Accounting is how we keep score in business; accounting is the language of business. Today, we keep score almost exclusively on the computer. There are a variety of powerful yet simple accounting software programs that help you to know how you are doing.
Before introducing those, it’s very important to have at least a rudimentary understanding of accounting. That’s what we call “Accounting 101”.
It’s important to realize why accounting is important. Accounting communicates information about a company’s business; it allows business owners and managers to make informed decisions; accounting also measures economic events.
But no matter how much accounting you know, you are almost certainly going to need an accountant or CPA to help you with your tax return at tax prep time if nothing else.
Basic Accounting Terms
Accrual Accounting – One of two accounting methods (accrual accounting and cash accounting). Accrual accounting records all earnings and business expenses as they occur, not when your customer pays or you write a check for a bill.
Accounting Cycle – The accounting cycle refers to the process steps that are taken to close the books and generate financial statements.
Bank Reconciliation – A bank reconciliation is a comparison of the transactions from the book balance or bank statements and the ending bank account balance to the ending cash balance in the general ledger.
Cash Accounting – Accounting method that recognizes and records revenue when money is received and expenses when they’re paid. Cash Accounting is the simplest of the two accounting methods.
Chart of Accounts – The chart of accounts lists all of the accounts found in the general ledger, which is where all of your accounting entries reside.
Cost of Goods Sold (COGS) are the expenses that directly relate to the cost of producing a product or delivering a service.
Certified Public Accountant (CPA) – is an accounting designation for a person who has met specific state and education licensing requirements and passed the CPA exam.
Debits & Credits – used to record small business transactions. The effect that a debit or credit has is dependent on the account type being affected, but it must always be equal.
Depreciation refers to the decrease in an asset’s value over time.
Double-Entry Accounting – is a common accounting system that ensures the company’s books are balanced. In double-entry accounting, the journal entries affect at least two accounts and have balancing debit and credit amounts.
General Ledger – the record-keeping system for a company’s financial data.
Journal Entries – the summary of a transaction and are how updates and changes are made to a company’s books.
Trial Balance – recorded at the end of an accounting period in the general ledger.
Basic Accounting Principles
Basic accounting principles start with the most basic financial statements. The three most basic financial statements we use in keeping score are:
The balance sheet tells you how much you own and how much you owe. The difference between the two is your equity in the business. The balance sheet has three sections as follows:
- Assets, including cash, accounts receivable, inventory, and fixed assets such as property and equipment,
- Liabilities, which is what you owe, including what you expect to pay this year and what you have to pay more than a year out,
- Owner’s equity, which is how much was put in by the owners plus or minus cumulative profits.
The profit and loss statement tells you how much your profit (or loss) was over a certain amount of time (a year, a quarter, a month). The profit and loss statement, also called the income statement, is calculated as follows:
- Sales – Cost of Sales = Gross Profit
- Gross Profit – Expenses = Net Profits
The cash flow statement tells you whether you have more cash than you had at the beginning of the period and what the sources and outflows were. This is a good predictor of your cash position in the future.
- Start with your beginning cash balance, add any cash taken in, and then subtract any cash going out.
- The difference between what you take in and what goes out is the “cash flow.” If you take your cash flow and add it to your beginning cash balance, you will have an ending cash balance. This cash balance then becomes the beginning cash balance for the next period.
- Cash comes in the form of cash sales, accounts receivable collections, new loans, and new investments.
- Cash going out typically goes to expenses paid, equipment purchased, accounts payable paid, inventory purchased and paid for, and loans paid.
Of the three statements above, the cash flow statement is the most frequently overlooked. Do so at your peril, though. No matter how profitable your business is, you will soon be out of business if you run out of cash. Remember that cash is king.
Tax Obligations
The tax obligations of small businesses are more complex than those for personal tax returns. One important consideration is the legal structure of the business. As a sole proprietorship, partnership, or S-Corporation, the entity isn’t taxed, and the business income “passes through” to the owner’s tax return. Certain entities will have to pay self-employment tax, which includes Social Security and Medicare taxes. While others hiring employees will pay a portion of the Federal Insurance Contributions Act (FICA), which includes Social Security and Medicare contributions.
Related: How is an LLC taxed?
Other Resources
BasicAccountingHelp.com – Lessons on small business accounting and free spreadsheets