Launching a small business requires hard work and dedication. Running it can be stressful as well. Many entrepreneurs are stronger in the creative, technical, or engineering areas than they are in business fundamentals. If you are not well-versed in the basics of bookkeeping, you may have engaged an accounting firm to handle your books. You might think that this frees you from having to learn anything about business accounting. However, without a basic understanding of accounting principles and terminology, you and your accountant will likely have difficulty communicating effectively. Furthermore, knowing what should be transpiring can help you judge whether your accountant is performing his or her job in a manner that protects you and your business. Here are the most important fundamentals of accounting that you need to know.
There are two primary methods of accounting.
1. The cash method is virtually identical to the way that you handle your personal checking account; you record revenue when it is received, and you record expenses as you pay them. If you have an inventory, the Internal Revenue Service will almost always forbid you from using the cash method. Because the cash method violates generally accepted accounting principles, commonly referred to as GAAP, your accountant will likely encourage you to avoid the cash method even if the IRS permits you to use it. One big problem with the cash method is that it violates the principle of matching expenses and revenue in the same time period. For example, suppose you purchase inventory items that cost a total of $10,000, but it takes you six months to sell them all. Your expenses will be overstated for the month in which you purchased the items, and the revenue that you receive in the subsequent months will also be overstated.
2. The accrual method involves recognizing earnings and expenses in the period they are earned or acquired regardless of when the money actually changes hands. To illustrate, suppose you order some inventory items on March 25 and use your company credit card to pay for them. You do not make a payment on the credit card until April 25. However, on March 29, you receive the order and a customer purchases the items, paying you in cash. You deposit the cash on March 30. You do not need to accrue the revenue, but you need to accrue the expense so that both the revenue and the expense are recognized in the same month.
There are a number of reports that your accountant could generate, including reports detailing the age of your accounts receivable or your accounts payable. However, there are three financial statements that he or she should generate for you to review. These are the income statement, the balance sheet and the cash flow statement. Although some companies choose to produce these statements quarterly or even annually, as a small business, you really should review them monthly. Monthly reports give you a chance to make corrections to your marketing plan, sales goals or budget before more harm can be done.
1. The income statement lists all of your revenue and expenses for a specified period. The last item on the statement will typically be a number that reflects the subtraction of the total expenses from the total revenue, i.e., your profit or loss for the period. Accounts appearing on the income statement will be reset at the end of the period, but the information is not purged. Therefore, most software systems will allow you to also print an income statement for the quarter, the entire year, or any other range of dates that you choose.
2. The balance sheet records your assets and liabilities. Your assets include the funds in your bank account, your accounts receivable and your inventory. If you are purchasing or own your building, vehicles, equipment or furniture, these will also be included as assets. Your liabilities represent amounts that you owe. For example, if you financed your vehicles, the balance that you owe will show as a liability on the balance sheet. Expenses that you accrued will also show as liabilities until you actually pay them. The final entry on the balance sheet is usually your equity, which is what remains after subtracting your total liabilities from your total assets. Unlike the accounts on an income statement, the accounts on a balance sheet are never reset automatically.
3. The cash flow statement is considered one of the most difficult reports to produce, but it is extremely valuable if you are a new or struggling business. Essentially, it shows how cash is flowing into and out of your business. It is primarily concerned with changes in your income and balance sheet accounts, breaking these changes into financing, operating and investing activities. Because the cash flow statement provides a picture of your company’s solvency and its ability to meet its financial obligations, most lenders and creditors will use this statement as part of their decision on whether to approve your request for a loan or financing.
Debits and Credits
The overwhelming choice for accounting is the double-entry system. In simple terms, this means that every transaction affects at least two accounts. For example, when you write a check to pay the rent on your building, you are affecting your bank balance and the account associated with your property rental expenses. Debits either increase expense and asset accounts or decrease a liability account. Credits either decrease expense and asset accounts or increase a liability account. Therefore, you would credit your bank account and debit your rent expense account. For each transaction, the total of all debits and all credits must be the same but opposite signs. When you add all of the negative and positive numbers, they should total $0. In accounting terms, they offset each other.
The cost principle is one of the most difficult concepts to understand for many people without an accounting background. Basically, it states that the cost of an asset is always reported at its purchase price even if the asset’s value decreases or increases. The changes in the asset’s value can be recorded to reflect depreciation or recognize a loss or gain on the sale of an asset. An automobile is a good example of an asset that will almost always need to be depreciated. When you purchase it, you record an asset in the amount of the purchase price. However, since the value of the automobile will decline over the next five years, you can make a monthly entry to record a depreciation expense, which is an income statement account, with an offset to accumulated depreciation, which is a balance sheet account. You do not change the asset itself. If you sell the vehicle for more than its depreciated value, you would record a gain on the sale of the asset, and if you sell it for less, you would record a loss.
Common Currency Principle
Sometimes referred to as the monetary unit principle, this is a GAAP requirement that all activities share a common currency. Suppose that you operate a business in the United States, but you extend credit and ship to a customer in Canada. The customer remits a check that is drawn on a Canadian bank and is in Canadian dollars. Since all of your other activities are in United States dollars, you must convert the customer’s payment to adhere to the common currency principle. Most banks can assist you with this, so the easiest way is to take the check and a blank deposit slip to your bank. The bank will convert the amount to reflect the current rate of exchange so that you can record the payment accordingly. However, because exchange rates fluctuate, the payment may be for less or more than your invoice. Your accountant can make a journal entry to record the discrepancy if it is deemed significant.
Like most professionals, accountants have a language of their own. If you have a working knowledge of this language, you will be in a better position to ask relevant questions, understand some of your accountant’s more mysterious requests, and spot errors in your records and statements. Furthermore, should your accountant retire, you will be able to immediately begin to communicate effectively with your new accountant. A basic understanding of accounting can make life easier for you as well as your accountant.
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