Accounting is a necessary part of all business however large or small. However, there comes a point where a business needs to have a more substantial accounting method than just marking down their immediate expenses and income.
This is because, as your business grows, it will need to take on larger amounts of debt, give clearer financial statements to investors and comply with the increasing government regulations for larger businesses. Also, by having bad accounting practices, your business may be losing money.
Bad accounting practices can lead to bad strategising and therefore bad financial decisions.
What is Accounting?
The accounting process is the analysis, summary and interpretation of your business’ financial transactions. The process aims to determine the financial health of your enterprise and then to recommend financial actions to improve the business as a whole.
At its atomic level, the accounting process for small businesses consists of:
- Bookkeeping – We have an in-depth guide to double-entry bookkeeping.
- Creating financial statements.
- Filing tax returns.
There are two types of accounting you should be aware of: cash basis accounting and accrual basis accounting. Although cash basis accounting is the easier method of the two, HMRC specifies the types of businesses who are allowed to use cash basis accounting as their sole form of accounting.
Cash based accounting refers to the method of accounting where you write down every payment when it happens. For example, rather than writing down the expense of paying a loan when you are given it, cash based accounting will write down the individual transactions as you pay it off. This type of accounting is good for understanding your business’ cash flow as it will give you a daily insight to how much money your business has in its bank account.
However, it is lacking when it comes to planning your business’ long term financial strategy and finding trends in your business’ accounts. We will not focus on cash-based accounting as it is fairly self-explanatory and is often not the best method of accounting for your small business.
How to do accrual basis accounting
Accrual basis accounting is probably the more relevant type of accounting for your small business. Furthermore, even if your business lies within the HMRC specifications for businesses that are allowed to use cash basis accounting, teaching yourself accrual accounting has many benefits, despite being harder to learn:
- It gives you a far more accurate picture of your businesses performance and finances than cash basis accounting.
- This allows your business to make short and long term financial decisions with more confidence.
- It is often easier to source funding as your business will have a better understanding of its long term financial plans.
The fundamentals of accrual basis accounting lie in the recording of expenses and income in the fiscal period they occurred. This is known as double-entry bookkeeping. Knowing the fundamentals of double-entry bookkeeping is critical for this method of accounting. If you don’t know these already, click on the link above to our in-depth guide on how to double-entry bookkeep.
Step 1 – set up a business currents account
A business account will separate your personal finances from your business finances. Making two distinct accounts will better organise your business. You will be able to better track its growth and plan its taxes. You can set up a business account along with a Ltd Company super quickly with the MachFast app.
Step 2 – Record all business transactions
As we stated before, one of the most important parts of accrual accounting is recording all the income and expenses as soon as they occur. Either taking the time to learn double-entry bookkeeping, or finding a software that does this for you is crucial. These financial records are the foundations of your business’ accounting process.
However, don’t forget to track as well as record business transactions. Tracking things such as loans and invoices is crucial. For example, if you pay tax on an invoice that a customer has not yet paid, and then the customer reneges the invoice, you will be able to claim the tax back on your next return. This is, of course, subject to you being able to track the invoice in the first place.
Step 3 – Adjust the balance
It is the role of the bookkeepers to create a trial balance by adding up all the expenses and revenues of the accounts. This ensures that none of the accounts have been marked down incorrectly. However, in accrual accounting, you need to adjust the account entries for the financial period in which they fall. For example, when rent is paid for an entire year, a monthly entry should be made to adjust for the expense incurred. This adjustment is the role of the accountant.
After the accounts have been adjusted, another trial balance is done to ensure that the adjusted accounts are all in order. This adjusted balance is the most accurate record of your financial activity and will be the one used for the financial planning of your business.
Step 4 – The accounting
Now you are able to start creating financial statements, cash flow projections, budgeting, and a balance sheet. These are the core functions of an accountant. The benefits of accrual accounting in this section are that it paints a more accurate picture of the long-term state of the business. This helps when conducting financial statements and budgeting because you will be able to use business trends over time.
However, in accrual-based accounting, you need to be careful when calculating your cash flow. This is how much money you currently have in your account rather than how much you will have. Most companies fail due to cash flow problems. In the UK, according to Xero, that number stands at around 50,000 failed businesses.
Step 5 – Closing off
In this section, you restart the accounting cycle. The final step of the accounting process is making post-closing entries to your temporary accounts. These close the accounts making your business ready for the next fiscal period.
Did you find this helpful? If so check out our other blogs designed to help small business owners like you. You may be interested in our blog on How to Write a Sales Forecast.
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