Have you heard the saying, “those who can’t do, teach?” I can proudly say the vast majority of teachers in my life prove this idiom false. They are wonderful, caring people dedicated to sharing knowledge and enriching minds. However, my college financial accounting professor embodied this phrase and made learning that much harder.
One of the requirements to graduate with a degree in Entrepreneurship and Small Business Management was completing a financial accounting class. The course intended to teach the ins and outs of managing books, keeping records, depreciating assets… you know, all the things necessary to operate a business. Unfortunately, the professor had no desire to teach us any of these things.
Throughout the semester, I gathered a few facts about the teacher:
- He was a CFO in his previous career.
- Something happened in said career (the details were never fully revealed), resulting in his termination.
- He became a professor of financial accounting out of necessity for a paycheck.
- He hated everything about the series of events that led him to teach and resented that his students didn’t already know how to be successful financial accountants.
These facts combined to make learning incredibly difficult. Instead of teaching, the professor’s lectures involved diatribes about his former career and an occasional rant about former colleagues none of us knew nor cared about. When questions were asked, the student was made to feel stupid for not knowing the answer and raising a hand in the first place.
His tests were difficult and contained questions about topics not covered in any of the lectures. To ensure I passed the course and stayed on track for graduation, I had to teach myself financial accounting.
Armed with a textbook and a few friends, I studied and devised my own form of education. I passed the course and took my self-taught accounting knowledge into my career.
Considering I was earning a degree in entrepreneurship, maybe that was his plan the whole time? No, I’m giving him too much credit. He was one of the rare, horrible teachers.
Throughout my career, I’ve built and maintained immaculate spreadsheets. For fifteen years, my detailed spreadsheets accounted for a six-figure organizational budget. When I started full-time freelance work, I developed a complete set of financial accounting spreadsheets to track and report my business.
The Three Parts of Every Financial System
Note: I am not an accountant, and this article does not contain financial or tax advice. This article includes what I have learned about financial accounting to help you understand the details. Questions about your business’s financial or tax needs should be directed to a certified CPA.
Every business financial system requires three components: the journal, profit and loss statement, and the balance sheet. These three things satisfy most reporting requirements and provide a good snapshot of your business.
Think of the journal, in simplified terms, as the business’ transaction log. Every bit of revenue, expense, or refund is captured in the journal. The journal requires a date, a payee, and the inflow or outflow of money from the business.
In addition to the basic requirements, I like to take things up a notch in my journal. Since the journal is the backbone of my financial system, I want to capture as much detail as possible. As a result, I track a lot of information in the journal, including:
- Date: When the transaction occurred.
- Payee: The company or individual responsible for the transaction. For example, when Square or Stripe deposits into my business account, they are recorded in the journal as the payee. When I pay for my annual business license, the Orange County Tax Collector is the payee.
- Memo: Notes (if any) about the transaction.
- Category: The pace this transaction falls in my profit and loss statement (more on this in a minute).
- Outflow: When the transaction is an expense for the business, the amount is recorded as an outflow.
- Inflow: When the transaction is income for the business, the amount is recorded as an inflow.
- Balance: A running total of all transactions to monitor cash flow.
- Receipt: While all transactions should have matching receipts, it’s not always the case. Some receipts are lost, and inflows often do not have receipts or logs. This checkbox shows which transactions do have matching receipts in case they need to be referenced later.
- Clear: When a transaction clears through the bank, I check this box. Ideally, every transaction should be cleared within a few days.
The journal is an ongoing, ever-growing home for every transaction throughout the year. This spreadsheet fuels the other two.
Profit and Loss Statement
At the heart of every business is the profit and loss statement, or P&L. Put simply, the P&L tracks money in versus money out. Ultimately, a P&L is the tool to follow a business’ profitability.
Granted, there are several things beyond income and expenses that determine a business’ profitability. For example, my business is a Limited Liability Company filing taxes as a sub-chapter S corporation (S-Corp). As such, there are additional deductions and categories beyond straight revenue and expenses that affect my profitability. When developing a P&L, it’s important to understand your specific business needs and talk to a CPA.
Since my business is an S-Corp, it must file IRS Form 1120S annually. To make things simpler at reporting time, I modeled my P&L after IRS Form 1120S. Without generating a separate report, I have all the details necessary to report earnings and understand my business’s profitability in one place. It also makes my CPA very happy come tax time.
Each line from Form 1120S is represented in my P&L. This includes income, returns, cost of goods sold, advertising, wages, taxes, and more. Remember the categories I use in the journal? They match with appropriate lines on the P&L. This way, when something is recorded in the journal, it is automatically represented in the correct location on the P&L.
Additionally, I split the P&L into four quarters and the total for the year. This way, I don’t need to do any extra work to generate quarterly reports. Everything is in one location.
The final necessary report for every business is the balance sheet. Think of this document as the bottom line for the business. It captures all assets and compares them to liabilities to determine the overall balance of the business. The balance sheet includes:
- Assets: Any cash, physical asset, or outstanding receivable is an asset. Since my business is freelance writing, my only asset is typically the balance in my checking account.
- Liabilities: Have a credit card balance? Owe money to a vendor? These are liabilities that are tracked on the balance sheet. Equity: Equity comprises two things: how much the shareholders invested into the business and the business’s current profit (or loss). For example, I started my business checking account with a $100 investment. That is my owners’ equity. The current profit (or loss) is automatically generated from the P&L.
- Balance: The formula to track balance is simple:
assets — (liabilities + equity) = balance. Ideally, the resulting number should be zero. If it’s not, look for missing transactions or uncultured outstanding debt/receivables.
Regardless of how you run your business, proper financial accounting is an essential component. The journal, the profit and loss statement, and the balance sheet provide businesses of any size the tracking and reporting necessary to succeed. These documents fulfill reporting requirements and provide business owners with the information needed to make financial decisions and grow their businesses.