Why is this Topic Important to Financial Professionals? Accounting is like a road map of the company’s financial operations.  It is essential to understand the accounting basics and how they relate to small businesses and insurance. 

Accrual or Cash Accounting Methods

Now that the business has been incorporated and is operating, what is required to keep the business accounted for?  The first determination a company must make is determining if the business will account using an accrual or cash system.  An accrual accounting method recognizes revenues and expenses in the period in which they occur whereas a cash accounting method recognizes transactions as they occur.

For example, an accrual taxpayer that performs services will account for income earned when the service is actually provided and not when the actual cash or payment is received.  A cash method of accounting is concerned only when cash is paid out and when paid in.  Expenses follow the same logic.  For example, if a service company that uses the accrual method incurs 500 dollars of phone expenses in December 2010 and the payment is not due until January 2011, the company will still account for the phone expense on its books in 2010 for December’s usage.

Accounting System

Once the business has determined its accounting method, it is ready to keep track of the transactions.  Every accounting system should provide a basic financial statement, income statement, cash flow statement, balance sheet, and statement of owner equity.  Each statement provides a view through a different window into the financial operation of the business.

The income statement is easy to understand.  The top item is revenues and beneath that line expense are deducted to determine the net income.

The cash flow statement is essentially a variation of the income statement.  However the cash flow statement will show the ability of the business to operate on a periodic basis given the ins and outs of cash payments.

The balance sheet will tell the financial planner what the business is comprised of.  Most accountants refer to the balance sheet as a snapshot of the business at any particular moment of time.  From it we can see what assets the business holds and how much money it owes others.

Lastly, the statement of owner’s equity shows how the business is owned and financed.

Financial Statements and Insurance

Properly kept financial statement can help ensure easier access to capital as well as give a truer understanding of the business’ financial position.  The financial statements are commonly used in the risk management processes including when insurance is purchased on a key man.  Small businesses are especially sensitive to this risk and keeping accurate books can help insurance agents and underwriters determine among other factors the insurance needs of the operation.

Key man insurance and buy-sell agreements are generally based on some total dollar amount that represents the value of the business.  This figure is usually based on some number that is related to the financial statements and accounting of the business.  Whether it’s the total assets, a factor of revenue or income, or some other determination, the need for a basic knowledge of financial accounting for small business is essential.

For a detailed analysis on business valuation and how it relates to buy sell agreements see AUS Main Libraries, Section 11 F—Insurance Needs Revealed In Financial Statements.