Starting a Business Requires More Than Just a Dream

by Ronda Pitts, CPA

How To Set Up an Accounting System

Setting up a business is a time-consuming, detailed process. You could save yourself future frustration and financial woes if you address all the necessary issues, especially your accounting system, at the beginning.

Once you have decided to start a business, selected the appropriate entity type, filed with all the necessary governmental agencies and developed a strategic plan, one of the next steps is to set up your own accounting records. Keeping accurate records on a timely basis is important in order to monitor the progress of your business, prepare financial statements, identify and track revenues and expenses and prepare income tax returns.

Set Up a Business Bank Account

First, you will need to open separate bank accounts in the business's name. All business revenue should be deposited into these accounts and all business expenses should be paid out of these accounts. Personal funds should never be commingled with business funds. Keeping business funds separate makes accounting for business transactions cleaner, easier to identify and eliminates potential questions upon possible scrutiny by the Internal Revenue Service or other agencies.

Cash Basis vs. Accrual Basis

Business transactions can be accounted for on a cash basis or an accrual basis. Under the cash basis of accounting, income is recorded when funds are received and expenses are recorded when they are paid. This method of accounting is most appropriate for businesses in the service industry such as doctors and lawyers. Under the accrual basis of accounting, income is recorded when it is earned and expenses are recorded when they are incurred. Once you have selected an accounting method, you must get IRS approval to change to a different method.

Selecting a Computerized System

Most accounting records these days are kept on a computerized system. Selecting the appropriate hardware and software to meet your present and future needs is an important decision. The first step in the selection process is to determine what types of information you need the system to be able to accept and what types of information you need the system to produce. Your certified public accountant is an excellent resource to assist you with this process. Your specific needs determine which software is appropriate for your business, and the software selected determines which hardware is needed.

Setting Up a Chart of Accounts

You will need to set up a chart of accounts which is simply a listing of all your general ledger accounts, each of which is assigned an account number. The numbers are usually in a sequence starting with the first group being set aside for assets, then liabilities, then equity. Within each sequence, the accounts are in order of liquidity. The next sequence of numbers is revenue and expense accounts (example: 1000-1999 assets; 2000-2999 liabilities; 3000-3999 equity; 4000-4999 sales revenue; 5000-5999 cost of sales; 6000-6999 operating expenses; 7000-7999 other income; 8000-8999 other expenses). The exact format of your chart of accounts depends on your particular type of business.

Ledgers and Journals

Each deposit is posted to a cash receipts journal, which identifies the source, amount and nature of the deposit. Each check is recorded in a cash disbursements journal, which identifies the payee, amount and nature of the expenditure. The totals from the cash receipts journal and the cash disbursements journal are posted to the general ledger. The purpose of the general ledger is to accumulate financial information about your business transactions.

When using the accrual basis of accounting, some additional journals and ledgers are needed. You will need to set up a sales journal and an accounts receivable subsidiary ledger. Each sale is posted to the sales journal. The sales journal identifies the source, amount and nature of each sale. The amounts from the sales journal are posted to the accounts receivable ledger in detail and to the general ledger in total. In addition, amounts from the cash receipts journal are posted to the accounts receivable journal in detail as well as to the general ledger in total. The accounts receivable subsidiary keeps detail records, by customer, of amounts that are owed to the company. The accounts receivable account in the general ledger should always tie to the subsidiary total.

You will also need to set up a purchase journal and an accounts payable subsidiary ledger. Every vender invoice is posted to the purchase journal. The purchase journal records the payee, amount and nature of each expenditure. The amounts from the purchase journal are posted to the accounts payable subsidiary ledger in detail and to the general ledger in total. In addition, amounts from the cash disbursements journal are posted to the accounts payable subsidiary ledger in detail as well as to the general ledger in total. The accounts payable subsidiary keeps detail records, by vendor, of amounts that the company owes to others. The accounts payable account in the general ledger should always tie to the subsidiary total.

Capitalized Costs

Certain expenditures are not recognized as expenses when they occur. These include the acquisition of business property and certain intangible assets such as start-up costs. Instead, these expenses are capitalized and expensed over a number of years. The cost of business property that has a useful life greater than a year are set up as fixed assets. Each year a portion of the cost is recognized through an expense called depreciation. For tax purposes, the life and method of depreciation is regulated by the IRS. The cost of intangible assets is recognized through an expense called amortization. Start-up costs are expenditures incurred prior to the start of business operations. These costs are capitalized and recognized equally over a 60-month-period.

When using the accrual basis of accounting, certain periodic payments may need to be capitalized as prepaid expenses in order to recognize the expense in the period that it occurs. An example of a prepaid expense is the payment of an annual insurance premium. The entire amount is recorded as prepaid insurance and is recognized as insurance expense equally over the policy period. Some expenses are incurred prior to the time when they are paid. Taxes, for example, should be recognized as accrued expenses as they are incurred. When the taxes are subsequently paid, the corresponding liability is reduced.

Periodic Closing Procedures

Periodically, usually monthly, a company should verify the accuracy of their general ledger account balances by performing certain closing procedures. These procedures include reconciling the bank account, verifying that the accounts receivable and accounts payable general ledger accounts tie to their subsidiary accounts. In addition, there are certain non-cash transactions such as depreciation, amortization and recognizing prepaid or accrued expenses that may need to be recorded. These and other adjustments are recorded in a general journal, which are subsequently posted to the general ledger.

Preparation of Financial Statements

Once you have adjusted and verified the accuracy of the balances in the general ledger, financial statements can be prepared. The three basic financial statements are the balance sheet, income statement and cash flow statement. The balance sheet shows the assets, liabilities and equity of the business on a given date. The total assets always equals the total of liabilities plus equity. The income statement shows the income and expenses of the business for a given time period. The cash flow shows the sources and uses of cash for a given time period.

Conclusion

Financial statements are useful internally to monitor the progress of your business as well as to satisfy requirements of a third party. In order to produce timely and accurate financial statements and other financial information, there must be a sound accounting system in place. It is always advisable to seek the assistance of a CPA in setting up your books and records. It can help you avoid pitfalls down the road that will cost you more time and money in the long run.

About the Author

Ronda Pitts, CPA, is a partner with KraftCPAs, PLLC in Nashville, Tenn. Pitts is a member of the Tennessee Society of Certified Public Accountants, the state professional organization for more than 8,000 CPAs in government, education, industry, business and public practice and its Nashville Chapter. TSCPA's Nashville Chapter is one of eight chapters across the state with more than 2,900 members in 20 counties. For more information on small business issues, visit the Tennessee Society of CPAs' Small Business Resource Center on the Web at www.tscpa.com.