When you’re starting a new business, accounting may not be one of your top priorities, but pushing this responsibility aside won't help you in the long run. In fact, you need to be managing your numbers as carefully as you’re checking your inventory or recording your expenses.
“From the very beginning, even if it’s just in a notebook, you need to record everything,” says Baruch Lev, an accounting and finance professor at New York University’s Leonard N. Stern School of Business. “Record everything you buy; record all of your sales.”
And act fast: The longer you put your accounting responsibilities on the back burner, the more money you're at risk of losing. If you don't understand all the ins and outs of business accounting, eventually, your business could even fail.
To help successfully set up the money end of your business from day one, here are the five critical steps you need to take:
1. Determine What Type of Business Entity You’re Going to Be
How do you decide what sort of business structure is best for you? It helps to understand the difference between the two most common forms of business type for startup entrepreneurs: sole proprietorship and limited liability company, or LLC. According to the U.S. Small Business Administration (SBA), a sole proprietorship is "the simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and you, the owner. You are entitled to all profits and are responsible for all your business’ debts, losses and liabilities.”
If you decide to form your business as a sole proprietorship, you don’t have to take any formal or legal action. In fact, many people are sole proprietors without even knowing it, such as freelance writers or graphic designers. However, you may still need to obtain necessary licenses and permits depending on your industry and the state and local area you live in.
On the other hand, if you elect to run your business like a corporation with tax efficiencies and the operating flexibility of a partnership, then you may want to choose to structure your company as an LLC. The SBA defines the owners of an LLC as "members," and depending on the state your business is incorporated in, the members can consist of a single individual (one owner) or multiple individuals. LLCs aren't taxed as a separate business entity, and all profits and losses are "passed through" the business to each member of the LLC, who then report those profits and losses on their personal federal tax returns.
If you think your business will grow beyond your own efforts, you may want to consider structuring as it an LLC. You may also decide to change structures down the road. “Some people start off as sole proprietors, and as they grow or take on more employees or as they weigh liabilities issues, they may decide to form an LLC,” says Gregg Wind, a CPA and partner at Wind & Stern LLP, an accounting firm in Los Angeles.
When deciding on a business structure, you should consult an expert on what would work best for your particular situation.
2. Open a Separate Bank Account for Your Business
One of the worst money mistakes you can make as a new business owner is mixing personal and business funds. In fact, Wind says having a business bank account that’s separate from your personal bank account will be critical when you’re doing your taxes or if you run into any issues with the IRS down the road.
“It’s a mistake small-business owners make because they’re used to living out of one account,” Wind says. “They pay business expenses, and then they pay their rent and their groceries with the same credit card. It’s really best if it’s all kept separate.”
While good bookkeeping and saving all your receipts will help when filing your taxes, in an event of an audit, Wind says, “the IRS or state or local authorities really appreciate it when taxpayers are treating their businesses like a real business and not an extension of themselves.”
3. Choose Which Accounting Method You'll Use
Before you begin setting up any accounting activities, you need to decide which accounting method you'll use. Choosing one over the other will have a major impact on your total revenue and the expenses subtracted from it. To help you decide, here are some essential facts about each:
The cash method of accounting is easier to understand because it simply tells you how much cash your business has, and you pay taxes on the cash you receive. However, this accounting method generally only works well for service businesses or those with a short cash conversion cycle.
The accrual method of accounting provides most business owners with a more realistic performance picture and long-term profitability, because the system tracks accounts receivables and accounts payable when the transaction occurs—not when it’s paid for. This means you’ll be paying taxes on income even if the customer hasn’t paid you yet, but you’ll also be able to claim deductions even if you won’t be paying for your purchases until a later date.
“The [accrual method] is especially important for a business with inventory or one that extends credit to customers,” says Scott Hess, a CPA and principal at Minneapolis-based CliftonLarsonAllen LLP, a financial services company. The accrual accounting method can also be helpful when first setting up a business, since it allows you to claim deductions immediately.
Before committing to a method, you should consult with an expert to determine what's best for you and your company.
4. Decide Whether You're Going to Hire an Accountant
Are you planning to handle the accounting duties for your new business? If you have the necessary skills, doing the books yourself can help you cut costs. However, if accounting isn't your forte, then you might want to consider hiring an expert early on to organize your financial reports and manage your accounting tasks. This way, you'll be able to focus your time in the right area while an expert focuses on what needs to be done.
If you don’t have the resources to employ a full-time accountant, one option may be to contract a bookkeeper or accountant for part-time help. “That way, the business only pays for what it needs, and it's scalable as the business grows,” Hess advises. “A flexible outsourced solution can help bring understanding and clarity to the numbers, such as budgeting and projections, and gets the business the timely information it needs.”
Whether or not you decide to do your own accounting, you'll need to understand the important accounting terms below:
Revenue is the total sales before a company subtracts its expenses. This is all the money that your business made by selling its goods and services.
Expenses is the amount of money you have to pay other people or companies for their goods and services so you can run your own business.
Assets include anything that your business owns that has a positive monetary value, such as cash, accounts receivable, property or equipment.
Liabilities are any debts your business is obligated to pay. For example, if you borrowed money from a bank to get your business off the ground, you’re obligated to repay that loan, and that's a liability. The taxes you owe to your state or the federal government are also liabilities.
An income statement shows whether a company is profitable or not by subtracting its expenses from its revenue over a period of time. An income statement is also known as a profit & loss (P&L) statement, statement of earnings, statement of income or statement of operations.
A balance sheet shows the worth of your company by using a three-part equation: Assets = Liabilities + Owner's Equity. This is also known as a statement of financial position.
A cash flow statement literally shows your company's short-term cash position by recording how much cash is coming in and "flowing" out. Its purpose it to show you whether your business will be able to pay its bills in the near future.
When recording your business transactions, it may be difficult at first to understand the difference between debits and credits in your accounting entries. In accounting, debits are always indicated on the left side of your business’s general ledger (which holds all your financial transactions); credits are recorded on the right side. A debit (or charge) will increase your company’s assets, but it's a debt that will decrease liability, income and equity amounts. On the other hand, a credit will increase the liability, income and equity amounts but will decrease the assets you have in your business. For example, if you buy equipment with cash, that's a debit because it increases your assets, but at the same time, the cash you spent will also be credited from your cash account. At the end of each tracking period, your total debits should equal your total credits.
To best keep track of things, business owners should use the double-entry accounting system to record transactions, and each transaction should always affect two accounts (debits and credits). You should also consider using what’s referred to as a T-chart to divide the left side (increases in cash) from the right side (decreases in cash) when recording a transaction.
5. Handle Your Taxes Properly
After taking care of your business’s accounting needs, there are still a few things you need to keep in mind in regards to your business's money. These tasks will help you avoid any problems with the IRS down the road.
1. Keep all your documents for six years. Most audits will occur within two years of a tax filing; the IRS will not go back more than six years to audit a return. To be on the safe side, however, you should save all your bank statements, credit card statements and any documents pertaining to the purchase of properties and equipment from the past six years, Wind advises. You should also keep copies of all your business tax returns forever.
2. Consider filing your taxes quarterly. Wind says doing so is especially helpful for new business owners so you can understand the process before it’s too late.
3. Determine what you’re going to claim. When you're in charge of your own business, you’re also eligible for certain tax deductions, so decide early on what you’re going to claim. Besides health insurance, you can also claim equipment, charitable contributions, entertainment and travel expenses, and even part of your home, if you use it for your business. If you’re going to claim the home office deduction, Lev says you have to determine which area you’re going to be working in so you can claim it. “You can’t just claim 20 percent of all your home expenses,” he says. “What room are you occupying? Is it a garage? An attic? You need to know this.”
As a final suggestion, you might want to consider using something more than an Excel spreadsheet to keep track of all your business's money. An app or professional accounting software can more effectively help you stay on track. For instance, consider a desktop solution such as QuickBooks if you’re at your desk a lot, or Xero if you’re on the go.
Before you decide on a solution, look into whether there's accounting software created specifically for the nature of your business (do you manage a diverse inventory?) and the industry you're in. From tracking invoices, expenses, inventory, payments and customer interactions, these types of software have become so easy to use that picking the one which suits you best will be time well invested.
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