Accounting Topics Every Small-Business Owner Should Understand: Part 2

Semangat Membara

Vlad Rusz is a CPA at Centaur Digital Corp, helping busy business owners efficiently manage their accounting system.

Part two of this series dives into the financial statements and business taxes that every business owner must understand.

Financial Statements

Any business, anywhere in the world, no matter how big or small can represent virtually all its operations with three main financial statements: the balance sheet, the income statement—also called the profit and loss statement—and the statement of cash flows. Small-business owners have a larger focus on their income statement, which usually best represents how much money the business is making.

While you don’t need to know all the ins and outs of the financial statements, you must be able to read them and at least understand the basic concepts. Becoming familiar with the main financial statements is also a great way to learn how to spot mistakes, and which accounts to double-check to ensure accuracy. Remember, the goal of most accountants isn’t perfect financial statements—since that’s impossible—but rather financial statements free from material errors.

The balance sheet, rightly named, shows the balances in your business accounts. In a simple business, this can simply mean the balance in the bank account, possibly some accounts receivable (usually unpaid invoices), any loan balances and the difference between assets and liabilities, which is equity. It’s the easiest financial statement to double-check against external documents like bank statements, credit card statements and loan documents. A mistake here likely means a mistake in income.

The income statement ultimately shows the amount of money your business makes, but adjustments and noncash deductions may make this number diverge from the actual cash available to you. Small-business owners usually don’t have access to easy capital or loans, so it’s important to know where your net income might diverge from the actual amount of cash your business makes.

In businesses such as sole proprietorships and partnerships, distributions to owners are not deductible expenses and thus it might look like your business made a lot of money even though there is little left in the business checking account. In addition, investments will appear on the balance sheet and not the income statement. Thus, if you use funds to purchase a capital asset or inventory, you will still pay tax on that money. These types of expenditures are typically reflected indirectly when the money is used for business expenses, depreciation and as cost of goods sold.

To tie the net income of your business into the amount of cash in your bank account, business owners need to look at the statement of cash flows. This is usually the hardest statement to interpret without a strong understanding of accounting fundamentals. However, it’s also the statement that will bridge many discrepancies. Rely on an accountant to help you understand how the statement of cash flows ties into the balance sheet and income statement.

Business Taxes

Every business in the U.S. faces taxation at the federal level in one manner or another. In addition, your state of residence and/or the state in which your business is registered will determine local taxation for your business. Also, most small businesses will have flow-through taxation, meaning the business doesn’t pay taxes, but rather the owners of the business pay taxes on their share of the business income.

To understand federal taxes, keep in mind that there are currently four main tax structures in the U.S.: sole proprietorship, partnership, S-Corp and C-Corp. Your tax structure options will depend on your legal structure. In order to take full advantage of the tax code, it’s advisable to consult with a tax professional before you set up your business.

Of these four tax structures, the first three fall into the category of flow-through taxation. The C-Corp is the only one that is different; here, tax is paid by the corporation. However, since dividends are not deductible as an expense for a corporation but are income for the receiver, there is double taxation.

Although the flow-through tax structures seem like they are the same, there are subtle differences that can have a large impact on your tax bill. This is principally due to the handling of self-employment taxes, which are the amalgamation of Social Security and Medicare, more commonly known as FICA. A great tax strategy is to structure your business as an S-Corp since the flow-through income from S-Corps is not subject to self-employment tax as they are for sole proprietorships or partnerships.

Your state taxes will again be impacted by your tax structure but also by your state’s specific tax code. Most states will follow the rules set by the IRS in determining taxable income. There are special cases where adjustments are needed and these should be handled by your tax preparer. Small businesses rarely have any actionable information from analyzing state tax issues, so it’s best to visit these topics at most once a year.

Unlike a full-time job, where taxes get taken out of your paycheck, no one is withholding taxes for money earned in your gig or business. Thus, profitable businesses must make quarterly estimated tax payments to the IRS and the state department of revenue. Further, for flow-through businesses, these payments will be paid by the owners, not the business itself.

To help reduce your liability and taxes, keep these topics in mind when choosing the best legal and tax structure for your business. Knowing how to read your financial statements will also give you a better insight into your business, but realize they are not your only tools and are not suited for the day-to-day management of your business. Outsource as much as you can and work to optimize your managerial accounting and treasury department so they require less of your attention.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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