BA350

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Chapter Twelve
Small Business Accounting:
Projecting and Evaluating Performance
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Education.

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Why Accounting Is Important for Small Business Success
There are several reasons.
• You must provide specific accounting information in order for investors
to consider funding your concept.
• Bankers require formal financial statements for any type of loan.
• You cannot fully know your business without accounting information.
• Planning and controlling require accounting information.
There are three types of accounting you will need in your business.
• Financial accounting is formal, rule-based accounting principles.
• Managerial accounting is intended for planning, directing, and
controlling a business.
• Tax accounting is based on governmental requirements.

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Financial Accounting
Financial accounting is based on a set of rules called generally
accepted accounting principles (GAAP) and reports:
• How profitable the business is.
• The value of the firm’s assets and who has claim to that value.
• How much and from where money was received and how much and to
whom money was paid.
These three financial reports are called the:
• Income statement.
• Balance sheet.
• Statement of cash flows.
Each report contains information on things that
have already happened.
Financial
accounting does
not have a lot of
value for running
the day-to-day
activities of a
business.

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Managerial Accounting
Managerial accounting is forward-looking where financial accounting is
concerned only with the past.
• There are no formal rules with the only issue being what is valuable.
• One of the most valuable functions of managerial accounting is
planning for future business activities.
• This is done through standard budgeting or profit planning.
• This method of organizing and formatting business planning is called
pro forma financial statements.
• The result is a detailed plan for future operations and is the standard
against which actual results are compared to assess performance.

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Tax Accounting
Tax accounting follows the tax laws and regulations.
• The final product is a set of returns, forms, and schedules.
There are many different business taxes including:
• Federal income tax.
• State income tax.
• Employment taxes.
• Inventory tax.
• Excise taxes.
• Various use taxes including sales tax and, in some countries, value-
added tax.
The primary value of tax accounting is to avoid penalties for non-
compliance and to legally minimize tax payments.

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The Concepts That Make Accounting Work
The assumptions that underlie accounting are very basic.
1. A business is an entity that is separate from its owners – business
entity concept.
2. An operating business will continue in business – going concern
concept.
3. Accounting information is valuable only if it is useful for the owners
and managers of the business.
4. Creditors (lenders and suppliers) have claim on business assets that
must be satisfied before any claim of an owner.
5. The claims of creditors and owners cannot be greater in total than the
asset value of a business – called the accounting equation.

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The Accounting Equation
Assets = Liabilities + Owners’ equity
If a business is an entity existing apart from its owners, then the value of
the business is the sum of the values of everything the business owns.
• The name for what a business owns is asset.
• Owners do not own the assets, the business itself owns them.
• The owners have a claim on the assets of the business and this claim
is called owner’s equity.
Courtesy of Natalie Gamez Meyer
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The Balance Sheet
The balance sheet entry to
report the equity transaction
between the owner and Red Jett
Sweets would look like this.
Liabilities are legally
enforceable future obligations.
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Total assets ($73,000) is exactly
equal to the sum of the claims of
the creditors and the owners.

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Cost, Revenues, and Expenses
Red Jett purchases
raw materials for
$2,040 on account,
then bakes and sells
3,000 cupcakes at
$2.75 each on account.
No cash changes
hands.
Red Jett incurred an
expense, called cost
of goods sold of
$2,040 and realized a
revenue of $8,250.
The difference
between the revenue
and the expense is a
profit of $6,210,
reported on the
balance sheet as
retained earnings.
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Red Jett Sweets – February Balance Sheet
Red Jett collects the
invoice due and pays
the bill it owes.
Imagine a year’s
worth of such
transactions.
Rather than enter this
on the balance sheet,
create an account.
Permanent
accounts are those
other than revenue
and expense
accounts.
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Why Do Accounting?
To produce information useful for managing the business.
• The information must be accurate and relevant to be useful.
• Improve accuracy by using an accounting program.
• Relevance must be evaluated for each decision as it is made.
To meet legal or contractual requirements.
• You own a buffalo wings restaurant and wish to purchase a $25,000
high-capacity fryer.
• You may save $1,000 a month on your lowered electricity bill and
lowered insurance premiums.
• You also consider the increased number of people you could serve.
• Your accountant would depreciate the fryer using the MACRS rate,
allowing you to claim a depreciation expense each year.

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Accounting Systems for Small Business
There are many software solutions
but the chosen system should
perform the following tasks.
• User-friendly interface.
• A thorough help function.
• Produce an income statement
using appropriate categories.
• Produce a classified balance
sheet clearly showing position.
• Help develop a cash budget.
• Help develop operating, and
investment budgets.
• Produce statements in
approved formats.
• Produce multiple-year
comparisons.
• Provide custom reports.
• Export data in a form
acceptable to tax programs.
• Maintain an internal “audit trail.”
• Enforce security measures.
• Allow for growth of the
business.

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Setting Up an Accounting System
One essential element of an accounting system is cash accounting that is
accurate, easy to use, and tracks all checks and all deposits.
These accounting functions will become important as your firm grows.
• Accounts receivable if you provide credit to customers.
• Accounts payable tracks what you owe.
• Payroll records to ensure taxes are kept current.
• Fixed asset accounting calculates and accumulates depreciation.
• Inventory accounting maintains and aids inventory levels.
• Credit card sales tracks discounts and chargebacks.
• Insurance register keeps insurance coverage current and in force.
• Investment records if you invest surplus cash in securities.
• Leasehold records if your have leased property or equipment.
Setting up your system can be outsourced to consultants.

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Financial Reports
There are six common financial statements.
• Income statement – records debits/withdrawals, like your debit card.
• Statement of comprehensive income – if you have financial derivatives.
• Statement of retained earnings – incorporated into balance sheet.
• Statement of owner’s equity – incorporated into balance sheet.
• Balance sheet – what you own and its worth, and what you owe others.
• Cash flow statement – the exact amount of cash right now.
Your monthly bank statement parallels the retained earnings statement.
The important thing about these financial statements is that they
articulate information flows from the income statement through the
balance sheet to the cash flow statement.

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Income Statement
The income statement is the primary source of information about a
business’s profitability.
Revenues – Expenses = Net Income
• There are two formats – a single-step and a
multiple-step format.
Two difficulties in understanding the statement.
• First, what is reported as revenue.
• Second, when to recognize revenues.
Similar problems arise in the timing of gains,
losses, and expenses.
• Yet the income statement reliably reports how
well a business is producing profits.
The income
statement is used
to analyze the
effectiveness of
business
operations.
Operating income
is the most used
item on the
statement.

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Figure 12.4A and Figure 12.4B
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Balance Sheet
The balance sheet presents a “snapshot” of financial holdings and
liabilities on a specified date.
• Usefulness is determined by the detail it includes.
Balance sheet information is used to determine liquidity, financial
flexibility, and financial strength of the business.
• Liquidity measures the time before an asset can be converted to
cash, and the expected time before a liability must be paid.
• The most common ratio to estimate liquidity is the current ratio or
dividing the value of current assets by the value of current liabilities.
• Financial flexibility indicates a firm’s ability to manage cash flows.
• A firm’s financial strength is a matter of informed judgment.

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Figure 12.6: Typical Balance Sheet
Problems interpreting balance
sheet information.
• All values are historical so the
cost is less than current value.
• Every balance sheet contains
estimated amounts, which may
be wrong.
• Certain assets and liabilities
are omitted.
Despite there problems, the
balance sheet supplies essential
information for outside investors.
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Cash Flow Statement
Cash flow statements are either direct or indirect statements.
• A direct statement is developed solely from the cash records.
• The indirect statement of cash flows starts with net income and
adjusts accruals and deferrals to easily reconcile to other statements.
There are six items that must be reported in the statement of cash flows.
• Cash flows from operating activities.
• Cash flows from investing activities.
• Cash flows from financing activities.
• Net effect of foreign exchange rates.
• Net change in cash balance during the period.
• Noncash investing and financing activities.

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Red Jett Sweets – Statement of Cash Flows
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Uses of Financial Accounting
Reporting to outsiders.
• Absentee owners, creditors and lenders, unions, and taxing and
regulatory agencies have an interest in the conduct of your business.
Record keeping.
• Criteria: simplicity, accuracy, timeliness, understandability, security.
Taxation.
• Employers withhold: FICA, Medicare, FUTA and disperse W2s.
Control of receivables.
• The key is to have account receivables aged.
Analysis of business operations.
• Items that appear unrealistic should be carefully examined.

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Uses of Managerial Accounting
Managerial accounting is based on understanding how costs change as a
result of business changes.
• External (cost) factors are aspects outside the business that could
cause the business costs to change.
• Internal (cost) factors are those aspects or choices within the
business that could cause the business’s costs to change.
There are two managerial accounting procedures that depend on being
able to forecast future revenue and expenses.
• Cost-volume-profit analysis.
• The budget cycle process.

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Managerial Accounting: Cost-Volume-Profit Analysis
This analysis sorts costs into two categories: variable costs and fixed
costs, with the resulting total cost the sum of the two.
Breakeven (in units) = Fixed cost/(Price/unit – Variable cost/unit).
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Figure 12.9: Cost-Volume-Profit Graph for Red Jett Sweets
Extending breakeven, find the level of sales necessary for any profit.
Unit sales for specific $ = (Fixed cost + Desired profit)/Contribution margin.
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Preparing Pro Forma Financial Statements for Your Business
Plan
Achieving your strategic goals requires a quantitative plan of action, called
a budget – A standard against which performance is measured.
• Budgeting provides an organized and consistent platform for providing
necessary information for effective management.
The first step in budgeting depends on where you are in your business.
• An established firm starts with a sales forecast.
• If in the early stages of business planning, first forecast expenses, then
return to the sales forecast using various sales volumes.
You need a set of pro forma statements that are consistent, accurate, and
easy to modify as you business plan evolves.
• Develop a “master” budget from basic inputs then add detailed item
budgets and finally a pro forma budget plan.

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Figure 12.10: Budgeting Relationships
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The Sales Budget
The first step
in preparing a
master budget
is to prepare a
sales budget.
All the
numbers, both
in an initial
business plan
and in later
budgets, are
based on
estimates.
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The Purchases Budget
Once sales
are projected,
the next step
is to plan for
inventory
purchases.
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The Cost of Goods Sold Budget
The business plan states that all unsold cupcakes are donated at the end of the day.
The budget is simply the number of cupcakes to be made multiplied by variable cost per
cupcake.
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The Inventory Budget
An inventory budget combines a purchases budget with a cost of goods
sold budget.
• Done to simplify the budget process.
• But when a business does not maintain significant inventories, such as
Red Jett Sweets, the budget is not needed.
• Here, the only inventory is raw materials with negligible amounts.
Managers decided the value of calculating the cost of goods sold is less
than the added complexity and expense the process entails.
• Also, the business plan says all materials will be purchased and
consumed within the same period making this budget unnecessary.

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The Labor Budget
The labor budget shows both the amount and cost of labor needed to meet
output goals.
If you need to predict varying labor costs, first estimate labor required for
each unit of production, then multiply unit labor cost times the number of
units produced.
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The Selling, General, and Administrative Expense Budget
It is common to combine all costs of selling into a single SG&A budget.
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Budgeted Income Statement
The budgets
completed to this point
can be combined into
a pro forma budgeted
income statement.
During the year,
comparisons of actual
results are made to
the budgeted items. ‘
If the budget is met,
the projected profit is
realized.
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Completing a Comprehensive Budget and Controlling
The final schedules to be completed to produce a master budget are:
• A cash receipts budget.
• A cash disbursements budget.
• And a cash budget.
From these, a pro forma cash flow statement and a pro forma projected
balance sheet are prepared.
The difference between actual and budget is called a variance.
• Variance analysis is simple in concept but complex in execution.
• Variances occur either because prices are different than estimated, or
quantities are different than estimated.
• Variances can be constructed to show two things: the effect of
changes in prices and the effect of changes in the quantity used or
produced.

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Decision Making
The primary purpose of managerial accounting is to support good
decision making.
Accounting has two basic methodologies to
simplify decision-making on investments.
• The differential revenues and expenses
method estimates changes from results.
• There is also net present value (NPV)
analysis which only considers cash flows.
Outsourcing
requires a decision
be made whether
the business
should make a
component of its
own product or
purchase the
component from
another business.

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