In this post, we’ll cover the basics of accounting, from budgets to other accounting functions. But if you want to jump straight to the how-to, you can download our free guide to small business accounting.
A simple definition of accounting
Accounting is how your business records, organizes, and understands its financial information.
You can think of accounting as a big machine that you put raw financial information into—records of all your business transactions, taxes, projections, etc.—that then tells you a story about the financial state of your business.
Accounting is how you get a clear picture of your financial position. It tells you whether or not you’re making a profit, what your cash flow is, what the current value of your company’s assets and liabilities is, and which parts of your business are actually making money.
Accounting vs. bookkeeping
Accounting and bookkeeping are both part of the same process: keeping your financial records in order. However, bookkeeping is more concerned with recording everyday financial transactions and operations, while accounting puts that financial data to good use through analysis, strategy, and tax planning.
The accounting cycle
Accounting begins with recording transactions. Business transactions—any activity or event that involves your business’s money—need to be put into your company’s general ledger. Recording business transactions this way is part of bookkeeping.
Bookkeeping is the first step of what accountants call the “accounting cycle”: a process designed to take in transaction data and spit out accurate and consistent financial reports.
The accounting cycle has six major steps:
- Analyze and record transactions. Collect any invoices, bank or credit statements, and receipts from business transactions.
- Post journal entries to the ledger. It’s time to take those documents and start making journal entries for your transactions. Journal entries include three components of a transaction: when it happened, what it was for, and how much it was. Some businesses use single-entry accounting where only the expense or revenue is entered. But more common is double-entry accounting, which records each transaction in two accounts: where money is coming from and where it’s going.
- Prepare an unadjusted trial balance. At the end of a reporting period, list all of your business’s accounts and figure out their balances.
- Prepare adjusting entries at the end of the period. When you need to update entries you’ve already made, you prepare adjusting entries. For example, if a client is late on paying an invoice and you offer a 5% discount to help them pay, you would enter the discount as an adjusting entry, as opposed to changing the entry you’ve already made.
- Prepare an adjusted trial balance. After entering in adjusting entries, you’re left with an adjusted trial balance. This information is now ready to be turned into financial statements.
- Prepare financial statements. Finally, all the information you’ve collected is converted into your financial statements. This final step includes summarizing all your financial information into succinct reports for easy review.
Accounting software takes your accounting information and automates most of these rules and processes, so we’re going to skip over the gritty details of the accounting cycle and talk about the end product: financial statements.
Suggested reading: A Beginner’s Guide to The Accounting Cycle
Financial statements are reports that summarize how your business is doing financially.
Let’s say you’re a self-employed surfing instructor who bills clients for surfing lessons. Financial statements can tell you what your most profitable months are, how much money you’ve spent on supplies, and what the total value of your business is.
Accounting software can help you generate financial statements easily, or you can have a bookkeeper do it for you.
Suggested reading: The ROI of Hiring a Bookkeeper
Generally accepted accounting principles (GAAP)
Every company is different, but in order to make accurate financial comparisons between companies, we need a common language to describe each of them. That’s what generally accepted accounting principles (GAAP) are: a series of standards and procedures that accountants at all companies must adhere to when preparing financial statements.
A non-governmental body called the Financial Accounting Standards Board sets the GAAP. While there are no laws enforcing these standards, most lenders and business partners in the United States will require that you adhere to GAAP. If you’re in Canada, you’ll use a different system called International Financial Reporting Standards, or IFRS.
Cash vs. Accrual
You can do your business accounting on a cash or accrual basis. The difference between the two comes down to timing.
Cash basis is the most basic accounting. On a cash basis, you only record transactions when money changes hands. If you receive an invoice on the 10th but don’t pay it until the 15th, the transaction is recorded on the 15th.
With accrual basis, you record transactions twice: when they occur and when they’re paid. For the invoice above, you record the expense on the 10th and the payment on the 15th as two separate transactions.
The method you use depends on what you need from your business finances. Cash basis is simpler and easier to stay on top of, while accrual offers greater insights for more detail-oriented business owners.
Most small businesses have more basic accounting needs, which means cash basis is often the right fit.
Suggested reading: Cash Basis Accounting vs. Accrual Accounting
The different types of accounting
Every year, your company will generate financial statements that people outside of your company—people like investors, lenders, government agencies, auditors, potential buyers, etc.—can use to learn more about your business’s financial health and profitability.
Preparing the company’s annual financial statements this way is called financial accounting. If you’re looking to hire a financial accountant, start with looking into how much an accountant costs.
Managerial accounting (or management accounting) is similar to financial accounting, with two important exceptions:
- The statements produced by managerial accounting are for internal use only.
- They’re generated much more frequently—often on a quarterly or monthly basis.
If your business ever grows to the point where you need to hire an accountant full-time, most of their time will be taken up by managerial accounting. You’ll be paying them to produce reports that provide regular updates on the company’s financial health and help you interpret those reports.
This is somewhat similar to the work a financial analyst might do, although a financial analyst will also look at past and current trends in the larger economy, not just your business, to inform their recommendations.
Tax accounting is designed to make sure that you don’t pay more income tax than you are legally required to by the IRS. An example of this is when your accountant provides you with recommendations for how to get the most out of your tax return.
Tax accounting is regulated by the Internal Revenue Service (IRS), and the IRS legally requires that your tax accounting adhere to the Internal Revenue Code (IRC).
Whenever you’re trying to figure out how to increase your margin or deciding if raising prices is a good idea, you’re doing cost accounting.
Cost accounting involves analyzing all of the costs associated with producing an output (whether it be a physical product or service) in order to make better decisions about pricing, spending, and inventory.
Cost accounting is often a prerequisite of managerial accounting because managers use cost accounting reports to make better business decisions. It also feeds into financial accounting since costing data is often required when compiling a balance sheet.
Credit accounting involves analyzing all of a company’s unpaid bills and liabilities to make sure that a company’s cash isn’t constantly tied up in paying for them.
Credit accounting can be one of the most difficult kinds of accounting to do well, in part because it’s a difficult subject to be critical about. Talking about debts can be a sensitive, but necessary, conversation.
Why accounting matters for your small business
Accounting helps you plan for growth
Every great journey begins with a roadmap. When you’re planning your company’s growth, it’s essential to set goals. What should your profits look like one year from now? How about in five years?
Keeping up with your accounting helps you stay on top of your business finances. That information is essential to assess how quickly your business is developing and guide future decision making. Without accurate reporting, you won’t have the full financial picture.
Has your cost of goods sold increased? Are margins thinner? Are your growth goals reasonable? Without financial statements, you won’t have an objective answer.
Accounting is essential for securing a loan
Up-to-date financial statements are essential if you want to fund your small business with a loan.
For instance, suppose you want to apply for a Small Business Association (SBA) loan through one of the big banks. You’ll need to provide, on average, three years of financial statements, plus a one-year cash flow projection. It’s virtually impossible to deliver any of these if you don’t have an accounting system in place.
Suggested reading: What to Prepare When Applying for a Business Loan
You need accounting to attract investors or sell your business
You may not be planning to court investors or sell your business right now, but it’s a good idea to leave your options open. And the best way to do that is to put a proper accounting system in place now.
Potential investors, stakeholders, or buyers will expect accounting records vetted by a CPA (Certified Public Accountant) that prove your business is profitable and on track for growth.
Accounting helps you get paid
The balance sheet tells you how much of your AR you’ve already pocketed during the month and how much is still outstanding.
By referring to your balance sheet, you can track how effectively you’re collecting payment. Then you can put in place processes—like harder payment deadlines or better follow-up with clients—to make sure you get your hands on the money you’ve earned when you need it.
Accounting helps you stay on top of your debts
If your business owes debts to a variety of sources, like credit cards, loans, and accounts payable, you’ll have to jump into multiple accounts to check what you’re left owing.
The balance sheet shows everything you owe in one place. It also shows all your bank account balances so you can reference both at the same time. It’s the perfect report to review to make sure you have the cash available to tend to your debts and plan future payments.
Accounting keeps you out of jail (or at least saves you from fines)
As your business grows, it can be difficult to keep track of all your tax information reporting obligations. What’s more, if there are mistakes in your financial reports, you run the risk of misreporting your income. Either mistake could land you in hot water with the IRS and other regulators.
Solid accounting gives you complete, accurate financial records, which reduces your risk of breaking tax laws and the chance of an audit. And, when you have an accountant filing your taxes for you, you can be sure they’ll be done accurately and on time.
Accounting helps you pay the right amount of taxes (and not a dollar more)
If you don’t pay your tax bill in full, the IRS will fine you. But they won’t give you a gold star for paying too much.
You can tell you’re paying too much in taxes if your business consistently receives large tax refunds.
Remember: a tax refund isn’t free cash from the IRS. It’s money you’ve overpaid the government that you could’ve used to invest in your business instead.
Refunds are often the result of miscalculated quarterly estimated tax payments. To calculate quarterly estimated tax payments accurately, you need to predict your income. It’s almost impossible to do so without reliable financial records produced through accurate accounting.
Suggested reading: The Top 19 Self-Employment Tax Deductions
What an accountant does
An accountant does more than just year-end tax preparation. A skilled CPA will save you time by communicating your company’s financial state to you in clear language, while anticipating your financial needs.
Accounting professionals like CPAs or tax advisors can also provide you with knowledge and insight that are simply inaccessible to non-accountants. These experts can offer guidance on tax deductions you didn’t know you qualified for, tax rules you didn’t know you were breaking, and best practices picked up while working for other companies in your industry.
If those are tips your business can benefit from right now, it might be time to hire an accountant.
Suggested reading: How to Find an Accountant
Small business accounting software has made big advancements as more people take the entrepreneurial path.
The self-service software you use is now almost equal to the accounting software used in firms all over the world. There are now a wide array of options available—which one is best for you depends on your business’s accounting needs.
Freshbooks offers integrated invoicing that makes it simple to manage your accounts receivable and your accounting in one place. Automated bank reconciliation will import all transactions from your business bank accounts, but you will have to review and categorize each one. Their time-tracking functionality also makes it easy for freelancers who bill by the hour. Freshbooks is a good fit for someone generating a lot of invoices with a low number of transactions.
Intuit makes both Quickbooks and a payroll processor, and allows you to bundle both for one monthly cost. The payroll service automates payroll taxes, checks, and all year-end forms, but the accounting platform is mostly manual. While the tool is powerful and can help a skilled user navigate multiple aspects of running a business, it takes a good amount of know-how to get the most out of it.
If you prefer a completely hands-off approach to bookkeeping and accounting, Bench might be right for you. Connect your business bank accounts to have transactions automatically imported, categorized, and reviewed by your personal bookkeeper.
Communication is quick and reliable—the Bench platform allows you to send messages straight to your bookkeeper or set up a call to go over any financial questions that might come up. Our premium package even includes tax filing, which makes all accounting tasks completely automated. Learn more about how Bench can help.