A Guide for Small Businesses
Still not sure what accounting is? We’ll explain exactly what accounting is, give you a primer on accounting history, and explain why it’s important to use accounting in your small business.
Accounting is the act of organizing, recording, and analyzing financial information, providing you with in-depth financial knowledge about your business. Accounting plays a starring role in your small business, helping you manage everything from business growth to locating investors and securing a business loan.
Overview: What is accounting?
I bet you didn’t know that accounting records more than 7,000 years old have been found in Mesopotamia.
Though that was the start, double-entry accounting didn’t make an entrance until the 14th century when Luca Pacioli, a close friend of Leonardo da Vinci, invented a system that used a ledger, journal, and memorandum to record transactions.
Pacioli closely described the double-entry accounting process in his book “De Computis et Scripturis,” which translates in English to “Reckonings and Writings,” and later became known as the father of accounting and bookkeeping.
Thought to be something of a genius, Pacioli’s book was translated into five languages, with the basic tenets of the book still used today.
However, it wasn’t until the 19th century that the modern accounting profession was born, with chartered accountants from the U.K. arriving in the U.S. to audit British companies.
Many of those accountants stayed in the U.S., eventually setting up accounting practices. From there, the first U.S. accounting society was created in 1887, with the American Institute of Certified Public Accountants (AICPA) soon to follow.
The 20th century saw the largest number of developments impacting accounting, with the Financial Accounting Standards Board (FASB) created in 1973, followed by the Governmental Accounting Standards Board (GASB).
Creating these financial standards boards ultimately led to the establishment of Generally Accepted Accounting Principles (GAAP), which incorporate 10 key concepts that are used by the FASB as their approved accounting methods. Today, U.S. law requires that any publicly traded company follow GAAP guidelines.
Today, it’s thought that organizations such as the International Financial Reporting Standards (IFRS) will play a much bigger role in creating global accounting standards that can be adopted by companies worldwide.
Types of accounting
Accountants don’t only prepare taxes. They can also perform a wide selection of services including the auditing of financial statements and general ledger reports, investigating financial irregularities, and preparing and reviewing internal reports.
Not all accountants perform the same tasks, as they vary depending on the type of accounting they are performing. Let’s take a look at a few of these types.
1. Financial accounting
Financial accounting tracks, records, and reports on company financial transactions through the preparation and analysis of financial statements.
Rather than being prepared for internal use, the statements are prepared to be distributed to those outside the company, including investors, creditors, and customers. Financial statements typically prepared by financial accountants include the following:
- Balance sheet: The balance sheet is a statement that summarizes company assets, liabilities, and equity using the accounting equation: Assets = Liabilities + Equity
- Income statement: An income statement covers a specific period and provides information on profit and loss for that period.
- Cash flow statement: The cash flow statement displays the amount of cash that regularly flows into and out of the company during any given period. The cash flow statement looks at cash flow from operating activities, investing activities, and financing activities.
- Statement of retained earnings: The statement of retained earnings covers a specific period and displays dividends paid to shareholders as well as any funds that are retained by the business for future use.
Financial accounting reports on past performance and does not look ahead. There are two types of financial accounting that businesses can use: cash-basis accounting and accrual-basis or double-entry accounting.
Many smaller businesses use cash accounting, but any business that has shareholders, as well as any publicly traded businesses, are required to use accrual accounting.
2. Managerial accounting
Unlike financial accounting, managerial accounting centers around internal processes.
Managerial accounting, also known as cost accounting, focuses on decision making by looking at current strategy, current company performance, and risk management, looking at fixed and variable costs, break-even points, production costs, and product and service pricing.
Managerial accounting uses the financial statements produced in financial accounting, but also generates the following reports for internal use:
- Product cost
- Operational budgeting
- Variance analysis
- Activity-based costing
Rather than analyzing past performance, managerial accounting always looks ahead for ways to improve future performance.
3. Tax accounting
Tax accounting is regulated by the Internal Revenue Code (IRC). Tax accountants work with their clients to ensure that businesses, nonprofits, and individual taxpayers follow IRC code properly.
While the role of a tax accountant includes preparing tax returns accurately and filing those forms promptly, tax accountants also offer tax planning advice, which includes developing a strategy around each client’s specific tax situation to maximize deductions and minimize tax liability.
Tax accountants need to be familiar with current tax laws and maintain that familiarity to properly serve their clients.
4. Governmental accounting
Governmental accounting focuses on spending and accountability for that spending, using funds to manage a variety of programs.
- General fund: The primary fund used by the government to manage activities not funded by a special purpose fund. Administrative and operational activities are usually paid for by the general fund.
- Permanent fund: A permanent fund uses only the earnings from the fund for the direct benefit of its citizens, such as the distribution of annual dividends.
- Special revenue fund: A special revenue fund is used to collect money from the public to be used for a specific purpose.
- Capital projects fund: A capital projects fund is used to construct or acquire a capital asset. Once the asset is completed or acquired, the fund is terminated.
- Debt services fund: A debt services fund is used for the payment of principal and interest on long-term debt.
The activity must be tracked for each of these funds to provide the public with information on how public funds are being used.
In these or any other type of accounting, the most accurate way to manage your financial transactions is by using accounting software, which is designed to simplify the entire accounting process, a major plus for business owners without accounting knowledge.
The role of accounting within businesses
It’s difficult to imagine running a business without the use of accounting. Collecting and analyzing financial data provides business owners and investors with the information they require to make informed decisions.
While financial statements are important to outside entities such as lenders and investors, they also play a major role in internal business decisions. These decisions can range from hiring another employee to raising the price of the products you manufacture.
For example, how will you know if your product is priced too high or too low if you don’t have data that tells you exactly how much it costs to produce that product? How will you know how much money your customers owe you if you don’t manage your accounts receivable properly?
How will potential investors know if they should invest in your company if they can’t view your current income? How will loan officers decide to loan you money without first taking a look at your balance sheet?
The short answer is that without accounting, they won’t be able to do any of those things. And you won’t know if your business is making money or losing money without the knowledge that accounting provides.
While many bookkeeping and accounting tasks overlap, bookkeeping’s focus is record-keeping, while accounting’s is analysis. In other words, while a bookkeeper may be responsible for recording transactions, it’s the accountant’s job to determine what those numbers mean.
Yes. While small businesses may not feel the impact as much as a larger business would, you still need to manage money coming in and money going out of your business. As your business grows, you’ll need to handle account reconciliations, payroll, accounts payable, and accounts receivable.
Good news for those struggling through accounting 101: Most of today’s small business accounting software applications are designed for the non-accountant, using easily recognizable terms and automating much of the accounting process.
Accounting is an important part of running a small business
Whether you’re running a consulting business from your kitchen table or a thriving business that employs dozens, you need accounting.
Yes, there are shortcuts you can take, and yes, you can record transactions on slips of paper, but implementing and using a proper accounting system is highly recommended. It might surprise you to learn that handling the accounting for your small business is a lot easier than you may think.
No more excuses. If business success is important to you, make sure a good accounting system is part of it.