Although some small business owners would rather have root canal surgery than do their own accounting, bookkeeping is an indispensable part of running a business. The benefits of accounting lie in its ability to tell a numerical story about what's going on in your company – one that can help you to improve operations, become more profitable and stay out of trouble with local and federal tax agencies. Thorough and accurate accounting can also help you to make your case with potential lenders and investors when your business is looking for financing.
The advantages of using accounting in business are linked to insights that the numbers provide. These figures help you to understand what is going well and where there is room for improvement.
What Is the Main Objective of Accounting?
The main objective of accounting is to track your company's revenue and expenditures. Revenue is all of the money flowing into your business from sales of goods and services and any other type of income, such as interest earned or rent or royalties collected. Expenditures are everything your business buys for its operations and infrastructure, such as:
- vehicle expenses
- professional services
What Is the Purpose of an Accountant?
Your accountant's purpose is to summarize your bookkeeper's work by compiling ledgers into reports. Your accountant may also complete your tax forms and advise you about the best way to spend and save your money. You may or may not need to hire a professional accountant, depending on your comfort level in working with numbers, the complexity of your business and your tax situation.
Your bookkeeper's purpose is to enter receipts and invoices into a database, ledger or spreadsheet so you can track expenditures and sales. Most bookkeeping systems are computerized because bookkeeping programs can organize and add numbers more quickly and efficiently than manual, handwritten systems. However, you don't need a computer program to do your company's bookkeeping. A handwritten system that tracks sales and expenses will also provide the information you need.
You can do your own bookkeeping by keeping track of income and expenses and tracking this information in a way that is useful to you and your accountant. The information should be easy to read and understand, and it should accurately reflect the financial activity of your business. Your bookkeeping information will be useful to your accountant because it provides the necessary information for compiling tax reports and loan documents. The same information can be useful internally to provide insights about your business, such as showing how much of your income comes from wholesale sales versus retail sales and how much you spend on materials versus labor.
Even if you hire an accountant and a bookkeeper to organize your financial information and prepare your tax forms, you still have accounting responsibilities as a business owner. You must save all of the information they need, such as the invoices you write and the receipts you receive for business purchases you've made. The more organized these documents are when you bring them to your bookkeeper and accountant, the less you'll have to pay for their time. It takes a bookkeeper longer to organize a shoe box full of receipts than to work methodically through a file with paperwork that has already been sorted by date or by credit card account.
What Are the Rules of Accounting?
The rules of accounting govern the ways expenses and earnings are entered into a system as debits or credits. These rules govern double-entry bookkeeping, a system that has been in widespread use since the late Middle Ages. Double-entry systems not only track your income and expenses, they also show how money and assets are moving around your company. In a double-entry system, every entry that is entered as a debit must be balanced with a corresponding credit and vice versa. The alternative to double-entry bookkeeping is a single-entry system in which you simply list and tally your income and expenses without built-in protocols for reconciling these entries with your actual financial situation.
When working with personal accounts, an individual who transfers assets to the business should be credited, while the receiver, or business, should be debited. This seems counterintuitive because the funds have left the hands of the individual and have been transferred into the hands of the business. However, bookkeeping accounts don't always describe actual cash balances. Rather, they refer to sums that are owed or owned. When an individual such as an owner transfers money to a business, this transaction increases, or credits, the account and represents the amount that the business owes to that individual. This same transfer of funds creates a debit for the business account because, even though the cash is on hand and available, it is now owed to the individual who has provided it.
When dealing with real accounts, such as real estate and machinery, the rules of accounting require you to debit new purchases and credit items that you have sold or otherwise taken out of service. The asset is originally posted as a debit because you have spent money to acquire it. If you sell it or take it out of service after it has outlived its useful life, you are removing the debit, or crediting the account that represents what you owe on the purchase.
When your business buys materials or pays rent, the rules of accounting require you to post these transactions as debits. Conversely, when you sell products or services, your accounting system treats these transactions as credits. Purchases that require outgoing funds decrease your company's capital, hence they are tracked as debits. Income and other gains, such as incoming rent payments, increase your company's capital, so they are tracked as credits.
Although these rules of accounting govern how each transaction appears in your bookkeeping system, you don't actually have to understand and apply them unless you're making entries into a double-entry bookkeeping system that isn't preprogrammed to organize your information. For example, if you use a handwritten ledger as the basis of your accounting system, you'll have to decide each time you make an entry whether that transaction represents a debit or credit and where the corresponding debit or credit will appear. However, if you are using bookkeeping software, such as QuickBooks, your checks, invoices and sales receipts will automatically appear in the proper credit and debit accounts, along with their corresponding debits or credits.
How to Use Accounting in Business
The advantages of accounting aren't just a matter of good business strategy, although accounting information certainly helps you to strategize and plan. No business can survive without some kind of accounting system. If your company makes purchases and sales without tracking the amounts you've bought and sold, you'll have no way to determine whether you've earned a profit or incurred a loss at the end of the year. You won't know how much you owe and how much you own, so you won't be able to assess how much of your incoming cash you can withdraw for personal use and how much you should keep in your company bank account for upcoming business expenses.
Accounting information also gives valuable insights about company operations. It allows you to compare your sales in different categories over time, such as looking at trends for different products across sales locations. It gives you the tools and information to look at your expenses as percentages of your revenue to see if your margins are sustainable and how your company's performance compares to that of competitors in your industry. A cash-flow pro forma will allow you to look for sources of capital before you actually need them and to plan major purchases to correspond with the times of the year when cash is bountiful. Operating a business without accounting information is like flying a plane without a radar.
Accounting is also necessary for your company's survival because you are legally required to report income and pay taxes. Without a complete and accurate accounting system, you won't know how much you've earned and spent, and you won't have the information you need to fill out local, state and federal tax forms. Also, if your business ever needs financing, your loan applications will almost certainly require you to include financial statements from previous years and most likely projections for upcoming periods as well.