Budgeting Fundamentals – Understanding Accounting Basics (before assigning #s)

Part 1 of a 5 Part Series on Budgeting Fundamentals and Finance for the Non-Financial Manager

Before putting #’s to paper, it’s important to understand a few basic accounting principles as they set the stage for how to prepare your budget. I’m sure most are familiar with the mother of all Accounting Equations:

Assets = Liabilities + Equity

Assets are what the company owns. Liabilities are what the company owes. Equity is the difference between assets and liabilities. Simply put, equity is what the company has left over after the bills have been paid.

An organization has two additional types of accounts: revenue and expenses. Revenues are 1) $ the organization earns for selling its products and services AND 2) revenues from investments or the sale of assets. Expenses are the costs the organization incurs to run the business. The difference between revenues and expenses – its profit or loss – goes into the equity of the business.

If you’ve worked with budgets, you’ve probably heard of GAAP or Generally Accepted Accounting Principles. GAAP is not a legal requirement, instead it allows for a wide variety of organizations to report their finances in the same way. If an organization’s financial statements are audited by an outside accounting firm, the auditors are required to disclose all deviations from GAAP. Such deviations can jeopardize a firm’s financial credibility. As a result, most organizations choose to comply with GAAP.

To conform to GAAP, a business must use accrual-based accounting (vs. cash-based). Accrual-based accounting means that revenues are recognized when they are earned (or invoiced) instead of when the payment is received. Meanwhile, expenses are “matched” with the time period when the services are used up NOT when you pay the invoice (the expense should be accrued in the month you received the service). This Matching Principle applies regardless of when cash changes hands!

Accrual accounting allows organizations to determine their profits more accurately, because it factors in that expenses are often paid in a different time period from when revenues are collected. As accrual accounting does not measure the cash flow of a business, the Statement of Cash Flow (which does) is as important as accounting profit detailed in the Income Statement.

Understanding basic budgeting concepts such as revenue, expenses, GAAP and accruals will help you put numbers to paper next week when we look at how to budget effectively.

Click here to read Part 2.