Archive: Repeat After Me: Most Accounting. Isn't. Hard.

A framework for demystifying most accounting confusion

This is an archive copy of a post that originally ran on Substack in September 2023.

When you tell someone that you are/were an accountant, the response you’re most likely to get is, “Can you do my taxes?!” Others might include: “That’s sounds so boring!” “I’m bad at math!” or “Accounting is confusing!” And sure, not everyone is going to get excited looking at a trial balance, but the day-to-day accounting for the vast majority of businesses requires neither a deep understanding of math or has to be complex. Most of accounting can be simply understood by asking yourself a few key questions, but first, let’s establish some basics:

What does accounting actually do?

In order for any business to operate, let alone succeed, owners need to be able to track and ultimately evaluate all of their activities. Accounting lets us capture and organize all of a businesses transactions so that we can generate financial statements. How much money did we make last year? How much inventory do we have? Who do we owe money to? All of these questions get answered by accounting processes which are part of the shared language of business.

Charting a course

This should come as no surprise, but there is no accounting, without the accounts themselves, as well as how they are structured. A chart of accounts organizes all of the different business activities that you might want to capture and defines how each of them roll up into the financial statements.

There is no such thing as a perfect chart of accounts and it is never set in stone.

As a business grows, accounts might need to be added to capture new types of activity. While hypothetically a business could have just one account for all expenses, the lack of granular data would make later tracking and analysis of results difficult if not impossible. A business owner can’t manage what they can’t see in the numbers.

It’s all about timing

Accounting comes in two main flavors: cash or accrual-based. For cash based, all that matters is when cash changes hands. For smaller businesses with simple operating models, this is potentially all that they will ever need. Did you actually spend money on something in a given month? If yes, categorize it into the appropriate expense account and then you’re done!

Example: You’re a freelance designer working on an ad campaign near the end of this year. Even if you were doing the work in November/December, if you don’t actually receive the payment for your work until January, then for purposes of your business that revenue/income would only apply to the following year.

For larger businesses, adherence to Generally Accepted Accounting Principals (GAAP), as well as IRS rules, require you to be on the accrual basis. The method can best be understood as existing to handle timing issues. Very often businesses will pay for certain services in advance, or conversely, have extended payment terms before cash must actually be handed over.

Example: Every year your advertising firm pays its annual rent of $1.2M on January 1st. Rather than recognizing the full $1.2M of rent expense in January, accrual accounting dictates that the impact would be spread out according to how the benefit is realized. The lump sum rent payment would create a prepaid asset that would be reduced over time. In this case, the asset would go down by $100K each month (1/12th of the original total) as the expenses are recognized until it is reduced to zero.

Even with accrual based accounting it is important to remember that anything you spend as part of your business is going to be considered some kind of expense eventually. Depending on your industry, GAAP may provide specific guidance for how to treat different types of activity, but broadly speaking the intent of the accrual basis is to provide consistency across businesses so that they can be valued and compared more easily.

What to ask yourself and when you might actually need help

To re-iterate, accounting treatments for the day-to-day operations of a business, activities like running payroll, buying inventory, or paying vendors are very straightforward. Quantifying these basic activities is often all that many business owners will need to deal with. Returning to our originally stated goal: How can we make understanding accounting more simple? Step back and ask yourself the following:

1. What are we doing? Describe the event or transaction in the simplest terms possible. Does that activity align with an existing account on your chart of accounts? If yes, that’s probably where it should go. If no, then you might need to create a new account.
2. Is cash changing hands now or later? If later and you’re on the accrual basis, booking a payable/receivable is probably necessary as part of that transaction.

When you are just starting out, don’t overthink it. You don’t need to be perfect. In many cases, just because you ended up booking something to the wrong account doesn’t necessarily mean you committed a crime. Instead, it just means you’re probably making decisions off of bad information. Levels of comfort with that will vary by person but professionals exist to fill these gaps and address those uncertainties. Industry specific software can also be tremendously helpful in this regard. If you find that you can’t come up with even a basic idea of how to handle a transaction, then it might time to bring in help. CPAs can be engaged to assess your accounting processes and procedures and make sure they adhere to GAAP. They can also advise on the tax consequences of different business decisions and how they should be reflected in your accounting.

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