Most accounting is little more than applied common sense. However there are two golden accounting rules that are not immediately obvious – and so it is worth spending two minutes describing them.
The Accruals Principle
Your accounts should reflect things when they arise or are earned – which is not necessarily the same as when you actually pay or are paid for them. For example, your accountant will include an April sales invoice in your April accounts, even if your customer doesn’t pay you until August.
Revenue v capital payments
Some of the things you spend money on will not be regarded by your accountant as reducing your profits. For example, the money you pay to buy a new car or pay off a loan. Accounting conventions say that payments like these shouldn’t appear in the profit and loss account – instead their effect is confined to the balance sheet.
The key distinction here is between capital expenditure and revenue payments:
Revenue payments are the running costs of the business – the type of expenses that buy goods and services that are used up quickly (eg wages, advertising, rent, stationery etc). This type of expenditure is shown in the profit and loss account (and is often referred to as having been “expensed”)
Capital payments, on the other hand, relate to things that continue to benefit the company for several years (eg computers, cars etc). They also include paying off loans. This type of expenditure is shown in the balance sheet (and is often referred to as having been “capitalised”)
We have now explained the building blocks of every set of accounts. NEXT you will see stylised versions of what these building blocks are used to construct – your profit and loss account and balance sheet.