, “For the month of May 2019” means that the income and expenses reported in the income statement have all been recorded in May 2019. No other period has been taken into account. If Sales is recorded as P100,000, then, that P100,000 was earned in the month of May 2019 only.
For Balance Sheets (see section below), for example, if you see “For the year ending May 31, 2019”, it means that the figures are cumulative over the entire financial year up to May 31, 2019.
4. Fixed and Variable Costs
When pricing your products or services, owners and managers should be aware that there will generally be two types of relevant costs: fixed and variable costs.
Fixed costs are the expenses that do not change with any increases in production or delivery. Take a plant factory for example. If the factory has a capacity to produce 100,000 units, then, even if you produce 100, 1,000 or 100,000 units, the cost of the factory depreciation remains the same.
Variable costs (also referred to as direct costs) are costs that change when production volumes change. Let’s say, for example, you run an ice-cream shop. The product recipe requires that for every unit of ice-cream you produce, you need 0.5kg of milk. So, if you produce 10 units of ice-cream, you will then need 5kg of milk. The milk in this case is a variable cost because it rises as production levels increase.
So why do you need to know about the difference between fixed and variable costs? Because it impacts your pricing models and profits! Check out a recent article on accounting processes in the F&B industry in which we explore the importance of food cost planning for restaurants.
Lets take an example.
Suppose, with the help of your accountant or bookkeeper, in order to forecast your sales and pricing, you calculate the following:
Maximum production capacity: 5,000 units
Variable cost per unit produced: P20
Fixed Cost: P100,000 per month
After studying your market and competition, you believe that you could sell 4,000 units by selling your product at P60 resulting in a 66.7% gross profit margin per product (i.e. margin over variable cost: (60 – 20) / 60 x100))
This would result in the following:
+ Total income: P60 x 4,000 = P240,000
– Variable cost: P20 x 4,000 = P80,000
= Gross profit: P160,000
– Fixed cost: P100,000
= Operating profit: P60,000
As an alternative you believe that by decreasing your price to P55 you could be operating at maximum capacity, selling 5,000 units.
This would result in the following:
+ Total income: P55 x 5,000 = P275,000
– Variable cost: P20 x 5,000 = P100,000
= Gross profit: P175,000
– Fixed cost: P100,000
= Operating profit: P75,000
In this case, reducing your price and increasing your production would improve your operating margin as your fixed cost is spread over larger quantities.
By understanding your variable and fixed costs, you can project profit margins, prepare budgets and develop financial plans with much more accuracy.
If you require assistance with your pricing models for any service or product that you sell or distribute, CloudCfo can help you to develop a pricing system that generates opportunity cost.
5. Income Statement
The income statement is a financial report detailing the income and expenses of a business over a defined period of time. It is also regularly called the Profit and Loss Statement or even the Statement of Recognized Income and Expenses under the International Financial Reporting Standards.
When you are preparing an income statement, it is standard practice to follow the format below:
Gross Sales or Gross Revenue
Less: Cost of Sales or Cost of Services
Equals: Gross Profit
Less: Other expenses
Equals: Net Profit
So what does each accounting term represent?
Gross Sales or Gross Revenue – This is the income earned for the period by a business, before considering any expenses
Cost of Sales or Cost of Services – This is the cost of producing an item being sold. For example, the cost of sales for a leather wallet will include the leather, the production labor and any other raw materials used to create the product.
Gross Profit – This is the income for the business after deducting the Cost of Sales from Gross Sales.
Other expenses – This includes all other expenses that are not directly related to producing the product. Examples are selling expenses, marketing expenses and administrative costs.
Net Profit – Net profit is the income of the business after deducting all associated costs of a sale(s) and taxes.
6. The Balance Sheet
A balance sheet is an accounting statement that shows the value of the assets owned by a company, the existing liabilities and the value of the shareholder’s ownership (see section on the Accounting Equation above for an explanation of these terms). Under the International Financial Reporting Standards, the Balance Sheet is called the Statement of Financial Position.
Ensuring that your company’s Balance Sheet includes all necessary information with the accurate figures and values can be difficult for individuals who don’t have an accounting or finance background. It is generally advisable to have an outsourced accounting firm or financial manager or an in-house accountant prepare the Balance Sheet to ensure it accurately portrays the financial status of the business.
Generally, balance sheets follow just one format, in the following order:
- Current Assets
- Non-current assets
- Current Liabilities
- Non-current Liabilities
What information does each section include?
Current Assets – These are the assets that are either cash or are expected to be converted to cash within one year. Examples are cash in bank, short-term receivables and inventories.
Non-Current Assets – Assets that are normally not intended to be sold, and at the same time will not be liquidated (turned into cash) within the year. Examples are furniture used in the office, machinery used to manufacture products and premises.
Current Liabilities – These are the liabilities that the business intends to pay within one year. Examples are liabilities to suppliers/creditors (who may have 30 or 60 day payment terms for example).
Non-Current Liabilities – These are the longer term financial obligations for a company. Examples are mortgage payables, which typically has payment terms of several years.
Equity – This is the portion of the balance sheet which shows the ownership stake of the owners of the business.
7. Bank Reconciliation
If you are managing your books of account on an accrual basis, the cash balance in your accounting books and the balance in your bank records will not always match. Why? Because, due to the nature of business, there will be items recorded in your books of accounts which have not been processed by your bank and vice versa.
The bank reconciliation process allows a company to identify gaps in recording and rectify any differences. Check out our previous article for more information on why the bank reconciliation process is so important for your business.
So what does the bank reconciliation process involve? There are usually two main activities required at the start:
1. Matching bank withdrawals with accounting book credits on the cash account; and
2. Matching bank deposits against accounting book debits on the cash account.
Once the activities at 1 and 2 have been matched, you might find that there are withdrawals or deposits that do not match credits or debits. These are unreconciled items and need to be investigated and matched. A completed and accurate Bank Reconciliation Report can then be generated.
Once you have identified the issue and rectified the recordings, the end result should be that the balances in your accounting books now match with your bank balance.
Startups and SMEs in the Philippines might find the following as common items that require reconciliation given the nature of the activities involved:
Deposits in Transit – These are bank deposits already recorded in the Books of Accounts but have not yet been reflected by the bank. In the bank reconciliation report, this would be added to the bank balance as it is already in the book balance and has already been processed.
Outstanding Checks – These are checks that have already been entered in the books but are not yet reflected in the bank account, most likely because they have not yet been cashed. As this entry is already likely to have been deducted within the accounting books, the value can be subtracted from bank balance in the bank reconciliation report.
Bank Charges – These transactions will usually appear in the bank account but will not be recorded in the accounting books. If you see unrecorded bank charges, deduct these from the book balance in the bank reconciliation report.
If you are performing the bank reconciliation process but you are experiencing real difficulty matching payments and withdrawals with no obvious solution, it may be necessary for you to go investigate your historic accounting processes. Catch Up Accounting is one potential solution!
Do you want to outsource accounting consultants in the Philippines?
CloudCfo is your go-to partner if you need real value added outsourced accounting services in the Philippines. Cloudcfo has a team of finance professionals and subject matter experts trained to use online accounting solutions and cloud accounting technology to generate real value-added financial reports for all types and sizes of businesses across the Philippines.
Cloudcfo provides accounting, tax, payroll, compliance and bookkeeping services. We also provide corporate services to companies looking to incorporate, expand or restructure in the Philippines.