Businesses often simplify accounting by presenting only a statement of revenue and expenses—the income statement. However, corporations should maintain complete financial records that include more than just revenue and expenses.
A corporation must have full accounting of its assets, liabilities, and capital. These are separate from the assets, liabilities, and capital of individual shareholders because the corporation is a distinct entity.
Corporate accounting requires a balance sheet. In fact, a corporation income tax return has sections for the balance sheet and a reconciliation of capital accounts. That’s far more than just the revenue and expenses. The balance sheet shows the condition of a corporation on a particular date as a consequence of all prior business activity. It tracks where income went such as to a bank account, to buy equipment, or for the reduction of debt.
Everything about the company is on the balance sheet. Only the details about revenue and expenses are missing since they are on the income statement. But the net effect of revenue and expenses from the income statement is on the balance sheet as an addition to capital. That income is “balanced” against where is went. Operating a small business requires familiarity with basic accounting statements in order to make effective management decisions.
Every business transaction affects accounts within five types—Assets, Liabilities, Capital, Revenue, and Expenses. Revenue minus Expenses is a component of Capital. Assets always equal Liabilities plus Capital. To maintain this balance, increases in some accounts are offset by either equal increases in different account types or decreases in other accounts of the same type.
Assets are either liquid current assets or fixed assets. Current assets are cash, bank accounts, inventory, accounts receivable, and other items that can be easily liquidated. Assets with significant costs and useful lives beyond one year must be capitalized, meaning their cost is depreciated over a number of years. Fixed assets are therefore recorded in a different category than other expenditures.
Operators of corporations should understand how sales and movements of cash through the organization affect these accounts. For example, sales increase either cash or accounts receivable. When payment on a customer account is collected, this decreases accounts receivable and increases cash. Purchases of fixed assets for cash cause a decrease in the cash asset and increase in fixed assets.
Liabilities are debts due within one year as current liabilities and long-term debt payable after one year. Current liabilities include accounts payable to vendors. A fixed asset purchase with loan proceeds increases both fixed assets and liabilities.
Depositing loan proceeds in a bank account increases both liabilities and the bank account asset. Loan repayment from the bank account decreases both liabilities and the bank account asset. Balance is always maintained for Assets equaling Liabilities plus Capital.
Capital type accounts are capital infusions provided by shareholders and accumulated retained earnings. Profit increases retained earnings. Since Profit is comprised of revenue minus expenses, revenue is an increase to capital and expenses are a decrease to capital.
Simple accounting only requires accounts for revenue and expenses. But corporations should track much more. A corporation has to know where its cash is utilized and how this affects shareholder value. Familiarity with both the income statement and the balance sheet helps lead to better corporate management.
A free tax consultation at the time of incorporating your business can help you to start the right way and save money from the very beginning.