How Business Accounting Works


Tracking every penny may seem like a bore, but it'll put you closer to success. See more banking pictures.

People are starting their own businesses every day. If you're thinking about joining them, you probably have a vision of what you want that business to be. What may excite you about your business is the product or service you have to offer, the success that you imagine, and the freedom of lifestyle that you are sure will come -- in time. What may bore or even frighten you is the plethora of numbers you have to wrestle with. You will be asked business questions that may elicit a blank stare as your response. Cash accounting? Accrual basis? Profit and loss statement? Projections? Huh?

Whether you want to create fine oil paintings or sell pork bellies on the street, your business will require some form of accounting. That term alone can cast a glaze over the brightest eyes, but in this article, we'll show you that accounting is a process larger than crunching your numbers. It is a tool that will help you "account for" what your business has done, is doing, and hopes to do in the future. Accounting can be a bit like painting a picture, and a little like solving a puzzle. Despite its bad press, it can actually be fun.

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Keys to Success

The first step to making accounting fun is to get a grip on the terminology. If your heart skips a beat when someone asks about your balance sheet, you can calm yourself by learning exactly what a balance sheet is and how it can help you. We've added a glossary of accounting terms at the end of this article to get you over the hump.

Second, realize that accounting is more than numbers. It includes databases of your customers, your vendors, and your employees, if you have them. The information you keep on these people and companies will help you track your business and plan your future. With proper accounting, you might discover that people in the Florida Keys buy barrels of pork bellies in February. You can legitimately plan a sales trip for the entire month. See? This is getting interesting.

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Third, the key to successful accounting is in the establishment of your accounting system and the reliable input of data. You will set up a system that is uniquely yours. Recording the transactions and information is called bookkeeping, and it must be done regularly. You won't get a good picture of your company if the paint (data) is stored in boxes in the basement. There is nothing harder than the task of going back to find and key in reams of old information. When you do, you stand a good chance of getting something wrong.

Do You Need a CPA?

CPAs can provide a wide range of services, from setting up and administering your accounting system to consulting and tax preparation.

If for no other reason than tax planning, it is a wise move to consult an accountant. Accountants can help you generate the reports and financial statements you'll need to manage your business, as well as help you keep up with tax laws and reduce tax liabilities.

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You need to find an accountant that you can build a friendly and trusting relationship with. Here are some things to look for when hiring accountants or CPAs:

  • Are they licensed to practice in your state?
  • Do they have experience with your size and type of business?
  • Do they have good references? (Remember to ask for referrals from your banker, associates, or peers.)
  • Will they be accessible and return your calls promptly?
  • Can they provide insights into other areas, such as human resources or operations?
  • Are they respected in the community?
  • Do you trust and feel comfortable with them?
  • Do they represent themselves in a professional manner?

In addition to helping you set up your accounting system and assisting you with tax planning and preparation, you may also want to consider hiring an accountant or CPA to:

  • compile financial statements
  • review the statements you've generated yourself to find any problems or questionable items
  • perform an annual audit of your books to ensure everything is being maintained accurately

For help locating an accountant or CPA, there are many searchable databases on the Internet, but the best bet is to get referrals from friends, business associates, your legal advisors, bankers, or other trusted sources.

Software or Shoe Box?

An early question you'll want to answer is whether to set up a manual system or purchase a software program. You might think that your small, sideline business doesn't merit a software program that looks, from the splashy box, like it could run the government of the District of Columbia. Think again. Let's say you cater weddings on weekends, one a week. The maximum events you'll do in a year will be 52. That sounds manageable from a shoe box. But you purchase meats here, cheeses there, and the wine is shipped in. You use some for Sally's wedding, the rest for Sue's. Sally's mom needs to pay you in three installments, and you've gotten so busy you can't remember if the last check came in. Did you write it down? Where?

Software can simplify your bookkeeping by avoiding double (or triple) entries of data. You log it in here and the system will put it there, where you'll need it another day. It will tally sums and group numbers for you, saving endless hours on the adding machine. Software will help you set up procedures for handling the endless flow of paper that your business generates. But, you'll need a system that ensures that Sally's payment was recorded, whether you put that system in a shoe box or into your computer.

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Accounting vs. Bookkeeping

On to the terminology: We have already said the words "accounting" and "bookkeeping." Accounting is the big picture, the system that keeps track of data (including people), records your transaction history, gives you reports -- those all-important pictures of your company. Accounting also encompasses payroll, an area of particular concern since huge fines can accompany small mistakes. Of equal weight is the tax status of your company. Accounting is the system that will provide the reports and information you need.

Bookkeeping is the tedious part -- the systematic recording of amounts, dates, and sources of every revenue and expense you generate. Think of accounting as a giant sifter and of bookkeeping as the process of pouring stuff into it. Things get stirred around and you get the information you need to run your business.

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Cash or Accrual

Somewhere along the line, you will be asked if your accounting system is on a cash or accrual basis. If all your sales are cash sales, and all your purchases are paid when you pick them up, then the answer is easy -- that is cash accounting. If, on the other hand, you deliver goods or services and are paid sometime later, or if you take delivery of supplies and pay for them at another time, an accrual basis might make more sense for you.

These two bases of accounting produce wildly different results. If you are already doing business and it is not strictly cash, you can try it both ways. Choose a month (or a quarter, if you don't have many transactions) and for that month, record cash in and cash out -- actual payments you receive and make. Add the columns (in and out) and subtract the smaller from the larger. You've just created a cash-basis Profit and Loss Statement (P&L) for the month (or quarter). Now, run the numbers again, but this time list invoice amounts and cash sales (but not payments on invoices), and list the invoices that you have received from your vendors and cash purchases you made. But don't list the payments you made on invoices. Add the columns and do the math. You'll get a different outcome. Accountants usually recommend the accrual basis to get a better picture of how your business is doing. This is one of the first questions you'll have to decide when you set up your books.

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Breaking the System Down

Now here are the steps that will follow:

Choose a starting point. Many new companies operate as a sideline before they are organized into a bona fide business. If this is your situation, you'll need to choose a starting point for your accounting system. Remember that you will need to record every transaction from that date forward, so don't go back too far unless absolutely necessary. If you are nearing your fiscal year, wait and start the new system with the new year.

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Choose your accounts. Think of these in terms of assets and liabilities. Assets include checking and savings accounts, accounts receivable (money owed by customers), inventory, and even equipment that could be converted into cash. Liabilities include the money you owe to others (accounts payable), your credit card balance, and any other liabilities that are scheduled to be paid in following fiscal year (this could include sales tax, payroll taxes, insurance, etc.). Gather the following information:

Choose your accounts. Think of these in terms of assets and liabilities. Assets include checking and savings accounts, accounts receivable (money owed by customers), inventory, and even equipment that could be converted into cash. Liabilities include the money you owe to others (accounts payable), your credit card balance, and any other liabilities that are scheduled to be paid in following fiscal year (this could include sales tax, payroll taxes, insurance, etc.). Gather the following information:

  • Company legal name
  • Employee identification number (EIN) or your Social Security Number
  • The dates of your fiscal year
  • The type of forms you will use for your taxes (Accountant help may be needed here.)
  • Sales tax rates, if applicable
  • A list of items you will sell (products and services) including an ID number or name, the price or rate of what you sell, and whether what you sell is taxable (sales tax)
  • How you want to track sales -- by item, type of item, etc. (The guides that come with accounting software are helpful in this regard.)
  • (If you choose to track inventory) The cost of your inventory and the quantity on hand
  • A list of customers, addresses, phone numbers and e-mail addresses
  • A list of vendors with contact names, addresses, phones, and e-mail
  • The list of categories that you will use to track expenses - Some categories are pretty universal, like utilities and postage. Others will be particular to your business. If you have already been running your business as a sideline, look at the costs you have incurred and the categories into which they fall.

There are other questions you'll have to face that are related to accounting, but not strictly within the realm of setting your books. We have already mentioned the task of keeping the paper trail accessible. Filing can become an art form -- and a real sore spot if you don't do it well. You'll need to ask yourself how you plan to handle unpaid bills. How will you collect the money that your customers owe you? Remember the bride, Sally, in our early example. What if her mom didn't make that last payment and ignored your statements and calls?

That decision doesn't sound like fun, and maybe the other decisions you face and the gathering of all of this information still scares you. Most folks face this task with some sort of trepidation. But think of it as a creative process. After all, you are birthing a business. When your business is humming along with transactions sliding into their proper slots, you'll be able to click a button on your computer screen and get a picture, hopefully printed in black. You'll be able to smile and say, "Hey, that's my business!"

Glossary

Accounting

This is the system that tracks the transactions that make up your business income and expenses and then uses this data to create reports that show the financial and task status of your business.

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Accounts Payable

This is the money that your company owes to its vendors.

Accounts Receivable

This is the money that your customers owe to your company.

Accrual Basis Accounting

This is the accounting system in which reports are drawn from accounts payable, accounts receivable, cash sales, and cash payments. Most accountants recommend accrual basis accounting if you bill your customers or incur debt. (See Cash Basis Accounting)

Assets

The are the things that add value to your company: cash in the bank, accounts receivable, property, equipment, stocks or bonds, etc.

Balance Sheet

Think of a Polaroid picture. This is a snapshot of where your company is on a particular date. It lists assets, liabilities, and produces your equity -- the net worth of your company. (Download a Sample Balance Sheet, and visit our Tools Library for more samples.)

Bookkeeping

This is the process of entering data into an accounting system, including the amount, date, and source of each revenue or expense. No accounting system will work without reliable bookkeeping.

Budget

This is a process for managing cash flow in your company.

Cash Basis Accounting

This is the accounting system in which cash transactions are recorded and reports drawn from actual payments made into and out of your company. (See Accrual Basis Accounting)

Cash Flow

This is a summary of your company's sources and uses of cash. A cash flow report will show you changes in your cash position over a period of time. (Download a Sample Cash Flow Statement, and visit our Tools Library for more samples.)

Cash Sale (Receipt)

This is a sale of a product or service that is paid for when it is delivered. The paperwork that accompanies a cash sale is called a receipt and documents the delivery and payment.

Equity

This is the net worth of your company when all assets and liabilities have been accounted for.

Invoice

This is the written record of a transaction, often given to a customer or client when a service or product is delivered, but not paid for. Sometimes invoices are called bills, or even statements, although statements are technically something else (see below).

Liabilities

These are the things that your company owes to others: accounts payable, credit card debt, mortgages, etc.

Profit and Loss Statement

This is one of the reports that your accounting system will generate to give you a picture of how your company is faring. A P&L statement will look at a period of time such as a month, a quarter, or a year. You can compare with other periods of time to make decisions. (Download a Sample Profit and Loss Statement, and visit our Tools Library for more samples.)

Statement

This is a written summary of unpaid invoices. Statements may contain several invoices and are usually sent as a reminder of payment due.

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