Accounting for Small Businesses
Accounting is a critical component of running a successful small business. It involves tracking income and expenses, assessing the financial health of the business, and making smart financial decisions. For small business owners, accounting tasks like bookkeeping and financial reporting may seem daunting. However, having a good understanding of small business accounting principles is hugely beneficial.
Accounting provides small business owners with concrete data on how their company is performing financially. It enables them to identify profitable products or services, determine which areas of the business are surplusing or draining resources, and make adjustments accordingly. Additionally, properly maintained accounting records are required for tax preparation, securing financing, forecasting future growth, and detecting fraud. For these reasons, accounting can be considered the financial language of any business.
This article will explore the fundamental concepts and best practices of small business accounting. Key topics include accounting methods, financial statements, accounting software, recordkeeping, taxes, budgeting, forecasting, reporting, and when to hire an accountant. Whether just starting out or looking to improve existing accounting practices, this guide will provide small business owners with the knowledge needed to manage their finances successfully.
Accounting Methods
Accounting methods refer to the system a business uses to record financial transactions and report revenue and expenses. There are two main accounting methods used by small businesses: cash basis and accrual basis.
Cash Basis Accounting
With cash basis accounting, income is recorded when cash is received, and expenses are recorded when cash is paid out. This method is very simple because you only account for cash inflows and outflows. However, it does not always accurately match revenue and expenses to the time period in which they occurred.
For example, if you receive payment from a client in January for work done in December, that revenue would be recorded in January under cash basis even though the work was performed in the prior year. Cash basis is a good option for small businesses and freelancers who do not carry inventory.
Accrual Basis Accounting
Under accrual basis accounting, revenue is recorded when it is earned, and expenses are recorded when they are incurred. This means income is accounted for when the sale or service occurs, regardless of when payment is received. Expenses are recorded in the period they relate to, even if cash is not paid out until a later date.
Accrual accounting provides a more accurate look at financial performance because income and expenses are matched to the correct time period. It provides a better long-term view of profitability and is required if you keep inventory. Accrual accounting is more complex than cash basis but gives a clearer financial picture.
Financial Statements
Financial statements are formal reports that summarize a business's financial performance over a period of time. The three main financial statements are the income statement, balance sheet, and cash flow statement.
Income Statement
The income statement shows revenue, expenses, and profit or loss over a period of time. It details how much money the business brought in from sales and services, minus the costs of running the business like materials, payroll, rent, etc. The result is net profit or net loss. It does not include cash flows, which is covered in a separate statement.
Balance Sheet
The balance sheet is a snapshot of the business's financial health on a given date. It lists assets (things the business owns that have value like equipment, buildings, inventory, etc.), liabilities (what the business owes like loans, unpaid bills, etc.), and equity. Assets = Liabilities + Equity. The balance sheet shows if the business has enough resources to pay its debts.
Cash Flow Statement
The cash flow statement tracks how money comes into and goes out of the business. It breaks down cash flows into operating, investing, and financing activities. This helps identify where cash is being generated and spent so businesses can adjust accordingly. It provides insight beyond net profit/loss on how well the business is managing cash.
Accounting Software
Accounting software plays a crucial role in small business financial management. With the right accounting software, small business owners can efficiently track income and expenses, generate financial statements, manage payroll, and complete a variety of other accounting tasks. There are two main types of accounting software to choose from – cloud-based and desktop.
Cloud-based accounting software is accessed online via a web browser. This type of software is hosted on remote servers and data is stored in the cloud. Most cloud accounting platforms offer a subscription-based pricing model. Examples of popular cloud accounting solutions include QuickBooks Online, Xero, FreshBooks, Sage Accounting, and Zoho Books.
The main benefits of cloud accounting software include:
-
Accessibility – owners and accountants can access the software and data anywhere with an internet connection. This enables remote work and real-time collaboration.
-
Automatic updates – the software is always up to date. There are no patches or upgrades to install.
-
Scalability – it's easy to add or remove users as the business grows or changes.
-
Lower start-up costs – no need to invest in on-site servers or IT infrastructure.
-
Data security – reputable cloud platforms invest heavily in data security and backup systems to keep data safe.
Desktop accounting software is installed directly on computers or local servers at the place of business. Data is stored on local hard drives or networked storage devices. Desktop software typically involves purchasing perpetual licenses with optional annual maintenance fees. Leading desktop accounting products include QuickBooks Desktop, Sage 50 Accounting, Microsoft Dynamics GP, and Xero Accounting.
Benefits of desktop accounting solutions include:
-
Full control over software and data storage. No reliance on internet connectivity.
-
Potentially lower monthly costs compared to cloud subscriptions.
-
Wider software capabilities for complex needs.
-
Ability to fully customize systems and integrations.
When choosing accounting software, small businesses should carefully assess their specific needs and budget. Key considerations include number of users, desired features, cost, IT capabilities, and accessibility requirements. With many options available today, small business owners can find accounting software that best fits the needs of their organization.
Recordkeeping
Proper recordkeeping is essential for small business accounting. You'll need to keep detailed records of all your business transactions, including receipts, invoices, and bank statements.
-
Receipts - Keep receipts for every business expense and purchase. File them by date or expense category. Having detailed records of your expenses will make tax time easier and ensure you capture all deductible expenses.
-
Invoices - Keep copies of all invoices sent to clients as well as invoices received from vendors and contractors. This provides documentation of monies owed to you or that you owe. Track invoices issued and paid.
-
Bank statements - Review bank and credit card statements monthly. Check for discrepancies, errors or fraudulent charges. These statements show money coming in and money going out of your accounts. Compare them with your recorded income and expenses.
Proper categorization of expenses, documenting income sources, and keeping detailed records ensures accurate accounting and financial reporting. Having your paperwork organized makes it easier for you or your accountant to create financial statements and handle taxes. Investing a little time each week into good recordkeeping saves hours later on.
Taxes
As a small business owner, you'll need to pay several different taxes. This includes sales tax, payroll tax, and income tax.
Sales Tax
If your business sells products, you'll need to collect sales tax from customers and remit it to your state. Sales tax rates vary by state, and in some cases, by city and county. Be sure to look up the sales tax rates for all areas where you have a physical presence. You may be required to collect sales tax for online orders shipped to states where your business has nexus. Utilize sales tax automation software to simplify the process of collecting, filing, and remitting sales tax.
Payroll Tax
You'll need to withhold federal and state income tax, Social Security and Medicare taxes from employee paychecks. You are also responsible for paying the employer share of Social Security and Medicare taxes. Stay up-to-date on payroll tax forms and deposit requirements. Use payroll software or work with a payroll processing company to handle all payroll tax filings and payments correctly.
Income Tax
As a business owner, you must pay estimated quarterly income taxes on your business's net self-employment earnings. You'll file an annual Schedule C form with your personal 1040 tax return to report your business's net profit or loss. Careful income tax planning and preparation can help minimize your tax liability. Consider working with a small business accountant or enrolled agent to navigate your federal and state income tax obligations.
Budgeting
Budgeting is a critical part of managing the finances of a small business. A budget allows you to plan for your expenses and revenue and make sure your business stays financially healthy. There are two main types of budgets small businesses should develop - operating budgets and financial budgets.
Operating Budgets
An operating budget outlines the costs associated with the day-to-day operations of your business. This includes things like:
- Employee salaries and benefits
- Rent and utilities
- Inventory purchases
- Supplies
- Marketing and advertising
- Insurance
- Equipment leases
When creating an operating budget, analyze historical financial statements to determine costs from the previous year. Then adjust for expected changes in the coming year. Be sure to include all foreseeable expenses and build in a buffer for unexpected costs.
Operating budgets allow you to plan and manage cash flow. By budgeting for operating expenses you can ensure you have enough cash on hand each month to cover costs. This helps avoid cash flow issues.
Financial Budgets
A financial budget helps plan for major expenses related to business growth and improvements. This includes things like:
- New equipment purchases
- Facility expansion or remodeling
- Development of new products and services
- Hiring additional staff
- Investing in professional development and training
Financial budgets require forecasting future needs and goals 1-5 years down the line. This allows you to save and allocate funds accordingly. Having a plan for growth and improvements will position your business for long-term success.
Regularly comparing actual results to budgets allows you to spot potential problems early. Make adjustments as needed to keep your small business financially strong. Both operating and financial budgets are essential planning tools for small business owners.
Forecasting
Forecasting is a critical aspect of small business accounting. By estimating future sales, expenses, and cash flow, small businesses can better manage their finances and plan for growth. There are two main types of forecasts that small businesses should develop:
Cash Flow Forecasts
A cash flow forecast estimates the inflows and outflows of cash over a future period. This helps assess whether the business will have enough cash on hand to pay expenses. Cash flow forecasts typically cover 12 months and are updated monthly as new data comes in. Key elements include:
- Projected sales or revenue
- Expected accounts receivable based on sales
- Salary, rent, inventory and other expense forecasts
- Loan payments, owner draws, or other cash outflows
By comparing actual cash flow to forecasts, small businesses can identify potential cash shortfalls and adjust spending or financing accordingly.
Financial Forecasts
Financial forecasts estimate future income statement and balance sheet numbers based on assumptions about revenue growth, margins, expenses, asset purchases, and more. These are used to value the business and assess performance. Key components include:
- Sales forecasts
- Projected profit and loss statement
- Forecasted balance sheet
- Breakeven analysis
Regularly updating the financial forecast provides an ongoing gauge of the business's growth and financial health. It also serves as the foundation for budgeting.
Accurate forecasting helps small business owners make smart decisions and avoid surprises. It is a best practice that pairs well with the other accounting basics.
Reporting
Reporting is an essential part of small business accounting. By analyzing financial reports on a regular basis, business owners can identify trends, catch errors, measure progress towards goals, and make informed decisions.
Small businesses should aim to generate monthly, quarterly, and annual financial reports. Monthly reports provide a snapshot of current cash flow, expenses, revenues, and profit/loss. Reviewing monthly reports helps owners understand the health of day-to-day operations and make any necessary adjustments.
Quarterly reports take a bigger picture view, highlighting trends across 3 months of business activity. Owners and managers can use quarterly reports to evaluate growth trajectories, seasonal patterns, and the impact of recent changes. Comparing quarterly reports year-over-year shows wider progress made.
Annual reports encompass the full 12 months of the fiscal year. These end-of-year reports indicate profitability, tax obligations, net worth, debts, operational costs, sales volumes, and more. Annual reports are critical for tax preparation, strategic planning, obtaining financing, and understanding the overall financial performance of the business.
Small business owners should analyze key performance indicators in their regular financial reports, such as revenue growth, profit margins, customer acquisition costs, inventory turnover rate, accounts receivable, operational efficiency metrics, debt ratios, and return on investment. Identifying and monitoring KPIs is vital for achieving financial goals.
Hiring an Accountant
As a small business owner, you may reach a point where you need to bring on an accountant or bookkeeper to help manage your finances. Here are some tips on when to hire an accounting professional and what to look for:
When to Hire an Accountant
-
Your business has grown beyond your ability to manage the books yourself. Accounting has become too complex or time-consuming.
-
You need help setting up accounting software and systems. An accountant can get you set up properly from the start.
-
You don't understand accounting principles. An accountant can ensure you're reporting finances accurately and legally.
-
You need help with financial statements, taxes, projections, or cash flow analysis. Accountants have specialized expertise.
-
You want to apply for financing. Lenders will want to see financial reports prepared by a professional.
What to Look for in an Accountant
-
Relevant experience in your industry and with small businesses. Understands your needs.
-
Proficiency with small business accounting software. Can help you use it effectively.
-
Strong attention to detail. Financial reporting must be precise.
-
Excellent communication skills. Can explain accounting clearly and answer your questions.
-
Affordable rates. Fits your budget as a small business.
-
Positive references from other clients. Demonstrates expertise and reliability.
-
Trustworthiness. Will handle sensitive financial information with integrity.
With the right accounting help, you can focus on running your business while ensuring your finances are handled accurately and efficiently.