The Importance of Accounting for Small Businesses
Updated September 26, 2022
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Editor's note: This article contains general information and is not intended as a substitute for professional accounting advice. Please consult an accountant before making any financial decisions.
Accounting is vital for every business. Savvy record-keeping is key for monitoring business expenses and discovering new avenues of growth. In addition, maintaining accurate records ensures that business owners remain responsible for tax obligations to the government and their employees.
As you review your accounting strategy, consider your company's financial goals. Whether you are a solo entrepreneur or employ staff, your business' success hinges on clearly stated financial objectives.
Experts agree that small businesses commonly fail when cash flow runs dry. Your business should implement efficient record-keeping policies and a sound financial strategy to avoid this situation.
Explore the Main Points:
What Is Small Business Accounting?
Small business accounting requires accurate bookkeeping, which entails maintaining organized records of a business's financial transactions, including sales, expenses, assets, and liabilities. If this is your first time exploring small business accounting, visit our helpful glossary to become familiar with basic accounting terms.
Bookkeepers commonly work with three types of accounting reports: balance sheets, income statements, and cash flow. Each report records different values and provides unique insight into a business's financial health. The following section explores the differences between these reports.
Balance sheets measure what a company owns and owes. This type of statement provides a snapshot of a small business's financial health at a specific point in time. Bookkeepers can view the company's assets and liability figures at a glance.
Companies typically prepare balance sheets at the end of every quarter, but individuals can prepare them at any time. Assets, liabilities, and shareholders' equity comprise a balance sheet.
Assets
Assets have economic value and can reduce expenses and improve sales. Examples of assets include real estate, inventory, cash, and accounts receivable. Balance sheets list assets in order of liquidity — how easily they can be sold, consumed, or turned into cash.
Liabilities
A liability is something a company owes to someone else. Examples of liabilities include employee wages, income taxes, mortgage loans, and accounts payable.
Shareholders' Equity
Shareholders' equity represents a company's net worth — the amount shareholders would receive if they liquidated all assets and repaid all debts. Net worth can also be understood as assets minus liabilities. For example, a company with $10,000 in assets and $2,000 in liabilities would have an $8,000 shareholders' equity.
Income statements, often referred to as profit and loss statements, summarize a small business's revenues and expenses over a specific period. Companies typically prepare quarterly and annual income statements.
Income statements focus on four key items — revenue, gains, expenses, and losses — which bookkeepers use to calculate net income.
Revenues and Gains
Revenue includes operating and non-operating revenue. Operating revenue makes up a business's primary activities, like selling products. Businesses obtain non-operating revenue through secondary business activities, like bank account interest.
Gains include money made from one-time, non-business activities, like selling off old equipment or unused buildings.
Expenses and Losses
Like revenue, expenses include costs accrued through primary and secondary business activities. Primary activities include general administrative expenses, research and development, and the cost of goods sold.
Losses include elements like unfavorable lawsuit settlements and assets sold for less than their value.
Net Income
Accountants calculate net income by subtracting a business's expenses from its revenue. If revenue is higher than expenses, the business gains net profit. If revenue is lower than expenses, the business experiences a net loss.
Cash flow statements summarize the amount of money entering and leaving a company. These statements focus exclusively on liquid assets like cash and cash equivalents — investments that individuals can readily turn into cash.
Accountants calculate cash flow by making adjustments to a business's income statement. Through addition and subtraction, bookkeepers remove non-cash items and transactions from the net income. Components of a cash flow statement include operating activities, investing activities, and financing activities.
Operating Activities
Operating activities include generating and spending cash for business activities. Businesses consider receipts from sales of goods, bank account interest, payments made to vendors, and wages paid to employees as operating activities.
Investing Activities
Examples of investments include asset sales or purchases, loans made to vendors, and payments related to business acquisitions or mergers.
Financing Activities
Financing activities include generating and spending cash to fund the company, such as paying cash dividends to shareholders, receiving cash from issuing stock, and receiving cash from paying down debt.
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How to Do Accounting for a Small Business
Effectively managing your small business's finances goes beyond bookkeeping. Using professional accounting methods allows you to properly strategize for your company's future and meet your legal requirements.
Using professional accounting methods allows you to properly strategize for your company's future and meet your legal requirements.
At this stage, successful small businesses should consider either outsourcing their accounting needs or investing in accounting software. Each option has its pros and cons, which are outlined in greater detail below.
Small Business Accounting Software
Tech-savvy business owners or those familiar with accounting principles typically use accounting software. Digital bookkeeping offers a much quicker method than manual calculations.
These applications automatically crunch numbers, perform data entry, track performance metrics, and produce business reports. After correctly entering your data, the software guarantees accurate calculations, which provides added comfort in tax season.
More advanced versions integrate with other office management programs, display data trends, pay accounts receivables, remit invoices, and ensure that tax requirements are met. Extensive data storage within accounting software increases your company's efficiency, allowing quick access to details like payment history.
Software Pros
- Automatic data entry minimizes redundancy
- Pre-calculated sales tax
- Cloud-based storage eliminates the need for costly desktop technology in the office
- User-friendly interface
Software Cons
- Security is riskier within cloud-based services
- Often packaged as subscription services that charge for annual updates
- Dependent on tech support from outside sources
- Costs can be high, especially for a desktop-based installation
Some software targets small business accounting professionals or bookkeepers, while other programs tailor to business owners looking to develop their accounting skills.
Companies with little or no inventory and few employees can use inexpensive or free basic accounting software. While business owners can easily implement this affordable software, it may leave you at risk of an IRS audit triggered by inaccurate reporting.
Popular accounting programs for small businesses include:
Accountants for Small Businesses
In some cases, small business owners may prefer hiring sole practitioners or accounting services firms that specialize in small businesses. Other businesses hire temporary accounting staff at certain times of the year or hire part-time bookkeeping employees with advanced training.
For a business owner who lacks accounting skills or dislikes crunching numbers, outsourcing the company's financial information offers an attractive option. Many business owners find comfort in an accountant's financial expertise and tax knowledge. A qualified accountant can also assist outside of managing day-to-day finances. For example:
- Advising on how best to structure a company before launching
- Consulting on the financial details of your business plan
- Identifying potential cost savings in operations
- Managing payroll
- Developing a financial safety net in case of catastrophic events or struggling growth
- Liaising with the IRS in the event of an audit
Though many small businesses begin with the owner as the sole employee, it eventually becomes advantageous to hand over accounting functions to a professional. In this situation, businesses may choose to hire inside or outside accountants in accounting firms.
For younger, growing businesses, using an accounting firm offers some flexibility. Keeping a firm on retainer for consultation helps businesses that need their expertise a few times per year.
This less expensive option still delivers high-level accounting expertise. Accounting firms generally charge by the hour, though some analytic functions cost more than others. If you are unsure, weigh the initial costs against what a firm can save your company over time.
Accountant Pros
- CPAs are licensed trusted advisors.
- Professionals possess crucial tax law knowledge.
- Accountants can provide IRS audit assistance.
- Accountants can assist in business growth strategy development.
Accountant Cons
- Hourly rates are costly.
- Most of your company's financial knowledge lies with one person, which is risky.
- Hiring an accountant can lead to a lack of control over daily transactions.
- Accounting services may be provided outside of the office.
Some may find choosing an accounting services provider just as daunting as keeping your own books. Most small business owners know the Big Four names in accounting:
- PricewaterhouseCoopers
- Deloitte Touche Tohmatsu
- Ernst & Young
- KPMG
These firms are established and well-staffed with qualified CPAs. However, their large size leads some small business owners to prefer smaller accounting firms that will not lose them among their larger clients. Smaller firms are generally much less expensive and can provide face-to-face service.
For established businesses, accounting firms' hourly rates can become exorbitant as transactions become more complex. In this case, it may make more sense to hire an in-house accountant.
Choosing Your Accounting Solution
Having a dependable, efficient accounting system can free up your time to focus on other business tasks. As you explore accounting solutions for your company, consider the following questions:
- What is the size of my company?
- What accounting technology best serves my company?
- Is my understanding of basic accounting up to the task?
- Does my cash flow allow for accounting expenditures on a monthly or annual basis?
- How comfortable am I handing over sensitive business data to an individual or accounting service?
- Is daily data entry something that my staff or I can reasonably accomplish?
- Does my company operate in a complex tax environment that may be subject to audit?
- Do my industry competitors find a particular method to be most useful?
- Are there compatibility factors to consider with other technological processes that regularly occur, like payroll?
Your answers to the questions above will help you decide on the most sensible options for your small business. Then, you can get back to doing what you love with confidence in your financial future.
Small Business Accounting FAQs
How do I do accounting for a small business?
Small business accounting typically involves three key reports: the balance sheet, income statement, and cash flow statement. Companies perform accounting tasks manually, with accounting software, or through professional accounting services.
What are accounting best practices for small businesses?
Key accounting best practices for small businesses include keeping businesses' finances separate from personal finances, maintaining accurate records, and tracking income and expenses. Small businesses may also want to consider hiring professional accountants or automating their finances with accounting software.
What is the most commonly used accounting software?
Common accounting programs for small businesses include QuickBooks, Xero, and FreshBooks. Each platform offers powerful features for small business owners, including bookkeeping tools, point-of-sale functions, and mobile apps.
Does my small business need a CPA?
Many sole proprietors get by without accountants. However, working with a CPA offers many benefits for LLCs and corporations. CPAs can analyze bookkeeping records, help with payroll and taxes, offer financial consulting, and represent you during IRS audits.
Should I hire an inside or outside accountant?
It depends on the size of your business and the complexity of its operations. Outside accountant costs typically increase with the size of the business. At some point, hiring a professional to handle in-house accounting may offer cost savings in the long run.
Reviewed by:
Lizzette Matos, CPA
Lizzette Matos is a certified public accountant in New York state. She earned a bachelor of science in finance and accounting from New York University.
Lizzette began her career at Ernst & Young, where she audited a diverse set of companies, primarily in consumer products and media and entertainment. She has worked in the private industry as an accountant for law firms and ITOCHU Corporation, an international conglomerate that manages over 20 subsidiaries and affiliates. Lizzette stays up to date on changes in the accounting industry through educational courses.
She is a paid member of Red Ventures Education’s freelance review network.
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