Small Business Accounting: The Basics

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Nearly half of all small businesses don’t employ a bookkeeper or accountant, but without solid financial records, it’s pretty hard to measure a company’s financial health. How do you know if you’re bleeding money or making money when you’re not actually keeping track of your cash flow? Plus, every for-profit business has to pay income tax, which means nearly half of business owners are either doing their small-business accounting on their own or rolling the dice and hoping for the best (seriously — don’t do the latter!).

Small-business accounting doesn’t have to be intimidating even if you do take on the task without the help of an accountant or full-time bookkeeper. With a solid record-keeping system — and the help of small-business accounting software like QuickBooks and FreshBooks — small-business accounting has never been easier.

Why Is Small-Business Accounting Important?

You might not think that keeping track of your business’s financial data is all that important as long as your business is depositing more money into your bank account than you’re spending, but that’s simply not true. You don’t want your business to just exist — you want it to thrive. Proper bookkeeping is the best way to set up your business for financial success because it helps you identify issues before they become completely devastating. You can also identify areas where you might be able to expand.

In addition, we all know the two words that make small-business owners everywhere shudder: IRS audit. With good record keeping, an audit really isn’t all that scary. You already have everything the IRS needs filed away and ready to go. Plus, keeping meticulous track of all your expenses will help you save money when you’re filing your tax returns.

What Is Bookkeeping?

Bookkeeping is an essential part of small-business accounting. Basically, it’s the process of recording your business’s financial data, from cash and credit card sales to outstanding invoices, debts and inventory. Whether you take on the task alone or hire a third party, a great bookkeeper is the backbone of your accounting process.

Bookkeepers generally keep track of five basic kinds of financial accounts (i.e., five types of financial transactions). These are:

  • Assets: Assets are the cash and resources your business owns — for example, your inventory, accounts receivables and the money in your business’s checking account.

  • Liabilities: This is your debt. Liabilities include things like accounts payables and loans.

  • Income and revenue: Revenue is the gross amount of money you receive from customers (i.e., the total people have paid you), and income is what is left over after expenses (i.e., your profit).

  • Expenses: This is the money you use to buy products and services for your business. For example, things like rent, salaries and monthly phone bills are expenses. Expenses may also include things like payments to independent contractors and equipment purchases.

  • Equity: This is what’s left over after you subtract liabilities. In other words, it’s the true monetary worth of your company and represents the owners’ bounty, like stock or retained earnings.

Bookkeepers also use four separate types of documents to keep track of these accounts:

  • Journal: In a journal, you’ll record all transactions and their descriptions in chronological order. This doesn’t have to be balanced and won’t be if you’re using single-entry accounting.

  • General ledger: In double-ledger accounting, this is where you’ll separate transactions into different accounts. This is what has to be balanced.

  • Trial balance: This is an accounting worksheet where the balance of all of your general ledgers is summed up and split into debit and credit columns to make sure that your bookkeeping entries are mathematically correct. If the columns don’t match, you have to go back to the ledger and find the mistake.

  • Financial statements: These act as summaries of your financial data and include things like balance sheets, income statements and cash-flow statements.

Each of these documents serves as a single piece of a full financial picture.

Single-Entry Accounting vs. Double-Entry Accounting

There are two ways to keep records: single-entry accounting and double-entry accounting. The method you choose shapes how you keep your financial records. Generally, single-entry bookkeeping is the simplest, and double-entry accounting is the most thorough.

For single-entry bookkeeping, you’ll only record transactions one time in your journal, and you won’t have a general ledger. In other words, if you’re a tutor who is paid $50 for a lesson, you’d record $50. Similarly, if you spend $20 on gas to get to the lesson, you’d subtract $20. This method works for sole proprietors and simple businesses with cash transactions and no inventory, but it can be a nightmare for a business managing a large inventory and various cash and credit card payments with different terms.

Double-entry accounting is much more complicated, but it’s the standard for most accounting software because it’s the most accurate and helpful. Unlike single-entry accounting, you’ll record two entries in a general ledger for that same $50 tutoring session: a debit and a credit. Debits are usually in the left column of the ledger, and credits are usually in the right column of the ledger. The sum of the left and right sides should be even, which helps catch accounting errors much quicker than you would with a single-entry system.

How to Make a General Ledger

The first step to small-business accounting is creating a general ledger. If you’re using a double-entry accounting system, this will be your record-keeping system and will hold all the account information you need to prepare financial statements. Before the digital age, this was done on paper, but now, about 82% of small businesses use accounting software. There are three major types of small-business accounting software:

  • Spreadsheet software
  • Desktop accounting software
  • Cloud-based bookkeeping software

Spreadsheets like Microsoft Excel are generally the cheapest option but the most difficult with which to work because they’re meant to be used in a variety of applications, not just as an accounting system. Desktop software like QuickBooks Desktop is the most costly up front, but it’s also the easiest to use because it’s created specifically to help small-business owners manage their financial data. Cloud software like FreshBooks or Wave is somewhere in the middle because it has a lower monthly cost with the ease of use of desktop software.

Recording Your Financial Transactions

Once you’ve decided on your accounting method and have chosen how you’re going to keep your books, you need to start recording your transactions. For single-entry accounting, this is easy: Simply record expenses in one column and revenue in another column and then subtract or add that to the total account balance.

If you’re using the double-entry method, it’s a bit more complicated. The sum of your overall account balances must match between the left and right columns (debit and credit). In order to record transactions properly, you need to know how debits and credits affect different accounts. It goes as follows:

  • Assets are increased by debits and decreased by credits.
  • Expenses are increased by debits and decreased by credits.
  • Liabilities are increased by credits and decreased by debits.
  • Equity is increased by credits and decreased by debits.
  • Revenue is increased by credits and decreased by debits.

For example, say you paid $2,000 in rent for your business property. This is an expense, so you’d record a $2,000 debit (on the left side of your ledger) in your expense account.

This money also must come from somewhere. In this case, it’s taken from the assets account because you’re making a cash payment and thus losing that asset. You’d note a $2,000 credit in your assets account (on the right side of your ledger).

In layman’s terms, you’ve increased your expenses by $2,000, which means you’ve lost $2,000 worth of assets. Once it’s recorded properly, both columns — the $2,000 expense debit on the left side and the $2,000 asset credit on the right side — should even out each other.

Types of Financial Statements

After you have a few general ledgers, you may wish to check the math with a trial balance. Essentially, this worksheet adds up all the sums in the debit columns and credit columns of your ledgers. The columns should be balanced, or you need to go back and look at your ledgers in detail to find the mistake.

If your ledgers check out, you can start making financial statements, which help give you an overview of your company’s financial help. Some important financial statements include:

  • Balance sheets: This sheet will report your company’s assets, liabilities and shareholders’ equities. In layman’s terms, it shows how much your company owns vs. how much it owes. It’s a snapshot of your company’s financial health. Is your business profitable, or are you still losing money?

  • Income statement: This is one of the most important financial statements because it shows how much income a business has made during a specific reporting period. It outlines revenue, expenses and profits and losses.

  • Cash-flow statement: A cash-flow statement reports how cash moves through a company. The bottom-line number is that it shows a net increase or decrease of cash through operating activities, investing activities and financing activities. This is used as a comparison to your income statement and can be helpful if your income statement’s profit-and-loss records don’t reflect the amount of cash that’s been passed through the business.

  • Statement of retained earnings: This statement shows changes in equity and includes things like dividend payments, sales and repurchases of shares or any changes in equity that may have occurred because of a profit or loss.

  • Pro forma: This type of financial statement is used to attract investors using pro forma financials, which exclude unusual or nonrecurring transactions. Publicly traded companies cannot legally use pro forma financial information to lead on investors, but it is a popular financial sheet for privately held startups looking to bolster their worth and show their potential. Be careful because these kinds of statements don't give a full financial picture.

Should I Outsource Small-Business Accounting?

Small businesses don't always need accountants. Simple businesses that use the single-entry method of accounting (like certain independent contractors including teachers and tutors, handymen, freelancers, child care workers and musicians for hire) may be able to handle their own accounting and bookkeeping accurately. You can even file taxes through a service like TurboTax, which guides you through the process of submitting IRS forms.

Nonetheless, simple businesses may still wish to hire an accountant during tax time and in the event of an audit. Most people aren't aware of the sheer number of purchases that qualify as business write-offs, and a good accountant can save you the highest amount of money on your tax return.

It is almost always a good idea to have an accountant and (at least part time) a bookkeeper or financial manager if you're running a business using the double-entry accounting method. Bookkeeping takes a lot of time, especially if there's a mistake that needs to be fixed. This person can also handle payroll taxes, any additional sales tax, overall tax filing, invoicing and purchase orders and making financial projections. It's important to have a team member who is focused on the financial health of your company.