Accounting Basics for Small Business Owners

Small business owners can do most of the accounting tasks themselves without having to hire an accountant. This is not uncommon when the business is just getting started. Even if business owners hire accountants to do this work, they should still learn the basics of accounting to understand what’s going on in the business.

This tutorial series will help you master basic accounting skills, so you can manage your business effectively.

Who Needs to Learn Accounting Basics?

Accounting is the language of business. The goal of accounting is to make accurate financial reports so business owners and stakeholders can make better decisions.

• Accountant/bookkeeper: It’s their job.
• Business Owners/Managers: A business needs a good bookkeeping and accounting system to operate day to day. A business needs accurate and timely data to operate effectively. The business owner needs to make sure enough money is coming in to cover all the money going out. A business needs to have accurate accounting data to file tax returns.
• Investors: They need to know how to make sense of financial statements to make savvy investment decisions.

Even if a business hires a full-time accountant to do the job, the business owner still needs to know some level of accounting to prevent from ripping off by the accountant.

Accounting Basics

In this tutorial, you will learn

• Financial statements
• double-entry accounting (debit and credit)
• accrual accounting and cash accounting
• The accounting cycle

These topics are the foundation of business accounting.

Bookkeeping VS Accounting

Bookkeeping and accounting may look similar, but they are not the same thing.

Bookkeeping is a part of accounting and it’s the dullest work in accounting. It has two main jobs:

• Recording all the detailed information regarding the transactions and other activities of a business.
• Generating a constant stream of documents and electronic outputs to keep the business operating every day

Accounting is much broader. It includes:

• Design the bookkeeping and accounting system
• Bookkeeping
• Create financial statements (monthly and yearly).
• Report to managers
• File tax returns (income tax, sales tax, payroll tax, etc)

Financial Statements

There are typically 4 common financial statements.

• Balance Sheet : The Balance sheet allows you to see how much wealth you accumulated since the business is born. The data is captured at a snapshot in time and not a time range. It’s like personal total wealth.
• Income Statement (aka profit & loss statement): The income statement allows you to see how much money you make each month. It’s like a personal salary each month.
• Statement of the Owner’s Equity: What the business has done with the profit (keep it in the company or distribute it to the owner).
• Cash flow statement: Where has cash come from and what does the business use the case for.

The accuracy of these financial reports is critical to the business’s survival. If you are a small business owner, you should at least get familiar with the first 2 statements. There is an equation for each statement.

Balance Sheet

For the balance sheet, you need to use the following equation.

 Assets = Liabilities + Owners’ equity

This is the equation for the balance sheet. It’s also called the accounting equation.

• Liabilities are creditors’ claim to the company’s assets
• Equity is the owners’ claim to the company’s net assets. Owner’s equity is also known as net assets.

If you liquidate your business (go bankrupt) today, you need to pay off your debts (liabilities) using the assets, then the owner can take what’s left in the business (the equity). You might see someone write this equation as

Asset - Liability = Equity

A company uses its assets to make money for the business. Assets include:

• Current assets
• Cash
• Accounts receivable
• Notes receivable
• Investments (long-term)
• Property, plant, and equipment
• Vehicles
• Intagible assets
• Other assets

Liabilities include:

• current liabilities: short-term financial obligations that are due within one year or within a normal operating cycle, accounts payable, notes payable, taxes payable, wages payable.
• noncurrent liabilities

There are two ways owner’s equity can increase:

• owner investment: Business owners transfer money from their personal bank account to the company’s business bank account.
• earn revenue

And there are also two ways owner’s equity can decrease:

• member distribution/dividend: Owners taking money out of the business.
• business expenses

Income Statement

For the income statement, use the following equation.

Revenue - Expense = net income

Revenue includes:

• Sales
• Investment income

Expenses include:

• Cost of goods sold
• Selling, general & admin expenses
• Interest expenses

If the net income is a positive number, then the business has profit, and there’s two things a company can do with the profit.

• Keep it. The profit becomes what is called owner’s capital in an LLC and retained earnings in a corporation.
• Pay it to the owners. This is called distribution or drawing in an LLC and dividend in a corporation.

Note: Although liabilities and expenses are things you subtract, you don’t need to add the negative sign (-) before the numbers in your financial statements.

When you prepare financial statements, you should follow this order:

1. Income Statement
2. Statement of the Owner’s Equity
3. Balance Sheet
4. Statement of Cash Flows

It’s common for businesses to prepare financial statements monthly, quarterly and yearly. Banks also create financial statements at the end of each day. Publicly-owned companies must hire a third-party auditor to examine their financial statements. Privately-owned companies such as single-member LLC are not required to do this, but they should still try their best to make sure the financial statements don’t have significant errors.

If the fiscal year of a business ends on December 31, then its yearly balance sheet should be prepared at midnight on December 31.

The Business Journey

Financing activities

The business journey begins with how the company is going to raise money.

• Equity Financing: Owners’ investment (such as member contribution in an LLC or IPO for a corporation)
• Debt Financing: Borrow money (such as a bank loan)

Investment Activities

Operating Activities

 

Double Entry Accounting

For every financial transaction, there are 2 entries in the book:

• Debit (DR): means left side
• Credit (CR): means right side

In the accounting world, debit just means the left side and credit just means the right side. Don’t think of them like debit card and credit card. There are 2 entries because they are needed to balance the accounting equation ( Assets = Liabilities + Owners’ equity).

 

Common financial transactions

Receive money from customer

• DR ⇑: Cash  $100                    CR ⇑: Revenue  $100

Pay bills

• DR ⇓: Electric Expense $50              CR ⇓: Cash $50

Withdraw Profits

• DR ⇓: Cash   $10,000                    CR ⇓:  Equity  $ 10,000

For cash, debit always mean increase, credit always mean decrease

The rule of debits and credits

1. Debit means left. Credit means right.
2. Debits must always equal credits.

Debit can be increase or decrease and credit can be increase or decrease. How do you know which account should use debit for increase and which account should use credit for increase?

• Debit balance account increases when you debit it and decreases when you credit it. (cash,
• Credit balance account increases when you credit it and decreases when debit it. (notes payable)

Asset and expense accounts are debit balance accounts. Liabilities, equity, and revenue accounts are credit balance accounts. There are some exceptions to this rule. For example,

• accumulated depreciation, which is a contra-asset, is a credit balance account.
• Owner withdrawal is an equity account, but it is a debit balance account. From the business’s perspective, the owner’s withdrawal is an expense, because it reduces cash in the business.

Normal balance

• For example, cash is a debit balance account. And we say the normal balance of cash is debit.
• notes payable is a credit balance account. And we say the normal balance of notes payable is credit.

 

Create a set of accounts

To begin bookkeeping, you need to create a set of accounts for your assets (such as cash, property), liabilities (such as bank loans). There’s no a single set of accounts that suits all business. You can pick a set of accounts here that seem close to your needs. You will be able to add, rename, modify, and remove accounts, at any time later on. You will also be able to add sub-accounts.

 

 

Business Transaction Workflows

There are typically 5 categories of transactions for a business:

• Receive money from customer
• Pay expenses to vendors
• withdraw profits
• purchase inventory
• pay employees

10 key accounting terms

• Operating revenue: revenue related to the business purpose
• Non-operating revenue: non-business related revenue, such as profit from selling a company asset
• Bottom-line: The bottom line is a figure in the income statement. It’s the net profit or net loss (Revenue less expense)
• Gross margin: It’s a ratio of gross profit divided by revenue.
• Profit margin: It’s a ratio of net income divided by revenue.
• Fixed asset: assets that last for more than a year such as equipment, furnishings, and vehicles
• capital expenditure: A capital expenditure is an amount spent to modernize, expand, or replace the long-term operating assets of a business. A business may also invest in
  financial assets, such as bonds and stocks or other types of debt and equity instruments. Purchases and sales of financial assets are also included in this category of transactions.
• bank reconciliation:
• internal control: a process established to keep accounting errors to an absolute minimum.
• petty cash:

cost accounting

✓ Choose accounts for a chart of accounts in your industry
✓ Create an audit trail to facilitate the review of your accounting records
✓ Adjust your accounting records with accruals and deferrals
✓ Make your business an attractive borrower
✓ Assess profitability of investments with present value and future value
✓ Manage inventory strategically to improve profit
✓ Eliminate bottlenecks that increase production costs
✓ Evaluate capital spending and opportunity costs
✓ Segregate duties to help prevent fraud

Withdraw Profits

Income statement shows net profit -> transfer money to owner -> cash account goes down, equity goes down (all on balance sheet).

• Never record owner’s draw on the income statement.
• If you use a payroll system to pay yourself, then it’s an expense and shouold be recorded on the income statement.

How to Set Up Quickbooks

Quickbook fetch transactions from your business bank account every day, but it only takes data of yesterday.

 

Software Overview

Setting Up An Accounting System for Your Business

Different Types of Accounting

Accounting can be divided as

• Financial accounting: Create financial statements for reporting to stakeholders such as lenders, shareholders, government, external auditors. They are external users of the company’s accounting information.
• Managerial accounting: Prepare internal accounting reports for business managers, so they can plan business activities and make informed business decisions.

Public companies need to publish financial accounting reports to stock holders.

Accouting Methods:

• Accrual accounting:
• Cash accounting:

In accrual accounting, there’s a principle called Revenue Recognition Principle, which states that revenue is earned when the product is sold or the service is completed, whether or not you received a payment. For example, if you sold an item in March, but you got the payment in April, then this revenue should be recorded in March. In cash accounting, the opposite is true. Revenue is earned when you receive the payment.

There’s also the Expense Recognition Principle.

The matching principle states that a company should match the expenses to the same periods in which the expense helped create revenue. For example, if your company prepaid auto insurance of $1,200 for the next year, then you should record the expense in each month next year ($100). You don’t record this expense at once ($1,200).

Most businesses use accrual accounting, which allows the company to match revenue with the expenses incurred to generate the revenue. A company must use accrual accounting to perform audits on the financial statements. Once you choose an accounting method, you should stick with it.

Generally accepted accounting principles (GAAP), which is a set of best practices for accounting in the United States, doesn’t recommend cash accounting, because it makes easy to manipulate financial statements. Both public and private companies should adhere to GAAP.

The Accounting Cycle

The goal of accounting is to create accurate financial statements, so the company management can know how the business is doing and make better decisions. And the IRS can audit your company using the financial statements.

The accounting cycle is a list of things that accountants need to do. All activities in the accounting cycle center around creating financial statements.

Step 1: Analyze Business Transactions and Events

You need to collect the source documents of business transactions and determine the financial effects of transactions. Source documents include:

• invoice
• Bills from suppliers
• Purchase orders
• bank statements
• sales tickets
• checks
• employee earnings records
• bank statements
• salary rosters and time cards (if you have employees)

Every business transaction affects at least two accounts. There are only 7 possible outcomes of business transaction.

• Asset goes up,

Your company should keep these source documents for at least 3 years. The IRS will likely request these documents if you get an IRS tax audit.

Step 2: Record Transactions in the Journal

Accounting involves a lot of recording transactions in the journal. This process is often called booking journal entries. Fortunately, you can automate this process with accounting software such Quickbooks.

The journal is also called the book of original entry. It’s created in chronological order to record each business transaction, like a personal diary. In your personal diary, you write what happens each day. In the accounting journal, you record what business transactions happened each day. If there’s no transaction in a day, then skip that day.

Journal entries are always in debit and credit format.

Step 3: Post to the Ledger

You can’t create financial statements directly from the journal. To achieve that, you need to create a ledger from the journal, which is known as posting to the ledger. The ledger records business impact on individual accounts. Each account has its own ledger, thus the financial statements can be created. If you combine all accounts in one place, it’s called the general ledger.

The difference between the journal and the ledger is that a journal keeps a record of transactions and events each day, whereas the ledger keeps a record of each account (cash, account receivable, expense, owner capital, etc).

This is very laborious work if you do it manually. You need to take accounts and numbers from transactions entered in the journals and record them in the correct ledger. Fortunately, this process can also be automated by accounting software such as Quickbooks, which is so affordable and easy to use. When you enter a transaction in the journal, Quickbooks automatically post it to the correct ledger.

• How to Set Up Quickbooks for e-commerce sellers

 

Step 4: Prepare Trial Balance

A trial balance is where you list the balance of each account, as of a certain date. You do this usually at the end of every month to check that you don’t make mistakes in bookkeeping. It’s a very simple process. You just need to take each account balance in the ledger and list them together like a journal entry. Normally you use the following order to list the accounts.

• asset
• liabilities
• equity
• revenue
• expenses

The purpose of the trial balance is to make sure all debits are equal to credits.

Step 5: Prepare Adjusted Trial Balance

Just because all debits are equal to all credits, doesn’t mean your bookkeeping has no errors. At the end of each accounting period (monthly, quarterly, and yearly), before the financial statements are created, a company should make adjusting journal entries. It’s a special type of journal entry that is used to bring an asset or liability account balance to its proper amount and to recognize a revenue or expense. Once it’s done, you have an adjusted trial balance.

There are 5 types of Adjustments:

• prepaid assets/expenses: convert assets into expenses. Some assets are going to become expenses. Examples are prepaid insurance, prepaid rent.
• depreciation:
• unearned revenue:
• accrued revenues
• accrued expenses

Rules of Adjusting journal entries.

• The cash account is never a part of adjusting journal entries.
• Every adjusting journal entry will either debit an expense account or credit a revenue account.

Adjusting journal entries will affect two of the following accounts.

• Revenue
• Expense
• Asset
• Liability

After making adjusted journal entries, you also need to adjust the accounts in the ledger, so you will have an adjusted trial balance. If you use accounting software like Quickbooks, it will automatically be done for you.

Step 6: Create Financial Statements

Now we can create the financial statements of off the adjusted trial balance.

When you prepare financial statements, you should follow this order:

1. Income Statement
2. Statement of the Owner’s Equity
3. Balance Sheet
4. Statement of Cash Flows

If you need to pay tax to the IRS, then you are going to calculate your income tax using the incoming statement. For example, if the business income tax is 21% and the net income is $1,000,000, then your income tax will be $210,000.

When you prepare the yearly income statement, just find your monthly or quarterly income statement and add the account balances up to generate the yearly income statement.

classified balance sheet

assets

• current assets: cash,  short-term investments, accounts receivable, merchandise inventory, prepaid insurance
• noncurrent assets: long-term investments, plant assets, intangible assets.

Liabilities

• current liabilities
• noncurrent liabilites

current ratio = current assets / current liabilities

asses the company’s ability to pay its debts in the near future. Higher is better.

Perform end-of-period procedures

• Proving out the cash
• closing journal entries

You need to close the journal entries by resetting revenue, expense, and withdrawal account balances to zero at the end of the period.  You can’t reset asset, liability and owner’s capital account to zero.

1. Close Revenue accounts to Income Summary
2. Close Expense accounts to Income Summary
3. Close Income Summary account to Owner’s capital
4. Close Withdrawals to Owner’s Capital

For example, if your company has a sales revenue of $200,000, then closing journal entry will look like this:

                      Debit        Credit
Revenue               200,000
    Income Summary                 200,000

and the expense for this period is $120,000, then next closing journal entry is:

                      Debit      Credit
Income Summary        120,000
     Expense                    120,000

So now the income summary account balance is 80,000. We close this to the Owner’s capital account.

                      Debit       Credit
Income Summary        80,0000
    Owner's captial                80,000

If the owner withdraws $50,000, then

                      Debit       Credit
 Onwer's capital      50,000 
     Owner Withdrawal             50,000

Now we have a Post-closing trial balance.

Step 7: Close the Books of the Year

close the books for one year and start with fresh books for the next year.

Recording Accounting Transactions (Keeping the Books)

Adjusting and Closing Entries

Preparing Financial Statements and Reports

• Income Statement
• Balance Sheet

Preventing and Detecting Fraud

Making Savvy Business Decisions

Auditing and Detecting Financial Fraud

 

Completing Tax Returns

 

Business accounting typically includes the following activities.

1. Setting Up Your Accounting System
2. Recording Accounting Transactions
3. Adjusting and Closing Entries
4. Preparing Income Statements and Balance Sheets
5. Reporting on Your Financial Statements
6. Planning and Budgeting for Your Business
7. Making Savvy Business Decisions
8. Handling Cash and Making Purchase Decisions
9. Auditing and Detecting Financial Fraud

Further Reading

• ✓ Choose accounts for a chart of accounts in your industry
  ✓ Create an audit trail to facilitate the review of your accounting records
  ✓ Adjust your accounting records with accruals and deferrals
  ✓ Make your business an attractive borrower
  ✓ Assess profitability of investments with present value and future value
  ✓ Manage inventory strategically to improve profit
  ✓ Eliminate bottlenecks that increase production costs
  ✓ Evaluate capital spending and opportunity costs
  ✓ Segregate duties to help prevent fraud