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What is Accounting?

Accounting – sounds dull right! Especially when you’re an entrepreneur who started a business to do something you love, not to be a bookkeeper! But the thing is, if you are looking to scale your business, build wealth or just want to feel in control of your money then you’ll need to learn small business accounting.

Contents

[This is part of the Understanding Self Employment Series]

1. What is Accounting?

Accounting is a record of all the money that comes in and out of your business with all the right numbers grouped and categorised together, presented to you in a format that lets you gauge what is happening inside your business so you can make smart financial decisions and fill in your tax returns.

In business, we use accounting to monitor how much cash, income and spending with these main three reports:

  • Balance sheet
  • Profit and loss account (also known as income and expenditure)
  • Cash flow statement

Each one of these focus’ on a different area of business finance and, for some, it is a legal requirement that they are sent to HMRC depending on your business structure. Regardless of legal requirements, some business owners choose to produce all three of these reports anyway because of the different insights into their business each one offers, helping to analyse how a business is performing and where there is room for improvement. The reports you’ll need really depends on:

  • Business structure;
  • The complexity of your business;
  • What numbers you feel are important to you;
  • Your future plans.

2. Why Does Accounting Matter?

A really simple way to think of the money in your business just like the fuel you put in your car. The more fuel you have, the further you’ll go – let the tank run dry and you won’t be going anywhere. When it comes to car ownership, we use the petrol gauge to find out how much fuel we have, when it’s about to run out and even make choices like driving slower to preserve what’s in the tank!

When it comes to money, both in business and personally, it’s important to know how much you do, and don’t, have so you can make choices, just like with the fuel in your car.

Even if you don’t consider yourself a ‘numbers person’ it’s important to track your finances, even just in a basic sense so that you can run a sustainable business – whether your definition of ‘sustainable’ means you never have to go back to a full-time job or you have ambitious plans to grow a team. According to The Telegraph a staggering 60% of businesses in the UK fail within their first 3 years mainly because they:

  • Lacked proper financial planning;
  • Suffered crippling cashflow problems;
  • Didn’t pay attention to financial data (their accounts).

Put simply, they didn’t pay attention to what was happening inside their business, burying their head in the sand when it came to numbers and didn’t invest time learning how to read financial reports.

Failing to track important numbers means that you are flying blind. Even if you think you know what your numbers are in your head you could be wrong and you’ll miss out on places when you can trim expenses to save money or overlook areas in your business drive revenue and deserve more of your energy. Worst of all you could run into some serious tax issues and miss out on tax-saving opportunities like forming a limited company when your income hits a certain level or legal ways to reduce your tax bill like contributing to a pension scheme.

3. Understanding The Numbers

Accounting is a huge topic and you really don’t need to know it all on day 1, you just need to start somewhere. What I want to do is give you enough information for you to start building your knowledge now, then, when you’re comfortable with the basics, you can start to fill the gaps. So here are the numbers you need to start paying attention to:

3.1 Turnover

Turnover is also referred to as revenue or business income. Understanding what makes this up will show you what is making you the most money and so you know which of your activities will have the biggest impact.

3.2 Operating Expenses

Your operating expenses are all the things you pay for in your business. Whether you have a VA, use freelancers or build a website – these are all expenses and by paying attention to them you can decide whether you can cut-back on spending or what spending had the greatest impact on your turnover.

It’s worth noting that not all expenses are tax-deductible so I’ve put together a list of allowable and disallowable expenses that you can download and keep.

3.3 Profit

Profit = Turnover – Expenses

Profit is everything that’s left over after deducting your business expenses from your turnover. So if you’re looking to invest in growing your business, you want some extra money to pay for a holiday or are planning to get a mortgage so need to save for a deposit on a house, then this is how you’ll pay for it. If you find that your income doesn’t cover your costs, by keeping an eye on your numbers you’ll have the opportunity to try and turn your loss into a profit to secure the future of your business.

3.4 Tax

You’ll need to pay tax on your profits but because there is a delay between earning your income and paying your tax, it’s good know exactly what you will owe by budgeting for your tax bill. The type of tax you’ll pay depends on your business structure:

  • If you have a Limited Company, you’ll pay corporation tax and possibly income and dividend tax, depending on how you pay yourself.
  • If you are a sole trader you’ll pay income tax as well as class 2 and class 4 national insurance (read more about self-employed tax here)

4. Keeping Accounts

Keeping accounts is your first step to getting the numbers you need to start to feel in control of your business finances. If you are self-employed and have a fairly straightforward business, then keeping a simple spreadsheet that summarises your income and expenditure is sufficient. But if you have a Limited Company, then I recommend setting up an accounting system like Quickbooks because this will produce a balance sheet and profit and loss account for you, legally required financial statements when you file your accounts.

Using a cloud-based accounting software really is one of the most important tools you can have in your business. Many of them link to most UK bank accounts, including Paypal, pulling your bank payments and receipts straight into your accounting system making your bookkeeping much quicker and easier and automatically generating accounting reports. In fact, even if you are self-employed I would recommend using an accounting software instead of a spreadsheet because it makes accounting so much easier.

5. Bookkeeping v. Accounting

You’ll probably hear both of these words when it comes to business finances. And although they are linked, they actually mean two different things which you should be aware of. Bookkeeping is the recording of your day-to-day financial transactions. Accounting is the grouping and categorising of these transactions to produce financial statements, like a balance sheet.

When you hear people talk about bookkeeping they really mean staying on top of things like allocating bank payments, receipts and raising invoices. But when they say that they are doing their accounts, they are closing off their bookkeeping, usually monthly, and running reports to see how their business has performed to try and improve what they do going forward.

[This is part of the Understanding Self Employment Series]

About Anita Forrest

Anita Forrest is a Chartered Accountant, spreadsheet geek, money nerd and creator of www.goselfemployed.co - the UK small business finance blog for the self-employed community. Here she shares simple, straight-forward guides to make self-employment topics like taxes, bookkeeping and banking easy to understand.