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How to Set Up an Accounting System, for Small Businesses

A desk with a laptop to the left, a calculator at the center, 4 piles of cash neatly stacked, and piles of paper with bar graphs and charts printed on them. The paper is scattered all over the desk, and the laptop is opened to accounting software. It's a picture of a small business that has set up an accounting system.

Business accounting can be pretty intimidating to new business owners. While most people have heard of debits and credits, assets and liabilities, and profit and loss, what do these terms really mean in accounting? And how do you read accounting reports like the income statement, balance sheet, and cash flow statement? What, exactly, do small business owners need to know to set up an accounting system? Luckily, you won’t need to have a deep understanding of accounting. Bookkeeping software can help you with most of it. You just need to have a general idea of how accounting works.

This post is the start of our series on the basics of business accounting for small businesses. We’re not trying to turn you into an accounting guru. We just want to give you enough information to be able to keep your books with bookkeeping software.

Let’s start with why businesses need to do bookkeeping in the first place.

Business Accounting is a Systematic Way to Keep Track of Money

Businesses have been keeping track of their incoming and outgoing money for thousands of years. There are clay tablets in cuneiform that recorded purchases of barley and payroll as far back as ancient Mesopotamia. But modern accounting using the double entry accounting method didn’t start until the 1300s, in Venice.

We’ll explain double-entry accounting later in this article. For now, just know that, even though double-entry bookkeeping is the most popular accounting method today, it’s not the only way to keep track of your business’s money.

At the end of the day, what every business needs is an accurate way of tracking how their money comes in and how their money goes out. No matter which accounting method you use or whether you use bookkeeping software, Excel spreadsheets, or paper and pen, keeping track of this inflow and outflow is your only goal. Accounting rules and methods help you set up your tracking in a logical way. The rules also help you check for logical and clerical mistakes. And that is all they do.

Yes, you’ll know how much you can pay yourself and you’ll be paying taxes based on the money you’re tracking. But these activities aren’t a part of an accounting system. They’re the result of knowing the inflow and outflow of money.

To Set Up an Accounting System, First Decide Between the Cash Accounting Method or the Accrual Accounting Method

It’s pretty common sense that, when you’re trying to keep track of your money, you’ll need to know how much you have in your bank accounts. But it’s also important to understand how much you expect to be paying out in the near future and how much you expect to take in.

In accounting, there are two ways to keep track of this sort of information: the cash accounting method or the accrual accounting method. When you set up an accounting system, one of the first things you must do is to pick one of these methods.

The Basics of the Cash Accounting Method

The cash accounting method keeps track of the money you actually have. If you send out an invoice, you don’t count the amount of the invoice as income until you actually receive the money. If you buy office supplies and have 30 days to pay the invoice, you don’t record the purchase until the day you actually pay for it. Your business bank account should match your books on the amount of cash you have at any given time.

The cash accounting method is a single-entry accounting method. For every business transaction you make, you only have to enter it into your books one time. The cash method is well-suited for service businesses like a freelancing business or a very small business with limited inventory. But, eventually, businesses tend to graduate to the accrual accounting method.

The Basics of the Accrual Accounting Method

The accrual accounting method, on the other hand, records money as you first expect to receive it or pay it out. So, when you send out an invoice, you record the amount right away as money coming in. When you buy something, even when the money is due in 30, 60, or 90 days, you record the amount right away as money that you have spent.

Because the accrual method lets you know of your expected revenues and expenditures, you can better plan how much cash you need in your bank at any given time.

The accrual accounting method is a double-entry accounting method. So, each business transaction is recorded as a credit to a particular account and then a debit to another account. Keeping track of which two accounts to use and whether the entry is a credit or debit can get complicated. But this method gives you a lot more insight into how your business is doing. This is why most businesses use the accrual method. And, if you’re located in the US, the IRS actually requires you to use the accrual method once your business hits an upper revenue limit.

There’s a lot more to the cash and accrual accounting methods. And there are some tax implications on which one you pick. We go into these details in our article on cash vs. accrual accounting methods.

Should a Small Business Use the Cash or Accrual Accounting Method?

Deciding Your Fiscal Year is Also a Part of Setting Up an Accounting System

Businesses, like people, have to pay taxes every year. For people, the year starts on January 1 and ends on December 31. So does their accounting year. But corporations usually get to pick when their accounting year starts and ends—and therefore when they have to pay their taxes.

The formal name for accounting year is fiscal year. Deciding when your fiscal year starts and ends is also a part of setting up an accounting system.

If you’re a sole proprietor or a single member LLC treated as a disregarded entity, then your fiscal year is the standard calendar year. This is because you must file your business taxes with your personal taxes, and your personal taxes follow the calendar year.

If you’re a partnership, figuring out your fiscal year can be a little tricky because it often depends on the fiscal year of the majority of the partners. Check your country’s tax rules to find the answer.

Corporations can pick their own fiscal year. Most of them pick the standard calendar year, but they don’t have to. Some businesses pick July 1 as the start of their fiscal year. The US government starts its fiscal year on October 1. We’ve even worked for a business that started their fiscal year on March 1.

Businesses have to file quarterly taxes, so the fiscal year decision does affect when the company has to pay. If you pick an unusual fiscal year start and end date, your quarterly taxes are due on the 15th day of the 4th, 6th, 9th, and 12th months of your fiscal year.

If you pick the calendar year, then your quarterly taxes are due on:

  • April 15th
  • June 15th
  • September 15th
  • January 15th (December 15th for corporations)

When Should You Hire an Accountant or Bookkeeper?

One standard advice to folks starting their own business is to talk to a CPA and a lawyer first. But we don’t think you always have to.

Not All Businesses Need an Accountant Right Away

Whether you should hire an accountant right away depends on how many owners there are in the business. It also depends on your accounting method.

If your business is a simple one like a freelancing business or small online vendor business, these should be relatively easy to run. Often, you’re the only employee. And, often, you can track your money using the cash method. You can run it as a sole proprietorship or set up your one-person LLC or corporation. In this case, you’re unlikely to come across complicated accounting questions. You might be able to run your business using a simple bookkeeping software and get by without a CPA for a long time.

But if you have business partners, have a large inventory, or have lots of employees, then using the accrual accounting method can be better in the long run. But setting up an accounting system using the accrual method can get complicated. So, hiring a CPA as early as possible can make a lot of sense.

What’s more, if you have a CPA, you can ask them to recommend an accounting software that they like. This way, when they have to access your software or sync your accounting data to their system, they’ll be working with something they’re already familiar with.

Here’s our article on how to find a CPA, if you need any tips:

How to Hire an Accountant or CPA for Your Small Business

You Should Eventually Work with a CPA

Even if you don’t hire a CPA right away, should you eventually hire one? Yes, we think so. Once your business is running smoothly, a CPA can help you analyze your business’s finances so you don’t overpay on taxes. But this isn’t urgent. Get your business up and running first. And, meanwhile, use a bookkeeping software to keep track of your money.

Use an Accounting Software to Simplify the Process

The first commercial accounting software was developed in the late 1970s. They ran on microcomputers, so they became relatively affordable for medium to small businesses to buy and use.

Fast forward to today, and accounting software have become cheaper to buy and easier to use. What is more, they’re designed so that you don’t really need a detailed understanding of accounting principles in order to use the software.

How Accounting Software Simplifies the Bookkeeping Process

It’s not too hard to set up an accounting system if you use accounting software. A lot of actions are automated so the software automatically records money coming in and money going out.

Depending on your type of business, you’ll either always have an invoice or a receipt for the money you take in. You’ll also usually have an invoice or receipt for the money you pay out. When you pay taxes or make payroll, you’ll always have bank records on when the money is paid out.

Most accounting software can sync to your bank accounts, your credit card processor or point of sale software, and your business credit card(s). This way, the software automatically records the money your business takes in and the money your business pays out.  

For payroll and tax payments, some accounting software will help you keep track of and—for a fee—manage all the payments. You may have to manually enter an invoice or reconcile your bank records from time to time. But you shouldn’t have to do this very often.

As long as the data is entered correctly, you can generate financial reports like the balance sheet at the push of a button, any time you like. You won’t have to understand which entry should be debited or credited in which ledger. And the software eliminates arithmetic and copying mistakes.

Features to Look for in a Small Business Accounting Software

Given all the automation an accounting software can do, what functionalities should you look for when buying bookkeeping software? Here are a few we think you should keep in mind:

  • Invoicing
  • Sync with payment processing information (webstore, point-of-sale, invoice)
  • Bank information (bank account and credit card syncing)
  • Payroll
  • Tax

With these factors in mind, we found some accounting software worth considering:

Which Small Business Accounting Software Should You Pick?

Accounting Concepts and Terminology You’ll Need to Know to Set Up an Accounting System

Depending on whether you selected the cash accounting method or the accrual accounting method, you may or may not have to know some basic accounting terminology and concepts in order to set up and run your accounting software.

If you’re using the cash method, you can probably get by with commonly understood definitions of terms like revenue and expense without going deeper. But if you’ve selected the accrual method, you’ll need to work with terms like accounts payable, accounts receivable, cost of goods sold, and similar. You’ll also have to know how to read reports like the balance sheet, the income statement, and the cash flow statement.

But don’t worry. You just have to have a general understanding. You don’t need an accounting degree.

We learned a little bit about accounting back in high school. That bit of knowledge and common sense have gotten us through everything we needed to know about accounting to run a small business. Here are two articles that summarize basic accounting concepts. They’re written by a non-accountant small business owner (i.e. us), for non-accountant small business owners.

Basic Accounting Concepts for Small Business Owners

Financial Reports Every Small Business Owner Should Understand

Software Related to Accounting Software You Might Want

One reason a business needs to set up an accounting system is so it knows how much taxes it has to pay. And, while common sense says you should be able to buy one tax software to handle all the taxes, that’s not how they’re sold.

On the highest level, and if you’re in the US, there are taxes you have to pay to the federal government and taxes you have to pay to your state and maybe even city. And both the federal government and state want several types of taxes from you. There’s the income tax. Then, there’s employment related taxes. Lastly, there might be sales tax, use tax, excise tax, or VAT that you may have to collect and then remit to the appropriate tax authorities.

While your accounting software will help you keep track of some of the taxes, you often have to figure out how much tax you have to pay and then remit the taxes yourself. Unless you pay a service to help you.

And this can be really frustrating. You already paid money to set up an accounting system. Why do you have to pay more to figure out all your taxes? This is what we’ll go into next. Our next series of articles will go over what you need to do when hiring employees, including figuring out all the employment taxes you have to pay. And our series after that will focus on the various income and sales/use taxes you have to track and pay.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

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