Basic Accounting Concepts for Small Business Owners

Every business needs to keep track of its money. But not every business owner has formal accounting training. Of course, the easiest way to solve this problem is to hire a CPA. But not every small business has the money—or, often, the need—to hire a professional. Modern day accounting software can handle a lot of the day-to-day data entry for you. Still, to set up the software, it helps if you understand at least some basic accounting concepts. That’s what we’ll go through in this article.

Most of the concepts we cover are important if you’ve picked the accrual accounting method. But even if you use the cash accounting method, we think this article will still be helpful.

Let’s start with what happens right after you’ve formed your business. This way, as we go through the accounting concepts, you’ll have better context so things will make more sense.

After You Form Your Business, Fund it With Money or Property

There are quite a few ways to start a business. Sometimes, you just start selling or providing services. In that case, you’ve formed a sole proprietorship. Other times, you file some paperwork—maybe for an LLC or a corporation. When your state approves the paperwork, you’ve got yourself a brand new business.

Next, you have to give your business some money so it can pay for the things it needs to do business with. People usually fund the new business with cash. But they also often give equipment like a laptop. You can also lend yourself money to start the business. (See this article for the proper way to write up the loan to yourself.)

What is Equity?

One of the most important basic accounting concepts is equity. Equity is the true value of the business.

Let’s assume you put $100 cash and a laptop into the business. When you put money or a physical item into your new business, everything added together is called owner’s equity.

Another important basic accounting concept is asset. Asset is everything the business owns, including all the physical property, cash, and intangible property like intellectual property. When you start your business, your equity and assets are the same.

Now, it’s pretty hard to start a business with just $100 cash and a laptop. So, you lend yourself $10,000. You deposit that cash into your business’s bank account and write up a promissory note that formally documents your personal loan to your business. You deposit that $10,000 cash into your business’s bank account. This increases your business’s assets by $10,000.

But the cash is a loan, and a loan is a liability—yet another important basic accounting concept. A liability is anything your business owes. Often, it’s some type of loan from you, a bank, or even an auto finance company (e.g., for your company’s delivery van).

To figure out how much equity you have in your business, you take your assets and subtract your liabilities. What is left is your equity. The math formula looks like this:

Equity = Assets – Liabilities

(Unfortunately, there’s math in accounting. But usually it’s very simple math, so don’t worry.)

Here, your assets include $100, a laptop, and $10,000. Your liabilities include a $10,000 loan. So:

Equity = ($100 + laptop + $10,000) – ($10,000)

Your equity is still $100 plus your laptop. Even though your business now has an extra $10,000 in the bank, your equity hasn’t changed because your liabilities have increased by $10,000 too.

When You Buy Things, Your Asset Value Doesn’t Change

Let’s say you use some of that $10,000 in the bank to buy a printer for your laptop. Depending on how you pay, there are two ways to look at the transaction.

If You Use Cash, then You Swap One Type of Asset for Another

Let’s say you pay cash for the printer. Cash is one type of asset. Your printer is another type of asset. So, even though your cash is reduced, your physical asset is increased by the same amount. Your total asset doesn’t change.

Because your asset hasn’t changed, your business’s total equity hasn’t changed.

If You Use Credit, then You Increase Assets but Also Increase Liabilities

Remember we said the loan you lent to your business is a liability because it’s something your business owes? Let’s say you bought the printer with a credit card. A credit card is just a short term loan from your bank to your business. You pay back the loan every month, when you get your credit card statement. So, while you take possession of the printer, you also owe your bank the cost of the printer.

The printer increases the asset value of your business. But the credit card loan also increases your business’s liabilities by the same amount. Equity = Asset – Liabilities. So, your business’s total equity remains the same.

Accounts Payable: A Basic Accounting Concept Related to Money To be Paid Out

One of the basic accounting concepts you need to know is the concept of accounts payable. When you pay for something on credit, you get to take the item right away but you pay on a later date. In accrual bookkeeping, accounts payable (or just payable) record the money you’ve already spent to buy something but haven’t paid for it yet. Your credit card charges are a type of accounts payable.

Other types of accounts payable include invoices for merchandise or raw materials. Often, you’ll have 30, 60, or even 90 days to pay for the items already delivered to you. Invoices from the freelancers you hired are typically recorded under accounts payable. You often have a few weeks to a month to pay these independent contractors after they’ve completed their work. Utility payments can be categorized as accounts payable too.

As long as you’re supposed to make the payment within 12 months, accounting rules let you categorize a payment as an account payable. You record the spend as soon as you make the purchase and remove the entry from the payable account into your cash account when you make the actual payment.

The Concept of Inventory Can Get Quite Complicated

If you’re a manufacturing business or a retail business, after you fund your business, you’ll be buying merchandise for resell or raw materials to make your product. In other words, you’ll be buying inventory.

Inventory refers to anything your business has that is for sale. Usually, a service business doesn’t have inventory. But some service businesses like plumbers or electricians will have a small amount of inventory of parts that they use and charge their customers for.

Inventory is a type of asset, but it doesn’t always behave like other types of asset. In fact, inventory is such an important basic accounting concept that we’ll break it into two broad types so we can present them more easily: retail inventory and manufacturing inventory.

Retail Inventory

Retail inventory is fairly easy to understand. Usually, you buy the merchandise in bulk and sell them separately, with a markup. Other than separating the bulk purchase, you don’t change the merchandise in any way. Most of the time, you put the merchandise on a shelf or display a photo of it on your website and wait for a customer to buy it.

You might have many different types of merchandise, so you record the cost of your wholesale purchases by type. Wholesale price for finished merchandise is usually pretty stable, so you probably won’t have to worry about pricing difference between the merchandise you bought 3 months ago vs. the merchandise you bought just last week. All you have to do is to track the different types of merchandise separately, and you’ll easily be able to figure out your profit per item.

Probably the most complex thing you’ll have to do for inventory is to count them at a set time every year. Once you’ve counted every item you have in your inventory and compared it with your recorded sales on paper, you’ll know how many items you’ve thrown out because they were damaged or have gone missing. You can reduce your inventory on paper by that amount. This way, your books show what you truly have.

Manufacturing Inventory

If you have a manufacturing business, accounting for inventory is a bit trickier. We’ll only go over the general concepts in this article. Our goal is to give you enough information so, when you think a situation applies to your specific business, you can look up the detailed information or ask your CPA for instructions.

Let’s say your business makes widgets. You buy raw materials to make your widgets. Then you make the widgets. Finally, you sell the widgets for a profit. Let’s first go through the actual process and introduce a few basic accounting concepts that go with the process.

Manufacturing Businesses Buy Raw Materials and Convert Them to Finished Goods

Raw materials are the materials you use to make your widget. Maybe your widget uses 10 types of raw materials. You buy them separately. Each material has a different cost. You track each material under its name, along with its cost. You use the raw materials to make your widget, but you won’t use the materials all at once. Sometimes, you’ll buy more of one type of raw material because the price is low but then buy less when the price is higher.

Depending on the complexity of your widget, sometimes, you can make the widget in a short time—a day, maybe. Other times, it might take you a week to a month to make the widget. Big airplanes can sit on the production line for a while, for example. If the process takes a while, then the half-finished widgets get their own accounting category called work-in-progress (WIP) inventory.

In addition to the raw materials that go directly into your final product, you might have to buy materials that will be used to make the widget but won’t be in the widget. For example, you might need to buy tape to hold the widget while you glue some of the widget parts together. But the tape won’t be in the final product. Raw materials that go directly into the product are called direct materials and the tape or similar are called indirect materials. Lastly, you’ll have to have packing materials to put your finished widgets in, so packing materials are a type of inventory as well.

Once you’ve finished making a widget and packaged it, then the widget becomes yet another type of inventory—finished goods. You sell the finished goods hopefully for a profit, thereby increasing the overall equity of your business.

The Manufacturing Process is Mirrored in the Books

What we’ve described above is what happens in a real manufacturing process. Your accounting records will mirror this process.

The exact method you track money depends on whether you’re using the cash or accrual accounting method. With the cash method, the process is fairly simple but not very nuanced. It should be used only with smaller businesses that do not mass produce—businesses like a crafting business that sells items on Facebook Shops, for example. We described how to book your inventory under the cash method in our article on cash vs. accrual accounting methods. If you’re using the cash method, check out the inventory portion of the article.

But if you’re using the accrual method, read on.

When you buy raw materials, you might have to pay right away or you might pay on a later date. If you pay right away, you take the funds out of your cash account, and your raw material is recorded as an asset. If you pay later, your raw material is still recorded as an asset. But the payment is recorded as an account payable. When the invoice is due and you make the actual payment, you reduce the payment amount in your account payable and reduce your available cash.

As you use your raw materials to make your finished product, you’ll make classification changes to track your inventory. So, some of your raw materials might change to WIP materials and then change to finished goods. Or they can go straight from raw materials to finished goods.

Once you’ve made your finished goods and packaged them for shipment, you’re ready to sell your widgets.

Your finished goods are still an asset of your business. Your raw materials are converted to your finished goods. But your business’s total assets remain the same.

Calculating Cost of Goods Sold

If you make a widget, most people understand intuitively that, to find out your profit per widget, you take your sale price and take out all your costs. In accrual accounting, there’s a systematic way to do this.

The formal accounting term for “everything you paid to make the widget” is cost of goods sold (COGS). Some typical types of COGS include:

• Raw materials
• Indirect materials
• Packing materials
• Labor that went into making the goods (e.g. salary and benefits of your line workers but not salary and benefits of your office manager)
• Utilities for the manufacturing site (e.g. if you have a separate HQ building, the utilities for that building isn’t a part of the COGS)

As long as the cost is directly related to making the final product, then it’s COGS. For example, if you have several factories and each makes a part of the widget, with a final factory that assembles all the parts together, then transportation of the parts to the assembly plant is a part of your COGS. But, once the widget is made, the transportation from you plant to your distributor isn’t a part of the COGS.

For retailers, and putting things in terms of COGS, these will include the wholesale cost of the widgets, your packing materials, and any commissions directly related to the sale of the widgets if you pay your sales team this way.

A Wrinkle in Calculating Your Raw Material Costs

Earlier in our article, we mentioned that, sometimes, you’ll buy more of one type of raw material because the price is a bargain. Later on, you buy less of the same material because the price is higher. This can happen if you’re, for example, a wholesale bakery business. Sometimes, the cost of flour is high and other times, it’s low.

To figure out your flour costs for COGS, there are a few ways you can track your inventory costs. They’re too complicated to get into in this article, but you can get a good explanation if you look at IRS Publication 538. Here’s the specific section where they explain how to calculate your raw material inventory costs.

Calculating Gross Profit and Gross Margin

To figure out your total costs of making the widget, you figure out your gross profit (or gross income).

Gross profit = revenue from sale of goods – COGS

You can express this as a percentage—which is called gross margin—by:

Gross margin = (gross profit/revenue from sale of goods) x 100

Expensing and Capitalizing: How to Book Assets That Get Used Up

When businesses spend money, they don’t always spend it buying physical goods like inventory. Sometimes they pay for services like cellphone lines or lunch with a customer or plane ticket and hotel stays for a work conference. In these cases, your asset—cash—simply gets used up.

How to deal with assets that just get used up is yet another important accounting concept.

All Businesses Have to Spend Money Just to Keep Going

To keep going, all businesses buy physical items or services from time to time. You can use cash to buy physical assets like a delivery van or office supplies. Or you buy equipment to use to make your widgets. Office supplies get used up. Vans and equipment go through normal wear and tear until you can’t use them anymore.

In accounting, you treat the two types of spending as expenses. An expense is simply an outflow of money of a business that reduces the equity of the business. To qualify as a business expense, the spend has to be ordinary and necessary to the running of the business.

Usually, when the spend is for something short term and is used up within a year (e.g. office supplies), the cost is expensed. But when the spend is for something that can be used for multiple years, the cost is capitalized. These two basic accounting concepts are significant because they have different tax consequences.

Every country’s tax law is slightly different. Because most of our readers are in the US, we’ll use US tax law to illustrate some of the points below. Specifically, we’ll use IRS Publication 535 to decide what can be expensed and what must be capitalized. While the general accounting principles in this article apply to most of the world, if your business is based in another country, be sure to double check your country’s tax laws to make sure you’re handling your accounting correctly.

What Happens When an Item is Expensed?

When you expense an item in a particular year, you get to deduct the entire amount from your revenues for that year. In effect, you reduce your profits. Because you have less profits, you’ll pay less income tax for that year.

Typically, things you can expense are items you can use up in 12 months. This includes little things like business lunches, office supplies, office software subscriptions, and business travel related costs. But this depends on the tax laws of each country.

Some of the big categories that you can expense include:

• COGS
• Employee pay (including awards, bonuses, and fringe benefits)
• Rent
• Interest
• Taxes
• Insurance

These are just the general categories of what you can expense. There are lots of detailed rules under each category on what can and cannot be expensed. If you use bookkeeping and tax software, they should help you categorize and deduct these spends correctly.

What Happens When an Item is Capitalized?

When an item is capitalized, this means you can’t deduct the entire amount you spent in the same year you acquired the item. Instead, you have to spread the cost over several years. Exactly how many years depends on the tax laws of your country.

There are two types of capitalization: depreciation and amortization. Both allow you to expense an asset over a period of several years. But there’s a key difference between them.

What is Depreciation?

When you buy a physical item and use it, the item will go through wear and tear until you can’t use it anymore. This is why a new item is usually worth more than a used item. Depreciation is a way to account for this loss of value of an item over time. And you can use the depreciated amount to reduce your profit—and therefore taxes—each year.

Depreciation is a basic accounting concept that applies to physical items (i.e. tangible property). After you’ve finished depreciating the item, you often still have the physical item. You can continue to use the item until it completely breaks, or you can sell the item to recoup some money.

There are several formulas you can use to calculate depreciation. The easiest is called straight line depreciation. It assumes an item loses the same value every years it’s supposed to last. For example, if you bought a machine to make your widget for $7,000, and the machine is to be depreciated over 7 years, then each year, you’re allowed to assume the machine is worth $1,000 less than its original value. By the 7^th year, the machine is assumed to be worth nothing.

There are other formulas for depreciation, but we won’t cover them here. If you have a CPA, they can help you figure out the best method.

In the US, the tax code tells you which items you can depreciate and over how many years. Usually, you can depreciate:

• Buildings (except land)
• Machinery
• Vehicles
• Furniture
• Equipment

Depending on the item, you can depreciate the property over 3, 5, 7, 10, 15, 20, or 25 years. Looking at IRS Publication 946, most properties a small business is likely to own fall under the 5 or 7 year depreciation schedule.

What is Amortization?

The basic accounting concept behind amortization is similar to the concept behind depreciation—some things get used up over a period of time. But the term amortized applies to intangible property. Once you finish amortizing the property, the property might have zero value (e.g. expired patent or older version of a software).

A small business might amortize its:

• Software
• Patents
• Trademarks
• Copyright
• Goodwill
• Business startup and organizational costs (if above $50,000)

For the items listed here (except for software), as of this writing, you amortize their value over a 15 year period. There are different accounting rules on how to amortize different types of asset and over how many years.

We won’t go into other details on amortization rules because they’re pretty complex. If you use accounting and tax software, they will typically help you determine which rules to follow. Or you can always look up the most current IRS Form 4562 for instructions.

Do You Expense or Capitalize Software?

These days, most businesses use some type of software. We even recommend you pay for accounting software for your bookkeeping needs. And some of our readers are software developers. So, we want to include a section to specifically address how you treat software.

Depending on your accounting method and how you use the software, you can expense, depreciate, or amortize software. But you have to pick only one type of treatment per software and stick with it.

The actual rules for software are fairly complex, so the safest way to deal with them is to ask a CPA. But if you’re on the cash basis, you don’t have to deal with depreciation or amortization. Everything is expensed as you pay out. That’s how you deal with software subscriptions and off-the-shelf purchases.

If you use the accrual accounting method and use software to run various aspects of your business, you can expense your software subscription costs. Or, if you buy off-the-shelf software to install locally, you can typically amortize the cost over 3 years. If you buy a computer and the OS software comes with the hardware, you can depreciate the software along with your hardware.

But some businesses develop software and sell licenses as a software-as-a-service (SaaS) business. If you’re using the accrual accounting method, then, as a rule of thumb, you capitalize your software development costs over a period of 5 years. There are a lot of conflicting information on the internet as of this writing because this is a new tax rule in the US. But we think we linked to the most reliable and clearest answer. CCH has been publishing tax law related information for over 100 years. Their answer is likely the correct one.

Accounts Receivable: When You Make a Sale but Don’t Get the Money Right Away

Once you’ve made your product or are ready to provide services, you’re ready to sell. Most small businesses receive payment in several ways:

For businesses using the cash accounting method, you record the payment when it lands in your bank account. But if you use the accrual accounting method, you’ll have to understand yet another important basic accounting concept: the accounts receivable.

The Typical Account Receivable Process

If you receive cash, then it’s recorded as an increase in your cash account right away. But if you send an invoice or get paid by credit or debit card, there are additional steps you have to take when you use the accrual accounting method.

When you send an invoice, you also specify an invoice due date. People don’t have to pay right away, and many don’t. So, in your books, you first record the invoiced amount as money you expect to receive in the future. This is called an account receivable (or just receivable).

When you receive the payment, you move the entry from your account receivable to your cash account. This way, you know you’re no longer owed the money but already have it.

Account Receivable for Credit and Debit Card Payments

If you take credit or debit card payments, the process of recording this payment is a little bit more complicated. First, it helps if you understand the credit card payment process and the debit card payment process. Basically, there can be a delay of a few days or even up to a few months between the time the customer charges the card and the time the money lands in your bank account.

Payment card processing isn’t free. Your payment processing provider charges you a fee for each swipe, and they can charge you other fees at the end of your monthly statement. When you do finally receive the money, all the fees will have been taken out. In other words, you won’t be receiving the full sale amount.

So, when a payment card charge is first made, you record the full sale price in your accounts receivable. Once you receive the money in your bank account, you move the payment to your cash account. You also record the credit card fees as an expense (usually as operating expense).

But, sometimes, you have to deal with a chargeback. If you do not dispute the chargeback or if you fight it and lose, you’ll have to pay the credit card company the money back. In this case, you move the disputed amount to accounts receivable while you fight the chargeback. Once the chargeback is settled and you know if you have to refund the money or if you get to keep it, you either expense it or you move the money back to cash. This is the same process if you receive a bounced check or if you have a disputed debit card or ACH transaction (both less likely).

In Presenting the Basic Accounting Concepts, We Haven’t Used the Terms Debit and Credit

The accrual method uses something called double-entry accounting. Double entry accounting is based on the equation we started with, in this article:

Equity = Assets – Liabilities, except it’s more often written as

Assets = Equity + Liabilities

Any time you add to or take away from one of these three big categories, you have to make a second entry to adjust one of the other categories so the numbers stay the same. Hence, double-entry accounting.

Usually, credit means an increase and debit means a decrease, except under Assets. In Assets, a debit means an increase and a credit means a decrease—the opposite of the general meaning of the words and quite counterintuitive.

This is why, throughout this article, we used increase and decrease instead of credit and debit. We want you to understand all the basic accounting concepts first before you use the somewhat confusing accounting terms credit and debit.

And, if you use accounting software, the accounting equation is automatically balanced for you. You typically won’t have to puzzle out whether an entry is a credit or a debit. You just need to know if the amount increased or decreased your assets, liabilities, revenue, or expense.

Now That You Know the Basic Accounting Concepts, You’re Ready to Read Some Financial Reports

We’ve gone over the big basic accounting concepts and matched them to what actually happens when you’re running a business. Next, we’ll go over some financial reports to show how these concepts can be used on the reports to give you a snapshot of your business: Financial Reports Every Small Business Owner Should Understand

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.