In this series, I’m focusing on providing an overview to give a new business owner something to think about and to show them where they need to get more info. This is especially true in the areas of income and expenses accounting. I can’t count the number of times that I have had a client tell me they’ve started a new business and they lost money. As the interview continues, it becomes clear that they can’t tell me how much they lost because they can’t tell me how much income or expenses they had. It sound very basic but that’s what really happens sometimes.
If you’ve set up your business books, you’re well on the way to being able to track your income and expenses. There are a few accounting terms that might good to discuss. Actual accounting procedures will depend on reporting year (calendar vs. fiscal) or if the business is a cash business or accrual business. Most individuals and small business are calendar based cash businesses. We report the income and expense in the year it is paid. Our year starts in January and ends in December. If a client pays me in January for a return I prepared in December, the income is reported in January because I am a cash business. An accrual business reports income in the year it is earned and expenses in the year they are incurred. In the example, that income would be reported as December income (even though I didn’t get it until January) if I was set up as accrual. (The only exception is that inventory is always treated as accrual. So I could be cash for everything else and accrual when it comes to my inventory. The IRS calls this a hybrid accounting method.) A fiscal year is any year that is not January through December.
Business income is the income that the business takes in during the course of doing business. This does not include any personal income; wages, interest, rentals, capital gain, etc. A business can have more than one type of income. A repair shop would have income from the sale of the parts used in the repairs, the income from the service labor, travel income and the cost of disposal that is passed on to the consumer. As you set up your business books, you need to decide if you’re going to lump income types together or have separate categories. My suggestion is to keep them separate. It gives you a better idea where your income is coming from and lets you check your markup on the parts vs. their cost. And if you have more than one business, these need to be kept separate.
The IRS says that legitimate tax deducible expenses meet the ordinary and necessary tests. And those are good rules for general business expenses too. Ordinary expenses are costs that are common in that type of business. If you are selling handmade jewelry, then the cost of making the products will be a key cost. Also the costs to sell the jewelry, like advertising, are ordinary costs. Necessary costs are helpful and appropriate to running the business. I could see our jewelry maker taking a trip to the plant which makes her supplies to learn about the products and how they are made. This would be an expense necessary to build a relationship with the firm and learn more about her materials for marketing and manufacturing. It is very good practice to keep expenses separated by type; travel, advertising, cost of goods, office supplies, to name a few. Most importantly you want to keep major purchases separate because they are handled differently. (You got it, another post.)
Let’s talk taxes for a second. I don’t want to scare anyone away from starting a business with a threat of an audit. In fact, good procedures will go a long way to keeping an audit away and letting you sail though one if you get hit. Besides keeping good records you need to keep the source documents. That’s a fancy way of saying you need to keep your receipts. Sorry, you can’t throw those away once you enter them into the computer or on your books. You need to create a system to keep those receipts should there ever be a question about an entry in your books. Let’s say our jewelry maker writes a check at Hobby Lobby for $150 for beads and she enters it into her checkbook and bookkeeping program as bead inventory. She’s done all she needs to operate the business efficiently. But if the IRS questions it, they’ll want proof that it was for beads and not Christmas decorations for her home. That’s where the receipt comes into play. This is especially true for any cash purchases and if a credit card is used. A credit card statement might not list the business name but the clearing house that actually processed the transaction. It’s easier to keep all your receipts safe and sound just in case there is a question later.
Shall we review? After careful research, you start your business and get separate bank accounts (and credit cards) for them. You create a bookkeeping system that you will use and will provide you with the info that you will need to operate the business and prepare your taxes. Does that mean success? That depends on you and the business. But you now have the tools you need to analyze, adapt and grow your business. I only have a few more business issues to talk about and they all deal with taxes. The purpose of this series has always been to put on paper what I do face to face with clients who want to set up a business or need help with business tax issues. There is more to running a business but there are all kinds or resources available to help you with those issues.
