Accounting 101

Accounting is the language of business. Too often, people mistakenly believe accounting is purely mathematical.

This is false!

Yes, accounting does involve numbers and yes sometimes you have to put those numbers into an equation. But that is not the meat of what accounting is.

Accounting centers around one major concept: business decisions.

Accounting is the process of recording financial transactions for the purposes of making decisions.

As a business owner, you are faced with business decisions day in and day out. And in any decision you make, there are considerations, mostly related to finances.

“Would this decision add value to my company?”

“Can I afford this decision?”

These are just a few questions you might ask yourself through your decision-making process.

Ultimately, the answers to these questions and more are found in your company’s accounting.

If you want a hyper-profitable business, you’ll need to establish a solid accounting process from the beginning.

Consider the following when establishing your accounting process:

1. 1. How will you track your income and expenses?

1. 1. How will you receive income for your services?

1. 1. How often will you review your books?

1. Who will be responsible for your accounting tasks?

As a full-service accounting firm, we’re experts in helping small business owners set up and manage their accounting systems, in a way that best suits their needs.

This article will show you the necessary steps and best practices for setting up and managing your company’s accounting.

1. Accounting 101: Open a Business Bank Account

Your business and personal funds should never commingle. And depending on your business type, that’s grounds for termination by IRS standards.  

Or what about when tax time rolls around? You have an individual AND business return to file (or Schedule C on Form 1040). It would be nearly impossible, or highly inefficient, to cycle through the year’s expenses and separate them as business and or personal. Granted this can be done by your CPA, however, they’re likely to charge a high price for it.

If none of those reasons rattle you,maybe your business’ cash flow will. By having a separate business bank account, you can monitor your cash flow more efficiently and frequently. There wouldn’t be any confusion when it comes the amount of cash you have on hand. You’re assured when you check your online banking, the bank balance is 100% related to your business. It also makes it easier for you and your bookkeeper to monitor your financial health.

So how do you open a business bank account?

Similar to how you open a personal bank account.  A major difference is that your business needs an employer identification number (or EIN) to open a business account.

EINs work in the same way as social security numbers for business. It is a unique number that only your business would have.

Getting an EIN is not hard. You just have to file the appropriate paperwork with your state’s secretary of state office.

Once you have an EIN, you can take that information to the bank of your choice and open an account.

To start, it would be great to open both a checking and savings account. That way, you can more easily organize your money between short and long-term needs.

As stated earlier, most businesses are legally required to have a separate business account. Although the sole proprietorship entity type is not legally required to do this, it is highly recommended to have personal and business accounts separate. As your business starts to grow, you’ll have more and more transactions to manage, which is complicated with personal funds in the mix.

2. Accounting 101: Set Up a Bookkeeping System

Bookkeeping is an ongoing task for every business. You will need to complete these tasks, at least monthly to know the financial performance of your company.

In general, bookkeeping comprises 3 steps:

1. 1. Business transactions

1. 1. Classification of business transactions

1. Reconciliation of business transactions to the bank statements

If you want an in-depth explanation of the steps involved with bookkeeping, check out this article.

In earlier times, all of this work had to be done by hand. Thankfully now, with the help of cloud software, apps, and online banking, bookkeeping does not have to take nearly as long to do.

The amount of time it takes to do bookkeeping largely depends on the volume of transactions and bank accounts. Each transaction has to be classified and each bank account has to be reconciled.

So when establishing a bookkeeping system, you need to consider the amount of time you can dedicate to your books each.

Not only that, but consider your level of financial knowledge in bookkeeping and accounting. In order to accurately classify a business transaction, you need to have more than a basic understanding of accounting.

Properly classifying transactions is important for 2 major reasons:

1. 1. Tax return preparation

1. Budgeting

A good bookkeeping system tracks all of your income and expenses and classifies them into specific categories. Those categories should then be translated on your tax return.

Most business expenses can be written off. But you would need to be keeping proper track of them in order to claim them. This includes maintaining records like receipts, banks statements, invoices, check copies, and any other evidence that supports a position on your tax return.

Bookkeeping also helps with budgeting. Seeing how much you spent in a certain area can help you plan for future expenditures. 

3. Accounting 101: Set Up an Accounting Process

You might be wondering, “What is the difference between an accounting and bookkeeping system?”

Bookkeeping involves the daily monitoring and management of your company’s transactions. Accounting is the high level analysis of your company’s books in order to make profitable business decisions.

Bookkeeping in tactical. (More short-term)

Accounting is strategic. (More long-term)

You not only need to classify and reconcile transactions, but you need to make decisions based on that data. This is where accounting comes into play.

But before you can start making decisions, you need financial statements.

Producing financial statements should be a regular part of your accounting system. The most frequently used financial statements are the balance sheet, income statement and cash flow statement. Each one of these statements paints the picture of your business performance from a different angle.

The balance sheet shows all of the assets and liabilities your company owns.

The income statement shows how profitable you are and the allocation of expenses.

The cash flow statement shows in which areas of your business you are spending cash and if you have a cash deficit or surplus.

All 3 statements are generated from your bookkeeping system.

But how will you use this data to make decisions?

One way is by performing ratio analysis.

Ratio analysis consists of taking certain line items on your financial statements and comparing them to industry metrics.

One ratio is the profit margin. Profit margin equals your profit divided by your total sales. Every industry has their own standards when it comes to each ratio.

For example, the restaurant industry has an average profit margin of 3%-6%. If you own a restaurant and your profit margin was 2%, this might spark you to make decisions to improve profits.

This is the sort of analysis you should be doing as part of your accounting system.

Below is a list of some common ratios that can help you make better decisions:

• Inventory turnover               = cost of goods sold ÷ average inventory
• Receivables turnover           = net revenue ÷ average receivables
•  Payables turnover               = purchases ÷ average payables
•  Asset turnover                     = net revenues ÷ average total assets
•  Current ratio                        = current assets ÷ current liabilities
•  Quick ratio                           = (cash + short-term securities + AR) ÷ current liabilities
•  Cash ratio                            = (cash + short-term securities) ÷ current liabilities
•  Debt-to-assets ratio            = total liabilities ÷ total assets
•  Debt-to-capital ratio           = total debt ÷ (total debt + total shareholder’s equity)
•  Debt-to-equity ratio            = total debt* ÷ total shareholder’s equity
•  Interest coverage ratio       = earnings before interest and taxes ÷ interest payments
•  Gross profit margin            = gross income ÷ net revenue 
•  Operating profit margin     = operating income ÷ net revenue
•  Net profit margin                = net income ÷ net revenue
•  Return on assets (ROA)     = net income ÷ total assets
• Return on equity (ROE)     = net income ÷ total stockholder’s equity

4. Accounting 101: Tax Obligations

Your tax obligations depend on your legal structure. LLCs, sole proprietors, partnerships, corporations, and nonprofits all have different filing obligations.

Entity types like the LLC and partnerships pay tax on income earned on the individual level. But a business return is still required.

Depending on how much income you earn, you’ll need to make quarterly payments to the IRS throughout the year.

5. Accounting 101: Find an Accountant

What you’ll find when establishing your accounting function, is that alot of this stuff can be easily explained but not necessarily easily performed. It takes time and knowlege. Both of which you may not have.

Consider outsourcing your accounting to a professional. Your company’s life line is it’s finances. You don’t want risk losing it because you thought you could do it yourself.

In fact, 9 out of 10 businesses that fail, fail due to poor financial management. Don’t let this be you.

Consider the following when looking for an accountant:

• • Education. Everyone who calls themselves an accountant does not necessarily have a formal education in accounting. Schooling is not everything but it does count and speaks to the knowledge the individual has.

• • Experience. Experience is just as important as education, if not, more. Someone with years of experience would be able to deliver the best service for you.

• • Price. It matters! Some accounting services charge significantly more than others. For example, if you hire a CPA, their rate is typically higher than that of a regular accountant. Their value could also prove to be worth it. It just depends on what you expect from your accountant. Check out this article which outlines the differences between an accountant and a CPA.  

• Communication. Some accountants don’t make it a point to consult and communicate with their clients. Or they charge a ridiculous hourly fee in order to talk to them. These are YOUR books. And you should understand them. Find an accounting service that will explain your return to you.

6. Accounting 101: Update Your Process

Once you have an accounting process in place, it’s important to reveiw and refine your process as necessary.

You might stumble upon a tool or just a better way of doing things. In either case, you should implement these methods for a more efficient accounting flow.

7. Accounting 101: Other Considerations

Every business is created differently. What one company does may not work for another. For example, you may have employees. In which case a payroll system would also need to be set up as part of your accounting function. Other businesses may not.

This is why having an accountant on your team is so vital. Their role is to help you through your every aspect of your financial situation.

Consider the accounting services at LYFE Accounting. We have accountants and CPAs ready to help you with the specific needs of your business. Contact us today!