If you have thought about starting a business, or if you already have a small business up and running, you’ve probably (at least once) thought to yourself, “what do I need to keep track of for accounting purposes? How do I even do accounting? Do I need to do it at all? Is it just a ‘taxes’ thing?”
Excellent questions!
Hopefully I can shed some light on why accounting is necessary (especially for taxes), but I am also hoping to go beyond why it is just necessary and broaden your horizons a little bit on the value that accurate and proper accounting can bring to your growing business.
Financial Accounting vs Tax Accounting
Ok. Everyone has to keep some kind of record in order to file their taxes each year. That is an absolute necessity. If you have questions about what you might need in order to file your taxes or what you can expect when that comes up, check out my other article specifically about taxes here.
Taxes are incredibly important, and they are a great reason to keep track of all of your business expenses and income; however, there is a lot more value that can be derived from your financial records as well. Your accounting can help you make important financial decisions, keep your business on track with its spending habits, gain insight into your spending, create a basis for financial and growth projections/forecasts, paint an accurate picture of the overall health of your business, and much, much more!
So how do we get all of that value from a few expense transactions thrown into Quickbooks? Well, first things first, your records need to be accurate and properly maintained. Generally, it is difficult for the founder of a company to find time to do this, so, if you see the value in this, it might be worth looking into hiring a bookkeeper or a staff accountant with some expertise in this field to help you out. Second, it really depends on the value that you want to get out of it. There are a few acceptable ways to keep track of your books, but the results that these methods provide can vary drastically. Know what you’re hoping to get from your financial statements before deciding which method to use.
Methods of Accounting
There are essentially two methods of accounting that you need to be aware of and need to take into consideration when starting or running a business. One method is called “cash accounting,” and the other is called “accrual accounting.”
Let’s take a look at some of the differences between these two methods and why you might want one over the other.
Cash Accounting
Cash accounting is the most basic and easiest form of accounting. It is used to track cash coming in and cash going out.
The whole premise of this is to know where your funds come from and where they are going. If you buy something, then the expense should instantly hit your books, regardless of what kind of purchase it is. If you spend $20 on office supplies, record that expense the moment the cash leaves your account. If you spend $100,000 on construction equipment, again, record that expense the moment the funds leave your bank account.
The same goes for revenue. Regardless of when you actually perform a service or deliver a product to your customer, as soon as you are paid by them, you record that cash as a bonafide sale or as revenue.
This information can be incredibly useful!
If you currently have no idea how much revenue you brought in last month, or last year, and you are unsure about how much money you actually spent on keeping your business running, it can be very difficult, or even risky, to make a large, impactful decision or to even know how well your company is actually doing.
If you have no experience in the accounting field and do not have the funds available to hire someone who does, then I would suggest that you at least start out with this method of accounting. It will provide you with a lot more insight that you currently have, and it will really help you when tax season rolls around.
This method does have a few weaknesses though. Mostly, those weaknesses revolve around the timing of recording expenses and revenue.
Let’s examine the previous construction equipment purchase that I mentioned earlier. Let’s say that in 2020 you spent $100,000 on equipment that you would be using for the next 10 years. In 2021, you did not spend that money on equipment as you already had the equipment. For simplicity’s sake, let’s just assume that you had $1,000,000 in revenue for both years. A really basic profit and loss (income) statement (also assuming no other expenses in the business) would say that in 2020 you had net income of $900,000 and in 2021 you had net income of $1,000,000.
On the surface, that might make sense. You might say, “well, yeah! In 2020 I spent $100,000, so, naturally, I made less money that year.” While that might be true, it doesn’t accurately reflect what actually happened in your business. You didn’t actually perform worse in the year 2020. You performed exactly the same. So, why wouldn’t your income reflect that? You had to buy that equipment in order to perform the work, right? Looking at this from an income perspective, it’s almost like you were punished for buying that equipment and it was a poor business decision to make.
Was it though? Shouldn’t your income for both years be the same? We might be able to fix that..
Let’s examine another scenario quickly though. We’re still looking at the cash method of accounting, right? Ok, so now let’s say that you signed a really big contract for the years 2020 and 2021. This contract is valued at $2,000,000, and you won’t be able to do any other projects during those two years. Now (as unlikely as this is) let’s say that the company you contracted with pays you that $2,000,000 right up front on January 1 of the year 2020. Using the cash method, we would record that $2,000,000 all as revenue on that single day, right? Now when we compare the financials for these two years, we have $2,000,000 in income for 2020 and $0 in income for 2021. Did your business do absolutely nothing in the year 2021? Well, no! You were finishing up the work for that big contract you signed.. But your financial statements are saying that you didn’t do anything at all – $0 in revenue that year! What a terrible year that was for your company!
But was it such a bad year? Again, you did that work all throughout both years? Wouldn’t it make more sense for your income to be reflected across both years that you were performing that work?
This is where the accrual method of accounting comes into play.
Accrual Accounting
Well hooray for accruals!!
*We can fix both of those above scenarios using the accrual method of accounting.
This method attempts to more accurately depict what your business did, when it did it. Expenses are recorded when the items you purchased are actually used, revenue is recorded when your actual work is performed, wages and salaries are recorded when people do the work associated with the payment, not when the payment goes out, etc.
Accrual accounting can get very complex, but it provides data that is so much more valuable to your company!
It can also be a little bit confusing to understand, so let’s look over our examples again and see how using the accrual method would make more sense.
Back to our construction equipment purchase. You might have heard of a little thing called depreciation. This is what we can use as an ongoing expense to show when we are actually using the assets that we purchase. In the case of our construction equipment, it might look something like this.
Since we are going to be using that equipment over the next 10 years, instead of saying that we spent $100,000 in the year 2020, we’re going to say that we are “spending” $10,000 a year for the next 10 years. So, in our example, in 2020 we would have $1,000,000 in revenue and $10,000 in expenses, which would leave us with $990,000 in net income. For 2021, we would have $1,000,000 in revenue and $10,000 in expenses, which, again, would leave us with $990,000 in net income!
Amazing, right?? Now we can look at those years and say, “Of course! We did the same amount of work each year, so it makes sense that our net income is exactly the same.” Then we can actually use that to analyze how our company did. Rather than saying, “man, we really didn’t do so hot in 2020. Good thing we really grew so much in 2021!” It becomes, “ok, so we performed the same as last year. How do we ramp that up for next year??” The analysis is completely different! The first analysis, you think you’re doing great and must have flipped a switch with your company to grow your income by so much. You really figured something out in 2021! But that’s so inaccurate! You didn’t figure anything out. You didn’t change at all! All that happened was you had to buy some necessary equipment in 2020 that you didn’t have to buy in 2021. Now, with the accrual method, you can look at that and actually think of ways in which you can grow and change the way that you do business. The data and insights gained are crazy different! And this is the simplest example that I could think of. When your business has more moving parts, the inaccuracies continue to grow and grow and grow until you could be looking at completely different sets of data.
Ok! Next example. Let’s look at our big, two-year contract! Cash method, we had $2,000,000 in net income for 2020 and $0 for 2021, right? Under the accrual method, that’s not how we would see things. Instead, in 2020 we would say that half of the work was performed, so let’s recognize half of that revenue ($1,000,000). Then, in 2021, we performed the other half of the work, so let’s recognize the remaining half ($1,000,000). Again, now our income for both years is exactly the same! That’s quite the change, right? But isn’t that just a more accurate picture of what our company actually did? Was the work done in 2021 really worth $0? Did we do nothing that year? No! We did work worth $1,000,000! Again, the analysis for these is completely different. Under cash we would say “wow! What a horrible year 2021 was for us. We might need to look at filing for bankruptcy. We have nothing going for us!” Whereas under the accrual method we’d say something more like “ok. Ok. We performed the same this year as we did last year. That’s still a pretty good year for us! How can we improve looking at 2022?” So different, right??
The accrual method will provide much more accurate data for you to use when looking ahead and making those major, game-changing decisions that you’ll have to make. Cash accounting is going to be better than doing nothing at all, but I highly recommend that you implement an accrual accounting system before you get too far along doing just cash accounting.
Now that you understand a little bit about how accounting works. Let’s examine a little bit about the actual results that good accounting produces – financial statements!!
Financial Statements
“Are financial statements even useful? What is the point of staring at a page for hours on end? Financial statements are boring..” etc. etc.
I completely understand where these thoughts come from, but, believe me, financial statements hold SO much value! In the examples that we looked at above, we wouldn’t have been able to perform that analysis or even look at the difference between cash and accrual accounting with a good profit & loss statement (P&L/income statement).
Financial statements summarize hours of accounting work and tons and tons of data in quick and easy-to-read pages of information that we are able to use to examine the company as a whole. They give us a zoomed-out view of the entire business and allow us to gain important insights into how our business operates and the overall financial health of our company.
So, you’re a small business, right? What financial statements would you want to have prepared? Well, this can also depend on the method of accounting that you use. If you’re using the cash method, then you’re probably going to be just fine looking at a P&L and a balance sheet. If you are using the accrual method, however, you’ll want both of those financials as well as what’s called a statement of cash flows.
Let me explain a little bit about these.
Profit and Loss
The profit and loss statement, or P&L, tells us how much money we brought in (sales/revenue) over a period of time (such as a month or a year) as well as how much money was spent during that period.
The final piece of information it gives us is how much money was left over after all of our expenses (profit) or how much more we spent than we actually made (loss).
Comparing these statements month to month, or year to year, allows us to see our company growth or decline, helps us to pinpoint trends or abnormalities (which is how we can find things like embezzlement or fraud going on), gives us a way to forecast into the future to help us make decisions today, etc.
This statement can be incredibly helpful; however, I will warn you that it will not be very accurate under the cash method of accounting and, therefore, is not the greatest thing to base your decisions off of.
Balance Sheet
The balance sheet looks at a moment in time versus a period of time. For this statement, you would create it based on information for December 31, 2021 rather than for the period of January 1, 2021 – December 31, 2021 for the P&L.
The balance sheet gives us information about all of the assets and liabilities that our company has on hand as well as some insight into the ownership of our company. It is to be used in tandem with the P&L, so that we can see what we currently have in the bank, at our disposal, for growth projects as well what we currently owe to other companies or people. It helps us to understand our upcoming obligations. For example, maybe we have $1,000,000 in the bank ready to be invested into a new project; however, looking at the balance sheet, we realize that we will owe $800,000 of that to debtors, creditors, shareholders, etc. Then we can know that we really only have $200,000 of freed-up capital that we can invest into new projects.
This is incredibly important! If we only look at our bank statement and see that we have $1,000,000 of cash, then we might make a poor or even harmful/detrimental decision for our company.
This statement is difficult to construct under the cash method. Again, it is likely to be inaccurate and might end up increasing your risk of making a poorly informed decision. The accrual method will provide a much more accurate view of your company.
Statement of Cash Flows
The final statement that I recommend that you utilize at your small business is what’s called the statement of cash flows. This statement is not necessary under the cash method, and you will see why momentarily.
Essentially, this statement takes your accrual basis P&L and unwinds it to show how cash moved during the same time period. It basically shows you what your cash method of accounting would have looked like if you had been using that method.
Now, after saying how inaccurate those cash basis statements are, why would I now be encouraging you to use a statement that shows practically the same information? Well, because, if you have your accrual basis statements, showing you a more accurate depiction of your company, then it can also be very, very useful to examine what did happen with the cold, hard cash during that time. It might not be accurate to say that all $100,000 of your construction equipment purchase should be recorded as an expense right when it happens, but it is very nice to know that you did, indeed, spend that $100,000 of cash, and that it is no longer in the bank. When used all together, you can gain powerful insights about your company.
The statement of cash flows does not accurately say, this is your true net income for the month of January, but it does tell you exactly how much cash came into your business and how much went out, which is very good to know.
When you use these three statements together, you will be setting yourself up for success, and you will be able to gather important information and sets of data for your team to look at together.
I hope that this is helpful information and can be somewhat of a guide to you as you begin to implement a system of accounting at your budding company! If you have any questions whatsoever (whether that be about taxes or accounting methods or setup), please feel free to reach out to me directly at [email protected]. I would be more than happy to help or point you in the right direction of who might be able to help you.
As always, if you have any digital marketing needs, please reach out to our team at Lemonade Stand here. We want to see your business grow!!
*These examples are meant to illustrate a point – not to provide advice on how to actually account for items in these situations. There are various methods of depreciation and income recognition that can get extremely complex. More research or professional guidance may be required for your specific circumstances.