Say “accounting” and the eyes of business owners often immediately glaze over. It sounds so…boring.
But it’s incredibly important.
Your accounting system represents the initial inputs that allow you to compile financial statements, forecast future cash flows, and determine the value of the business you’re building.
It’s critical to understand your accounting system, why you need it, and how to set it up to maximize the value you extract from it.
What is an accounting system?
An accounting system is basically a system that captures all of the individual transactions in your business and categorizes them in a logical way.
Your accounting system will monitor the status of your bank accounts, track all revenues and expenses, monitor the state of any money your customers owe you or that you owe to other vendors, and more.
Accounting has a set of rules governing how transactions are recorded, in order to accurately prepare your financial statements and understand the state of the business.
It’s important to understand those rules and utilize an accounting system that follows them.
The Components of Your Accounting System
The General Ledger
The first tool in your accounting system is your general ledger. This is basically a record of all of the transactions in your company.
Every time you receive money and every time you spend money, it gets recorded in your general ledger, in chronological order.
The transactions in your general ledger should be based on source documents as much as possible. Source documents include things like receipts, invoices, and other documents. These are critical to provide the paper trail of these transactions in case you need to refer back to them later (for IRS reporting purposes, etc.)
The Chart of Accounts
Those transactions are each assigned to a category. Your chart of accounts is a listing of all of the categories used in your accounting system. It’s like the index of your general ledger.
Your chart of accounts should accurately reflect the type of business you have. The categories should map to the actual business activities you engage in.
That said, you will often find a number of consistent account types. Generally speaking accounts are broken into 5 major categories:
- Owner’s Equity
Double Entry Accounting
It’s important to understand that every transaction is actually is two transactions, usually (although not always) between two parties.
- A customer gives you money, and you give them a product or service.
- An employee works for you, and you pay them for their time.
- You take a loan from a bank and have cash in your account, but that is money you owe and have to track.
Your general ledger will recognize this transaction twice, under two different categories in your chart of accounts. This is called the double entry method of accounting, and is what every accounting system uses.
It can sometimes be confusing at first, but is critical in showing you how money flows in and out of your business.
Finally, you have your Financial Statements. These are reports that are generated based on the transactions in your general ledger, that tell you how the business is running.
Common reports include:
- The balance sheet
- The income statement (or profit and loss statement)
- Statement of cash flows
- Aging reports
- Budget variance reports
These reports should be able to give you a picture of your business at any time. They can help you answer questions like:
- Are we profitable? How profitable, compared to the previous period?
- Do we have enough cash to cover our upcoming liabilities?
- How long are customers taking to pay their bills?
Cash vs. Accrual Accounting
There are two primary ways that businesses record transactions in their financial system. One is called cash-based accounting, and the other is called accrual-based accounting. The main question these two systems answer is when you recognize transactions.
In the cash-based method, you recognize revenue when you receive it, and recognize expenses when you pay them. Cash-based accounting is typically used for smaller businesses with relatively simple operations. It’s definitely easier to understand.
But most companies use accrual-based accounting instead. Accrual accounting recognizes transactions when they are incurred - whether or not cash changes hands.
As an example, imagine you sold a client 6 months worth of services but they pay it up front. In cash-based accounting, you wold recognize all of the revenue when it was paid up front. Under an accrual-based system, you would recognize the revenue as it was earned - you would spread it out over 6 months.
Most businesses use accrual-based accounting because it provides a more accurate picture of the business, its income and expenses.