“Accounting is the language of business and there’s nothing like getting it early and getting it into your system.”
-Warren Buffett[1]
Content created by Darin Gerdes. Copyright Great Business Networking.
As a graduate student, I attended a conference at the University of Virginia where Nobel Prize winning Economist James Buchanan spoke. Buchanan wrote The Calculus of Consent. He won the Nobel Prize for “contributions to the theory of political decision-making and public economics”[2] in a field called public-choice economics.
After his lecture, Buchanan took time to answer questions. I was amazed by how humble he was. When he didn’t know an answer, he shrugged his shoulders and said, “I don’t know. That’s a good question.” That was the response from a genius who had won the Nobel Prize in economics.
If memory serves correctly, he said something to the effect that if you understand economics, you can explain it using math, but if you really understand economics, you can explain it in English.
I’m going to take Buchanan’s approach and try to explain accounting in English. Before I do, however, I want to tell you about Andrea.
Andrea’s Story
Andrea completed her MBA four years ago. Since then, she’s been very focused on eliminating all debt and improving her net worth. Andrea is in sales, a job that she loves because every day is a challenge and she can easily keep score. She works for straight commission and the numbers don’t lie. Straight commission is a double-edged sword. She bears all of the costs for making the sale, but there is a tremendous upside if she is successful. If she sells, she makes an oversized commission; if she does not sell, she does not eat.
This was an especially good month for Andrea. She earned a record $11,500 this month in sales commissions. Technically, it’s not quite that high because she spent nearly $1000 traveling to see potential customers to wine and dine them, and that money comes out of her own pocket. It was worth it though because she acquired three new large accounts, and these accounts will continue to provide her a stream of income well into the future.
She’s driving a new car because she was an in accident last month. Her Toyota was totaled, so the insurance company will be writing a check for nearly the full value of her car. She used this as an opportunity to upgrade. After all, she felt that she needed to make a good impression on her clients.
As she drives home from work, she mentally deducted her other costs. She realized that she is probably down another $500 in general administrative and marketing expenses. So she is only clearing $10,000 before taxes. After the government takes its 35%, she will take home $6,500. She sighs to herself as she pulls into her driveway.
She picked up her mail as she entered her house. There were only three items– her mortgage statement, her bank statement, and an advertisement for pizza. She plopped down on the couch, turned the TV on, and examined her bank statement.
She heard he self exclaim “What?” when she realized that she had twice been charged $20 fees for exceeding the limits of her debit card. She did a double take. How could that happen? After all, she was making plenty of money. But then she realized that while she had put down a large down payment on her new car, the insurance company had not yet paid her after the wreck. It wasn’t as bad as she thought, but she made a mental note to pay closer attention to her checkbook.
Next, she opened her mortgage statement.[3] She purchased her house four years ago for $215,000. She took out a fifteen-year loan and she has made additional payments of $500 almost every month. Her goal was to pay it off in ten years, but it seems like that target keeps getting pushed back. In four years, she has paid just over $100,000. Of that, she has paid $33,241 in interest and paid off $71,851 of the principle, but the $143,149 balance that she still has to pay seems daunting. At this rate, however, she will only be paying her mortgage for seven more years.[4]
She recently refinanced in order to get a better rate, and she was pleasantly surprised to see that her home was now worth $250,000. That was some good news. It means that she has a net worth of over $100,000.
She picked up the phone to order a pizza but then she remembering that she has a negative balance. She will be paid in a few days, but until that time she decided that she will try not to spend any money.
Accounting in Plain English
If you followed Andrea’s story, you understand basic principles of accounting and you should have no trouble with the three major instruments—the Income Statement, the Cash Flow Statement, and the Balance Sheet. I will explain how each of the statements work.
The Income Statement
In business, the Income Statement is also called a P & L or Profit and Loss statement. It tells you whether you are generating a profit. In Accounting for the Numberphobic, Dawn Fotopulos explained that the Income Statement will
reveal whether your business is generating a profit, breaking even, or losing money. If the number on the bottom line is positive, you’re making money. If it’s zero, you’re breaking even. If it’s negative, you’re losing money. The bottom line is what’s left after every direct and indirect expenses paid from net revenue.[5]
In Financial Intelligence, Bergman, Knight, and Case explain, “An income statement, like a report card in school, is always for a span of time: A month, quarter, or year, or maybe year-to-date.[6] Andrea was looking at her income over the past month.
The authors added, “There are three basic types of profit: gross profit, operating profit and net profit. Each one is determined by subtracting certain categories of expenses from revenue.”[7] In our story, Andrea did this systematically in her head. First she calculated her gross profit by subtracting her direct costs. While Andrea earned a fat paycheck $11,500, she spent $1000 courting prospective customers. This was a variable expense because she does not pay this expense unless she is actively selling customers. Cost of Services (COS) comes out of the top line. When she has removed that expense from her calculations, she has her gross profit.
She then subtracted her administrative costs (the fix costs that she has to pay whether she is selling clients or not). When she deducts that expense from her gross profit, she has earnings before interest and taxes, or EBIT. This is her operating profit.
Andrea doesn’t have any interest expense, but when she subtracts her taxes, she gets to keep what’s left. In her case, she’s left with $6,500. That is a lot less than the $11,500 that she started with, but Andrea is profitable. This is called her net profit, or her bottom line. On paper, Andrea’s personal income statement would look something like this:
INCOME STATEMENT
Revenue $11,500
Cost of Services (COS) $1,000
Gross Profit $10,500
Selling, General, and Administrative expenses $500
EBIT – Operating Profit $10,000
Taxes $3,500
Net Profit $6,500
The Cash Flow Statement
Andrea is profitable, but right now she is out of money. How did that happen? Andrea didn’t watch the cash that flowed in and out of her bank account. She is making good money at work, and she’s expecting a big check from her insurance company, but she spent more than she had because she was not managing her cash carefully.
A cash flow statement is like the gas gauge in your car.[8] You must have enough money in your account to power your engine or the engine stops. As Emily Chan wrote in Harvard Business School Confidential, “Profit is an abstract entity. Profit is not tangible. You cannot touch or count profit. You cannot pay your bills with profit. Only cash is real. Your suppliers will gladly accept your cash—but not your profit.”[9] You know how cash flow works because you are familiar with your own bank statement. The same is true in business—it is just on a larger, more complicated scale.
The Balance Sheet
When Andrea opened her mortgage statement, she saw a balance sheet for her home. “What is the balance sheet? It’s no more, and no less, than a statement of what a business owns and what it owes at a particular point of time”[10] In Andrea’s case, this balance sheet was limited to her property, but the principle is the same.
A balance sheet will show assets on the left side and the liabilities and owners equity on the right. Remember this formula: Assets = Liabilities + Equity.
Andrea’s asset is her home. She purchased it for $215,000 and she has paid just over $100,000. Of that, $33,241 went to interest, but the home also appraised for $35,000 more than her purchase price, so her balance sheet should look something like this.
BALANCE SHEET (MORTAGE STATEMENT)
Assets Liabilities
Home: $250,000 Remaining mortgage: $143,149
Owner’s Equity
$71,851 principle + New Appraised value $35,000
=$106,851
Conclusion
If you could follow the basics of Andrea’s story, congratulations. You understand how accounting works. From this point, you just need to add more detail.
Andrea’s story discussed her income, her bank account, and her mortgage separately. In business, these three statements will interact and a change in one will create a change in the others.
When it comes to accounting, you need to understand what is going on. You don’t have to do all of the accounting yourself, but you do need to understand what is going on in your business. If you need to learn more about the subject, read one of the following books about accounting and finance:
- Accounting for the Numberphobic by Dawn Fotopulos
- Accounting made simple: Accounting explained in 100 Pages or Less by Mike Piper.
- Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean by Karen Berman, Joe Knight, & John Case
- Financial Literacy for Managers: Finance and Accounting for Better Decision-Making by Richard Lambert
- Financial Management: A Primer by Stephen R. Foerster
All of these books are accessible reads. These authors do their best to simplify the subject so that the rest of us can understand the subject.
Before I leave the subject let me add one more thing. Professional help may seem expensive, but not acquiring professional help will be far more expensive when you deal with the IRS or the bankruptcy court. Don’t be penny-wise and pound-foolish. Learn the rudiments and then hire an accountant to deal with your operations.
Actionable items:
Do you understand Andrea’s story? If not, what part do you struggle with—the Income Statement? Cash flow? The Balance Sheet?
What will you do to learn what you need to learn about accounting? Read books? Take a class? Work with an accountant?
Do you need to find professional help? Where will you look?
End Notes
[1] Crippen, A. (2014, July 31). Warren Buffett surprises teen cancer patient on CNBC. CNBC.com Retrieved from http://www.cnbc.com/2014/07/31/warren-buffett-surprises-teen-cancer-patient-on-cnbc.html
[2] James M. Buchanan Jr. (n.d.). Nobelprize.org. Retrieved from http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1986/buchanan-facts.html
[3] Note: Fotopulos used a similar example in Accounting for the Numberphobic. While I conceived of my example independently, I thought it prudent to mention this example of a mortgage statement as a balance sheet.
[4] Note: For the Mortgage scenario I used bankrate.com. You can follow the math by plugging in the same variables: http://www.bankrate.com/partners/sem/mortgage-calculator-rates.aspx?loanAmount=215000&years=15.000&terms=180&interestRate=4.50&loanStartDate=04+Aug+2016&show=true&showRt=false&prods=215&monthlyAdditionalAmount=500&yearlyAdditionalAmount=0&yearlyPaymentMonth=+Aug+&oneTimeAdditionalPayment=0&oneTimeAdditionalPaymentInMY=+Sep+2016&ic_id=mtg_calc_amortization_btn
[5] Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 5).
[6] Berman, K., Knight, J., & Case, J. (2006). Financial intelligence: A manager’s guide to knowing what the numbers really mean. Boston: Harvard Business School Press. (p. 40).
[7] Berman, K., Knight, J., & Case, J. (2006). Financial intelligence: A manager’s guide to knowing what the numbers really mean. Boston: Harvard Business School Press. (p. 65).
[8] Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 93).
[9] Chan, E. (2009). Harvard Business School confidential: Secrets of success. Singapore: John Wiley & Sons (p. 151).
[10] Berman, K., Knight, J., & Case, J. (2006). Financial intelligence: A manager’s guide to knowing what the numbers really mean. Boston: Harvard Business School Press. (p. 76).