Accounting Basics 101: What Small Business Owners Must Know

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Welcome to Accounting 101: Accounting Basics for Small Business Owners.

In this article, we’ll break down everything you need to know about accounting.

Understand these concepts and put them into practice to improve your financial literacy.

Here’s what we’ll cover:

What Is Business Accounting?
Accounting vs Bookkeeping
Accounting Basics
Accounting Principles
How to Do Accounting for Small Business
CPA vs Bookkeeper
Frequently Asked Questions

What Is Business Accounting?

So, what exactly is business accounting?

Business accounting is the process of recording, summarizing, analyzing, and reporting financial transactions and information related to a business.
It involves tracking the flow of money into and out of your business, keeping tabs on expenses, income, assets, liabilities, and equity.
Accounting serves as the language of business, allowing you to make informed decisions, understand your financial health, and comply with legal and regulatory requirements.
By maintaining accurate and up-to-date accounting records, you gain valuable insights into your business’s performance, profitability, and areas for improvement.
Business accounting encompasses several key components, including bookkeeping, financial statements, tax compliance, budgeting, and financial analysis.
It’s important to note that accounting principles and practices may vary based on your location and the size and nature of your business. However, the fundamental concepts remain consistent across the board.

Accounting vs Bookkeeping

Let’s compare and contrast accounting and bookkeeping, two essential components of managing your business’s financial records:

Accounting:

Accounting is a broader concept that encompasses bookkeeping. It involves the entire process of recording, analyzing, interpreting, and reporting financial transactions and information.
Accountants typically have a higher level of education, such as a degree in accounting, and may hold professional certifications like Certified Public Accountant (CPA).
Accountants provide a more strategic and analytical perspective. They analyze financial data, interpret trends, and offer insights to support decision-making and long-term planning.
Accounting involves preparing and presenting financial statements, such as the income statement, balance sheet, and cash flow statement. These statements provide a comprehensive overview of the business’s financial position and performance.
Accountants play a crucial role in ensuring compliance with relevant laws, regulations, and accounting principles. They handle complex matters like tax planning, audits, and financial reporting requirements.

Bookkeeping:

Bookkeeping is a subset of accounting and focuses on the systematic recording and organization of financial transactions.
Bookkeepers primarily handle the day-to-day financial activities, such as recording sales, expenses, and other transactions into the books or accounting software.
While bookkeepers don’t typically require advanced education or certifications, they need strong attention to detail and a solid understanding of accounting principles.
Bookkeeping involves tasks like maintaining general ledgers, reconciling bank statements, tracking accounts payable and receivable, and generating financial reports.
Bookkeepers provide the foundation for accurate and reliable financial data. They ensure that all transactions are properly recorded, classified, and organized, laying the groundwork for the accounting process.

Accounting Basics

1. Income Statement & Profit and Loss Statement (P and L)

Definition:

The Income Statement, or Profit and Loss Statement (P&L), is a financial statement that summarizes the revenues, expenses, gains, and losses of a business over a specific period, typically a month, quarter, or year. It provides a snapshot of a business’s financial performance during that period.

Why It’s Important:

The Income Statement is crucial for several reasons:

Performance Evaluation: It allows you to assess your business’s profitability and overall financial performance. By comparing revenue and expenses, you can determine if your business is generating a profit or incurring losses.
Decision Making: The Income Statement helps you make informed decisions about various aspects of your business, such as pricing, cost control, and investment opportunities. It provides insights into which areas are driving profits and where there might be opportunities for improvement.
Investor and Creditor Perspective: External stakeholders, such as investors and creditors, often review the Income Statement to assess the financial health and potential risks of a business. It helps them gauge the viability and profitability of investing or lending to your business.
Tracking Trends: By examining Income Statements over multiple periods, you can identify trends in your business’s financial performance. This analysis enables you to spot patterns, anticipate changes, and make strategic adjustments to enhance profitability.

What It Tells About Your Business:

The Income Statement reveals several key insights about your business:

Revenue Generation: It shows the total revenue your business has generated during the specified period. This includes sales of products or services, as well as any other income streams.
Cost Analysis: The Income Statement breaks down various expenses incurred in running your business, such as cost of goods sold (COGS), operating expenses, taxes, and interest expenses. It helps you understand where your money is going and identify areas where costs can be reduced.
Gross Profit and Net Profit: The Income Statement calculates the gross profit by subtracting the COGS from the revenue. It then deducts operating expenses, taxes, and other expenses to arrive at the net profit or net loss. This indicates the overall profitability of your business.
Profit Margin: By comparing the net profit to the revenue, you can calculate the profit margin, which represents the percentage of each dollar of revenue that translates into profit. It provides a measure of efficiency and helps evaluate the financial viability of your business.

2. Balance Sheet

Definition:

The Balance Sheet is a financial statement that provides a snapshot of a business’s financial position at a specific point in time. It presents a summary of the business’s assets, liabilities, and shareholders’ equity, also known as the accounting equation: Assets = Liabilities + Equity. The Balance Sheet reflects the business’s financial health and its resources and obligations.

Why It’s Important:

The Balance Sheet holds significant importance for several reasons:

Financial Position: It offers a comprehensive view of your business’s financial position at a given moment. It shows what your business owns (assets), what it owes (liabilities), and the owners’ investment (equity).
Assessment of Solvency: The Balance Sheet enables you to evaluate the solvency and liquidity of your business. By comparing assets to liabilities, you can determine if your business has sufficient resources to cover its obligations.
Financial Planning: It assists in financial planning and decision-making. The Balance Sheet provides insights into the composition and value of assets, the amount and nature of liabilities, and the shareholders’ equity. This information helps in setting financial goals, determining financing needs, and making informed investment decisions.
Stakeholder Analysis: External stakeholders, such as investors, creditors, and potential business partners, often review the Balance Sheet to assess the financial strength and stability of a business. It provides them with crucial information to evaluate the risks and opportunities associated with engaging with your business.

What It Tells About Your Business:

The Balance Sheet offers valuable information about your business’s financial standing:

Assets: It provides a breakdown of your business’s assets, such as cash, accounts receivable, inventory, property, plant, and equipment. This helps in assessing the value of resources available to your business.
Liabilities: The Balance Sheet outlines the liabilities your business owes, including accounts payable, loans, and other obligations. It reveals the short-term and long-term financial commitments.
Shareholders’ Equity: The Balance Sheet displays the owners’ equity, which represents the net assets or value of the business after deducting liabilities from assets. It reflects the owners’ investment and retained earnings.
Working Capital: By comparing current assets (e.g., cash, accounts receivable) to current liabilities (e.g., accounts payable, short-term debt), the Balance Sheet helps determine the working capital, indicating your business’s ability to cover short-term obligations.
Financial Ratios: The Balance Sheet serves as a foundation for calculating important financial ratios like the current ratio (current assets divided by current liabilities) and debt-to-equity ratio (total liabilities divided by shareholders’ equity). These ratios provide insights into liquidity, leverage, and overall financial health.

3. Cash Flow Statement

Definition:

The Cash Flow Statement is a financial statement that provides an overview of a business’s cash inflows and outflows during a specific period. It focuses on the cash movements resulting from operating activities, investing activities, and financing activities. The Cash Flow Statement tracks the actual cash transactions, reflecting the business’s liquidity and cash management.

Why It’s Important:

The Cash Flow Statement holds significant importance for several reasons:

Cash Management: It helps you monitor and manage your business’s cash flows effectively. By analyzing the sources and uses of cash, you can make informed decisions about budgeting, cash reserves, and optimizing cash flow cycles.
Liquidity Assessment: The Cash Flow Statement enables you to assess the liquidity of your business. It provides insights into the availability of cash to cover immediate expenses, debt obligations, and investments.
Financial Health: It offers a comprehensive view of your business’s financial health beyond profitability. A business can be profitable but still face cash flow challenges. The Cash Flow Statement helps you understand the actual cash position of your business.
Decision Making: The Cash Flow Statement aids in making informed decisions about financing, investment opportunities, and day-to-day operations. It provides insights into the cash impact of various activities and allows you to evaluate the potential risks and rewards.

What It Tells About Your Business:

The Cash Flow Statement provides valuable information about your business’s cash movements:

Operating Activities: It shows the cash generated or used by your business’s core operations, including revenue collection, payments to suppliers, employee wages, and other operating expenses. This section reveals the cash generated from day-to-day business activities.
Investing Activities: The Cash Flow Statement outlines cash flows related to investing activities, such as the purchase or sale of assets, investments in securities, and loans to other entities. It provides insights into your business’s capital expenditures and investment decisions.
Financing Activities: It highlights cash flows related to financing, including cash obtained from borrowing, repaying loans, issuing or repurchasing shares, and payment of dividends. This section shows how your business raises capital and manages debt.
Net Cash Flow: The Cash Flow Statement calculates the net cash flow by summing the cash flows from operating, investing, and financing activities. It indicates whether your business had a net increase or decrease in cash during the period.
Cash Position: The Cash Flow Statement shows the beginning and ending cash balances, providing a snapshot of your business’s cash position. It helps you evaluate the adequacy of cash reserves and potential cash shortages.

4. Categorizing Transactions

Categorizing transactions in accounting refers to the process of classifying and assigning specific labels or categories to individual financial transactions. Each transaction is assigned to a particular account or category based on its nature and purpose.

Here’s a breakdown of what categorizing transactions entails:

Chart of Accounts: A chart of accounts is a structured list of all the different accounts used in a business’s financial records. It serves as a reference guide for categorizing transactions. Accounts can include assets, liabilities, equity, revenues, expenses, and more.
Transaction Identification: When a transaction occurs, it needs to be identified and analyzed to determine its appropriate category. This involves reviewing the supporting documents, such as receipts, invoices, and bank statements, to understand the nature of the transaction.
Account Selection: Once the nature of the transaction is understood, the appropriate account or category is selected from the chart of accounts. For example, a sale transaction would be categorized under the “Sales Revenue” account, while a payment to a supplier would be categorized under the “Accounts Payable” account.
Consistency and Accuracy: It is crucial to consistently categorize transactions across all financial records to maintain accuracy and ensure that the financial statements provide a true representation of the business’s financial position and performance.
Double-Entry Bookkeeping: Categorizing transactions also involves applying the principles of double-entry bookkeeping. Each transaction affects at least two accounts: one account is debited, and another is credited. This ensures that the accounting equation (Assets = Liabilities + Equity) remains balanced.
Software or Manual Recording: Transactions can be categorized using accounting software or manually recorded in a ledger or spreadsheet. Accounting software often streamlines the process by providing predefined account categories and allowing for automatic categorization based on predefined rules.

5. Bank Reconciliation

Reconciling accounts in accounting refers to the process of comparing and matching the balances recorded in a business’s financial records, such as bank statements or credit card statements, with the corresponding balances in the business’s internal accounting records. It involves identifying and resolving discrepancies to ensure that the recorded balances are accurate and complete. Here’s a breakdown of what reconciling accounts entails:

Bank Reconciliation: One common type of account reconciliation is bank reconciliation. It involves comparing the transactions and balances recorded in a business’s bank statement with the transactions and balances recorded in the business’s accounting system.
Process of Reconciliation: The reconciliation process typically involves the following steps:
a. Gathering Statements: Obtain the bank statements and other relevant financial statements, such as credit card statements or merchant account statements, for the period being reconciled.

b. Comparison: Compare each transaction recorded in the business’s accounting system with the corresponding transaction on the bank statement. Ensure that the amounts and dates match.

c. Identifying Discrepancies: Identify any discrepancies, such as missing transactions, duplicate entries, or variations in amounts or dates.

d. Investigating Differences: Investigate the discrepancies to determine the reasons behind them. This may involve contacting the bank or reviewing supporting documents to resolve any discrepancies.

e. Adjustments: Make necessary adjustments in the accounting records to align them with the information on the bank statement. This can include recording missing transactions, correcting errors, or reconciling outstanding checks or deposits.

f. Final Reconciliation: Once all discrepancies are resolved and adjustments are made, reconcile the ending balances on the bank statement and the accounting records. The goal is to ensure that both balances match.
Regular Reconciliation: Reconciling accounts should be performed on a regular basis, such as monthly or quarterly, to ensure that any discrepancies are identified and resolved promptly. This helps maintain the integrity of financial records and supports accurate financial reporting.

Accounting Principles

1. Principle of Regularity

The principle of regularity states that once an accounting method or practice is adopted by a business, it should be consistently applied over time, unless a valid reason exists for a change. It emphasizes the need for uniformity and consistency in financial reporting, ensuring that financial information is reliable, comparable, and meaningful.

2. Principle of Consistency

The accounting principle of consistency states that once an accounting method or practice is adopted by a business, it should be consistently applied from one accounting period to another, unless a valid reason exists for a change. Consistency requires businesses to use the same accounting policies and methods for similar transactions and events, ensuring uniformity and comparability in financial reporting.

3. Principle of Sincerity

The accounting principle of sincerity, also known as the principle of truthfulness or veracity, states that financial statements should accurately and faithfully represent the financial position, performance, and results of an entity. It requires businesses to present information that is free from bias, manipulation, or misrepresentation. Sincerity emphasizes the importance of honesty, integrity, and transparency in financial reporting.

4. Principle of Permanence of Methods

The accounting principle of Permanence of Methods, also known as the principle of consistency in application, states that businesses should consistently use the same accounting methods and procedures over time, unless a valid reason exists for a change. It emphasizes the importance of stability and continuity in financial reporting, promoting comparability and reliability of financial information.

5. Principle of Non-Compensation

The accounting principle of Non-Compensation, also known as the principle of separate recognition, states that revenues, expenses, gains, and losses should be recognized and reported separately in the financial statements. It requires businesses to avoid offsetting or netting transactions that are of a different nature or arise from different sources.

6. Principle of Continuity

The accounting principle of Continuity, or Going Concern principle, assumes that a business will continue to operate indefinitely, without any intention or necessity of liquidation or significant interruption. It assumes that the business will maintain its operations and fulfill its obligations in the foreseeable future.

7. Principle of Periodicity

The accounting principle of Periodicity, also known as the Time Period principle, states that the economic activities of a business should be divided into regular and consistent time periods for the purpose of preparing financial statements. It requires businesses to report financial information at regular intervals, such as monthly, quarterly, or annually.

8. Principle of Materiality

The accounting principle of Materiality states that financial information should be disclosed or presented in the financial statements if its omission, misstatement, or misclassification could influence the decisions of users of the financial statements. Materiality refers to the significance or importance of an item or event in relation to the overall financial picture of a business.

How to Do Accounting for Small Business

Running accounting for a small business entails the following:

Set up a Chart of Accounts:
- Create a list of accounts that categorize your business transactions, such as assets, liabilities, equity, revenue, and expenses.
- Customize the chart of accounts to fit your business’s specific needs and industry.
Choose an Accounting Method:
- Decide whether to use the cash basis or accrual basis of accounting.
- Cash basis records transactions when cash is received or paid, while accrual basis recognizes revenue when earned and expenses when incurred.
Record Transactions:
- Maintain a record of all financial transactions by entering them into your accounting system or software.
- Ensure each transaction is properly categorized based on your chart of accounts.
Reconcile Bank and Credit Card Statements:
- Regularly compare your bank and credit card statements to your accounting records.
- Identify any discrepancies and make adjustments to ensure accurate financial reporting.
Track Sales and Invoices:
- Generate and send invoices to customers for products or services rendered.
- Keep a record of sales transactions, including sales receipts, invoices, and any related documentation.
Manage Accounts Receivable and Payable:
- Track outstanding customer invoices and follow up on overdue payments.
- Monitor and pay vendor bills within their due dates to maintain good relationships with suppliers.
Monitor Cash Flow:
- Maintain a cash flow statement to track the inflow and outflow of cash in your business.
- Monitor your cash position to ensure sufficient funds are available for day-to-day operations.
Perform Regular Financial Analysis:
- Review your financial statements, such as the income statement, balance sheet, and cash flow statement. Use our free Monthly Finance Meeting Agenda.
- Analyze key financial ratios and indicators to assess your business’s financial health and performance.
Prepare and File Tax Returns:
- Keep your financial records organized to facilitate the preparation of accurate tax returns.
- Comply with tax regulations and deadlines, and consider seeking professional assistance from a CPA or tax advisor.
Maintain Proper Documentation:
- Keep copies of all financial records, invoices, receipts, and other relevant documentation.
- Maintain organized and secure records for future reference, audits, or inquiries.
Seek Professional Help if Needed:
- Consider consulting with a certified public accountant (CPA) or hiring an accounting professional if you need assistance with complex accounting matters or want expert guidance.

CPA vs Bookkeeper

Here’s a comparison between a Certified Public Accountant (CPA) and a bookkeeper:

CPA (Certified Public Accountant):

Education and Qualifications:
- A CPA is a professional accountant who has met specific education, experience, and examination requirements set by the state board of accountancy.
- They hold a bachelor’s degree in accounting or a related field and have completed additional coursework in accounting principles, taxation, auditing, and business law.
- They are required to pass the Uniform CPA Exam to obtain their certification.
Expertise and Scope of Work:
- CPAs possess a broader and more comprehensive knowledge of accounting principles, tax regulations, financial analysis, and auditing.
- They can provide a wide range of services, including financial statement preparation, tax planning and compliance, audit and assurance, financial consulting, and business advisory.
- CPAs often work with complex financial transactions, provide strategic financial advice, perform audits, and assist with long-term financial planning.
Licensing and Regulation:
- CPAs are licensed and regulated by state boards of accountancy.
- They must adhere to professional standards, ethical guidelines, and continuing professional education requirements to maintain their license.
- CPAs have a legal and professional obligation to uphold the highest standards of integrity, confidentiality, and objectivity in their practice.

Bookkeeper:

Education and Qualifications:
- A bookkeeper typically holds a high school diploma, an associate’s, or a bachelor’s degree in accounting or a related field.
- They may have completed some formal bookkeeping training programs or obtained certifications such as Certified Bookkeeper (CB) or QuickBooks Certified ProAdvisor.
Expertise and Scope of Work:
- Bookkeepers specialize in recording and organizing financial transactions, maintaining general ledgers, reconciling bank statements, and preparing basic financial reports.
- They handle day-to-day financial tasks, such as managing accounts payable and receivable, payroll processing, invoicing, and maintaining financial records.
- Bookkeepers focus on ensuring accurate and timely data entry and providing essential financial information to assist with decision-making.
Licensing and Regulation:
- Unlike CPAs, bookkeepers do not have a specific licensing requirement or regulatory oversight.
- However, professional bookkeepers may choose to join organizations such as the American Institute of Professional Bookkeepers (AIPB) and adhere to their code of ethics.

Frequently Asked Questions (FAQ)

1. What are the 4 basic accounting rules?

The four basic accounting rules, also known as accounting principles, are as follows:

Revenue Recognition: Recognize revenue when it is earned, regardless of when payment is received. This principle ensures that revenue is recorded in the appropriate accounting period.
Expense Matching: Match expenses to the corresponding revenues they help generate. This principle ensures that expenses are recognized in the same period as the revenue they contribute to, enabling accurate determination of net income.
Historical Cost: Record assets at their original cost, rather than their current market value. This principle provides reliable and verifiable financial information based on actual transactions.
Conservatism: Exercise caution by recognizing potential losses as soon as they are probable, but only recognize gains when they are realized. This principle aims to avoid overstatement of assets and income and ensures a more conservative approach to financial reporting.

2. What are the 3 C’s of accounting?

The three C’s of accounting are as follows:

Clarity: Accounting information should be clear, concise, and easily understood by its intended users. Clear financial statements and reports help users make informed decisions based on accurate and comprehensible information.
Consistency: Consistency refers to applying the same accounting methods and principles consistently over time. It ensures that financial information is comparable between different periods, allowing for meaningful analysis and evaluation.
Comparability: Comparability means that financial information can be compared and benchmarked against similar businesses or industry standards. Comparable financial statements help users gain insights into a company’s performance and position relative to its peers.

3. How can I teach myself accounting?

To teach yourself accounting, you can follow these steps:

Start with the basics: Familiarize yourself with the fundamental concepts and principles of accounting by reading textbooks, online resources, or taking online courses.
Practice with real-world examples: Apply what you’ve learned by working on practice exercises and solving accounting problems. Look for sample financial statements and practice recording transactions and preparing basic financial reports.
Utilize accounting software: Gain hands-on experience by using accounting software such as QuickBooks or Xero. These tools can help you understand how transactions are recorded, financial statements are generated, and reports are analyzed.
Seek additional resources: Take advantage of online tutorials, video lectures, and forums dedicated to accounting. Join professional accounting organizations and attend webinars or workshops to stay updated on industry trends and practices.

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Conclusion

Feel like you have a better understanding of accounting basics now?

Knowing accounting can drastically help you run your small business.

When you’re financially literate and understand how the accounting and bookkeeping of your business runs, you can make smarter decisions and grow profits faster.

If you still have questions, reach out to us at [email protected].

Cheers!