If there’s one thing all business owners can agree on, it’s that tax accounting can be a lengthy process.
Although accounting and taxes are unavoidable, there is a silver lining. Armed with the most essential concepts around keeping the books, you can become familiar with the intricacies of your business’ tax accounting so that the numbers work for you—and not the other way around.
What is accounting?
Accounting in businesses defines the process of recording, tracking, storing, and sorting a company’s financial transactions. In doing so, the accounting team produces reports, analyses, and statements essential to understanding and analyzing a business’ financial health. It can also help form the basis for future decision-making.
In this context, evaluating a company’s “financial health” relies on measurable metrics such as profitability and operating efficiency and three key financial statements that provide those details:
- Balance sheets: Balance sheets show a company’s financial position at a specific point of time. These statements help measure what assets the business has, what money needs to be repaid (debts), and the type of financing that is put into the business. The equity section of a balance sheet also contains information about common stock, treasury stock, additional paid-in capital, and retained earnings. However, it’s not always used to measure the health of a company as it doesn’t necessarily translate to enterprise value.
- Income statements: Income statements also show a company’s financial position during a specified period of time—but instead, they primarily focus on revenue, expenses, profits, and losses. They are excellent resources for measuring profit over time, which may help business owners make major decisions on how to move forward.
- Cash flow statements: Cash flow statements measure how a company used its cash during an accounting period (monthly, quarterly, or annually). In this context, cash is actual money that moves in and out of a business—so it doesn’t include non-cash transactions, deprecation, amortization, and depletion. This statement is produced to measure the company’s liquidity, operational efficiency, and whether cash flow has increased or decreased.
Understanding the accounting basics can help you piece together how all the different aspects of financial reporting come together—which is key for sustainable business growth.
Financial accounting encompasses small to big-picture details and everything in between. And the better you can grasp the meaning behind all the numbers, the easier it is to monitor financial performance and tackle tax planning.
Accounting for small businesses
Depending on the size or nature of operations, some small businesses handle their own accounting and bookkeeping functions while others hire a certified public accountant (CPA) or bookkeeper who can help keep their information organized. In fact, 62% of small businesses find value in retaining an in-house accountant.
And those that turn to outsourced accounting experts, or choose to integrate accounting, budgeting, and expense management software, are looking for ways to cut down on the complexity and scrutiny that accompanies taxation and accounting.
Why tax and accounting fundamentals are crucial for business owners to understand
While the complexities of accounting are best left to the pros, it’s vital for you as a business owner to understand the fundamentals of tax and accounting as it relates to your operations. Being in the know about your business’ financials empowers you to make informed decisions.
You can, for example, make a pivot in your offerings, services, or products in a sustainable way because the numbers show a healthy financial outlook. On the flip side, understanding the essentials can also help you avoid errors like incorrectly recording transactions or inaccurate statements that may flag the IRS for an audit.
The principles of accounting
In the United States, most businesses must abide by Generally Accepted Accounting Principles (GAAP), standards enforced by the Securities and Exchange Commission (SEC), and the Financial Accounting Standards Board (FASB).
GAAP helps ensure that a company’s financial statements are clear and consistent so that the public, investors, and shareholders can easily understand that company’s financial health. And this consistency and transparency lay the groundwork for several other benefits such as:
- Empowering businesses to plan ahead by producing a clear picture of your business’ financial health, i.e. business spending vs. income, which may help you better understand your cash flow, and create better forecasts.
- Reducing the risk of fraud by following national regulations, which may result in costly GAAP violations.
- Establishing transparency through a consistent format that allows investors to better compare investments for a sound decision.
Learn more about the ins and outs of Generally Accepted Accounting Principles (GAAP) and how it supports businesses, stakeholders, and regulatory bodies.
Types of accounting methods
Most business owners can choose between cash and accrual basis accounting methods.
Note that the IRS does allow a hybrid method if you’re consistent and doing so accurately represents your income. However, as with all tax rules, there are exceptions so make sure to consult the IRS directly on hybrid methods for accounting.
Cash-basis accounting is typically used by small businesses and companies that make less than $25 million in revenue, while accrual accounting is for larger corporations or businesses that surpass this threshold. Taxes are also recorded differently depending on which method you use.
Accounting documents businesses should have
One of the most important things you need to know about accounting is that almost everything comes down to three main financial statements: Balance sheets, income statements, and cash flow statements.
- Balance sheets show a business’ financial position at a specific point in time.
- Income statements show how much revenue a business generates and the net income or loss over a period of time.
- Cash flow statements help you monitor your sources of cash and keep tabs on incoming and outgoing money.
Each statement offers different information, which is why accounting teams formulate custom reports and analyses for each of them. This financial information can help your business identify growth opportunities or narrow in on potential expense problems.
The general ledger is your accountant’s best friend: It is a master sheet that holds a complete record of all the financial transactions that occur in your business.
It covers all of your assets, liabilities, equity, revenue, and expenses during a given period. Filing tax returns is easy with a general ledger because you can view all of your expenses and income in one place.
A trial balance sheet is a document that records the balance of all the ledgers. It is categorized into debit and credit account columns with equal totals.
Trial balance sheets help accountants avoid mistakes since the balance has to agree: Every dollar is accounted for if the credit and debit columns match.
However, there is one main caveat to this method that is worth noting: If you do happen to miss recording an expense, then it wouldn’t show up on the trial balance sheet, allowing the credit and debit columns to still match—but incorrectly.
For example, if you paid $100 in cash for office supplies, then your entry should read against petty cash and office supplies expenses. But since you don’t have a bank statement for cash on-hand, it could be missed, but the total would still equal each other.
So, how do you prevent this with a trial balance sheet? Be sure to record every transaction—including petty cash.
What are business taxes?
As an American citizen, you’re probably fairly familiar with tax season and what you owe every spring when returns are due. As a taxpayer, you’ll typically owe property tax and personal income taxes. You might also pay other state or local taxes, but overall, the details of your tax return won’t change much from year to year.
But for a business, taxes are a whole different ballgame. They’re a lot more complicated since “the business entity” will have to account for multiple factors like revenue, expenses, payroll, deductions, equity, and debt. Additionally, as a business owner, you might also pay income tax, employment tax, and self-employment taxes.
For tax preparation, you need to consider:
- Which form you’re supposed to fill out: C corps, for example, use Form 1120, while sole proprietors would use Schedule C to report profits and losses from the business. This information would then populate Form 1040.
- Your tax rates: Tax rates vary depending on the type of business you run. Sole proprietors must adhere to a self-employment tax rate as well as a progressive tax rate, depending on taxable income, while corporations have a 15% to 39% federal tax rate.
- When your estimated tax payments are due: For most businesses, they’re due every quarter—in January, April, June, and September instead of once a year.
There is a silver lining to more complex taxes. Businesses spend a lot of money to continue operations, so they receive far more tax deduction opportunities than individuals.
But this also means that tracking your deductions is an essential part of tax prep and accounting, so you want to make sure you leave no stone unturned.
How do business taxes affect accounting?
Taxes are heavily reliant on accounting. What you owe and what you can deduct depend on the information you have in your accounting system. Furthermore, your business structure and accounting method affect how you file, when your taxes are due, and what taxes you are required to pay.
On the other hand, taxes impact the net income your business ends up making. Here’s how:
- Depending on your business type, what you owe for taxes directly affects your net earnings.
- Tax expenses limit the profit that may go to shareholders and investors.
Recording and tracking all of your taxable income can be difficult—especially when the numbers begin adding up and you need to record a high number of eligible deductions.
This is exactly why medium-to-large businesses and corporations have a dedicated tax accountant or tax accounting department. This subsector of accounting focuses on everything tax-related, like tax returns and payments, qualifying deductions (home offices, for example), investment gains and losses, and donations.
Types of business taxes: What are you required to pay?
Everybody is required to pay taxes in the United States (unless you are a 501(c)3 organization or make less than $18,000 per year under 65 years old, among a few other exemptions).
Still, business owners pay a little more because they’re responsible for their own income taxes, alongside their business taxes, and this includes self-employment, estimated, and excise tax.
Business owners also need to calculate employment taxes and ensure that the correct amounts are withheld from their paychecks every pay period.
Income tax is the one type of tax that both businesses and individuals must pay but what constitutes “income” differs based on your business format.
In the case of a business registered as an LLC, income tax isn’t based on the business’ income. Instead, the business income gets allocated to your personal share of income (how much your “take-home” amount would be) and your income taxes would be based on this figure of personal taxable income.
The federal government generally asks that income taxes be done via the “pay as you go” method, meaning that you pay what you owe on taxes quarterly throughout the year.
If you own a business, you are required to pay self-employment taxes—but the IRS always provides exceptions to its own rules. Similarly, an owner of a corporation wouldn’t generally pay self-employment taxes, but those details really differ on a case-by-case basis.
The current self-employment tax rate is 15.32% (which is split between Social Security tax and Medicare tax).
Since you don’t have an employer setting aside taxes for your paychecks, you need to pay estimated tax. You must pay estimated taxes if your business is likely to owe $1,000 or more when you file your returns (Form 1040-ES), while corporations must pay estimated taxes if they owe $500 or more (Form 1120-W).
Excise taxes are a type of sales tax that only applies to certain goods and services.
It’s important not to get the two confused: Sales tax is applied as a percentage of the product price, while excise taxes are applied at a per-unit rate. Excise taxes are placed on fuel, airline tickets, tires, tobacco, and alcohol for consumers. Usually, a business pays this tax directly to the wholesaler when purchasing goods.
When you have employees, you must withdraw money from their paychecks to pay for payroll or employment taxes. These include:
- Social security taxes: 6.2%
- Medicare taxes: 1.45%
- Federal income tax: Percentage is calculated based on the wages earned.
- Federal unemployment tax (FUTA): 0.6% to 6.0%, depending on how much you pay for in-state unemployment tax. There is also a wage base every year. The current base is $7,000 so you’ll pay the FUTA percentage on the first $7,000 paid.
As an employer, it’s your duty to make sure you’re deducting the correct amount of taxes while also calculating what you owe. While you can do these calculations manually, you may save a lot of time and avoid mistakes using payroll software services.
Two types of accounting methods—and how they affect your taxes
There are two financial accounting methods that every business must choose between. Technically, the size of your company could be a determining factor when choosing one over the other but a large majority of businesses today opt to go for accrual-basis accounting over cash-basis accounting anyway.
Cash basis accounting
The cash-basis accounting method is used to track all the money that comes in and goes out. This is done by looking at when the business receives money or makes a payment instead of when a transaction is planned or a contract is signed.
This accounting method is typically used by small to medium-sized businesses. It can only be used by companies that make less than $25 million in gross receipts over three years.
How it affects your taxes
Cash-basis accounting affects the way your taxes are calculated because you only have to report income and deductions for the year that the cash was paid or received.
Because cash-basis taxpayers only consider the money that was paid or received within a time period, but not necessarily the time period the transaction occurred, you could reduce your tax burden for a particular period.
For example, if you pay for a business service upfront, you can claim that payment as a deduction in the period you make the payment, even if you don’t start using the service until the following period.
Accrual basis accounting
The accrual-basis accounting method considers revenue when it’s earned and expenses as incurred. For example, if you sign a contract with a supplier for another year of service, you would record expenses as incurred. A full-year service contract would then require you to amortize the expense and recognize a small piece each month for the full year.
Larger businesses and corporations typically use the accrual method. They are legally required to use it once they reach more than $25 million in revenue over three years.
How it affects your taxes
The accrual method requires you to report income as you earn it and expenses as they’re incurred. This might not be the same as when you make or receive the payment.
In some cases, you could get a lower tax bill under this method if you defer revenue or accrue for expenses.
However, since you must pay taxes on your accounts receivable regardless of the payment date, you may find that taxes are due for earnings before you actually receive payment for them.
Recording your taxes in accounting
Ask any accountant how they keep track of a business’ transactions, and they’ll tell you that they use journal entries.
Journaling is a simple yet effective way of recording all of the business transactions for an accounting period. Journal entries must affect at least two accounts—one is debited and another is credited—so they are equal.
Every debit offsets a credit, so you can clearly see that the calculations are correct and every dollar is accounted for. (If this sounds familiar, you may be thinking of a trial balance sheet—and although similar, trial balance sheets aren’t generated until journal entries are recorded and posted.)
Here’s an example: As a small business owner, you do not record income taxes on your income statement or balance sheet (unless your business is classified as a corporation). This is because there is no tax liability to offset them since the business taxes flow through to the business owners.
If your business is a corporation, the company compiles all of the taxes that it owes for the current period. This number is recorded as a debit in the company’s journal entries.
Income tax payable is the amount of taxes the company expects to owe within the next year. This number is recorded as a credit in the journal entries.
Tracking your taxes in accounting
Managing taxes and accounting can seem overwhelming—but there are easy ways to decipher and track what you owe and what counts as a deductible throughout the year within your accounting processes. It all comes down to organization and recording the proper information.
Step #1: Keep and digitize your receipts
It’s a no-brainer that you should keep every receipt that comes in and out of your business. They’re essential for reimbursement, tracking payments, and calculating how much you’re spending versus earning.
But receipts get lost, so digitizing is essential. With a simple scan or snapshot of your receipts, you can store them on your company’s server or easily organize them on management software so you can search for them by name, date, and amount.
Step #2: Use software to organize your expenses
Automation is in, and there are several reasons why. Software that can automatically track and organize your expenses isn’t just useful for streamlining bookkeeping. It’s also extremely beneficial to the company overall:
- You can save time by eliminating repetitive tasks.
- There are fewer human errors.
- You can make faster payments on invoices and employee reimbursements.
- It’s easy to track past financial records and statements.
- You can ensure you’re compliant with essential guidelines like the GAAP.
- Productivity improves because you spend less time doing data entry.
And, automated software’s functionality is designed to go far beyond these immediate benefits. In fact, it’s becoming the default for businesses all over the world, thanks to its ability to seamlessly integrate with existing systems; its ease of use for even the least tech-savvy users; and of course, transparent reporting that helps provide clarity into trends or patterns.
All in all, the beauty of automated software is that it can do virtually anything you need it to. Want to know where your deductions are? Trying to figure out how much you will owe in taxes next year or what your employees’ tax rates should be? Whatever it is, taxes become a whole lot easier with software that organizes your expenses.
Step #3: Choose your accounting method
As covered earlier, there are two main accounting methods that you may choose between for tracking expenses:
- Cash-basis accounting records transactions when paid, not when earned
- Accrual-basis accounting records transactions when earned, not necessarily when paid
Typically, smaller businesses with revenue less than $25 million in gross receipts will opt for the cash method because it’s a simpler and more straightforward way to track expenses. This could, arguably, make tax season all the easier.
Larger businesses—like corporations—that hold physical inventory and/or make more than $25 million in gross receipts per year will move to the accrual method.
Choosing between the two is not a light decision. Both have their pros and cons, and your choice will affect how much your business owes in taxes each year.
Step #4: Have a dedicated company card and account
You know the old saying: Don’t mix business with pleasure.
Since much of your personal finances affect your business finances’ status, combining your checking or savings account with your business account is tempting. But many experts advise against this—in fact, it’s the law for some types of businesses.
The Internal Revenue Service (IRS) requires that all incorporated businesses have a separate business bank account. But even if your business isn’t incorporated, separate business accounts will demonstrate to potential auditors that you’re running an authorized and legitimate business.
Plus, it’s good to keep these expenses separate from your personal finances. It’s much easier to manage, track, and record business-related expenses when they’re not mixed in with your personal expenses.
Think of it this way: The last thing you want to do is spend your accountant team’s manpower separating your grocery shopping expenses from legitimate business purchases every day, week, or month.
You’ll also be able to apply to business-specific credit lines that may give you benefits like cash back or other rewards that you could reinvest back into your business.
Step #5: Review your expenses regularly
Don’t let possible deductions fall through the cracks: Reviewing and tracking your expenses throughout the year can save your accountant a lot of time, and it can save your business a lot of money.
This is especially crucial since tax laws change almost every year.
Most recently, the deductible mileage rate and the cap on how much you can deduct for business interest went down. Additionally, a business can no longer count its entire net loss as a deduction if it earned less money this year than the year before—now, there are specific limits on the business loss deduction.
Generally, tax-deductible business expenses include ordinary and necessary expenses, which are:
- Mileage and vehicle expenses
- Rent and utilities
- Employee pay and benefits
- Miscellaneous or general office expenses
- Charitable contributions
- Home office and other home expenses
Review and track your expenses regularly—at least once a month. Come tax season, this means you can lower your tax liability and are prepared to file with a ready list of deductions and payments.
Track and record your taxes with automated accounting software
Although it can be daunting to understand business tax accounting, you need to be familiar with the accounting essentials, the different types of taxes you have to pay, and how your accounting method affects the way you pay taxes. That way, you and your accounting team can make the right decisions for your company.
Even so, keeping track of and recording every transaction can be time-consuming and expensive—but luckily, that’s where BILL comes in. BILL Spend and Expense is an automated accounting platform with solutions for tracking your revenue, tracking business expenses, taxes, and more. Get software that takes the stress out of the tax and accounting equation.