Owning a business is a minute by minute learning opportunity.  While the real life experiences can never be matched by schooling, it is critical to have a solid grasp of basic accounting and business practices in order to be a successful entrepreneur.  Whether the education is found in a university, through a SCORE mentor, or even through your business accountant, taking the time to understand the financial basics can translate to cost savings and business growth beyond what you thought possible.

You can protect your business by understanding that there are two small business issues of special interest to the IRS:

1. When business owners minimize social security taxes and Medicare by taking substantially lower ‘salaries’ and then using the excess funds to pay dividends or loan repayments.
2. How the business pays payroll taxes.  This process is discovered through the business’ lack of making timely or accurate payroll tax payments.  Payroll taxes are especially important because they are a ‘trust’ tax, where a third party collects and is responsible for making the tax payment for another party, in this case the employee.  The IRS takes these types of taxes very seriously. Employers withhold tax payments on behalf of employees and are then responsible for submitting those payments to the IRS, state and local agencies.  When businesses are new or working on very tight budgets, it becomes very tempting to neglect those tax payments in favor of greater cash flow.  A few weeks of slipped payroll tax withholdings and the problem can mount quickly.  Add in IRS penalties and interest payments on delinquent tax withholdings and the final amount owed can often equal or exceed the original tax amount. 

Failure to make these tax payments can not only have painful repercussions for the business, but also leave the business owner personally liable for the debts.

What is a small business owner to do?
Don’t assume that the little mistakes won’t add up to larger more costly errors, fast.  Take the time, even amidst hectic daily operations to take a basic accounting class geared toward small business ownership.  Even if you seek outside professional accounting help or have an in-house accountant, it’s important that every business owner have a basic understanding of money in, money out, and tax liabilities. 

Let’s start with a quick primer on accounting.

Debits and Credits
Debits and credits consist of any items that impact the assets or liabilities of a business.  These items are posted to a journal by way of a debit (DR) or credit (CR).  Oddly enough to the untrained eye, debits affect the bottom line by increasing cash and credits decrease it. 

To illustrate the point, look at the following from James Clausen, a business expert and writer for Suite101.com:

Debit Increases and Credit Decreases
Assets
Expenses
Dividends

Debit Decreases and Credit Increases
Liabilities
Revenue (sales)
Equity

For example, if Bob’s T-shirts sells $100 in product to Client A, with a 6% sales tax ($6.00) then the following situation happens in his journal posting:

A cash debit (DR) of $106.00 is posted (to include the sale and tax liability)
A sale credit (CR) of $100.00 is recorded
A tax credit (CR) of $6.00 is posted
The cost of the sale is actually $55.00 to the business
The inventory credit (CR) of $55.00 is recorded

The cash to the business increased by $106.00 and the tax liability increased by $6.00.  There is a reciprocal relationship between the cost-of-sale and inventory, meaning when side of the equation one goes up the other goes down.  The total debits and credits offset each other and balance. 

Now, in a perfect world, at the end of each business day all of the transactions should be compiled and entered into the general ledger.  Realistically, this may only happen every few days or once a week (or gasp, monthly).  For businesses that have a retail component, closing out cash registers is a necessity both to keep careful watch on the daily operation as well as any errors or petty theft that may occur with employees.  Most likely, the errors will be unintentional, but it’s best to catch them daily rather than let a week or a month’s worth of errors add up to more serious totals. This is especially critical when dealing with credit card transactions, the associated credit card fees and personal checks.

At the end of each month, all of the daily and weekly numbers entered into the general ledger totals should then be transferred into a monthly financial statement.  These statements are what can help drive the business forward by providing snapshot views and comparisons (either month by month or year to year) regarding sales, expenses, i.e. have rising gasoline prices adversely affected the cost of doing business, and other trends.  Without fully understanding where the business stands in relation to cash in and cash out, business operations are blind and can be dramatically affected

Why worry about accounting?
It’s also important that the business owner has an accurate representation of income with proof of that amount.  This doesn’t become obvious to many business owners until the first time they need to purchase a house, buy a vehicle or seek funding to grow the business.  Years often pass where the owner’s personal equity is grossly underreported making securing loans difficult if not impossible in the tighter economy. 

Owner’s Equity
To establish what the business and in many cases, what the business owner(s) are worth there are a few basic steps in making the calculation.  First, gather information on all personal assets including the home, jewelry, cars, vacation property, retirement, savings and any other personal belongings.  Next total all liabilities the individual has including outstanding debts such as a mortgage, credit card debt, student loans, or any other financial obligations.  Now take all assets and deduct liabilities.  This number will be the individual’s total net worth. 

The same calculations hold true when looking for a business’ net worth.  Using the balance sheet, liabilities are subtracted from assets resulting in a net worth figure.  For corporations, the calculation will need to include shareholders/stockholders on the equity portion of the balance sheet.  Included in the stockholder section would also be line items for reserves, retained earnings, stockholder equity, and capital.

Two other reports which are critical to understanding the business’ financial health include the income statement, which reports the company’s profit and/or loss and the statement of cash flow, which provides a reporting of the business’ ability to generate cash.

You don’t need to be a small business accounting expert in order to properly manage your finances.  Understanding the basics and then bringing in a few experts to help can help your business grow and be profitable.  To learn more, talk with a Fiducial Advisor by calling 866-FIDUCIAL or visit the web site at www.Fiducial.com.