Accounting simply follows the money flowing within, to, and from, a business. It is important to remember that the accounts reflect the finances of the business, not of the owner(s).
There are three basic financial statements which describe the activities and financial state of any business:
- The profit and loss account (P&L)
The profit and loss account (P&L) shows how a business performed over a specific period and reveals the total revenue and total expenditure related to that period.
- The balance sheet
The balance sheet summarises the state of a business at a specific date. Balance sheets are linked by a P&L, which covers the period between the two dates.
- The cashflow statement
The cashflow statement summarises cash receipts to, and payments from, the business. A cashflow forecast is a useful management accounting tool, providing an estimate of the business’ cash requirements for the next trading period.
It is often helpful to split up funds to show sources - from where money has come - and applications - to where money has gone. Until recently, British balance sheets showed finance or liabilities (sources) on the left and assets (applications) on the right. (The rest of Europe and the US reverse the columns.) Whilst balance sheets now tend to be set out in a single column, it can still be helpful to consider sources and applications separately.
In double entry book keeping every financial transaction requires two entries, normally with each entry in a different ledger and mirroring one another. In other words, the sources and applications need to balance.