As a business owner, you need to have a clear picture of various sides of business management. Accounting is one of the most important parts of a business. So every business owner needs to be familiar with its basics, as it gives a clear picture of the state of their finances, allows them to make informed business decisions, and react to any negative changes faster.
So let’s take a look at how to do basic business accounting, understand what books tell you, and manage them efficiently.
What is accounting?
Accounting is a broad concept. But for small businesses, it means recording financial transactions, summarizing and analyzing them through accounting reports, and timely providing data for tax returns.
There are three major reports a business needs to create for every accounting period, such as balance sheet, income statement, and cash flow statement. They give a summary of the financial operations, cash flows, and overall financial performance of a business in this period. An accounting period is a set tracking period for accounting performance within which records were gathered and analyzed. It can be either a calendar or fiscal year, but also a week, month, quarter, etc.
Understanding how to set up a small business accounting system means you can do it more accurately at the start. This way it can help prevent many issues that small businesses face, such as poor cash flow management or mixing personal and business finances or reporting wrong data to the IRS.
So let’s break it down.
1. Create your bank business account
The first and one of the most important steps is setting up a business bank account. Surprisingly, some SMBs, especially at the early stages, as well as many self-contractors, often ignore this step, preferring to process business transactions through their personal bank accounts. Though it can initially reduce bank processing fees, it can turn to significant losses and mess in the future, including the wrong classification of your business, incorrect tax filing, missed deductions, etc.
So opening a separate business account is a must. And here’s a simple step-by-step guide you can use as a checklist.
2. Choose your accounting method
Next is to decide how you are going to track your business income and expenses. In other words, you need to choose the accounting method that will fit your business needs. Basically, you can choose either single-entry or double-entry accounting.
The single-entry method supposes entering each transaction only once. For example, upon a sale, you record the sum of the purchase in your account. It’s a rather simple method of accounting that doesn’t provide for your inventory, for example, or supplies, etc. Thus it can suit only very small businesses with few transactions.
The double-entry method is more sophisticated, but it gives you a clearer view of your finances. It implies recording two entries for a transaction: a debit and a credit – thus keeping your books balanced. The method allows for faster errors and fraud detection, better identifying profit and loss, and easier creating financial statements. For small businesses aiming at more accurate accounting, a double-entry method is a better choice.
3. Set up accounts for recording transactions
Ironically in accounting, the word “account” doesn’t mean your bank account but stands for the type of certain financial transactions, such as sales or payroll, etc. Learn more about payroll management, and how it can help your business.
The concept behind various accounts helps differentiate different types of transactions to help track all your incomes and expenses more efficiently. The major types of accounts comprise assets, liabilities, income, expenses, and equity.
- The assets account includes the data on cash and resources that belong to a business. It includes cash, accounts receivable, equipment, inventory, supplies, real estate, etc.
- The liabilities account comprises all the obligations or debts that a business might have. They are accounts and interest payable, loans, etc.
- The income account stands for business earnings – the cash a business gets through selling its products or services, including sales income, rental income, interest income, etc.
- The expenses account gathers all the outcoming business transactions – the money that business pays for various resources and services, such as utilities, supply expenses, insurance, salaries, paid interests, etc.
- Equity account shows what remains after liabilities are subtracted from assets. It represents the owner’s held interest in the business, which can be the owner’s capital, dividends, retained earnings, etc.
Thus, all your business transactions, depending on their type, will go to one of these accounts that you will need to track.
4. Record transactions in accounting
All business accounts are recorded in the general ledger – your accounting books. Of course, accounting books are not real books, as they used to be back in years. They are rather a means of keeping and tracking your accounting records. Typically they are papers, spreadsheets, and accounting software, and each of the means has its pros and cons that you will need to consider when making your choice.
- Paper accounting is surprisingly quite popular among small businesses. Back in 2018, a survey by Clutch showed that 25% of SMBs still recorded their finances on paper instead of on a computer. This method can fit for a very small business that has minimum transactions. There’s no need to say that it is error-prone, and the risk of losing the transaction data is very high.
- Spreadsheet software is a means of keeping your accounting data in electronic tables, such as MS Excel or Google Spreadsheets. With them, you can record, correct, safely keep your accounting data on your computer, as well as share it with an accountant when you need it (as both provide sharing and multi-user options). One of the biggest drawbacks is that you need to enter your data manually, which takes time and still bears the risk of errors.
- Accounting software comprises various tools designed for keeping accounting books and facilitating their management. There is a wide range of solutions available on the market: from simple to sophisticated. But at large, they can connect with your bank account, allow for importing data from different sources, and perform several business operations, such as sending and managing invoices, for example. They can vary in cost and functionality, as well as work online or require installing it on your computer. The most popular solutions for small businesses are QuickBooks Online, Xero, and FreshBooks. But there are much more than these, so depending on your situation and needs, you can decide which would fit the bill for you.
So whichever method you choose, it’s essential to record all your business transactions and correctly categorize them into corresponding accounts. Thus you will have a clear view of your finances coming and going and be able to analyze your overall performance.
Accounting software dramatically enhances the management of your books owing to its inbuilt logic (such as double-entry accounting method, etc.) that allows for understanding and categorizing entries for you. So even if you don’t have an accountant or a bookkeeper, you will be able to perform simple accounting operations yourself.
5. Generate financial statements
So as your business is up and running, you will need to make sure it’s running in the right direction. Financial statements that you will do for every accounting period will help you always be in the current of your financial performance. As it was mentioned at the beginning of this guide, there are three major statements, such as balance sheet, income statement, and cash flow statement.
Let’s take a closer look at each.
- The balance sheet is a concise summary of your business’s assets, liabilities, and equity at a certain period. This report gives you the idea of the financial health of your business and helps understand your next steps, such as expanding or reserving more cash, etc.
- The profit and loss, or income statement, this report shows your business revenues, costs, and expenses over a given period. Based on sales and expenses, you can forecast your future performance and make the necessary tweaks to your business management.
- The cash flow statement provides information data regarding all cash inflows your business receives from either its operations or external investment sources (should they exist) and cash outflows – the money a business pays for certain resources or services.
These reports need to be done regularly, which requires a significant investment of time and effort. Using accounting software can facilitate the process of generating financial statements. But regardless of how you’re keeping your books, the more accurately you record your transactions there, the easier for you it will be to create financial statements.
6. Reconcile and close your books
The final stage of the accounting cycle is to balance books and reconcile them with your bank account.
The main reason to reconcile is to ensure the accuracy and validity of your financial information. When you reconcile transactions, any mismatches, unauthorized changes that have occurred during the reporting period come to light, which allows you to timely react and correct them. It will make filing your taxes much easier, as well as avoid penalties from the IRS for providing incorrect tax filing. Here is a more detailed guide to reconciliation.
Of course, this guide won’t make you an accountant, but it can give you a general idea of how to do accounting for a small business. You will definitely, at a certain stage of your business management, need an accountant to help you with reconciliation, taxes, or understanding your finances better. However, knowing how to keep books, you can perform some of the simple bookkeeping operations yourself, should you face such a need, and feel more comfortable with it.
Do you usually do the accounting yourself or prefer to delegate it to a professional? Feel free to share your thoughts in the comments.