Advantages of double-entry accounting
Anyone who manages a business cannot ultimately avoid the task of keeping accounts. The legal form of a company and the type of business it engages in will determine the conditions of entry in the Commercial Register, as well as the statutory accounting and reporting requirements. For instance, the financial reporting requirements for companies are set out in Article 1045 of the Liechtenstein Persons and Companies Act (PGR). In Switzerland, this obligation is contained in Article 957 et seqq. of the Swiss Law of Obligations (OR).
But what happens if a business is not subject to mandatory financial reporting? In this case, will a simple 'cash book' suffice, which records incoming and outgoing payments, i.e. simplified accounts'? The answer to this question is a categorical 'no'. Even where no legal obligation exists, it makes a great deal of sense to practise double-entry accounting, as I will explain below.
What does double-entry accounting actually mean? As the term suggests, with double-entry accounting, each relevant transaction is recorded twice. Firstly, the accounts comprise a balance sheet, showing assets on the assets side and liabilities and accruals on the liabilities side, as well as a company's equity. The figures in a balance sheet are always based on the balance-sheet date. Secondly, an income statement is kept in which income is set against expenses, enabling the calculation of an annual profit or loss. The income statement always covers a clearly-defined period.
The individual positions of the balance sheet and income statement are referred to as accounts. All double-entry accounting does is record each transaction twice, i.e. in two different accounts. For example, if an invoice for a vehicle repair is paid via the bank, then the expenditure on vehicles will increase but at the same time the company's bank balance will be reduced by the same payment. I can therefore record two changes in the annual accounts with one entry. A cash book, on the other hand, would merely show that, as a result of the invoice being paid, I have less money in the bank balance account. A possible third component of annual accounts consists of the cash flow statement. This shows all transactions during a financial year which impact on liquidity: inflows and outflows of funds from business operations as well as inflows and outflows from financing operations.
Keeping accounts therefore also serves to provide important information. The balance sheet shows the assets and liabilities existing as at a defined reference date, as well as the amount of equity capital at that date. The income statement indicates whether or not a specific period, generally a financial year, has been successful. Thus, annual accounts also have a documentary function. This documentation not only serves a company's own requirements but it can also be provided to owners (e.g. shareholders), the tax administration and other authorities, as well as to potential lenders such as banks or other business partners or investors.
Annual accounts also function as a management tool; if current figures are compared with those from the previous year or with a budget, perhaps also showing percentage changes, this provides an analysis of the figures produced. The indicators used to analyse balance sheets and income statements vary and range from liquidity ratio I – III, asset cover ratio, equity ratio and return on equity, through return on sales to cash flow analysis. And we should not forget the 'golden rules' applying to balance sheets and financing, which provide management with the valuable fundamentals. All of these evaluations help the board of directors or management board to assess the financial performance of their business and to draw conclusions regarding future developments. The more often such analyses are undertaken (half-yearly, quarterly, monthly), the more accurately will be able to reveal discernible trends, which will then enable the management to take appropriate measures, in particular in order to identify negative trends on a timely basis and to steer such trends in a positive direction.
Finally, annual accounts also play a role in planning. Generally, the latest set of annual accounts is used as a basis for budgeting for the coming year or years. Very often, it is not considered enough to just plan for a single year but, instead, a rolling plan may be generated with a five-year horizon. In such a process, current results always influence future results as well. Normally, however, shorter-term planning is undertaken. In particular, planning for available funds is a key factor when it comes to the survival of a business. For example, projecting anticipated future sales revenues, set against relatively stable ratio to expenses and available liquid funds, including bank credit facilities, will allow financial shortfalls to be identified in advance and therefore corresponding precautions can be taken.
Being aware of anticipated cash funds for the coming months or even years enables this information to be taken into consideration when planning future investments. As a result, depending on the liquidity of a business, it may make more sense to lease rather than purchase a new acquisition.
Double-entry accounting plays a vital role in a business, providing documentation and assisting with management and planning. We would highly recommend that even small businesses consider the circumstances and advantages described above and invest in double-entry accounting. It does not have to be too expensive.
If we have convinced you of the benefits of double-entry accounting, please do not hesitate to contact us. The specialists at First Accounting Est. will be delighted to provide you with advice and support.