Most small business owners aren’t accountants by trade. But whether their background is in product development, HR, management, or anything else, they have to learn the nuts and bolts of accounting.
The good news is that small business accounting is relatively simple. Companies that operate in a single state and have a simple business structure have three accounting priorities: ensure their revenues exceed expenses, keep their books clean and pay their taxes. Still, small business accounting can be tricky for leaders without any sort of financial background. Use these tips to make sure you’re on the right path:
1. Keep business and personal accounts separate
One of the messiest accounting blunders small business leaders can make is to mix their business and personal funds. Although plenty of entrepreneurs chip in their own startup money, business revenue and expenses must be kept separate from personal ones.
The best solution is to start with a sound structure. Establish your company as a distinct legal entity, such as an S Corp or LLC. Open a business checking account as your financial hub, and pay yourself a salary from it each month. Get a business credit card for expenses you can’t, or don’t, want to pay cash for, and open a business savings account as a rainy day or investment fund. Track any usage of personal items for business reasons.
2. Classify workers properly
When it comes time to build a team, you have two choices: employees or contractors. The IRS considers employees as those who you have behavioral authority and financial control over, as well as a long-term relationship with. Contractors, meanwhile, are people who work for your company on a per-project basis and retain control over their own schedules and business decisions.
Beware that the penalties for misclassifying workers are steep. On top of the $50 for each W-2 form that the employer of misclassified contractors must pay, the employer pays fees of 1.5% of wages and 40% of FICA taxes that it didn’t withhold from the employee. The employer must also pay 100% of the FICA taxes that it would’ve paid per employee. And if the IRS believes the misclassification was intentional, the employer can be fined up to $1,000 per worker or imprisoned for a year.
3. Calculate total labor costs before you hire
If you do decide to hire employees, know that you’ll be on the hook for more than just their wages. At least once a month, you’ll have to come up with the funds for their benefits and payroll taxes. Those costs add up faster than many small business owners realize. According to an OnPay survey, just 43% of those who do payroll themselves are confident in their ability to pay their employees on time. The rest are either behind on their books or too eager to expand their team.
Don’t put yourself in the position of having to cut compensation post-hire. Even if you were generous with your initial wages and benefits, your workers will feel cheated if you pare them back. Small businesses can’t afford high turnover, especially among their first few hires.
4. Create profit and loss statements regularly
A profit and loss statement is a staple accounting tool that summarizes your company’s income and expenses over a given period. All public companies are required to put them out once per quarter. Although small business owners aren’t required to create them by law, P&L statements are great ways to see whether you’re on track to meet your financial goals.
To generate a P&L statement:
Total up all the revenue you generated in the quarter.
Then, itemize your company’s expenses. Break those expenses into two categories: operating expenses and cost of goods sold (COGS).
Subtract total expenses from your gross profit to get your operating profit.
Subtract interest and taxes from that operating profit, and you’ll know whether your business operated at a profit or a loss that quarter.
Although individual P&L statements are valuable, quarter-by-quarter comparisons are even more important. Are your operating expenses growing? Is your profit shrinking, despite the fact that your sales figures are up? Checking P&L statements against one another yields those sorts of insights.
5. Always get a receipt
A good chunk of your company’s expenses can later be claimed as tax deductions. Bookkeeping service Bench lists 16 categories in which expenses are fully or partially deductible. Everything from meals with clients to ad campaigns to office rent is deductible. In order to claim them, though, you need a receipt for proper tracking and verification.
Donations are one area where small business owners often forget to get a receipt. Although companies of certain structures, such as LLCs and partnerships, can’t claim contributions to charities as business expenses, the owner often can. Ask recipients of in-kind donations for written confirmation of the time spent, and use documentation to defend the fair market value of any property donations you make.
6. Keep a close eye on accounts receivable
Although staying on top of accounts payable is important, it doesn’t dictate the company’s survival like accounts receivables do. If there isn’t money coming in the door, then the company can’t continue to operate.
Each month, review the percentage and total amount of outstanding revenue. Generally speaking, no more than 10 to 15% of your accounts receivable should be past due. Reach out weekly to those clients. Don’t send them to collections on a whim, especially if you want to work with them in the future. But, you also can’t let them stiff you.
One solution is to institute penalties for late payment. Set a monthly finance charge of 1% to 2% of the principle. If you decide to charge 2% on an initial charge of $5,000, for example, you’d add $100 to the invoice every month that it isn’t paid. Be sure, though, that you tell clients in advance. Not only is it legally important to do so, but the threat of penalties is often enough to dissuade poor payment practices.
7. Stay on top of tax deadlines
As an individual, you pay taxes once per year. Most small businesses, however, have to file estimated quarterly tax payments. Quarterly tax payments are made on two types of taxes: self-employment taxes, which include Social Security and Medicare taxes; and income tax on the profits your company makes. To decide whether you need to pay quarterly taxes:
Subtract your federal income tax withholding from the amount of federal taxes you expect to owe this year. If that figure is less than $1,000, then you don’t need to make quarterly payments.
Take the total federal tax you expect to owe this year, and multiply it by 0.9. If you’ve withheld at least that much, then there’s no need to make quarterly payments.
Compare your total federal income tax on last year’s return to your withholding amount. If it’s at least as much, you don’t need to pay those quarterly taxes.
What if you do need to make estimated tax payments? Fourth quarter 2019 estimated taxes are due January 15, 2020. Q1 2020 quarterly taxes are due when most people file their taxes, on April 15. Q2 2020 tax payments are due June 15, Q3 on September 15, and Q4 on January 15, 2021.
8. Set (and stick to) your own payment terms
Big companies commonly pay on net-60 or even net-90 terms, meaning that they actually transfer funds either two or three months after receiving an invoice. Your small business can manage its cash flow by operating the same way.
The key is consistency. Say you pay on net-30 terms. Make clear at the time of service that your vendors can expect you to pay in 30 days. Don’t pay early, or the vendor will expect the same next time; don’t pay late, or they may not want to work with you in the future.
Accounting may not be the sexiest part of small business ownership, but it’s an essential one. Mistakes in your books will come back to bite you. Tax troubles will only get worse. If you’re in over your head, call an accountant. There’s no shame in asking for help.