You can not know how your business is doing without at least some understanding of small business accounting. It shows you how you are performing financially and lets you know how much your business is worth. Your ability to track, understand, and manage the financial aspects of your business will make or break your future success.
Although there are a number of options for managing your accounting, such as hiring a bookkeeper or accountant or using small business accounting software, you still at least need to know how to set up small business accounting for your business.
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How to Set Up Small Business Accounting
1. Open a Business Checking Account
One of the first things you should do when starting a business is to open a small business bank account.
There are several reasons why you need a business bank account. A small business bank account helps you separate your business and personal finances, adds professionalism and legitimacy to your new venture, provides some personal liability protection, and helps prevent piercing the corporate veil.
The type of accounts you will need depends on the type of business you have and your specific needs. However, some of the first accounts you will need to open are small business checking accounts and small business savings accounts.
We highly recommend reading our review of the best banks for small business to help you choose the right bank account for your business.
2. Choose an Accounting Method
One of the first things you will have to do when setting up your small business accounting is choosing an accounting method.
The two methods of accounting are: cash basis and accrual basis.
- In cash basis accounting, you record income and expenses when the transaction is complete. For instance, if you accept payment on credit, you would not record income until it is received.
- In accrual basis accounting, you record income and expenses when they occur. This means that if you accept payment on credit or accrue liabilities that are owed, they would be recorded whether you actually received payment (for accounts receivable) or made payment (for liabilities) or not.
3. Track Income and Expenses
The underpinning of small business accounting is accurate recordkeeping. It is important to establish a system of tracking and organizing income and expenses from the beginning.
Whether you are planning on handling your small business accounting yourself, purchasing small business accounting software, or planning on hiring an accountant, you will still need a system in place to track income and expenses and get this information into the right hands to keep your books.
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4. Set up a Payroll System
If your business is going to employ anyone at all, you will need to set up a payroll system. This involves setting up a payroll schedule, tracking hours, withholding taxes, issuing employees their pay, sending out tax payments, and issuing year end tax information.
While this sounds like a lot, there are a number of services and software applications that can help. We recommend reading our review on the best payroll services for small business to help select the right payroll system for your business.
5. Set up Your Bookkeeping
Next, you will need to set up your bookkeeping. There are several options for setting up your bookkeeping system.
- You could go old school and rely on paper journals and ledgers, but this method requires a significant amount of knowledge of the accounting process and a lot more time and energy.
- You could use a spreadsheet program like Excel. While you have to have a little more knowledge of the accounting process, many small businesses rely on spreadsheets for tracking their financial performance.
- You could choose from the many providers of small business accounting software, such as Quickbooks and Freshbooks. Small business accounting software takes a lot of the work out of the accounting processes, and allows you to create financial statements easily.
- You could hire an accountant. This is the most sure-fire way to make sure your organization's finances are in good hands. Accountants can help you with managing your books, preparing your financial reports, and filing your taxes.
Make a Chart of Accounts
The first thing you will do in setting up your bookkeeping is compiling a chart of accounts.
A chart of accounts is a list of all of the business transactions along with how you organize and categorize them. There are five basic types of “accounts” in small business accounting:
- Revenue - Revenue, or income, is all money earned by the business, typically through the sale of products or services.
- Expenses - Expenses are all money transferred out of the business to generate revenues and include all costs associated with the business.
- Assets - Assets are everything that your business owns. Assets could include land and buildings, equipment, machinery, inventory, accounts receivable, and cash.
- Liabilities - Liabilities are everything that your business owes. Liabilities include all unresolved debts, including short- and long-term loans, as well as outstanding invoices, salaries, rent, or utility expenses.
- Equity - Equity is the interest held in the business by the owner(s) including capital investments and retained earnings.
Within each of the main accounts, you will need to create sub-accounts categorizing specific accounts. The sub-accounts will become accounts in your journals, while the main accounts will become accounts in your ledger.
After compiling a chart of accounts, the next step in getting started on your bookkeeping is recording transactions. Transactions are recorded in a journal using either single or double-entry accounting systems. However, while some of the smallest businesses may use single entry accounting, double-entry accounting is the norm. In double-entry accounting, each transaction is recorded twice – once in a debit and once in a corresponding credit account in its corresponding journal.
Balance and Close the Books
The next step in small business accounting is to balance and close the books at the end of each period. To do this, you will total the journal entries you made for the period and post them to the general ledger. Updating the general ledger balance in the process. The general ledger, or Book of Final Accounts, is where you account for all income, expenditures, assets, liabilities, and equity each period.
For each account in your general ledger, you will need to update it with the appropriate journal entries. Remember, because each journal transaction is recorded twice, the amount of the debits should equal the amount of the credits.
Once all journal entries are recorded, this is called the unadjusted trial balance. To test your trial balance, you will need to make sure that your account balances confirm to the accounting equation: assets = liabilities + equity.
If your account balances do not meet the accounting equation, you will need to return to your journal and ledger entries to find where the errors were made. Once your entries are corrected and your accounts “balance”, you can finalize what is known as the adjusted trial balance. It is from here which you will prepare your financial reports.
6. Prepare Financial Reports
Once your ledgers are complete, you will finally be ready to create your financial reports. Your financial reports or financial statements are what tell you the financial health and performance of your business.
The three key financial statements are the balance sheet, the cash flow statement, and the income statement. But, other types of financial statements are also used to understand the finances of the venture.
The Statement of Shareholder’s Equity describes any changes to the equity of shareholders. And, another common financial statement, the Note to Financial Statements breaks down types revenue, expenses, assets, and liabilities not detailed within the key financial statements.
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Common Accounting Equations
Your financial reports can be used to generate important metrics through which you can assess your business. Below are some of the most common accounting equations used to assess the financial health and performance of a business.
“The” Accounting Equation
Assets = Liabilities + Equity
Net Income Equation
Revenues - Expenses
Break Even Point (# of Units) Equation
Fixed Cost / (Average Price per Unit - Variables Costs per Unit)
Break Even Point (sales $) Equation
Average Price per Unit * Number of Break Even Units
Cost of Goods Sold (COGS) Equation
Beginning Inventory + Added Inventory - Ending Inventory
Retained Earnings Equation
Beginning Retained Earnings + Net Profit (or minus Net Loss) - Dividends Paid
Gross Profit Equation
Sales - COGS
Gross Profit Margin Equation
Gross Profit / Sales
Current Assets - Current Liabilities
Debt to Equity Ratio
Total Debt (Liabilities) / Total Equity
Return on Assets Ratio
Net Income / Total Assets
Return on Equity Equation
Net Income / Total Equity