From small mom-and-pop shops to multi-million dollar corporations, knowing who you’ve paid or who owes you is vital for a successful operation.

Here is an overview of how companies use accounting to keep track of their money.

Journal Entry

When a company has a transaction (i.e. buys a piece of equipment, sells inventory to a customer, etc.), they will record this transaction by creating a journal entry. The journal entry shows the date, the accounts that are involved with the transaction, as well as the amounts of money.

Below is an example of a journal entry. There are two accounts involved in this journal entry, Accounts Payable and Cash, and there are two amounts, $900 and $900. Notice that those amounts are the same—this should always be the case! Depending on the size of the company, there can be hundreds, thousands, and even millions of journal entries made each year!

General Ledger

Have you ever heard the phrase ‘on the books’? This is referring to a company’s general ledger, which used to be a large, hand-written book containing all of the financial accounts of an organization. The general ledger is basically like the diary of a company, showing a chronological listing of transactions.

Below is an example of what a general ledger used to look like. Thankfully, most of this is done on computers now!

Trial Balance

The trial balance contains a listing of a company’s financial accounts along with their balances. It’s a tool that helps check the clerical accuracy of transactions that have been recorded to date. As its name suggests, it’s a trial or a test to see if all of the entries add up, or balance, properly before creating the financial statements.

Financial Statements

Financial statements are prepared reports that represent the financial operations of a company. They can be used internally by managers to make strategic decisions; they can be used externally by stakeholders to make investment decisions. The most commonly known financial statements are the Balance Sheet, The Income Statement, and The Statement of Cash Flows.

The Balance Sheet shows a company’s assets, liabilities, and shareholders’ equity for a given point in time (usually year-end).

The Income Statement summarizes the revenues and expenses over a given period of time (usually one year).

And, The Statement of Cash Flows summarizes a company’s cash flows related to operating, financing, and investing activities.

It can be helpful to think about this accounting process like a funnel. As we move down, the information gets less detailed and more concentrated.

Each of these processes play an important part in accounting and help businesses to understand, track, and improve how they earn and spend money.

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Let’s talk sunk costs. In business speak, a sunk cost is a payment or investment that has already been made. It can't be recovered and therefore shouldn't be a factor in decisions moving forward because no matter what, it can't be recouped. Businesses and organizations often have difficulty abandoning strategies because of the time spent developing them, even if they aren't the right choice for the company.

Imagine a company that decides to build a new factory. They already did their analyses and determined that the future benefit they will receive from the factory will outweigh the cost of construction. They pay for the factory up front and expect to earn a certain level of cash flows from the factory’s production each year. But after a few years, the factory is underperforming and cash flows are less than expected. 

A decision has to be made: should the factory be shut down or not? At this point, the initial cost of the factory is a sunk cost and cannot be recovered. The decision should only be based on the future cash flows—or the future expected benefit—of the factory compared to the value of selling the factory today, not the original cost of the factory.

However, sunk costs aren't just useful for large companies deciding whether to enter new markets or close down factories. This principle can be applied in everyday life, and understanding it may impact how you make decisions. 

Feel free to leave the baseball game if it’s raining.

Some may call you a fair weather fan, but the cost became sunk the instant you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive, but if leaving makes you happier, do it! Either way, you aren't getting your money back.

Don’t go to the gym just because you have an annual membership.

Working out may be advantageous to your health, but your annual membership shouldn't dictate whether you go to the gym on any given day. If you paid up front, that’s money you won’t see again—if you’d rather take a hike, watch a movie, or spend an hour trolling Snapchat, you should. Your annual membership isn’t coming back into your checking account either way. (Although, this is not to say there are no other benefits to working out.)

There's no need to clean your plate.

How many times have you been at a restaurant and felt compelled to finish your meal? What about dessert? You ordered it, so you have to enjoy it and eat as much as you can. Before you give yourself a stomach ache and ruin a perfectly enjoyable meal, let’s think about this in terms of sunk costs: you've already committed to paying for the dinner and dessert in front of you no matter how much you eat. If you are full or don’t like the taste, stop eating. It’s that simple.

Sometimes there is an emotional component to sunk costs.

Maybe you went to law school, passed the bar, started working, and then realized you hate being a lawyer. What should you do? You invested so much time, energy, and money in that degree, so it can't be worth starting over again with a new career, right? Unfortunately, these are all sunk costs, so if your end goal is your own happiness, you might need to cut your losses and refocus your energies elsewhere. 

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Gone are the days when people paid cash for the goods and services they needed. More often than not, companies (and individuals) prepay, or pay later for goods and services. The form of accounting that allows companies to keep up with these more complicated transactions is called Accrual Accounting.

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Accrual Accounting: An accounting method that recognizes revenue in the period in which it is earned and realizable, not necessarily when the cash is received. Similarly, expenses are recognized in the period in which the related revenue is recognized rather than when the related cash is paid.

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Accrual Accounting is helpful because it shows underlying business transactions, not just those where cash is involved. Most transactions that a company has are straightforward, with payment happening at the time of the transaction. Other, more complicated transactions, involve buying and selling on credit, which requires a company to account for monies that they will have to pay at a future date or receive at a future date.

Even more complicated are transactions that require paying for goods or services in advance or receiving money from customers in advance. The timing of when revenues and expenses are recognized related to these more complicated transactions can have a major effect on the perceived financial performance of a company.

How does all of this work in the real world?

Deferred Revenue

When a company receives cash before a good has been delivered or a service has been provided, it creates an account called deferred (or unearned) revenue. This account is a liability because the company has an obligation to deliver the good or provide the service in the future.

Suppose you paid a gym $1,200 on January 1, 2016 for a year-long membership. Using the accrual accounting method, the gym would set up a deferred revenue account (a liability) for the $1,200 to show that they had received the cash but not yet provided the service. As each month of 2016 passes, the gym can reduce the deferred revenue account by $100 to show that they have provided one month of service. They can simultaneously record revenue of $100 each month to show that the revenue has officially been earned through providing the service.

Prepaid Expense

When a company pays cash for a good before it is received, or for a service before it has been provided, it creates an account called prepaid expense. This account is an asset account because it shows that the company is entitled to receive a good or a service in the future.

Suppose that a dental office buys a year-long magazine subscription on January 1, 2016 for $144, so patients have something to read while they wait for their appointments. At the time of the payment, the dental office will set up a prepaid expense account for $144 to show that they have not yet received the goods, but they have already paid the cash. As each month of 2016 passes, the dental office can reduce the prepaid expense account by $12 to show that they have ‘used up’ one month of their prepaid expense (asset). They can simultaneously record an expense of $12 each month to show that the expense has officially incurred through receiving the magazine.

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We all know that accounting is nothing but number crunching. Accountants simply add numbers and subtract numbers while drinking copious amounts of coffee. Just kidding. Go hug your accountant or your closest accounting student, because accounting is a challenging process of measuring, validating, and reporting financial information for an entity.

Most would say that accounting is the language of business, and without it, you can’t talk the talk. Just like any language, there are words that cause great confusion for those learning it for the first time. Here are a couple of accounting terms that disgruntle fresh-faced accounting students (as well as established accounting professionals):

Deferred Revenue

You see the word revenue and automatically think, ‘REVENUE, REVENUE, REVENUE! Money is immediately coming my way!’ Put on the breaks there, pal. What if I told you that Deferred Revenue is actually a liability, an obligation to pay? You saw the word revenue, but did you happen to see that word in front of it—DEFERRED? This means that you can’t claim any revenue just yet. Some people find it helpful to use the word ‘unearned’ as opposed to ‘deferred’ to make it clear that the revenue isn’t yet realizable.

Unearned/Deferred Revenue is a liability account that represents the obligation to provide goods or services to a customer in the future. Unearned/Deferred Revenue is recorded when a business receives a payment in advance from a customer, but the business has not yet delivered the good or provided the service. Once the business fulfills its obligation to provide goods or services, the liability is reduced and the revenue is recognized. Say it with me, ‘Unearned/Deferred Revenue is not a revenue account!’

Prepaid Expense

You see the word expense and automatically think, ‘EXPENSE, EXPENSE, EXPENSE! Wait, wait, is this similar to Deferred Revenue? Where the word ‘prepaid’ makes the word ‘expense’ behave differently?’ Yes, you got it! Prepaid Expense is in fact NOT an expense account, but rather an asset account.

A Prepaid Expense is an asset that represents the right to receive goods or services in the future. Some common examples are prepaid rent or prepaid insurance, where a company pays for rent or insurance in advance of the coming month or year. At the time of the payment, the transaction is recorded as an asset, and as time passes, the asset is reduced and the expense is recognized. Say it with me, ‘Prepaid Expense is not an expense account!’

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Want to learn the language of business and develop an essential understanding of financial accounting, business analytics, and economics for managers? You may be interested in HBX CORe, an interactive online program from Harvard Business School! 

 

When you tell your friends that you’ve signed up for an accounting class, you’ll likely get a reaction that sounds something like this: "Ugh, why?" Or, perhaps they will be slightly more sympathetic and say, "Oh, sorry to hear that."

Accounting gets a bad rap, but it's an incredibly useful subject to learn. Plus, it's not as complicated as you might think! Hear me out - here are four reasons why everyone can benefit from understanding basic accounting.

1) So you don’t get ripped off!

Buying a car is a big investment. It can be overwhelming to try to negotiate a better price, so why not walk in with confidence, knowing you understand how a business like a car dealership is run and the ways you can get a better deal? If you’ve had an introduction to accounting, you’ll know that the car you’re about to buy is on the car dealer’s balance sheet as inventory. You’ll also know that in order to keep the car dealership operating, they must make a profit on the car (you can still talk ’em down; they don’t need that much profit).

Once you drive away, the car is taken out of the dealer’s inventory and payment received (cash or loan), as well as profit are recorded. You also know that most dealerships work on a monthly sales cycle and have quotas for the amount of inventory they need to turn over in the given time period. With this understanding, you can walk in at the end of the month, explain what you’re looking for, provide comps on similar cars at other dealerships, and walk out with a better price on your dream car (and probably the respect of the salesperson).  

2) So you aren't intimidated by your own finances.

Be honest, can you explain where all of your money goes after your paycheck gets deposited? Even if you’ve managed to find a job that pays the bills (collective sigh of relief from all of the parents out there), it can seem impossible to set aside money for savings each month. With some accounting knowledge under your belt, you will gain a much deeper understanding of what goes on with your own finances and learn important skills like how to effectively track expenses and work within a budget. 

Many people use the excuse that they are "no good at math" to explain their reluctance to study accounting, but the math actually involved is quite basic. If you can add and subtract, multiply and divide, you are set! With your new savings savvy, maybe you can save up enough to send your parents on a cruise as a thank you for the many years they supplemented your meager earnings!

3) So you can make better sense of current events.

There is no shortage of scandal in the accounting world. You’d be hard-pressed to turn on the news and not hear about a recent manipulation of numbers that has caused thousands of people to lose their shirts. Just like any industry, there will always be people who play by the rules and people who don’t. Why trust the media to fully explain what happened in an unbiased way? With a basic understanding of accounting, you can understand what these companies have done wrong and why it matters. You can even explain it to your friends and sound really smart at cocktail parties!

4) So you can impress your boss.

Picture this: You’re in a staff meeting and the CFO wants to discuss the past quarter’s financials. If you’ve had an introduction to accounting, you’ll not only be able to understand what the CFO is talking about, but you’ll also be able to chime in with your own financial wisdom and impress not only the CFO, but also your supervisor and all of your coworkers who are nodding their heads blindly and hoping no one calls on them.

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Want to learn the language of business and develop an essential understanding of financial accounting, business analytics, and economics for managers? You may be interested in HBX CORe, an interactive online program from Harvard Business School! 

 

Haven’t we learned by now? You simply should not lie about any numbers that appear on your financial statements. Even if you somehow manage to get away with it in the short run, the truth will eventually come out. And when it does, the implications will be far, far worse than whatever deficiency you were initially trying to cover.

Take for instance Toshiba, the 140-year-old Japanese tech giant, that recently came under fire for overstating revenues by approximately $1.2 billion over the course of five years. Since the news broke, stock prices have dropped by more than 30%, and eight of the company’s senior executives, including CEO Hisao Tanaka, have resigned.

So why didn’t Toshiba learn from other companies like Enron, Tyco, or Adelphia that have gone through similar scandals in the past? Why did they feel such pressure to overstate profits?

Toshiba CEO resigns over $1.2 billion accounting scandal: http://t.co/MEeKD1aXSo via @sophia_yan pic.twitter.com/Y7h9qTR5kB

— CNNMoney (@CNNMoney) July 21, 2015

As any basic accounting class will tell you, one of the most common ways to evaluate a company is by its profitability: stakeholders use profit margin to evaluate a company’s ability to turn sales into net income, which is important for a variety of reasons. Potential stock owners want to make sure the profit margin is high in order to receive the greatest possible dividends, while lending institutions evaluate profit margin to determine their chance of being paid back on a loan.

This logic is pretty straightforward, but what else could be making senior executives want to overstate profits? There are a plethora of reasons, but it’s important to note that more often than not, executive compensation is tied to profits.

Apart from the sheer size of the cover-up, perhaps most newsworthy aspect of the Toshiba scandal is the attention being given to overall corporate governance practices (or lack thereof) in Japan. Internal controls, external auditing, and non-biased boards are not commonly found, but it seemed like Japan was making a move in the right direction when Prime Minister Shinzo Abe established a rudimentary corporate governance code a couple of months ago. Now many are wondering if this move was a "too little, too late" situation. It will be interesting to see how the governance landscape in Japan changes as the Toshiba scandal turns more and more company stakeholders into financial detectives.

Toshiba scandal sheds harsh light on Japan's corporate governance http://t.co/RreAMF72Jv

— Guardian Australia (@GuardianAus) July 21, 2015

A word of caution—enhanced corporate governance has its advantages and disadvantages, and just as Toshiba should have learned from the actions of executives in the American scandals of 2001, it should also study the effects. The introduction of Sarbanes-Oxley in 2002 greatly improved governance in America, but misstatements still occur. It seems that people will always find a loophole. Additionally, some would argue that the costs of compliance have changed the landscape of business, with more companies choosing not to ‘go public’ or changing from public to private in order to avoid the expenditures.

Will Toshiba be able to recover? How will Corporate Governance evolve in Japan?