Understanding Basic Accounting Principles for Small Business Owners

Why Accounting Knowledge Matters for Small Businesses

Accounting isn’t just for big corporations. For small businesses, it’s the backbone of informed decision-making. Accurate financial records help you:

  • Track income and expenses
  • Understand profitability
  • Make smarter investments
  • Prepare for taxes

Failing to grasp accounting basics can lead to poor financial management and even business failure.

Understanding the Fundamental Accounting Equation & Debits and Credits

Learning this basic concept will help you understand your books and communicate effectively with your accountant, if you have one.

The accounting equation is the basis for the double-entry bookkeeping system. It's simple: Assets = Liabilities + Equity. Like any equation, these two sides must always be balanced. If you go through your books and find that these do not align, you have made a mistake in recording (or not recording) one or more transactions.

Assets are things your business owns. Liabilities are what your business owes.

Equity represents the value which would be returned to your company's owners or shareholders, if all of the assets were liquidated and if all of the company's debts were paid off. It is the same as assets minus liabilities; equity is all the value left over.

This equation is based on the idea that every transaction has two sides, because there are always 2 parties involved. From the perspective of your business, the two sides are debits and credits. For every debit, there must be an equal and opposite credit.

  • Debits: Represent money coming into your accounts.
  • Credits: Represent money leaving your accounts.

For example, when you sell a product:

  • Debit: Your cash or accounts receivable account increases.
  • Credit: Your sales revenue account increases.

Financial statements, such as cash flow statements and income statements, are all based on the accounting equation. They follow the same structure of balancing debits and credits.

Tools and Resources for Accounting Beginners

You don’t need to be an expert to manage your business’s finances effectively. Here are some tools to help:

  • Accounting Software: Tools like QuickBooks, Xero, and Wave simplify bookkeeping.
  • Online Tutorials: Platforms like Coursera and YouTube offer free or low-cost courses.
  • Professional Help: Consider hiring an accountant or bookkeeper for complex tasks or tax filing.

Cash vs. Accrual Accounting: Which Method Is Right for You?

Understanding whether to use cash or accrual accounting is crucial. In summary:

  • Cash Accounting: Records income when cash is received and expenses when paid. It’s straightforward and works well for small businesses with simple transactions.
  • Accrual Accounting: Records income when earned and expenses when incurred, regardless of when money changes hands. It provides a more accurate picture of your financial health but is more complex.

Many small businesses start with cash accounting but may need to switch to accrual as they grow. Accrual accounting keeps track of credit and obligations, so larger businesses benefit from these more detailed financial records.

Recording Transactions

How to Record Transactions with the Cash Accounting Method

Transactions are categorized as either revenue or expenses. Keep in mind these principles for recording each type of transaction:

  • Revenue Recognition: Record income only when cash is received. For instance, if you issue an invoice on January 5 but receive payment on February 10, the income is recorded in February.
  • Expense Recognition: Record expenses only when cash is paid out. For example, if you receive a bill on March 3 but pay it on April 1, the expense is recorded in April.

To begin recording transactions, you need:

  • A cash receipts journal to record all cash inflows.
  • A cash payments journal to record all cash outflows.
  • A general ledger, whether physical or in accounting software, to categorize transactions into appropriate accounts.
    When you receive cash (e.g., from sales, loans, or asset sales), in your cash receipts journal and your ledger, you should:
    1. Note the date of receipt.
    2. Record the amount of cash received.
    3. Specify the source of the cash (e.g., customer name, invoice number).
    4. Categorize it as income or another relevant account.
    For example: On February 15, you receive $500 from a customer for services rendered. You record:
    • Date: February 15
    • Description: Payment for services (Customer: John Doe)
    • Account: Revenue
    • Amount: $500

    When you pay cash (e.g., for supplies, utilities, or employee wages), in your cash payments journal and your ledger, you should:

    1. Note the date of payment.
    2. Record the amount of cash paid.
    3. Specify the purpose of the payment (e.g., vendor name, invoice number).
    4. Categorize it as an expense or another relevant account.

    For example: On March 3, you pay $200 for office supplies. Record:

    • Date: March 3
    • Description: Office supplies payment (Vendor: ABC Supplies)
    • Account: Office Supplies Expense
    • Amount: $200

    Even professionals make mistakes. You need to periodically reconcile your records to ensure all transactions match your cash balance.

    1. Compare your journal entries with your bank statement.
    2. Verify that all inflows and outflows are accurately recorded.
    3. Adjust for any discrepancies, such as bank fees or unrecorded transactions.

    A good time to regularly do this is at the end of an accounting period, such as the end of the month or the quarter. At this time you should also review your cash balance to ensure it aligns with your bank statement.

    How to Record Transactions with the Accrual Accounting Method

    In this accounting system, there is a distinction between when cash is received and when revenue is "earned." You need to define when revenue is considered earned, with criteria based on your industry or business model. For example:

    • Services: Revenue is earned when the service is completed.
    • Products: Revenue is earned when goods are delivered.

    There is also a distinction between when an expense is incurred and when it is paid.

    So, the two main principles of accrual accounting are:

    1. Revenue is recorded when earned, not when cash is received.
    2. Expenses are recorded when incurred, not when they are paid.

    In this system, you need to record transactions (or accruals) in multiple accounts. Use general ledger entries to record accruals.

    • For accrued revenue:
      • Debit: Accounts Receivable
      • Credit: Revenue
    • For accrued expenses:
      • Debit: Expense Account
      • Credit: Accounts Payable

    Accounts receivable (AR) represents money owed to your business by customers who have received goods or services but haven’t yet paid. It's an asset on your balance sheet because it’s expected to be converted into cash in the future.

    Accounts payable (AP) represents money your business owes to suppliers for goods or services received but not yet paid for. It’s a liability on your balance sheet because it reflects obligations to pay in the future.

    To record revenue in accounts receivable:

    1. Identify revenue earned during the period (e.g., services performed, products delivered).
    2. Record the transaction as follows:
      • Debit: Accounts Receivable (to increase the amount owed to you).
      • Credit: Revenue (to reflect the income earned).

    For example, you deliver a service worth $5,000 in December. The customer agrees to pay in January. In December, record:

    • Debit: Accounts Receivable $5,000
    • Credit: Service Revenue $5,000

    When the customer pays in January, record:

    • Debit: Cash $5,000
    • Credit: Accounts Receivable $5,000

    This ensures that revenue is recognized when it is earned, even if payment is received later.

    To record expenses in accounts payable:

    1. Identify expenses incurred during the period (e.g., supplies received, utilities used).
    2. Record the transaction as follows:
      • Debit: Expense Account (to reflect the cost incurred).
      • Credit: Accounts Payable (to increase the amount owed).

    For example, you purchase $2,000 worth of office supplies in December, with payment due in January. In December, record the transaction:

    • Debit: Office Supplies Expense $2,000
    • Credit: Accounts Payable $2,000

    When you pay your supplier in January, record:

    • Debit: Accounts Payable $2,000
    • Credit: Cash $2,000

    Adjusting entries and reconciling accounts regularly is even more important in the accrual accounting system. You need to reconcile your accounts receivable and payable with actual payments and receipts. You also compare bank statements with the general ledger to ensure accuracy, like in cash accounting.

    Overview of Key Financial Statements

    There are three main financial statements you should understand:

    1. Balance Sheet: A snapshot of your business’s assets, liabilities, and equity.
    2. Income Statement: Shows your revenue, expenses, and profit over a specific period.
    3. Cash Flow Statement: Tracks the flow of cash in and out of your business, highlighting liquidity.

    These documents are essential for evaluating your business’s performance and securing loans or investors.

    Balance Sheet

    Here is an example of a balance sheet:

    Organizing assets as a separate column from liabilities allows you to easily compare the two. Remember the fundamental accounting equation: Assets = Liablities + Equity. The two sides of your balance sheet must always match up.

    Income Statement

    Here is an example of an income statement:

    Income statements track the company's revenue, expenses, gains, and losses. They cover a specific period, like a month or a year, not the lifetime of the company.

    Cash Flow Statement

    Here is an example of a cash flow statement:

    A cash flow statement categorizes the company's inflow of cash into its operating activities, its financing activities, and its investment activities. Unlike an income statement, it does not include expenses and losses.

    Operating Activities: Includes cash generated from core business operations.
    Investing Activities: Covers investments in assets or proceeds from asset sales.
    Financing Activities: Includes cash from issuing stock, paying dividends, and managing debt.
    Net Increase in Cash: Combines all activities to show overall change in cash.

    Conclusion

    Mastering basic accounting principles may seem intimidating at first, but it’s a skill that will pay dividends in the long run. Start small by learning the essentials, leveraging tools, and seeking professional advice when needed. Remember, staying on top of your finances is key to building a thriving business.