An overview of the accounting principles and practices that small business owners need to be aware of when preparing financial statements and tax returns, whether done monthly or annually.
When you reach the end of an accounting period, you need to "close the books." At a minimum, you will close your books annually, because you have to file an income tax return every year, and you should prepare annual financial statements as well.
Most businesses, however, close their books at the end of each month. Sending out customer statements, paying your suppliers, reconciling your bank statement, and submitting sales tax reports to the state are probably some of the tasks you need to do every month. You may find it easier to do these if you close your books.
Unless your business is very small and has few transactions each month, it's likely that you'll want to have your accountant close your books for you. We describe the basic procedure here just to give you a feel for what you're paying your accountant to do.
After you finish entering the day-to-day transactions in your journals, you are ready to "close the books" for the period.
- Post entries to the general ledger. Transfer the account totals from your journals (sales and cash receipts journal and cash disbursements journal) to your general ledger accounts.
- Total the general ledger accounts. By footing the general ledger accounts, you will arrive at a preliminary ending balance for each account.
- Prepare a preliminary trial balance. Add all of the general ledger account ending balances together. Total debits should equal total credits. This will help assure you that your accounts balance prior to making adjusting entries.
- Prepare adjusting journal entries. Certain end-of-period adjustments must be made before you can close your books. Adjusting entries are required to account for items that don't get recorded in your daily transactions, such as accrual of depreciation, accrual of real estate taxes, etc. In a traditional accounting system, adjusting entries are made in a general journal.
- Foot the general ledger accounts again. This will give you the adjusted balance of each general ledger account.
- Prepare an adjusted trial balance. Prepare another trial balance, using the adjusted balances of each general ledger account. Again, total debits must equal total credits.
- Prepare financial statements. After tracking down and correcting any trial balance errors, you (or your accountant) are ready to prepare a balance sheet and income statement.
- Prepare closing entries. Get your general ledger ready for the next accounting period by clearing out the revenue and expense accounts and transferring the net income or loss to owner's equity. This is done by preparing journal entries that are called closing entries in a general journal.
- Prepare a post-closing trial balance. After you make closing entries, all revenue and expense accounts will have a zero balance. Prepare one more trial balance. Since all revenue and expense accounts have been closed out to zero, this trial balance will only contain balance sheet accounts. Remember that the total debit balance must equal the total credit balance. This will help ensure that all general ledger account balances are correct as of the beginning of the new accounting period.
Preparing financial statements
One of the major purposes for closing your books at the end of each accounting period is to allow you to prepare financial statements that give you a picture of your business's financial status. The financial statements prepared for most small businesses are a balance sheet and an income statement.
Usually these are prepared by an accountant. But with the help of computer software, you may be able to prepare your own financial statements. If you need to prepare financial statements for third parties, such as a banker, sometimes the third party may request that the financial statements be prepared by a professional accountant or certified public accountant.
Also called a statement of financial position, a balance sheet is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your owner's equity, or net worth. The accounting equation (assets = liabilities + owner's equity) is the basis for the balance sheet.
Also called a profit and loss statement, or a "P&L," an income statement lists your income, expenses, and net income (or loss). The net income (or loss) is equal to your income minus your expenses. Your business's tax return will use a variation of the income statement to determine your potentially taxable income.
Accounting for tax purposes
One of the most important uses of your financial records is to help you comply with federal and state tax laws and prepare tax returns. A good bookkeeping system will help make dealing with Uncle Sam relatively painless.
You don't always have to use the same accounting rules for tax purposes as you do for financial reporting. However, we highly recommend that you do use the same rules for both purposes, to avoid complicating your life with two sets of financial records.