A Guide to Accounting Basics for Small Business
A FREE guide to accounting basics for your small business
Running a small business is a thrilling adventure full of creativity, passion, and the potential for big rewards. But let’s face it, dealing with numbers and finances might not be your favourite part. The good news is that accounting doesn’t have to be a headache! Understanding a few basic principles can make a difference in your business’s financial health and peace of mind.
Accounting helps you track where your money is coming from, where it’s going, and how much is left over. This knowledge is essential for making decisions, whether pricing your products, investing in new equipment, or planning for the future.
Understanding basic accounting terms is crucial for small business owners as it helps them make informed financial decisions and maintain accurate financial records.
In this beginner’s guide, we’ll demystify accounting basics and give you the tools to confidently manage your business finances. There is no jargon or complicated formulas, just clear explanations and practical tips.
What Is Accounting Basics?
In simple terms, it’s the practice of tracking your business’s income and expenses to understand its overall financial health. Think of it as keeping a close eye on business transactions, such as sales, purchases, receipts, and employee compensation. This information lets you make informed decisions, gauge your profitability, and plan for taxes.
Accounting vs. Bookkeeping
While accounting and bookkeeping are often used interchangeably, they are not quite the same. Bookkeeping is the process of recording financial transactions. It’s like keeping a detailed diary of your business’s money moves. Bookkeeping includes logging sales, purchases, payments, and receipts; please see our section on Bookkeeping Basics for more information.
Accounting, on the other hand, goes a step further. It involves analysing and interpreting the data collected through bookkeeping. Accountants transform the raw financial information into meaningful financial reports through financial accounting. These reports, such as the income statement and balance sheet, provide valuable insights into your business’s financial performance and position.
Types of Accounting
The field of accounting encompasses various specialised areas, each serving a distinct purpose and catering to different needs:
Core Accounting Types:
- Financial Accounting: Focuses on recording, summarising, and reporting financial transactions to external stakeholders (investors, creditors, regulators) through financial statements prepared according to Generally Accepted Accounting Principles (GAAP).
- Management Accounting: Provides internal financial information and analysis to help managers make informed decisions about operations, budgeting, and performance evaluation.
- Tax Accounting: Deals with tax planning, preparation, and compliance with tax laws and regulations.
- Cost Accounting: Analyses the costs associated with producing goods or providing services to help determine product pricing and improve cost efficiency.
- Forensic Accounting: Investigates financial crimes, fraud, and disputes by analysing financial records and providing expert testimony in legal proceedings.
- Government Accounting: Focuses on accounting for public sector entities (government agencies, schools, hospitals) and ensuring compliance with specific regulations and standards.
- Auditing: Involves independent examination of financial records to verify their accuracy and fairness.
Accounting Basics Terms Useful to Know
Now that we’ve covered the basics, let’s explore some key accounting terms you’ll need to know about as a small business owner.
Revenue
Revenue is the lifeblood of your business, the money you earn from selling products or providing services. Revenue is your business’s income and the first line on your income statement.
Expenses
These are the costs of doing business. Expenses include rent, salaries, supplies, advertising, utilities and more. Monitoring expenses is crucial for managing cash flow and profitability.
Assets (Balance Sheet)
An asset is anything your business owns that has value. It can include cash, inventory, equipment, real estate, and intangible assets like trademarks or patents. Assets are what your business uses to generate revenue.
Liabilities
Liabilities are your business’s debts or obligations. Liabilities include loans, accounts payable (money you owe suppliers), and taxes owed.
Equity:
Equity is the owner’s stake in the business. It’s what’s left over after subtracting liabilities from assets. Equity can increase through owner investments or profits generated by the business.
Profit or Loss:
Profit or Loss is determined by calculating the net profit, a business’s earnings, after subtracting all expenses and costs from its revenue. Net profit is a crucial indicator of a company’s financial health and is presented in financial statements such as income and cash flow statements.
Accounting Period
An accounting period is a set timeframe to track and report a business’s financial activity, often a month, quarter, or year. It’s the period covered by financial statements.
Understanding these terms will help you interpret financial reports and communicate effectively with your accountant.
Accounting Methods
When it comes to accounting methods, there are two main approaches you’ll need to understand: cash accounting and accrual accounting. The one you choose can significantly impact how you view your business’s financial performance.
Cash Accounting: This is the simplest of the two methods. With cash accounting, you record income when you receive payment and expenses when you pay bills. It’s a straightforward way to track your cash flow. Still, it doesn’t always reflect the accurate financial picture of your business, especially if you offer credit to customers or have outstanding invoices.
Accrual Accounting: This method provides a more accurate view of your financial health. With accrual accounting, you record income when it’s earned, regardless of when you receive payment. Similarly, you record expenses when they’re incurred, even if you haven’t paid the bill yet. This method gives you a better understanding of your profitability over time, but managing it can be more complex.
Which method is best for your small business?
The best method for your business depends on various factors, including your industry, size, and personal preferences.
Cash accounting Cash Accounting might be suitable for small businesses with straightforward transactions, few receivables or payables, and a desire for a simple bookkeeping system.
Accrual accounting is often recommended for larger businesses, those with inventory, or businesses that extend credit to customers. It provides a more accurate picture of your financial position, crucial for making informed decisions and securing financing.
Consult a bookkeeper or accountant if you’re unsure which method to choose. They can help you assess your business’s needs and recommend the most appropriate approach. Remember, the goal is to choose an accounting method that accurately reflects your business’s financial reality and helps you make sound financial decisions.
Accounting Equation
Now that we’ve covered the accounting basics let’s explore a key concept that underpins accounting: the accounting equation.
This equation is the foundation of your business’s financial picture. It shows the relationship between what your business owns and owes and the owner’s investment. Understanding this helps you grasp your business’s overall financial health.
The accounting equation is simple yet powerful:
Assets = Liabilities + Equity
Let’s break down each component:
Assets are anything your business owns that holds value. Assets could be cash in the bank, inventory ready to sell, or the equipment you use to produce goods or services.
Liabilities are the debts your business owes to others. Examples include bank loans, money owed to suppliers, and unpaid taxes.
Equity represents the owner’s investment in the business. It’s what’s left after subtracting liabilities from assets. Think of it as the owner’s claim to the business’s assets.
The accounting equation demonstrates a crucial relationship: your business’s assets are financed by either debt (liabilities) or the owner’s investment (equity). This equation must always balance, meaning the total value of your assets must always equal the combined total of your liabilities and equity.
Understanding the accounting equation can be incredibly valuable for small business owners. It helps you:
- Assess your financial position: By analysing the equation, you can see how much of your assets are financed by debt versus equity.
- Make informed decisions: The equation helps you understand the potential impact on your financial structure when considering new debt or investments.
- Track changes over time: As your business evolves, the accounting equation will change, too. Monitoring these changes can reveal trends and insights into your financial health.
Accounting Cycle
The 8 steps of the accounting cycle are the processes companies use, from processing transactions to producing a trial balance, making adjustments, preparing the financial statements and closing the year-end.
Financial statements
Financial statements are like your business’s report card. They provide a snapshot of your financial performance and help you make informed decisions about the future. Let’s take a closer look at the three primary financial statements you’ll encounter as a small business owner:
Income Statement (Profit and Loss Statement)
The Income statement shows how much profit or loss your business generated during a specific accounting period, usually a month, quarter, or year. It summarises your revenue (money earned) and expenses (money spent) and calculates your net income (profit) or net loss. You can identify trends, assess your profitability, and adjust your business operations by analysing your income statement.
Balance Sheet (Statement of Financial Position):
The Balance Sheet provides a snapshot of your business’s financial position at a given time. It shows what your business owns (assets), such as accounts receivable, what it owes (liabilities), and the owner’s equity (investment). The balance sheet helps you evaluate your liquidity (ability to meet short-term obligations), solvency (ability to meet long-term commitments), and overall financial health.
Cash Flow Statement (Statement of Cash Flows):
The cash flow statement tracks the cash flow in and out of your business. It shows where your cash came from (operating, investing, and financing activities) and where it went. The cash flow statement is crucial for understanding your liquidity, managing your cash flow, and ensuring you have enough money to cover expenses and invest in growth.
Why are financial statements essential for decision-making?
Financial statements provide you with valuable data that can guide your business decisions. By analysing these statements, you can:
- Identify areas for improvement: Are your expenses too high? Can you increase revenue through pricing or marketing strategies?
- Monitor cash flow: Do you have enough cash to cover payroll and other expenses? Should you adjust your spending or seek additional financing?
- Assess your profitability: Are you making a profit? If not, what changes can you make to become more profitable?
- Plan for the future: Based on your current financial position, should you invest in new equipment, expand your operations, or pay down debt?
By regularly reviewing your financial statements, you gain a deeper understanding of your business’s financial health and can make informed decisions to drive growth and success.
The Trial Balance
A trial balance lists all the general ledger accounts (assets, liabilities, equity, revenues, and expenses) and their balances (debit or credit) at a specific time.
Accountants use a trial balance to help prepare financial statements. It checks for errors and whether the total debits and credits are equal. This ensures the accounting equation balances and identifies potential errors.
Financial Ratios
Financial ratios are key indicators of your business’s financial health. They help you assess your performance, identify strengths and weaknesses, and make informed decisions.
There are many different financial ratios, including liquidity, profitability, solvency and efficiency. Please read our ratio section to better understand and see examples.
Accounting Software for Your Small Business
In the digital age, manually keeping your accounting records is no longer necessary or advisable! Accounting software has become an indispensable tool for small businesses, offering a range of benefits that can save you time, reduce errors, and provide valuable insights into your finances.
Benefits of Using Accounting Software:
Automation: Say goodbye to manual data entry! Accounting software automates tedious tasks like recording transactions, generating invoices, and reconciling bank statements. This saves you valuable time and minimises the risk of errors.
Accuracy: Software calculations are far more reliable than manual calculations. This helps ensure the accuracy of your financial data, leading to more informed decision-making.
Organisation: Accounting software neatly organises and makes your financial records easily accessible. You can quickly find invoices, receipts, and other documents, saving you the hassle of rummaging through paperwork.
Generating Financial Reports: Most accounting software offers robust reporting features. With just a few clicks, you can generate various reports, such as income statements, balance sheets, and cash flow statements.
Tax Preparation: Accounting software can simplify tax preparation by producing the reports required and submitting taxes to HMRC, including VAT.
Recommended Accounting Software for Small Businesses:
For Business Owners
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Xero: This cloud-based accounting software is popular among small businesses for its user-friendly interface, extensive features, and mobile accessibility. Xero offers various pricing plans to suit different needs and integrates with numerous other business apps.
QuickBooks Online: Another popular cloud-based option, QuickBooks, offers many features, including invoicing, expense tracking, and payroll. It’s known for its scalability, making it suitable for growing and evolving businesses.
Consider your business needs, budget, and desired features when looking at accounting software.
Excel Bookkeeping
Excel is used for various accounting tasks; we have developed over 25 free Excel bookkeeping templates for your business. The templates include cash book, cash flow, Profit and Loss, Balance sheet, accounts payable and accounts receivable.
Do I need an Accountant or Bookkeeper?
While accounting software can be a game-changer, there comes a point when enlisting the help of a professional bookkeeper or accountant becomes invaluable for your small business. Here’s why:
Expertise and Experience: Bookkeepers and accountants are trained professionals with in-depth knowledge of financial principles and regulations. They can handle complex accounting tasks, ensure accuracy, and provide valuable insights into your financial data.
Time Savings: Outsourcing your bookkeeping and accounting frees up your time to focus on what you do best – running your business. Let the experts handle the numbers while you focus on growth and innovation.
Tax Compliance: Tax laws are complex and ever-changing. A professional can help you navigate these regulations, ensure compliance, maximise deductions, and minimise tax liability. This can save you from costly errors and potential penalties.
Financial Analysis: Beyond just recording transactions, a bookkeeper or accountant can analyse your financial data to identify trends, potential problems, and opportunities for improvement. This can help you make informed decisions about pricing, inventory, staffing, and other critical aspects of your business.
Peace of Mind: Knowing that your finances are in the hands of a trusted professional can bring peace of mind and reduce stress. You can rest assured that your accounting records are accurate, your taxes are filed correctly, and you’re making sound financial decisions.
Follow GAAP: Adhering to Generally Accepted Accounting Principles (GAAP), set by the Financial Accounting Standards Board (FASB), ensures consistency and transparency in financial reporting. This is especially important for publicly traded companies, which must comply with GAAP by law.
When to Seek Professional Help:
Consider hiring a bookkeeper or accountant if:
- Your business finances are complex.
- You’re struggling to keep up with bookkeeping tasks.
- You’re unsure about tax laws and regulations.
- You need help analysing your financial data.
- You want to ensure accuracy and compliance.
- You want to free up your time to focus on your business.
Whether you hire a bookkeeper for day-to-day tasks or an accountant for strategic advice and tax preparation, having a financial professional on your team can be a valuable asset for your small business.
Accounting Basics Courses
If you want to learn more about accounting basics, it may be worth looking into an accounting course; these can either be completed at home in your spare time or a part-time college course. You can learn anything from the basics to becoming a fully qualified accountant.
All the accounting bodies offer courses, which generally start in September. The Open University also offers a one-year Certificate in Accounting.
If you are looking into a course because you work in accounting and want to learn more, it may be worth asking your employer to fund the course.
Further Reading
Accounting History We have produced a short introduction to accounting history, explaining how it started and who first invented the double-entry system.
Accounting Regulating Bodies: If you are looking for an accountant, it is worth checking their qualifications. All accountants should belong to one of the regulatory bodies.
Accounting Basics Conclusion
Mastering accounting might seem daunting, but with the proper knowledge and tools, it becomes a manageable and empowering part of your entrepreneurial journey. Remember, a firm grasp of your financial health is key to making informed decisions, navigating challenges, and ultimately achieving your business goals.
By implementing simple practices like separating business and personal finances, utilising accounting software, and seeking professional guidance, you’ll gain the confidence and clarity to steer your small business toward a prosperous future. So, take charge of your finances, embrace the learning process, and watch your business thrive.
