To make and keep your business successful, you’ll need to have a good grasp of accounting basics.
Basic Accounting Terms
There are some terms that small business owners need to know to understand the basics of accounting.
- Accounts receivable: This is money owed to your business for services or goods that has not been collected. These are reflected as assets on your balance sheet.
- Accounts payable: This is money your business owes and is a liability on your balance sheet.
- Assets: These are everything your business owns that has monetary value. Assets can be tangible, like equipment, land, or cash, or intangible, like stocks and patents.
- Break-even point: A business’s break-even point is when total costs equal total revenue. At this point, there is no loss or gain for the business.
- Capital: Capital is a type of asset that provides an ongoing service to your business. For example, cash, facilities, software, or a brand name are all types of capital.
- Cash flow: Cash flow is the amount of money going in and out of your business.
- Credit: Credits are everything flowing out of your business, so they increase a liability or equity account or decrease an asset or expense account.
- Debit: Debits are everything flowing into your business, so they increase asset or expense accounts and decrease liability, revenue, or equity accounts.
- Depreciation: This is the decrease in an asset’s value over time.
- Expenses: These are the costs of doing business. Expenses fall into two different categories: cost of goods sold (COGS) and operating expenses. COGS are the direct costs of producing your services or products. Operating expenses are the indirect costs, such as property taxes or accounting fees.
- Gross and net margin: Gross margin is the amount of money your business has after deducting COGS. The equation is gross profit divided by revenue. Net margin is the net profit after all your expenses are taken into account. Your net margin shows your business’s profitability.
- Gross profit: Gross profit is your business’s revenue less COGS. In other words, take the money your business makes and subtract from it the costs of producing the good or service sold.
- Income statement: This is a financial document of a company that shows the business’s net profits and losses over a period of time.
- Inventory: Inventory is a type of asset. It’s the products you have for sale and the materials used to produce them.
- Liabilities: Liabilities are everything your business owes, such as money or services.
- Liquidity: Liquidity is all about measuring the ability to turn an asset into cash. If a company has a lot of liquidity, that means its assets can easily be sold for cash without much disruption to the business.
- Net profit: Net profit is your gross profit less all other expenses. Sometimes net profit is referred to as net earnings, net income, or your bottom line.
- Revenue: Revenue is the money your business makes from selling its products or services. This doesn’t include any expenses, but is only the money made.
- Valuation: Valuation is the process of determining the present value of an asset or an entire company.
Once you understand all these terms, you can start creating a balance sheet and managing your business accounts.
How to Create a Balance Sheet
A balance sheet is a snapshot of your business’s financial health at a single point in time. These are useful documents because they can show your business’s net worth and liquidity by comparing your current assets and liabilities. This information is useful to investors, banks and financial institutions, third-party suppliers, customers, and regulators, such as government agencies or stock market regulators.
A balance sheet will show your business’s assets, liabilities, and equity. The foundational equation for a balance sheet is:
Remember from our definitions above that assets are everything your business owns and liabilities are everything your business owes. Equity is the company’s value after all liabilities are deducted, and it’s the portion of the company owned by the business owners or shareholders.
To produce a balance sheet, create two sections and list all assets on one side and all liabilities and equity on the other. You then compare the total amount of assets to the total liabilities plus equity and see if the numbers are in balance.
How to Do a Cost-Benefit Analysis
A cost-benefit analysis (CBA) is an evaluation process that measures the benefits against the costs of a decision.
To do a CBA, tally up all the costs of a decision and subtract that number from the estimated benefits of the decision. If the benefits are greater than the costs, arguably this is a good business decision. If the costs outweigh the benefits, it may not be a sound decision.
There are four basic steps to a CBA.
- Determine the framework for your CBA — what are your goals or objectives for the decision?
- Identify your costs and benefits — create two lists, one with projected costs and one with estimated benefits of the decision.
- Assign a value to each cost and benefit — each cost and benefit needs a dollar amount for you to accurately compare the two.
- Add up the total values and compare — after you’ve assigned a dollar amount to the costs and benefits, tally up each list and compare the numbers. Remember to circle back to the goals for your decision.
By conducting a CBA, you may discover costs and benefits that you wouldn’t otherwise have considered had you not sat down and gone through them all. While it may be difficult to make predictions about estimated benefits or to assign dollar amounts to intangible costs, it’s still worth the effort, and there are methods and software available to help determine values.
Methods of Accounting
An accounting method is a set of rules used to decide when and how to report your business’s income and expenses. The two main types of accounting methods are cash accounting and accrual accounting. Some businesses are required to use the accrual method, so it’s important to check with the IRS before selecting your accounting method.
Under the accrual accounting method, you record and recognize transactions in your books once the sale is complete, even if you haven’t been paid.
The accrual method is common because it provides a more accurate representation of a business’s true profit by recording revenues and expenses at the time of the transaction. This method can also potentially reduce your tax burdens. Since expenses are accounted for at the time they are realized, you may be able to deduct some expenses before actually paying them.
On the other hand, the accrual method isn’t as simple as the cash method. The calculations are more difficult, and there are more rules and regulations. If you get a calculation wrong, you may be left with an inaccurate picture of your business’s financial state.
Under the cash accounting method, you record transactions only once you receive payment.
The cash accounting method is more straightforward and easier to understand than accrual accounting. It gives you a clear picture of the actual cash your business has on hand. There are no future estimations used in cash accounting.
A major disadvantage with cash accounting is that you don’t see the full picture of your business. Since you don’t include liabilities with this method, it may appear you have more cash than you actually do. There are also some restrictions set by the IRS on who can use the cash accounting method.
What is GAAP?
There are different ways to create your business’s financial statements. The generally accepted accounting principles (GAAP) are a set of rules, regulations, and guidelines that standardize the financial reporting process. The goal of GAAP is to create consistent and transparent financial reporting across companies.
The organization that oversees GAAP is the Financial Accounting Standards Board (FASB).
GAAP is required for all publicly traded and regulated companies. Even if your business isn’t required to use GAAP, it’s still useful. Under GAAP, you use the accrual method of accounting, so you have more accurate profit and loss reporting and a more realistic forecast of your projected revenues and expenses. Ultimately, GAAP can help generate financial statements that are accurate, complete, and comparable.
Bookkeeping for Your Business
Bookkeeping is a part of accounting, but they’re not the same. Bookkeeping is regular recordation and organization of a business’s financial transactions. Accounting encompasses more and is the process of recording, analyzing, and reporting financial information. Accurate bookkeeping is essential to understanding your company’s financial position and gives you the information to make sound business decisions.
There are some basic steps for keeping good books for your business.
Understand Your Business Accounts
We’re not talking about bank accounts, but rather your accounts for assets, liabilities, income, expenses, and equity. You need to be able to record each transaction in the appropriate account.
Create a Tracking System
Have a system in place to track and organize each account through the use of a ledger. A ledger is a centralized place to collect and record all account data — for example, a book or bookkeeping software.
Choose a bookkeeping method
Your bookkeeping method can be either single-entry bookkeeping or double-entry bookkeeping. Single-entry is when you enter each transaction only once in one account. With double-entry bookkeeping, you record the transaction twice: once as a debit and once as a credit. This keeps your books in balance.
Keep documentation of every transaction
It’s important to keep records of all your transactions. This can be a receipt, invoice, purchase order, or some other type of financial record of the transaction.
Periodically balance your books
Whether it be weekly, monthly, or quarterly, look at your debits and credits to see that the totals match.
Get the help you need
While you can do your own bookkeeping, you also have the option of using a bookkeeping software, hiring your own bookkeeper, or outsourcing the task to an accounting service.
Business credit is a company’s ability to obtain financing. Having credit allows your business to
purchase what it needs to operate, such as products or services.
Dun & Broadsheet, Inc.
Dun & Bradstreet, Inc. (D&B) is a corporation that provides data on companies and uses that information to create commercial credit reports.
It’s important to find out whether you have a business credit profile with D&B because one can be created without you knowing. For example, if you have overdue invoices, the vendor could report this to D&B establishing an unfavorable file for your business. Lenders often look at D&B reports to determine your business’s eligibility for financing. To know if you have a credit profile, visit D&B’s website and search with your company’s information to see if your business is listed.
How to establish and maintain good business credit
To create business credit, you first need to establish your business as an independent legal entity, such as a corporation or limited liability company (LLC). The next step is to apply for a tax identification number, also known as an Employer ID Number (EIN), which is essentially a social security number for your business. Once these steps are complete, you can apply for business credit.
To maintain good credit, fulfill all business obligations on time and regularly monitor your business credit reports and scores for accurate reporting.
Your business credit reports not only impact your ability to obtain financing, but they can also affect your interest rates, payment terms, and insurance premiums. Other parties can pay to access your credit reports without you even knowing, so you want to check that they’re accurate and up to date.
The most commonly used business credit agencies are D&B and Equifax. If you already have a credit file with the agency, you will know by doing a search for your business on their website. From there you can order a business credit report to review. If you don’t have a file yet, you can open one by applying for a Data Universal Number System (DUNS) number through D&B. A DUNS number is a nine-digit identification number assigned to your business. This will open up a credit file with D&B.
How to check the business credit of clients and vendors
Just as you can use D&B or Equifax to check your own credit report, you can also use those agencies to request the credit report of a potential client or vendor. Depending on which credit report service you choose, you may need to pay a fee.
Focus on the Basics
While accounting may seem like an overwhelming task, it’s necessary to the success of your business. Having an understanding of the accounting basics will hopefully help you decide if you need to bring in the professionals. There are plenty of resources available, such as software programs or hiring bookkeepers and accountants.
When you use ZenBusiness to form a corporation or LLC, you will receive a free accounting consultation with one of our experts. We provide recommendations on your accounting, bookkeeping, and tax needs during your first year of business. Let us help you get your business off on the right foot, so you can grow with confidence.
Accounting Basics FAQs
- Should I hire an accountant for my small business?
While it’s possible for you to do your own accounting, the expertise and skills of an accountant can be incredibly beneficial as your company grows. Accountants are trained in the best accounting practices and procedures and can analyze financial data. These professionals can also develop financial strategies and produce detailed financial reports.
- How much time do small business owners spend on bookkeeping?
According to the latest survey by the National Small Business Administration (NSBA), small business owners spent more than 40 hours per year preparing and filing federal taxes.
- How much does it cost to hire an accountant?
The cost of an accountant varies based on their experience and the work you’re asking them to do.
- What is the best accounting method for a small business?
Small business owners typically choose the cash method of accounting because of its simplicity. Businesses that have inventory for sale to customers must generally use an accrual method for sales and purchases. However, small business taxpayers with gross receipts of less than $25 million a year may use a cash method for sales and purchases.
For those who choose or are required to use the accrual method, keep in mind that there are software programs that can help you with this more tedious method of accounting.
- Should I have a separate bank account for my business?
Commingling personal and business funds can be a nightmare come tax time. Having to go through and decipher which transactions were for yourself and which were for your business can be a painstaking and time-consuming task. The IRS actually recommends that small business owners open a separate bank account, even if they’re not required to.