When launching a business, you need to understand your industry inside and out, but as an entrepreneur, you have to wear a lot of different hats and that includes playing the accountant. Whether you plan to track your own numbers, hire a bookkeeper, work with a professional accountant, or use accounting software, you need to understand a few accounting essentials.
To brush up on your accounting knowledge, check out this quick and easy guide to accounting 101 concepts.
Revenue refers to the money you collect from your customers for your products and services. For example, if a client pays you $1,000 to do some graphic design work, you have $1,000 in revenue. Similarly, if you run a toy store and you sell $200 in toys, that is your revenue.
Profit and Business Expenses
Revenue is not the same as profit. To determine your business’s profit, you need to subtract your business expenses from your revenue. To explain, imagine your business earns $100,000 in revenue over the course of the year. However, you also pay $12,000 in office space rent, $2,000 in utilities, and $10,000 in other business expenses. When you subtract the $24,000 of business expenses from your revenue, you have $76,000 in profit.
In most cases, you pay income tax on your business’s profits, but the exact tax situation varies based on the structure of your business. If you run a sole proprietorship, you report your business profits as personal income and you pay tax accordingly. With a partnership, you report your percentage of the business’s profits and pay personal income tax on that amount.
In contrast, if you have a corporation, the business has to submit a corporate income tax return and pay corporate income tax on the profits. However, in this case, the business generally pays you a salary or dividends — that counts as a business expense, helping to lower the corporation’s profits on paper and saving you money on corporate income tax.
Cash Vs Accrual Basis Accounting
There are two main business accounting methods: cash basis and accrual basis. With cash basis accounting, you account for transactions when you receive or spend the money. For instance, if you pay your electricity bill, you note the expense in your accounting records when you write the check. Similarly, if a client pays you for work, you also record that revenue when you receive it.
With the accrual basis method, you record transactions when you make the deal rather than when the cash exchanges hands. To explain, imagine you issue an invoice for a client. Under the accrual method, you record the revenue as soon as you issue the invoice. You don’t have to wait until you receive the cash. In most cases, you can choose the accounting method that works best for you, but if you carry inventory, are a c-corporation, or have more than $5 million in annual gross revenue, the Internal Revenue Service requires you to use the accrual method.
When running a business, you can’t just focus on profits. You also need to think about your cash flow. Although often confused with profits, cash flow is not the same. It refers to the amount of cash that flows through your business. In some cases, especially if you use the accrual basis of accounting, you can have a lot of profits on paper but not a lot of cash flow.
To give you an example, imagine a client hires you to do a $50,000 project. Because you use the accrual method, you record the revenue in your accounting records when you agree to do the project, but you don’t actually have the payment yet. While working on the project, you incur $10,000 in business expenses. As a result, you have $40,000 in profits, but you don’t actually have any cash flow from this project yet.
As a business owner, you need cash to cover expenses and pay wages to employees, and a cash flow statement can be instrumental in helping you keeping tabs on cash flow. You may also want to create cash flow projections that show you how much cash you are likely to have on hand in the future so that you can plan for expenses based on that information.
Profit and Loss Statement
One of the most popular accounting statements used by business, a profit and loss or P&L statement details business revenue and expenses over a specified time period. You can use profit and loss statements to compare profits and losses between different time periods, and that helps you assess how your business is growing. Companies that are publicly traded on the stock market are required to release P&L statements quarterly and annually.
Accounts Receivable & Accounts Payable
When you run a small business, you may hear the phrases accounts receivable and accounts payable. Receivables are the amounts your clients or customers owe to your business. For instance, if you issue 10 invoices worth a combined total of $30,000, that is your accounts receivables.
Accounts payable are the bills that your business pays. This accounting category can include bills to your vendors and suppliers as well as regular monthly expenses such as rent, wages, utilities, subscriptions, and more.
Keeping on Top of Small Business Accounting
Keeping on top of your business accounting is essential. To be compliant with the IRS’s rules, you have to report all your revenue, but to keep your tax liability as low as possible, you also need to ensure that you claim all your business expenses. If you don’t track the numbers during the year, filing your tax return can become very time consuming and cumbersome.
Ideally, you should set aside time on a regular basis to deal with your accounting. A separate business bank account or credit card can be incredibly helpful for tracking income and expenses, but you may also want to look into apps that can help you stay on top of everything easily.