3 Accounting Concepts that Non-Accountants Should Know
I am a huge believer in learning about things outside my regular discipline to help grow myself as a person and professional. Over the years, I've realized the value of having skills outside what's expected of me because those skills represent the "extra mile" in many situations that has been a differentiating factor. Today, I'm going to share with you non-accountants some basic accounting knowledge that you can learn to help you better understand your personal finances and small business activity.
Basic Accounting Vocabulary
The number one thing that I see people misunderstand and misinterpret is basic accounting vocabulary. Accounting is the language of business. and like many languages, certain words have very rigid definitions. This is important because it is commonplace to miss label something as a liability when it's simply not, or to never use the terms and revenue or expense. To get started, remember these:
Assets - a resource that provides a future benefit. Examples - Cash, Receivables, Cars, Real Estate
Liabilities - something owed to another entity. Examples - Loans, Payables, Mortgages,
Equity - the amount of money that would be returned to (or owed by) the company’s owners in the event of liquidation
Revenues - Money brought in through regular operations, such as sales or the performance of services.
Expenses - Money spent to operate the business. This includes salaries, rent, and cost of goods sold.
Net income - Revenues - Expenses. This represents the actual benefit that the business generates after taking into account the costs.
Taxation
Taxes are the thing that everyone loves to complain about. While areas of tax code can be very complex and convoluted, most of the misconceptions I see are in these basic areas:
Marginal Taxation - in the US, federal income tax is calculated on a marginal bracket system. This means that if you're in the 28% tax bracket only a portion of your income is being taxed at 28%, not all of it. Read this blog here for more details about this.
Tax Withholdings - the federal and state income taxes withheld every paycheck are based on the W-4 form you fill out with your employer. If you owe money at the end of the year, it means you didn't withhold enough from your paycheck throughout the year. People love to evaluate their tax situation based off how big a refund they get, but in reality, most people will pay the same amount of income taxes no matter what gets withheld.
Employment Taxes - also known as FICA taxes, also known as social security and Medicare taxes, are withheld from every W-2 employee in the US. These are separate and distinct from income taxes and will lower most people's take-home pay by 7.65%.
Accrual Basis Accounting
This last one is for the entrepreneur-minded readers. I work with many businesses and it is very common for a company that started their business from the ground up to be very cash centered. There's nothing wrong with this in many business models rely on this type of thinking to stay functional. However, banks usually require accrual basis financial statements to get a loan, which can be the catalyst to really grow in your business. The key characteristic of accrual basis accounting is that revenues and expenses are recorded when they are incurred, not when they are paid (which is the case for cash basis accounting).
For example, let’s say your business performed services for a customer on December 30th, and collected the cash for those services on January 7th. In this case, the revenue should be recorded in December, not January. For smaller businesses, this distinction is not too critical because of inherently smaller operations. However, when the business has more going on (more payables, more receivables, increased reporting requirements) understanding the business on an accrual basis is critical.
As always, if you made it this far, thanks for reading! I challenge you to see you can take these accounting concepts and use them to help you better understand the world around you.