Accounting for Small Businesses: A Comprehensive Guide to Financial Management

Fact checked by Yarilet PerezReviewed by Andy SmithFact checked by Yarilet PerezReviewed by Andy Smith

Accounting is an instrumental part of running a small business. Implementing systems and best practices for keeping track of expenditures and revenues is key to managing cash flow. Without these systems in place, it’s all too easy to lose track of funds or create the financial records necessary to file taxes and apply for small business financing, if necessary. Proper accounting for small businesses encompasses important tasks, which we explore in more detail below.

Key Takeaways

• Accounting is crucial for small businesses to effectively manage their finances.
• Setting up accounting systems involves opening a business bank account, choosing an accounting method, setting up a chart of accounts, and determining the fiscal year.
• Basic bookkeeping includes tracking expenses, recording transactions accurately, documenting receipts, and reconciling bank statements.
• Financial statements provide insights into a small business’s financial health.
• Small businesses need to understand their tax obligations, track deductible expenses, and file taxes on time.

Setting Up Accounting for Small Businesses

Accounting is a very important part of running any company, including small businesses. It helps business owners keep track of their business-related expenses, liabilities, assets, and income among other things. It also allows company heads to prepare their tax filings. As such, it helps a small business owner lay down a proper foundation. This includes four key activities:

• Opening a small business bank account
• Choosing an accounting method (cash or accrual)
• Setting up a chart of accounts
• Determining the fiscal year for the business

Here’s a closer look at each step.

1. Open a Small Business Bank Account

Opening a business bank account allows you to separate business and personal spending, which can be helpful when it’s time to file taxes if you plan to deduct eligible expenses. To open a bank account for a small business, you’ll generally need to have the following:

• Employer Identification Number (EIN) or a Social Security number if you operate as a sole proprietor
• Business formation documents
• Ownership agreements
• Business license, if your state requires one to do business

You may also need a minimum opening deposit if the bank requires one. Minimum deposit requirements can depend on the type of business account and whether you’re opening the account at a traditional bank, credit union, or online bank.

Important

Remember to compare the fees, features, and benefits associated with different business bank accounts to find the one that best aligns with your needs.

2. Choose an Accounting Method

Your accounting method determines how you report income and deduct expenses for the year. The Internal Revenue Service (IRS) allows you to choose between two options: cash and accrual. Here’s how they compare.

• Cash Method: With the cash method, you report income in the year that you receive it and deduct expenses in the year they are paid.
• Accrual Method: With the accrual method, you would report income in the year that you earn it, regardless of when it’s received.

Note

If you select one accounting method and then decide that you’d like to change it after filing your taxes, you’d need to complete IRS Form 3115 to formally do so.

3. Set Up a Chart of Accounts

A chart of accounts is a list of all accounts available for recording transactions in your accounting software program if you use one or a general ledger if you don’t. To create this chart, you’d first organize your accounts into specific categories, then further break your organization down into relevant subaccounts.

Each category is assigned a range of numbers that are used to track individual accounts. For instance, if you have a category for business asset accounts, your organization might look like this:

You’d follow this system for all of the account categories that you have. Common categories include asset, liability, equity, revenue, and expense accounts.

4. Determine Your Fiscal Year

A fiscal year is 12 consecutive months for which accounting activity is recorded. Small business owners can decide when their fiscal year begins and ends—the only rule is that it must be 12 consecutive months.

For instance, you might choose to start your fiscal year on July 1 and end it on June 30 of the following calendar year. Or you may choose a more traditional approach and have your fiscal year follow the standard calendar year, depending on what works best for your business. If you operate a seasonal business, for instance, then you may choose to begin your fiscal year at the beginning or end of your peak sales season.

Basic Bookkeeping for Small Businesses

Basic bookkeeping for small business owners revolves around a core set of tasks, all of which are designed to help you keep track of where funds are going. The most important bookkeeping practices include:

• Tracking small business expenses
• Recording transactions accurately
• Documenting and filing receipts
• Reconciling bank statements

But, which expenses should you track for a small business? The short answer is all of them.

Anything that you spend money on—whether it’s your monthly lease payment, utilities, office supplies, or postage fees—should be recorded in your accounting system, and those transactions should be recorded accurately. This ensures that you have the correct amounts when you’re ready to deduct business expenses on your annual tax return.

The IRS encourages small business owners to maintain proper documentation for expenses, such as receipts showing the amount spent, the date, the payment method, and what was purchased.

Taken separately, those tasks can be time-consuming. Using a comprehensive bookkeeping software program often becomes easier over time. The best bookkeeping software syncs with your business bank account and payroll systems so that you’re easily able to import and export transaction history. We’ll cover some of the best business bookkeeping software options a little later.

Financial Statements for Small Businesses

Financial statements can yield valuable insights into how well your small business manages its income and expenses. You’ll also need to present up-to-date financial statements to lenders if you plan to apply for small business financing at some point.

There are three financial statements that all small businesses should consider creating.

• Income Statement: An income statement shows a business’s expenses, income, losses, and gains over a set period. These figures are used to determine your net profit or net loss accordingly. Income statements are also commonly referred to as profit and loss (P&L) statements.
• Balance Sheet: A balance sheet records a business’s assets, liabilities, and shareholder equity. In simple terms, this financial statement will tell you what your business owns and what it owes.
• Cash Flow Statement: A cash flow statement provides a snapshot of how cash moves in and out of the business. It can also tell you how well your business is equipped to pay its bills.

If you’re already using an accounting software program for small businesses, you may be able to generate these statements automatically using the expense and income information you’ve already entered.

Tax Considerations for Small Businesses

Running a small business means you have to file a tax return and pay what you owe, if anything, to the IRS. Businesses will need to pay federal and state taxes, as well as any local taxes that may apply. There are five types of small business taxes at the federal level:

• Income tax
• Self-employment tax
• Estimated tax
• Employer tax
• Excise tax

Your business structure determines which types of tax you must pay. Remember that if you have employees, you’ll also need to account for payroll tax. If you’re unsure about your tax obligations, you may want to talk to a professional accountant or tax expert for advice.

Warning

Small businesses that are required to pay estimated quarterly taxes but fail to do so may be assessed a penalty by the IRS.

Deducting Business Expenses

The IRS allows business owners to deduct different expenses. Deductions reduce your taxable income for the year. Some of the expenses you may deduct include:

• Business meals
• Business travel
• Business insurance
• Home office expenses
• Utilities and rent for business premises
• Inventory purchases
• Vehicle purchases or eligible vehicle expenses
• Employee benefits
• Retirement plan contributions

Remember that you’ll need to keep track of all of these expenses and maintain the proper records for each one. Keeping accurate records serves two purposes:

1. It ensures that you’re deducting the right amounts when you file your taxes.
2. It allows you to prove your deductions should your business be selected for a tax audit.

If you’re using tax filing software, you may have the option to organize and store receipts electronically.

Software and Tools for Small Business Accounting

Software programs, apps, and tools can save your business time and potentially money if you’re able to ensure more accurate accounting. Using a software program can also eliminate the need to retain a full-time accountant, which can add to your business expenses.

Additionally, accounting software can help you to:

• Create cost predictions
• Run forecasts to determine the potential return on business investments
• Manage inventory
• Manage payroll
• Send and receive invoices
• Track accounts payable and receivables

There are numerous software options for small businesses, with QuickBooks and FreshBooks being two of the most popular. When deciding which software program to use for accounting, it helps to first consider what your business needs. You can then compare different programs to evaluate the range of features and benefits that are included, and the overall cost of using it.

Outsourcing Accounting Services for Small Businesses

While you could handle accounting for your small business on your own, you may consider outsourcing it to an accounting professional.

If you need to choose an accountant, consider asking other business owners for a referral. If you’re able to get a few names, you can schedule meetings with those that look promising. During your meeting with them, consider asking the following questions to get a better idea of how well they align with your business:

• How long have you worked in the accounting field?
• Are you a certified public accountant (CPA), or do you hold any other professional credentials?
• What type of small business owners do you typically work with?
• What’s the full range of services you provide?
• How much do you charge, and how are the fees structured?
• How often will we communicate, and what is your preferred communication method?

You might choose to work with a virtual bookkeeper if you’re comfortable connecting via Zoom or email. The fees may be lower, but be sure to ask about their background and experience before you sign a contract for their services.

Advantages and Disadvantages of Outsourcing

Letting someone else handle your accounting means you have one less thing to worry about. Instead of crunching numbers, you’ll be free to focus on other tasks that are necessary to run or scale your business. An accountant can also ensure greater accuracy and may be more knowledgeable about the tax code and reporting requirements.

The disadvantage, though, is that outsourcing means your business’s financial information is being viewed by someone else, which you may or may not be comfortable with. Aside from that, you also have to consider what you might pay to hire an accountant on a full-time or part-time basis.

Best Practices for Small Business Accounting

Following best practices can minimize room for errors in your small business accounting and help you to keep better records. What those practices look like may vary from business to business, but at a minimum, it’s a good idea to include the following:

• Maintain separate bank accounts and credit cards for business and personal spending.
• Ensure accuracy in business record-keeping.
• Regularly review financial statements.
• Seek professional advice when needed.
• Back up and secure records.

Setting up a document management system can help with organizing your records so that they’re easier to review. There are different ways to organize files, depending on what you need to store.

You might choose to use document management software to keep track of key financial information and statements. You’ll want to periodically back up your files and ensure that you’re adhering to security protocols so your information isn’t compromised. For example, if you need to save a copy of a document separately from other files, you may put it in its password-protected folder inside your document management software.

What Are the Benefits of Using Accounting Software for Small Businesses?

Using accounting software can allow you to save time when managing the books for your business. You can sync financial accounts to easily import transaction history, track expenses, double-check transactions for accuracy, and generate important financial statements.

What Are the Best Practices for Maintaining Accurate Financial Records?

Some of the best ways to ensure accuracy in financial records include keeping business and personal accounts separate, using an accounting software program to track cash flow, regularly updating financial statements, and conducting an annual audit to review your business’s financial history.

What Types of Records Do Small Businesses Need to Keep?

Small businesses need to keep accurate records relating to any expenses they incur, particularly for expenses they plan to deduct. It’s also important to keep records of any agreements with vendors and suppliers, bank statements, documents showing payment of estimated quarterly taxes, and annual tax returns.

The Bottom Line

The importance of accounting for small businesses can’t be underestimated. Whether you’re starting a brand-new business or you have some experience under your belt, creating a solid accounting plan can help you monitor and maintain your financial health. If you follow the tips we’ve laid out above, you’ll likely be able to focus some of your time on other important facets of your business.

Read the original article on Investopedia.