It’s usually not necessary or even desirable for owners to immerse themselves in the details of business accounting. However, it is important to have a general knowledge and understanding of the basics of accounting. Following is an accounting primer to help get you up to speed on accounting basics or refresh your accounting knowledge if it has gotten a little rusty.
Defining Accounting and GAAP
First, here’s a simple definition of accounting: Accounting is the practice of recording, analyzing, interpreting and reporting financial information and transactions. By following what are referred to as generally accepted accounting principles, or GAAP for short, you ensure that your business is following a common set of accepted standards and procedures for accounting and financial reporting. This gives stakeholders assurances that your financial information is accurate, timely and consistent.
GAAP includes 10 basic principles and guidelines:
1. Economic entity assumption — Business transactions are always kept separate from personal transactions.
2. Monetary unit assumption — All economic activity is measured in U.S. dollars.
3. Time period assumption — The assumption that it’s possible to report business activities in a relatively short interval of time.
4. Cost principle — The term “cost” refers to how much money was spent when an item was first purchased.
5. Full disclosure principle — Any information that’s important to financial statement users be disclosed in the statements or in footnotes attached to the statements.
6. Going concern principle — The assumption that the business will continue to exist and not liquidate in the foreseeable future.
7. Matching principle — A requirement that businesses use the accrual method of accounting in which expenses are matched with revenue.
8. Revenue recognition principle — Under accrual accounting, revenue is recognized upon the sale of a product or performance of a service, regardless of when payment is received.
9. Materiality — Accountants are allowed to use their professional judgement to decide whether amounts are insignificant, such as rounding to the nearest dollar.
10. Conservatism — The principle that if there are two acceptable alternatives for reporting, accounts will choose the one that results in less net income.
A System of Recordkeeping
Following GAAP first requires that your business establish a system of financial recordkeeping by setting up accounts in which financial information is stored. These accounts generally include the following:
• Assets: These are things that your business has purchased and paid for but has not yet received payment for, such as inventory, accounts receivable and equipment.
• Liabilities: These are financial obligations that must be paid at a later date in the future, such as loans and accounts payable.
• Equity: This represents each owner’s ownership interest in the business. It’s determined by subtracting liabilities from assets.
• Revenue: This is billings to customers in exchange for goods delivered or services rendered.
• Expenses: These are business assets that are consumed in the process of delivering goods or providing services, such as office rent and employee wages.
A number of different kinds of transactions are recorded within these accounts, including the following:
• The sale of goods and services: This usually requires the creation of an invoice documenting how much the customer owes.
• The purchase of goods and services: This usually requires that purchase orders be issued and supplier invoices paid.
• Receipt of customer payments: Cash that’s received from customers must be matched with outstanding invoices.
• Payment of wages to employees: Employees receive wages based on the number of hours worked during the pay period, less deductions for the payment of taxes, health insurance and other expenses they are responsible for paying.
Preparing Your Financial Statements
After completion of these and other transactions, the next step in the accounting process is financial reporting. This consists of the preparation of three main types of financial statements:
1. The income statement — Also known as a profit and loss (or P&L) statement, this subtracts expenses from revenue to reveal a net profit or loss for the period being measured. This net profit or loss is often referred to as “the bottom line” for a business.
2. The balance sheet — This statement presents a business’ assets, liabilities and equity at the end of the reporting period. It provides a snapshot of your financial condition at a given point in time and also helps determine your company’s ability to pay bills and other financial obligations.
3. The cash flow statement — This statement details all of the sources and uses of cash during the period being measured. It will analyze all of your business’ operating, financing and investing activities so you can see where cash is coming from and where it’s going.
Financial statements can be prepared for any length of time (or reporting period) and at any given point in time. Many businesses prepare financial statements on a monthly or quarterly basis, though this isn’t necessary for every business. However, financial statements should be prepared at least annually at the end of your business’ tax year.
Working with an Accounting Professional
Accounting might not be your favorite part of running a business, but it’s critical to running a business that’s financially sound. This is true even if you’re not a “numbers” guy or gal.
If you choose to purchase your own small business accounting tools, be sure to discuss with your accounting professional what their needs are and which software solution will work best for both of you before you make any investment of time and money.
Most businesses retain an accounting professional such as a CPA to do the bulk of their accounting work. Depending on the size of your business, you can retain a full-time accounting professional on staff or hire an outsourced accountant.
Regardless, it’s important for you as the owner to understand the basics of business accounting. This will help you make sure that your business is running on all cylinders from a financial perspective.
Recap: Small Business Accounting 101
- Ensure that your business is following a common set of accepted standards and procedures for accounting and financial reporting
- Establish a system of financial recordkeeping by setting up accounts in which financial information is stored
- Financial statements should be prepared at least annually at the end of your business’ tax year
- If you choose to purchase your own small business accounting tools, be sure to discuss with your accounting professional
- Most businesses retain an accounting professional
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