Day 1: Introduction to bookkeeping and accounting
Key terms and concepts
• Small business: defined by the Australian Taxation Office (ATO) as a business with an annual turnover of less than $2 million. They are often referred to as micro businesses.
• General ledger account: holds the details of business transactions of the same type.
• Debit: an entry in a general ledger account that represents the economic inflows from a business transaction.
• Credit: an entry in a general ledger account that represents the economic outflows from a business transaction.
• Chart of accounts: a numerical index used within general ledger accounts.
• In all business transactions the economic inflows (debit entries) must equal the economic outflows (credit entries).
So that we’re all on the same page let’s examine the classification structure of business in Australia. The Tax Office defines small businesses with a turnover of under $2 million per year as small business entities and will often refer to them as micro businesses. There are certain taxation concessions available to micro businesses that will be discussed later in this book. Micro businesses usually account for their business transactions under Tax Office rules and on a cash basis.
Classified next are small to medium enterprises (SMEs), also defined by the Tax Office as small businesses, with a turnover in excess of $2 million, and finally large corporate entities, which have a turnover of more than $20 million per year and are often listed on the stock exchange. These enterprises account for their business transactions on an accrual basis under Australian accounting standards, but they still use the same bookkeeping methods as micro businesses.
This book is written for a small family business, probably run from home, with a turnover, that is, your annual ‘business’ sales, of less than $2 million. The main taxation concession available to you is that you can calculate your net income for income tax purposes on a cash basis. If you elect to do this, you can also calculate your goods and services tax (GST) liability on a cash basis. This book assumes that you have elected to use cash accounting for both your income tax and the GST.
It also assumes that your annual turnover exceeds $75 000. If it is less than this amount, you do not have to register for the GST. You can use this book to determine how to keep your records, but ignore the GST information as it will not apply to you.
This book also caters for the SME, the small to medium enterprise, with a turnover in excess of $2 million but less than $20 million per year. As this type of business accounts for its GST and income tax on an accrual basis, the cash accounting sections within this book can be ignored by this business group.
Why keep accounting records?
Accounting is the process of identifying, measuring and com-municating economic information to permit informed judgements and decisions by users of the information. In the case of small business, the users are the owners themselves, using the information to determine the profit made. They also use the information to report their GST liability to their accountant via their quarterly Business Activity Statement (BAS) and calculate their income tax due on an annual basis.
The accounting system identifies and records business tran-sactions through a mechanism known as journals that summarises the information that is then recorded into a set of accounts, based on a system of accounting known as double-entry bookkeeping.
Accounting information, once recorded in the set of accounts, is then communicated using financial statements prepared from those accounts. The recording of the accounting information is called bookkeeping, while the interpretation and reporting of that information is called accounting. The boundary between bookkeeping and accounting is usually considered to be the trial balance, which is a summary of all information entered into the system over a given period. It is from the trial balance that the financial statements are derived.
The main financial accounting statements
The purpose of financial accounting statements is mainly to show the financial position of a business at a particular point in time and to show how that business has performed over a specific period.
The three main financial accounting statements that help achieve this aim are:
• a balance sheet for the business at the end of the reporting period
• the income statement for the reporting period
• a cash flow statement for the reporting period.
A balance sheet shows at a particular point in time what resources are owned by a business (‘assets’) and what it owes to other parties (‘liabilities’). It also shows how much has been invested in the business and what the sources of that investment finance were. It is often helpful to think of a balance sheet as a ‘snapshot’ of the business — a picture of the financial position of the business at a specific point.
By contrast, the income statement (or profit and loss statement as it is also known) provides a perspective for a longer time period. It is the story of what financial transactions took place in a particular period — and (most importantly) what the overall result of those transactions was. Not surprisingly, the profit and loss statement measures ‘profit’. Profit is the amount by which sales revenue (also known as ‘turnover’ or ‘income’) exceeds ‘expenses’ (or ‘costs’) for the period being measured.
The third report, the cash flow statement, reveals details of the source of the business cash inflows and where it expended its cash outflows. Its primary purpose is to provide the reader with details of the liquidity of the business. Further discussion of this statement is beyond the scope of this book.