Small business accounting: a quick overview
Accounting for your small business essentially comes down to three elements:
- Bookkeeping. Bookkeeping is the process of recording and tracking your business’s financial transactions.
- Financial statements. Financial statements summarize transactions into reports that show how the business is doing.
- Filing tax returns. You may owe federal, state and other types of taxes on the profits your business makes each year.
Now, let’s dive into each of these elements in more detail.
How to do accounting for a small business
Here are some basic steps to get you started keeping track of your small business’s financial information, generating financial statements, and filing taxes.
Step 1: Select your accounting method
One of the first accounting decisions you need to make in your small business is the method you’ll use to record financial transactions. There are two basic accounting methods:
- Cash basis. Under the cash accounting method, you record income and expenses when money changes hands. For example, you record revenue from a sale only when a customer pays you.
- Accrual basis. Under the accrual accounting method, you record income when you make a sale and expenses when you incur them, regardless of when cash changes hands. For example, you record revenue when you sell to a customer on credit, even if the customer won’t pay the invoice for 30 days or longer.
The cash basis is easier to use, but the accrual method of recording transactions gives you a clearer picture of actual revenue and expenses during a particular period. Most small businesses that don’t carry inventory choose the cash basis. Large and inventory-heavy businesses may need to use the accrual method.
For some businesses that prefer to keep things simpler throughout the year but need to file on an accrual basis, they convert cash basis accounting to accrual basis once they start their tax prep.
Further Reading: Cash Basis Accounting vs. Accrual Accounting
Step 2: Open a business bank account and business credit card
Open a business bank account and business credit card and run all your business’s income and expenses through those accounts rather than your personal checking account or credit card. A separate bank account makes it much easier to have a clean record of business transactions.
- What Do I Need to Open a Business Bank Account (Checklist)
- Top 16 Greatest Small Business Credit Cards
Step 3: Use accounting software
Once you have a business bank account in place, it’s time to connect it to accounting software. Most reputable accounting software can streamline the accounting process by connecting to your bank account to ensure your financial statements reflect every transaction.
The key is to ensure every transaction is recorded correctly and in the right account. To do this, you need to review your transactions regularly. For example, the software may have categorized a transaction as “Office expenses” when in fact it should be “Software subscriptions.” Categorizing transactions into the right accounts ensures you get meaningful reports from your accounting software.
Besides tracking income and expenses, accounting software can help you keep tabs on your business’s financial health, including how much cash you have available, how much clients owe you, and how long they take to pay invoices.
Further Reading: Accounting Software: The Top 12 Options in 2023
Step 4: Stay on top of accounts payable and accounts receivable
Track all invoices received from vendors (also known as accounts payable) and make sure you have the cash available to pay suppliers on time. This will ensure you avoid late fees and keep your vendors happy. If vendors offer discounts for early payments, you may want to take advantage to reduce costs.
Also, keep a close eye on outstanding customer payments (a.k.a. accounts receivable). Slow-paying customers can impact your ability to pay your own bills, and the earlier you can identify problems in collecting payments, the sooner you can resolve them. Consider sending a reminder the day before an invoice is due or the moment it becomes past due.
If you don’t get a response, pick up the phone to follow up. Written collection letters and emails are a lot easier to ignore than phone calls. Calling them allows you to find out quickly if there’s a problem so you can work with your customer to resolve it.
Step 5: Keep good financial records
Now that you have a business checking account and an accounting system to capture all your financial transactions, you may wonder whether you need to bother keeping copies of invoices, receipts, and other accounting records. The answer is yes.
If the IRS or another taxing authority decides to audit your business, the auditor will want more than bank statements and reports from your accounting system. They’ll also want to look at supporting documentation showing:
- The date of the transaction
- The amount paid
- Whom you paid
- A description proving that the purchase was a business expense
The good news is, you don’t need to keep paper receipts. Most reputable accounting software allows you to scan or snap a picture of receipts and other documents using your phone and attach it to the transaction.
Step 6: Prepare adjusting journal entries
At the end of the accounting period, you (or your accountant or CPA) need to record adjusting journal entries to record any transactions that don’t impact your bank account. There are three main types of adjusting journal entries:
- Accruals. Accruals are only necessary if you use the accrual accounting method. They ensure your financial statements reflect all revenues and expenses that occurred during the period. For example, you would record accrued wages and payroll taxes for hours that your employees worked during the last week of the year, even though you won’t cut payroll checks until after year-end.
- Deferrals. Deferrals are also only necessary if you use the accrual method. They account for cash received or paid in advance that actually belongs in the following accounting period. For example, if a client pre-pays for services you haven’t yet performed, you would record the payment as deferred revenue until you perform the service.
- Other adjustments. You may need to account for other transactions that didn’t go through your business checking account or credit card statement, such as:
- Purchasing business supplies with your personal credit card
- Correcting errors, such as the purchase of a piece of equipment accidentally recorded as supplies expense instead of a fixed asset
- Recording depreciation expense
- Estimating reserves, such as an allowance for doubtful accounts
- A Beginner’s Guide to the Accounting Cycle
- Debits and Credits: A Simple, Visual Guide
- Adjusting Entries: A Simple Introduction
Step 7: Generate financial statements
At the end of the month, quarter, or year (or any time in-between), you can generate financial reports from your accounting software.
Depending on your business, you may use several different financial reports. Here are the most common financial reports used in small business accounting:
- Balance sheet. A balance sheet summarizes your business’s assets (what you own), liability (what you owe), and owner’s equity at a point in time. This gives you a snapshot of the current health of your business and whether you have the resources to expand or need to cut costs.
- Income statement. An income statement, also known as a Profit and Loss or P&L statement, summarizes your business’s revenues, costs, and expenses over a particular period. It can be useful for comparing your sales and expenses to your budget.
- Cash flow statement. The cash flow statement tells you how much cash entered your business during a particular period, how much cash you spent over that same period, and how much cash you have on hand. This helps you make cash flow projections and ensure you have the cash on hand to pay bills.
If you don’t have accounting software to generate your own financial reports, we’ve got you covered with these easy-to-use templates:
Step 8: File tax returns
Your small business tax filing obligations vary depending on how your business is structured, the types of products and services you sell, whether or not you have employees, and where you’re located.
Your business may need to pay:
- Federal income taxes
- Self-employment taxes
- State and local taxes
- Payroll taxes
- Sales tax
- Excise taxes
- Property taxes
- Estimated taxes
If you’ve done a good job of tracking your small business revenues and expenses and have accurate and up-to-date financial statements, filing tax returns could be as easy as selecting the right tax forms and entering your numbers in the right boxes.
Further Reading: How to File and Pay Small Business Taxes
How Bench can help
For most entrepreneurs, learning how to do accounting for a small business isn’t exactly a passion project, but it is necessary for getting the financial information you need to run a successful business.
Of course, if the demands of running a business mean you just don’t have time to learn QuickBooks, or if you’d rather leave your bookkeeping to a professional, try Bench (that’s us). We give you a team of bookkeepers to handle your bookkeeping and simple software for keeping track of your business finances.
And if you want more information on small business accounting, be sure to check out our guide: Small Business Accounting 101: A Guide for New Entrepreneurs.