Accounting principles are essential for starting a business. They will help you assess the health of your company and track its progress toward its goals.

Transactions are the foundation of businesses. Accounting starts with the system of recording and reporting transactions. Even if your goal is to outsource bookkeeping and accounting, it’s important to understand the basics of financial reporting.

Let’s start with a few questions:

1. Which type of business are you running?

Are you a service, merchandising, or manufacturing business?

Some companies combine two or more types of business: A meal shake company that imports its raw materials to process the meals is a manufacturer. But when it sells the shakes it is a merchant. It becomes a service when the shakes are prepared and delivered to customers if it has a physical address. It may also offer classes on how to sell smoothies and shakes.

The transactions that make up the bulk of your accounting will depend on the type of business.

The next question is what ownership structure should you choose? Many bookkeeping and banking requirements differ for sole proprietorships and partnerships, corporations, limited liability companies (LLCs), cooperatives, and corporations. 

2. Are you a holder of business permits and licenses?

These documents are required to open a bank account for your business and to properly file taxes. You will need different documents depending on what type of business you are running and where you operate.

3. Are you able to open a separate bank account for your business?

A separate business account is required by most ownership structures. It is recommended that every business has a separate account. If possible, you do not want your transactions to be mixed with your business transactions.

4. Do you plan to hire employees?

You’ll find it much easier to manage your accounting processes if you don’t. If you have employees, however, you will need to establish procedures for withholding taxes.

Even if you are the only one hiring contractors, likely, you will still need them for specific projects. Contractors paid more than a certain amount annually in the U.S. have to be sent a 1099.

• Keep track of who you have paid and how much.
• Each contractor should be provided with a W-9 form.
• For each person, you hire, keep current addresses on hand

5. Are you using accounting software?

Accounting software such as FreshBooks or QuickBooks is necessary if you plan to process hundreds of thousands or more transactions each month. An Excel spreadsheet is fine for small businesses, but manual entries are not possible for high-volume businesses.

Accounting software automates many of the necessary processes and takes most of the workout. It stores retrieve and records transaction data, which is used to create financial statements and reports. Accounting software can create invoices or write checks.

These basic questions are answered and your business foundations have been established, it’s time to move on to the next step in the accounting process.

Let’s first be clear about some terms.

Transactions

A transaction is when money is given, received, or requested by a vendor or business.

Any of the following could be considered a transaction:

• The owner invests money in the business.
• Sales revenue.
• Invoices.
• These expenses include marketing, wages, travel, and building materials.
• Assets bought, such as vehicles and office equipment, property, or materials.

One transaction may have multiple components. For example, if you want to pay an hourly worker, you need to know how much they worked, what their gross wages were, the tax deductions, and their net pay. All of these tasks can be performed by your accounting software.

Credits and debits

A system of credits and debits tracks all transactions. This basic accounting equation is the best way to grasp it.

Assets = Liabilities + Equity (Owners or Corporation).

The left side of the equation is given a debit. Credit is added to the left.

For example, let’s say you sell $500, and that $500 is debited. This means it goes to your business assets. It also gets credited to Owner’s Equity as income. Something else must be credited whenever something is debited. This keeps the equation in balance.

This is a simplified version of a topic we could write several books about. However, it will give you an idea of how your accounting software handles transactions.

Cash method, accrual method accounting

Two basic accounting methods exist the cash method and the accrual. The accrual method is more popular and may be required by law depending on your business’s size.

The main difference between these methods is how a transaction is recognized.

Cash accounting recognizes a transaction when actual money changes hands. Accrual accounting recognizes a transaction when work is completed and an invoice is sent. Let’s say you order office paper in January. You then place the order on your business credit card. The office paper is delivered immediately. However, you don’t pay for it until February when your credit card statement arrives.

Accrual accounting records the transaction as soon as you purchase the paper. The receipt is taken, stored in your file system, and recorded as an expense. You can use the receipt as a January expense even though it isn’t due until the next month.

Cash accounting is when you pay the bill. This is when the actual money changes hands. It is therefore a February expense even though the paper was received in January.

Income works in the same way. If you send an invoice to customers in May but they don’t pay it until July then the transaction is recorded using the accrual method and in July using cash.

For larger businesses, accrual accounting is preferred. Accrual accounting gives you a better understanding of the cost of goods and services each month. If you purchase paper in August you are paying part of your business’s cost. You made the sale in May if the customer sends you the money in July if you did it in May.

You can use the accrual method to reconcile your costs of doing business for each month so that you can identify the best months. This equation will calculate margins:

Margin = (Revenue-Cost of Goods) / Revenue

These are the three main financial statements

Once you have your accounting software and systems in place, and all your transaction data entered into the system, you can prepare your three most basic financial statements: your income statement (also known as the “profit and loss statement” or P&L), your balance sheet and the statement cash flows.

Income statement

The income statement shows profit over a specific period such as a month. When people use the term “bottom line”, they mean profit. Your profit is your income. Your net loss is if you lose money in that period.

Simply put, profit is simply calculated by subtracting revenue from expenses. This is why accrual accounting is preferred. You won’t see how much you earned or spent in a given month if you use the cash method.

Balance Sheet

The balance sheet is a snapshot of your assets, liabilities, and equity at a particular point in time. It typically shows the end of a month or quarter. It provides a snapshot of your financial status.

Assets are items that have value such as cash and supplies, equipment, vehicles, or inventory. An “account receivable”, is the term used to describe money that you owe but has not yet been paid.

You owe liabilities, which are things like loans, interest payments, and wages. Liabilities are often called “payables.”

Equity is simply the difference between assets and liabilities. This can be seen if you go back to the basic accounting equation. Add liabilities to assets and you get the “book value”, or equity of your company.

Statement of cash flow

This simply shows how cash has changed over time.

Your accounting software can quickly produce these three basic financial statements, provided you are diligent in entering transaction data. You might consider hiring a bookkeeper if you don’t have the time.

Two last accounting basics for small business

1. All receipts, invoices, and payment records should be kept safe.

Accounting’s Reliability Principle states that transactions should only be recorded if they have supporting documentation. You can’t record a transaction as income or expense if you don’t have the records. Tax fraud could occur if you try to claim a tax deduction on an expense that you don’t have proof of.

Keep physical receipts safe in a file. You can also take photographs and store them digitally. You should also keep all receipts and invoices emailed to you in a separate folder.

2. Know your tax requirements

Many tax requirements vary depending on what type of business you run and where you live. It is important to be familiar with sales tax, import taxes if there are international transactions, tax withholding, estimated quarterly taxes, and other taxes that may apply to your country, state, province, or city.

These taxes will be included in your financial statements and accounting software. To ensure that you are following the correct procedures, it is always a good idea to consult a tax professional.