Running your business with a subpar accounting system is like driving a car with your eyes closed – it’s only a matter of time before you get into an accident. With the right accounting processes, on the other hand, you can give your small business the foundation to prosper.
In this accounting guide, we will focus exclusively on small businesses. As a small business owner, you may not be able to match the resources of larger outfits. But at the same time, you have fewer accounting tasks and the freedom to choose between accounting methods.
Let’s start by talking about why a strong accounting system is a necessity for small business owners.
Your Accounting Processes Have Wide-Ranging Impacts on Your Small Business
A lot of small business owners do the bare minimum – from an accounting standpoint – to stay compliant with the IRS. You won’t get into any trouble if you pay your income tax and payroll tax on time, and your accountant files your tax return at the end of the year. But you will miss an opportunity to get visibility into your financial picture that can help you make better decisions and improve your financial health.
Here are some of the benefits of keeping up-to-date financial records and understanding accounting concepts:
Prevent Cash Flow Issues from Cropping Up
You could rely on your bank statements to give you information on your cash flow position, but that won’t factor in future invoices and payables. If your business bank account has $20,000, you may not see any problem with spending $5,000 on new equipment. But what if you also have $30,000 in accounts payable vs. $5,000 in accounts receivable? That $5,000 piece of equipment would be a problem in reality. Not to mention, you’d have to find a way to make up for the shortfall.
If you record your financial transactions in real-time, you can prevent yourself from running into cash flow issues.
You Can Evaluate Your Financial Picture
By learning how to read income statements, cash flow statements, and balance sheets, you can see how the different parts of your business come together to produce your bottom-line results. The ability to quickly pinpoint weak links (or double down on your strengths) is a game-changer for your business.
With financial know-how, you also have the ability to evaluate the future implications of new undertakings. Let’s say you’re thinking about hiring more staff. Should you hire freelancers or full-time employees? Can you handle the additional business expenses? What are the business tax ramifications?
You don’t have to be a CPA to answer those questions, but you do need a basic understanding of accounting.
Easier to Get Financing
If your accounting is on point, you have a much better chance of getting financing at an attractive interest rate. Consider the following two examples:
Imagine that Jerry, a small business owner, approaches a lender and asks for a loan. Jerry doesn’t have updated financial statements or knowledge of basic accounting principles but requests a loan based on his feeling that he will have the cash flow to make the monthly payments. Jerry’s chances of getting the loan wouldn’t be too high. And if he did get it, he could be stuck paying an extremely high interest rate to compensate for the uncertainty that he brings to the table.
Let’s say that Lisa, another small business owner, is also looking for financing for her small business. Lisa, on the other hand, has been maintaining excellent financial records since her startup days. While she doesn’t have CPA-level accounting knowledge, Lisa is familiar with accounting best practices. On top of that, she points to low-risk future cash flows that will allow her to easily make the monthly payments. Barring something unforeseen, Lisa would have an excellent chance of getting a loan at a reasonable interest rate.
By now, you are likely convinced of the benefits of putting a strong accounting system into place. But you may be wondering what types of systems you can put into place. Next, we will look at two options for small business owners: the cash method and the accrual method.
Cash vs. Accrual Accounting
When it comes to accounting method choice, small business owners have an advantage over large corporations. That’s because the IRS requires corporations that make more than $25 million per year in sales to use the accrual method. If your business makes less than $25 million a year in sales, however, you are free to use accrual method accounting or cash basis accounting. Your choice.
So, what’s the right choice for small business owners?
There is no right or wrong method. For some small business owners, the accrual method is best. For others, the cash method is the way to go.
Let’s look at the basics of cash and accrual accounting to give you the financial information to make the right choice for your business.
With the cash accounting method, you only record income when it hits your bank account and business expenses when they leave your account.
For example, if you invoice your customer in August, but they don’t pay until October, you would record it as an October sale. The same goes for your payables; if your supplier invoices you in June and you don’t pay until July, you record it as a July business expense.
The cash method doesn’t even require you to record your receivables and payables, making it simpler, but also opening up your business to blind spots. We’ll look more into the advantages and drawbacks in a bit, but first, let’s look at the accrual method.
With the accrual accounting method, you are required to record your income and expenses when they are incurred, as opposed to when they are paid.
So, even if the August invoice from the cash accounting section wasn’t paid until October, you’d still have to record it as August revenue. Again, the same goes for payables.
The accrual method gives you a clearer picture of your long-term financial health, but it’s more work for small business owners.
Advantages and Drawbacks of Cash Method
Since you’re only required to track money when it enters or leaves your bank account, the cash method is similar to how you might track your personal finances. So, for small business owners that aren’t accounting whizzes, the intuitive nature of the cash method could allow them to keep track of their business transactions with fewer headaches.
The cash method also offers a more tangible benefit: the ability to delay income tax payments. Let’s say you made a sale in October 2020, but your client doesn’t pay you until February 2021. With the cash method, you would record that as 2021 revenue and push the tax burden back a year.
The cash method’s simplicity is not only an advantage but also a drawback. If the timing of your clients’ payments is all over the place, you could see wild fluctuations in your sales, even if you are selling a similar amount every month. That can make forecasting and budgeting a challenge for your business.
Then there’s the $25 million sales threshold. Your business may not be making $25 million in sales now, but that could change. If it does, you would be forced to change to the accrual method.
Advantages and Drawbacks of Accrual Method
The accrual method requires you to stay more on top of your bookkeeping, but in exchange, you get a more accurate look at your long-term financial picture. If you’re thinking about hiring seasonal staff, for example, wouldn’t you want to know when exactly you’re getting an influx of sales?
Once you implement an accrual accounting system, you can keep it forever. You don’t have to worry about what will happen if/when you exceed $25 million in sales – or if the IRS decides to adjust the accrual accounting sales threshold.
While the accrual method provides a better long-term look at your financial picture, it introduces challenges for your short-term cash flow management because it tracks sales and expenses when they are incurred, not paid.
To ensure you can meet your obligations, you’d have to separately track your cash flow if you are using accrual basis accounting. Bottom line: the accrual method can be a lot of work.
You Don’t Have to Handle Small Business Accounting on Your Own
If you don’t have the time or inclination to handle all of your accounting on your own, you’ll be happy to hear that outsourcing is an option. And it doesn’t have to break the bank.
For day-to-day accounting tasks, it’s possible to use Microsoft Excel, but using accounting software is a better bet. There are countless options including QuickBooks, Xero, FreshBooks, and Wave. The best accounting software will vary based on your accounting needs, budget, tech-savviness, and more. In the end, you should be able to find a mobile app that is user-friendly and saves you a lot of time.
If you want to detach yourself even more from the day-to-day, consider hiring a bookkeeper. For most small business owners, a freelance bookkeeper can handle their recordkeeping needs without incurring too many billable hours.
For more complex accounting needs, you’ll want to use a Certified Public Accountant. A common misconception about CPAs is that they can only file your tax returns. They can certainly do that – and you certainly want them to do that – but CPAs can also help your small business beyond tax season.
By using a combination of yourself, accounting software, a bookkeeper, and a CPA – the mix will be different for each small business owner – you can give your small business a strong accounting foundation.