Accounting Basics for Small Business Owners
By Eric Rosenberg
As a small business owner, you wear many hats. Unless you outsource the jobs, that includes bookkeeper and accountant. You don’t need a fancy four-year accounting degree to handle your bookkeeping and business accounting basics, but it is important to have a grasp of central concepts to ensure accurate management reporting and tax filings.
Cash basis vs. Accrual basis
The first important accounting decision is your accounting method. For service-based businesses, you can choose between cash basis and accrual basis.
Cash basis means all of your accounting books are based on the date that cash moves hands. For example, if you provide a service on January 1st and get paid of February 1st, the transaction is recorded on the books for February, when the cash changed hands.
Accrual basis means all of your accounting books are based on the date the service is performed. Following the example above, the transaction would be recorded on January 1st, as that is when the service took place.
Doesn’t seem like a big deal? It is a huge deal! While the difference in January 1st and February 1st isn’t dramatic for bookkeeping and tax purposes, those dates could just as easily be December 1st and January 1st, where the difference of cash basis and accrual basis accounting changes the fiscal year the transaction takes place, which impacts your tax filings.
There is no right or wrong here, just what makes the most sense for your business. Typically cash basis is easiest, particularly if you are doing your own books. However, accounting software like Quickbooks makes it easy to manage your books either way.
Product-based businesses also have to choose between FIFO and LIFO inventory accounting, but that’s an article for another day.
Debits and credits
Now that you have your accounting method picked, you have to do the actual accounting. Again, most accounting software like Quickbooks, Xero, and others take care of the heavy lifting, but you should still understand the concept of debits, credits, and how your general ledger works.
Every time money (or inventory) moves, it should be recorded on the general ledger. The general ledger is a log of every financial transaction in your business’s history. Each transaction has two components, a debit and a credit. Because every entry has two components, this is called double-entry accounting. This article on t-accounting makes it a little easier to understand why each transaction requires two entries.
Create a transaction every time money moves (or is expected to)
Accounts payable (AP) and accounts receivable (AR) are not just processes to track invoices and expenses, they tie directly into your AP and AR accounts on your company’s general ledger.
For example, when you get a bill, don’t just pay it, enter it into your accounting software. That will create a new accounts payable entry that flows into your balance sheet. When you pay the bill, enter it and it moves off of your balance sheet and lowers cash while increase expenses paid.
Doing this consistently helps keep everything organized, in order, and accurate while you are busy running your business and hustling to keep bringing in the cash!
Owner’s equity and member draws
You can’t just pay yourself and not record it in the books. There are a couple of general ledger accounts that are impacted when you put money into the business and take money out.
First, owner’s equity. If you spend money out-of-pocket on the business, that should be recorded and reflected. Startup costs and other expenses should be recorded as expenses, and the cash you used to fund those expenses should be recorded in the owner’s equity account.
When you get paid and are operating as a single member LLC or sole proprietorship, that income should be reflected as a member draw, a contra-account to owner’s equity. If you work as an employee, it is even more important to run payroll entries correctly for proper tax reporting at the end of the year.
Clean books create clean reports
All of these debits and credit and accounts come together to perform two very important business functions.
First, your accounting record sits behind any business reporting you have access to through your bookkeeping software. Profit and loss, balance sheet, cash flow, and other reports that you can use to make the best business decisions possible all rely on accurate bookkeeping. You don’t know where and how you are making and losing money without good management reporting!
Second, your tax preparation relies on your bookkeeping accuracy. Whether you outsource it to an accountant or do it all yourself, having up-to-date books is vital in accurate tax preparation and filings. Doing this wrong can lead to audits and penalties!
If you have any doubt, you can always take an accounting class or hire a professional bookkeeper or accountant to handle things for you. It’s better to be safe than sorry!