definition accounting
26-Jun-2021 By - team

Accounting is the process of gathering information on business activities, posting transactions and producing financial statements. And a well-managed accounting system can keep your business running each day.

Accounting functions to keep track of all business transactions, protect assets from loss or theft, and report financial results to stakeholders.

Managing a small business is challenging. But if you can produce accurate accounting information, you can make better decisions and grow your business.

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Why is accounting important for small businesses?

Often, small businesses operate on slim profit margins, and their access to cash may be limited. These businesses have less room for errors, but accounting information can help the business owner stay on track.

You can protect assets from theft.

Assets are resources—vehicles, machinery, equipment, etc.—you use to generate sales and profit. As such, businesses must invest in asset purchases and maintenance. Without assets, companies can’t operate.

Accounting tasks protect assets from loss and theft. A retail store, for example, should perform an inventory count each month. They should confirm that each item in the accounting records is on store shelves. If an item is missing, the owner can investigate quickly.

You can report financial results to stakeholders.

Business owners may keep stakeholders informed for a variety of reasons. Stakeholders include employees, investors, creditors, regulators, and suppliers. Investors want to know if the business is generating a profit and that the value of the business is increasing.

Creditors need to know if the company is generating enough cash to repay a loan. Suppliers want to know if the industry will continue to order goods and services and that the business can pay invoices on time. If you can provide reliable financial statements, you’ll maintain good relationships with the stakeholders.

How accounting methods impact business results

The accounting industry maintains generally accepted accounting principles (GAAP) to produce financial statements compared to other companies. Your stakeholders expect you to follow the GAAP to compare your results with other businesses in your industry.

Companies can use accrual basis accounting or cash basis accounting. The GAAP requires businesses to use the accrual basis because it presents a more accurate picture of their profitability.

Why you should use the accrual method

The accrual method of accounting requires a business to post revenue when they earn it and expenses when they incur them. This method applies the matching principle, which matches payment with the costs that relate to the amount. This method ignores the timing of cash inflows and outflows when computing the profit. Here’s an example that explains the accrual method:

Seaside Home Furnishings builds custom furniture. When a customer orders a dining room table, Seaside tracks the accounting activity related to the sale.

  • Seaside paid $1,000 cash for the wood, metal and other materials on 30 January.
  • Seaside paid $600 in cash for labour costs on 20 February.
  • Seaside shipped the completed table on 5 March, and the customer paid the retail price of $2,300 on 5 March.

Using the accrual method of accounting, Seaside posted revenue of $2,300 on 5 March, along with the material and labour costs. The payment matches the expenses incurred, generating a $700 profit.

Seaside can calculate the profit accurately because the timing of the costs is not essential. It’s more important to match the revenue with the expenses incurred to generate the revenue.

On the other hand, the cash basis method distorts a business’s actual profit.

Why cash basis accounting can be misleading

understanding-bookkeeping

What if you used your chequebook activity to post your revenue and expenses? When a client pays you cash, you increase your income. And you post costs when you pay money.

That’s how the cash basis method works. Using the dining table example, Seaside would post the material expenses in January, wage expenses in February, and revenue in March. And they would base each transaction on the cash inflow or outflow. The cash basis wouldn’t match the payment with the related expenses. As a result, the business owner wouldn’t know their actual profit from that sale.

How to use the accounting cycle to create financial statements

The accounting cycle represents the tasks that a business must perform to post transactions into the accounting records and generate accurate financial reports. The accounting cycle has six parts.

  • A source document: a source document is generated when an event happens in your business. Source documents include purchase receipts and client invoices.
  • A financial impact: accountants or business owners can decide how the event impacts their accounting records. For example, if a business owner purchases $3,000 of inventory with cash, the inventory account increases and cash decreases.
  • A journal entry: the accountant or business owner records the event using a journal entry.
  • A general ledger: the publicspend ledger records every transaction an accountant or business owner posts to the accounting records. Review the public ledger frequently to verify that you posted transactions correctly.
  • A trial balance: the trial balance lists each account and the current account balances. After reviewing the general ledger, the accountant generates a trial balance.
  • A financial statement: accountants or business owners use the trial balance to generate financial statements like balance sheets, income statements and cash flow statements.

How accountants differ from bookkeepers

A bookkeeper handles the most basic accounting tasks for a business. They gather source documents and post transactions into the accounting system. But they can perform additional tasks to keep a business running smoothly. For example, a bookkeeper can monitor the accounts receivable balance and help manage cash collections.

On the other hand, accountants review the bookkeeper’s work and post any necessary adjustments to the financial statements. They generate the trial balance and produce financial statements.

When someone opens a business, they may take on all accounting responsibilities. As the number of accounting transactions increases, the owner may hire a bookkeeper and act as the accountant. Eventually, the owner may hire a full-time accountant.

How financial statements can help you make better business decisions

Business owners use financial statements to make better business decisions. If a business owner is considering a business loan, a new product line or an expensive piece of equipment, they may analyse their financial statements.

Business owners should generate a balance sheet, income statement and statement of cash flows at the end of each month.

Balance sheets monitor assets and liabilities.

The balance sheet summarises a company’s financial position as of a specific date. It’s a financial statement that subtracts assets from liabilities to determine equity:

Assets – liabilities = equity

Imagine that you sell all of your business’s assets for cash. Then you use the money to pay off all of your accounts payable balances and your long-term debts. Any cash remaining is your equity, which is the actual value of your business.

Income statements assess the profitability.

An income statement reports a business’s profit or loss over time—typically, a month or year. It’s a financial statement that subtracts revenue from expenses to determine net income or profit:

Revenue – expenses = net income

Net income increases equity in the balance sheet. Many business owners focus on the balance sheet and income statements. But the cash flow statement is equally important.

Cash flow statements show cash generated for business operations.

The statement of cash flows reports the cash inflows and outflows over time. Accountants or business owners can separate cash flow into three activities: operating, investing and financing. The ending balance in the cash flow statement must equal the cash balance in the balance sheet.

Make decisions that help your business grow.

If you set up an effective accounting process and understand the basics, you’ll produce helpful information that you can analyse quickly. Use the financial statements to make more informed decisions and to grow your business.

Which accounting method should I use?

When someone mentions accounting methods, they refer to the set of rules that their company uses to decide when its revenue and expenses are recognised in its book of accounts.

There are two main types of accounting methods that dictate these rules for businesses: accrual accounting and cash accounting.

Each of these two methods comes with a distinct set of rules on when to use it and how. Which one you decide to use will depend upon your company’s needs and requirements. Which accounting method should your small business choose?

First, let’s layout your options.

What are the types of accounting methods?

The two general methods of accounting are known as accrual and cash. These two methods will dictate how income is recognised based on the timing of transactional records in accounts. Each one will produce materially distinct financial records and reports.

On top of these two methods, there is a third grouping fitted explicitly to the inventory of a business. This is known as inventory accounting and includes three specific methods known as FIFO (first in, first out), LIFO (last in, first off) and the weighted-average process.

How to use the accrual method of accounting

Accrual accounting is the method that records a company’s transactions when the original transaction takes place. Therefore, accrual revolves around the event of a trade rather than the actual transfer of funds. This method regards the usage of something like the time when the transaction should be recorded.

For example, a company receives its electricity bill in the mail for February, but it does not pay it until April. Using accrual, the company will record this transaction when it receives the bill in February, even though it does not transfer funds out of an account until April.

Principle rules of accrual

Following accrual accounting means a business must adhere to two principles.

The Revenue Recognition Principle. This principle dictates that revenue be recorded within the fiscal period where the sale occurs, even if the company has not received payment.

Stated more simply, you might see on your financial statements that you record revenue from sales for March, but you might not have that cash in hand until April or May when your customer pays you.

The Matching Principle follows this first rule, ensuring accrued expenses must be recorded in the same period as the revenue to which those expenses are connected.

How to use the cash method of accounting

accounting definition

The cash accounting method records transactions only when the cash element of a deal has switched hands. Cash accounting revolves around the actual transfer of funds to an event. Using this method means that a company will record a transaction when paid for, not when it has happened.

Taking the same example as above, the company receives its electricity bill in the mail for February, but it does not pay it off until April. In the case of cash accounting, the company would record the transaction in its books for April, as that is when the transfer of funds takes place.

This method is straightforward and allows businesses to record their income when received, not when contracted. This method can also cause cash flow issues, so companies need to keep an eye on their cash flow statements. This is because cash accounting won’t take into account your accounts receivable and accounts payable: the products or services you haven’t received payment for yet, as well as the outstanding bills you still need to pay.

What is the best accounting method for a small business?

The difference between the accrual and cash accounting methods lies in the timing and recording of transactions. Various business types will find that one or the other accounting form works best for them.

Accrual accounting is most commonly used by someone self-employed. They will record their earnings in the fiscal period in which their work is contracted, even if they receive payment for it in the next period. The cash method is most commonly used by small businesses, especially when there is no in-house accountant. This basis of accounting narrows the gap of errors, as it creates a clear path of transactions that are easy to follow in the books.

However, larger companies and corporations must always use the accrual accounting method dictated by the Australian Taxation Office.

Does QuickBooks use the cash or accrual method?

What makes QuickBooks so great for small businesses and accountants is its ability to use either method. The application makes it easy to convert income and expenses from cash to accrual and back again. No matter which accounting method you choose—whether for self-employed people or small businesses—the QuickBooks accounting software has you covered.

Are old-school accounting methods holding back your business?

There’s so much to get your head around when you start up a new business. The set-up phase can feel like a whirlwind from sales to marketing to getting your website or brick-and-mortar presence just right.

What’s wrong with a good old pen and paper?

With so much to do establishing a new business, startup owners can feel too swamped to give their business financials much thought. Setting up on the run, many startups simply turn to traditional pen-and-paper systems or spreadsheets to manage their incomings and outgoings.

Yet Australian Bureau of Statistics figures reveals one in four startups close down within their first year, in many cases due to poor financial management.

A recent survey conducted by Intuit revealed 42 per cent of business startups use spreadsheets to manage their finances, while 22 per cent use pen, paper and ledgers. And while these methods may feel familiar, the reality is they offer little in the way of bottom-line benefits.

Using more modern accounting tools can give you instant access to up-to-date financial data, which can be vital in helping turn your startup into a profitable venture.

Managing your business finances, 21st-century style

Old-fashioned accounting methods are limited. Spreadsheets are usually saved on one hard drive, only generally on your desktop or laptop. Meanwhile, pen-and-paper systems are stored in a fixed location in your filing cabinet! In both cases, your financials are neither transportable nor easily accessed.

By contrast, 21st-century cloud-based accounting software is easy to use, and it’s accessible online, so you can use it anytime, anywhere and from any device. Track your spending, send invoices or obtain a snapshot of business performance data from your office, the café or even from the other side of the world!

Another benefit of cloud-based accounting is that you don’t need to install or constantly upgrade software to use it you simply sign up for it via an affordable online monthly subscription.

Take advantage of the cloud

Making profitable business decisions is easier when you have a solid, real-time understanding of your financial position. Cloud-based financial management tools provide this, while also saving your business time and money.

Intuit’s QuickBooks Online, for example, allows you to manage your finances anytime, anywhere. From sending invoices and managing BAS and GST obligations to tracking expenses, sales and cash flow, using QuickBooks Online means all your financial data is accessible 24/7 from your laptop, smartphone or tablet. Best of all, QuickBooks Online is an affordable accounting system that costs as little as $12 per month.

Sleep easy

Starting up a small business can be super stressful. You may have business loans or staff you need to pay. Then there are the inevitable issues that arise around cash flow.

A whopping seven out of 10 startup business owners lose sleep over business worries, and concerns about business finances are at the top of the list.

Using cloud-based accounting tools to stay on top of your finances can help you sleep soundly and focus on what’s most important: making good business decisions that underpin growth and success.

If you’re a small business owner who still relies on the old pen-and-paper methods, now is the time to get up to date and streamline your accounting with online software.

Guest post by : team Form -

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