You probably didn’t get into selling handmade soaps so you could spend your time on accounting and bookkeeping. That’s why, if your business can afford it, hiring an accountant to take care of your finances is a great idea. However, it is still a good idea to understand the basics of accounting to avoid surprises and make solid business decisions. Thankfully, accounting and bookkeeping today are made much easier by cloud-based software, such as QuickBooks, which allows you to track expenses, sync with your bank and generate reports and financial statements in just a few clicks. Here, we’ll cover some basic terms and concepts you should know.
The first step in the accounting process is recording journal entries that are triggered by business transactions. Today, few transactions are conducted with cash exchanging hands, which has made recordkeeping much easier. Most business transactions are done on credit, usually through a line of credit or credit card.
In accrual accounting, transactions are recorded when they happen, not when they are actually paid for. So when you purchase something on credit, the transaction occurs at the point of sale, not when you pay the bill later on.
A journal entry consists of a debit and credit to at least two different accounts. Assume that you use a credit card to buy $100 worth of office supplies. One journal entry would be a $100 debit to the supplies account since you have increased your assets by the amount. The other journal entry is a $100 credit to the accounts payable account since that amount is now a liability owed to your credit card company. Note that the debit equals the credit entry, so they balance to zero.
Company transactions are recorded in a general ledger as journal entries. It will show changes in each account and is normally reconciled monthly. Traditionally, accountants created a "T" summary for each account, with the name at the top and two columns on either side of the T-stem. The left column lists all the debits and the right column lists all the credits.
The information from the T accounts is used to create the trial balance. This is a table that lists the balances of all the asset accounts, and the equity and liability accounts. Asset accounts normally have a debit balance: buildings, land, equipment, cash, inventory, accounts receivable, etc. Equity and liability accounts normally have a credit balance: owner's equity, mortgages, outstanding loans, accounts payable, etc.
The trial balance should reflect totals for debits and credits. During certain accounting periods, adjustments are made for items such as prepaid expenses and depreciation.
For most small businesses, monthly reviews of your financial status are adequate, although you may want more frequent reports or information. At a minimum, you'll need financial data to complete your annual tax returns.
Depending on the legal structure and organization of your business
, you may be required to produce financial statements on a regular basis. For corporations, this is usually quarterly and consists of a balance sheet, cash flow, income statement and accompanying notes:
- Balance sheet: Shows who owns the company (stockholder's equity), what the company owes (liabilities) and what the company owns (assets). Remember this simple formula: Assets = Liabilities + stockholder's equity
- Cash flow: Summarizes changes in cash position during the year
- Income statement: Displays the revenue (sales) and expenses that were experienced during the reporting period
- Notes to statements: Contains explanations necessary to understand and analyze the statements, as well as details regarding company accounting methods
The process is completed when the accounts are closed and reset for the next reporting cycle.
The Financial Accounting Standards Board (FASB) establishes private sector standards for financial accounting. The standards are recognized by the Securities and Exchange Commission and the American Institute of Certified Public Accountants.
The FASB sets generally accepted accounting principles (GAAP) primarily through its Statements of Financial Accounting Standards. These statements provide the highest level of financial guidance and are sometimes expanded upon by other FASB pronouncements.
Understanding your finances is critical to successfully running your business. Your customers, suppliers, and lenders are counting on you to keep accurate financial records. Whether you use an accountant or not, you still have a legal and ethical obligation to maintain the integrity of your finances. It will also make tax time and dealing with the Internal Revenue Service a whole lot smoother.