Contents

  1. 1. What is small business accounting? 
  2. 2. How to do your own small business accounting
  3. 3. Download Ember 
  4. 4. Glossary: Key Accounting Terms

The Ultimate Guide to Small Business Accounting

June 17, 2021
It can sometimes feel like accounting operates in a completely different language, with enough rules and regulations in place to blow your mind. But it doesn't have to be this way.In this complete guide to small business accounting, we address the main aspects of accounting, from how to do your own accounting as a small business, to explanations of key accounting terms.As a small business owner, having a basic understanding of your accounting can make all the difference when it comes to the success of your business. You don't need to know absolutely everything, you just need to know what is relevant to you and how best to utilise it.Remember to bookmark this article for your reference later, and use the content table on the left to jump to specific sections as and when you need them.

What is small business accounting? 

Small business accounting is the overall process of recording, reporting and interpreting your business finances so that you are better equipped to make decisions about your business, your strategy, and your growth. Small business accounting consists of three main features:
    Bookkeeping – the process of keeping a record of all the financial transactions within your business.Creating financial reports – the process of understanding and interpreting your business finances so that you can make important decisions about your business. Filing for tax – the process of correctly paying your taxes to the government to avoid fines from HMRC.

Bookkeeping

Bookkeeping is the process of recording your business' financial transactions and cash flow, which means tracking your income and expenses. This allows you to see what you have earned, spent, and your overall profit.Not only is this important for HMRC and tax purposes but it also allows you to make educated decisions about your business by interpreting and understanding your financial position.There are several different methods of bookkeeping to choose from. When you are deciding on the best method of bookkeeping for your business, you'll need to consider your business structure (are you a small or large business?), the volume of daily transactions, and how much revenue you make. The two main data-entry methods of bookkeeping for small businesses are single and double-entry bookkeeping.

Single-entry bookkeeping method

Single-entry bookkeeping is often preferred by small sole trader businesses and freelancers, especially those with little physical assets and inventory. This method simply requires one entry per transaction of either incoming or outgoing funds. For example, if you have just purchased new computers for your team, then this expense will be recorded.

Double-entry bookkeeping method

Double-entry bookkeeping is used by all limited companies and is particularly favoured by those that buy and sell on credit. There is much less room for error with this bookkeeping method as both the credit and debit accounts need to balance. For this method, all of the transactions are referenced as debits and credits. It is important that the total credits equal the total debits in what is called balancing your books. For example, if you make a £100 sale then you debit the cash account of £100 but credit the sales account with £100. There will always be two records of every transaction.

Cash or accrual based bookkeeping

Deciding between cash or accrual depends on various different aspects. Depending on the type of business that you run, by law, you may have to choose one over the other.In a nutshell, the difference between Cash and accrual bookkeeping is just the moment in time in which the sales and transactions are accounted for and are written down. 
Cash-based accounting
Many small businesses use the cash-based method as it is a clear way to track exactly what cash your business has at any time. In addition to this, the business is not taxed on any income that has not yet been received.To use the cash-based method you must have a turnover of £150,000 or less per year. Even if you have multiple businesses, this is still the case. Limited companies and limited liability partnerships are not able to use this method, along with various other specific types of businesses.
Accrual-based accounting
For accrual-based accounting, revenue is recognised when it is earned, and likewise, expenses are recognised when they are incurred. For this method, the cash does not actually need to be in or out of the bank for the transaction to be recorded in the books. This means that expenses incurred or sales made on credit will be recognised in your bookkeeping.The accrual-based method allows you to make realistic predictions of your income and expenses over a longer period of time, which you wouldn't be able to do so easily using the cash method. Nevertheless, the accrual-based method may not accurately reflect your cash position at a given point in time. For example, it may seem like a business is doing well and making profits, but there may actually be very little cash in the bank.It is crucial that your bookkeeping is accurate so that you can gain meaningful insights into the health of your business, allowing you to make informed growth decisions.

Financial reports

Financial reports are the documents and financial statements that provide an overview of your business's financial health. Both having and understanding these financial reports will ensure that you are fully equipped to make financial decisions and will help ensure the success of your business.The balance sheet, profit and loss, and cash flow statement are the main three financial reports to familiarise yourself with. These major reports will clearly outline the financial health of your business. We have also included a further breakdown of the accounts receivable and payable to make sure you feel comfortable with the finer details.

Balance sheet

The balance sheet shows what your business owns (assets) and what it owes (liabilities). Primarily a balance sheet is used to track assets and liabilities, however, it's also a great tool to show the residual profits held in the business. There are three components of a balance sheet; assets, liabilities, and shareholders' equity. The shareholder's equity is the difference between your assets and your liabilities. This means that the following equation should always be true if your books are balanced: Assets - Liabilities = Shareholder's Equity
Assets
The assets in your business are anything that can be converted into a cash value. You can have both current assets and fixed assets. Current assets are cash and cash equivalents, including inventory and money owed to the business. Fixed assets are not considered liquid, for example, buildings, software, machinery and so on.
Liabilities
The liabilities in your business are anything that you owe or that you will owe in the future. You can have both current liabilities and non-current liabilities. Current liabilities include money the business owes such as loans and accounts payable, particularly those that are due within the year. Non-current liabilities are much longer-term and include things like long-term lease obligations, bonds payable and long-term loans. 
Shareholders' equity
The shareholders' equity, also known as stockholders' equity and net assets, is fundamentally the amount of money the business has (the assets) after the liabilities have been deducted. This is particularly important should the business go into liquidation, as it shows how much would be returned to shareholders after debts and loans (liabilities) have been paid. 

Profit & Loss

The profit and loss statement, also known as the income statement, shows the business' revenue and expenses over a specific period of time. Simply put, your profit and loss statement shows you whether or not your small business or startup is making any money. Typically, the profit and loss statement is evaluated over specific time periods – monthly (usually at the end of the month), quarterly and annually.  Depending on the size and structure of your business, your profit and loss statement will look slightly different. However, the main focus is on the different income and expenditure streams across the business.
Income
Expenditure
Expenditure consists of all the costs of doing business. Similar to income, the details of expenses are typically summarised on the profit and loss statement as a total sum. Typical business expenditure might include the cost of sales (the amount you pay for your inventory that will be sold to your customers), software and office supplies, marketing and PR, tax expenses, and bank fees. The net profit is then calculated after the total expenditure sum is deducted from the total income sum. The net profit is often shown both before tax and after-tax for a realistic representation of your profit and loss. The ultimate purpose of the profit and loss statement is to see if your business is operating at a profit or a loss. It is a clear indicator of whether or not your business is sustainable, or if you need to pivot to improve your current trajectory. Understanding this will enable you to see if your current growth strategy is working, for example, whether or not you can take on employees or afford a bigger workspace. It can also help you plan out your taxes.

Cash flow statement

Small businesses are generally exempt from preparing cash flow statements. However, preparing your own detailed cash flow statement is still advised for internal purposes and for your own understanding.The cash flow statement provides you with an awareness of your current cash flow position. This enables you to monitor and track any cash flow discrepancies that may limit you and your business. It is not uncommon to find that your business appears profitable, but in actuality, slow invoice payments mean that you have less cash in the bank than you had thought.The cash flow statement shows where your business' revenue is coming from and going to, or in other words, where cash is coming from and your business is using it. Typically a cash flow statement assesses operating, investing, and financial activities to determine this.
Operating activities
This refers to all the general and regular business operating activities. Examples of inflows (money coming in) may include revenue from selling your products or services, dividends, and interest received. Examples of outflows (money going out) may include overheads, tax, payroll, and payment to suppliers.
Investing activities
Investing activities are any gains or losses that you may incur from investments. Examples of inflows may include sales of business assets or repayment of loans that your business provided. Examples of outflows may include investing in assets and loans.
Financial activities
Financial activities refer to externally raised capital. Examples of inflows may include money that has been borrowed, which includes loans. Examples of outflows include dividend payments and external debt repayment.A cash flow statement can either show a positive cash flow, which means that the cash coming in is greater than that which is going out. Alternatively, it can also show a negative cash flow, which means that the business might not be able to afford daily operations and may need to borrow money.
Calculating your cash flow statement
There are two different methods to calculate your cash flow statements: the direct method and the indirect method. Both methods typically consider the cash flow across a twelve-month period, however, the direct method is much more detailed and requires a lot more information than the indirect method.
Direct method
The direct method of calculating cash flow only takes into account cash transactions, such as cash spent and cash received, and ignores all non-cash transactions. The direct method is commonly favoured by the Financial Reporting Council (FRC,) so for this reason, it may be the best option for your business.
Indirect method
To produce a cash flow statement using the indirect method, the net income is considered the base and non-cash revenue and expenses are taken into consideration. This method aligns with the accrual bookkeeping method as it includes money that is not physically in the bank. Whilst this is a popular option for many businesses, it is not always the most accurate and often needs to be amended.

Accounts receivable & accounts payable

The accounts receivable and accounts payable are both stated on the balance sheet. The accounts receivable is the money that customers owe you for your products or services and are considered current assets on your balance sheet. The accounts payable is the money that you owe suppliers for products or services that you received and are considered liabilities on your balance sheet. Let's dig a little deeper into each of these.
Accounts receivable
Accounts receivable refers to the money that is owed to your business through outstanding invoices or cash owed by your customers. Businesses can record the accounts receivable as a current asset on their balance sheet, as the customer has been delivered a product or service and has a legal obligation to pay. Accounts receivable are considered current assets as the balance is typically due in 30, 60, or 90 days. If the customer does not pay then they may be susceptible to a late fee. Accounts receivable are generally considered positive for your business, as they will turn into cash within a specific time frame. However, if your customers don't pay their invoices, this can cause problems with your business, especially if you have to spend time and money chasing a debt. 
Accounts payable
Sometimes, vendors will incentivise early payment by offering a discounted invoice within a set period of time. If you are unable to pay this within 30 days for example, then you have to pay full price.

Tax

Tax obligations are core to your accounting as a small business. Tax is a mandatory fee by the government and affects all individuals and businesses to a greater or lesser degree. The type of tax you pay will depend on your business structure (sole trader, limited company, or partnership).To help simplify the tax return process the government has initiated a Making Tax Digital (MTD) programme which came into effect in 2019. The aim of this initiative was to support individuals and businesses with their tax affairs and to be both more effective and efficient. 

Business tax

Beyond business structure, the tax you pay will also differ depending on business income, profits, whether or not you have employees, and even whether or not you operate from an office. In this section, we'll break down the main business taxes to help you identify which ones are relevant to you and your business.
Corporation tax
If you are a limited company, a foreign business that is registered in the UK, or a club or co-operative, then you must pay corporation tax when you start making a profit. It is your responsibility to calculate and report your corporation tax to HMRC. 
Business rates
If you conduct business from an office or any non-domestic property then you may need to pay business rates. Bear in mind that these are handled slightly differently if you are based in Scotland or Northern Ireland. Certain properties are exempt from this payment such as farm buildings, and if you work from home then you may not need to pay this. You can consider business rates as a council tax, but for the workplace. The deadline for your business rates will vary depending on your local council, however, typically you will receive the bill for this tax in February or March of each year. 
VAT
No matter what kind of business you run (sole trader, limited company or partnership), if you make £85,000 or more in VAT taxable turnover, then you must register for VAT (value-added tax). This means you'll need to add an additional 20% to your invoices. Certain goods and services are exempt from VAT, this includes insurance, postage stamps or services, and health services provided by doctors. These do not contribute to the total £85,000 or more annual turnover. If you are below the £85,000 threshold then charging VAT is not mandatory, however, you may still choose to register. By doing so you are able to reclaim VAT on your business expenses. VAT returns and payments are due on a quarterly basis and it is important to follow the rules set by HMRC. 

Payroll tax

Whether you have employees or not it is still important to be aware of the payroll taxes. Below we explore PAYE as well as a breakdown of some of these taxes.  
PAYE (Income tax)
PAYE is calculated depending on how much you earn. Everyone is eligible for a tax-free personal allowance of £12,570 (as of 2021-2022). If you make more than this total, you will be taxed either 20%, 40%, or 45% depending on your rate, which is determined by your income. The higher your income, the higher the rate of tax you have to pay. Income tax is an annual tax and if you have been charged too much or too little then the difference is calculated at the end of the tax year. 
Employer & employee National Insurance contributions (NICs)
National Insurance is a tax that is usually deducted through the PAYE system and allows you and your employees to qualify for "certain benefits and the state pension". As the business owner, you have to contribute to this as well as your employees. There are different National Insurance classes that vary depending on your income and employment status. 
    Class 1 - Employees earning over £184 per week and under state pension age. This is deducted by the employer.Class 1A or 1B - Paid directly by employers on employee's expenses and benefits.Class 2 - Self-employed earning profits of £6,515 or more per year. To avoid gaps in the national insurance record you can make voluntary payments if you are making less than £6,515.Class 3 - Voluntary contributions for those making below the above thresholds.Class 4 - Self-employed earning profits of over £9,569 per year.
For example, if you are a limited company and you are earning a salary, the business has to deduct class 1 employee's National Insurance from this salary. In addition to this, the business will also have to pay class 1 Employer's National Insurance to HMRC. 

How to do your own small business accounting

We've covered some of the main features that business accounting consists of, so now let's dive into how you can do your own small business accounting. With Ember at your fingertips, you'll be able to master your own accounting before you know it. 

Set up your business bank account

First, you need to decide where to store your money, and creating a separate business bank account can be really beneficial. We recommend opening two accounts, one current account, and one saving account for taxes, funding, and unforeseen expenses.When it comes to choosing your business bank account, be selective. Choose a bank that can integrate with your technological needs, including your point-of-sale (POS) system and online banking requirements. Bear in mind that business bank accounts are typically more costly and have a higher minimum balance than personal accounts. However, some bank providers such as Tide and Revolut offer some great features and bonuses for business owners.Before committing to a bank provider it is worth checking:
    Transaction and withdrawal feesInternational feesMonthly feesSupport featuresAdmin features (such as instant payment alerts & safety features)Introductory offers available
Ember can connect with any business bank, so take the time to find the best one for your needs.

Record your business expenses

By this point, you know the importance of recording your business expenses and how they contribute to your bookkeeping, your financial reports, and your tax obligations. This is a pivotal part of your accounting and can distinguish between business success and failure.Your expenses are the costs of running your business. These might include rent, utilities, equipment, salaries, marketing fees, and so on. You will deduct these expenses from your income to calculate your taxable profit.

Tax deductions on expenses

One of the greatest benefits of running your own business is tax deductions. Tax deductions are a type of tax relief in which the tax you would normally pay on an expense is removed. Fortunately, many business expenses are viable for tax deductions.Typical expenses that are tax-deductible include:
    Business premises – such as rent, utility bills, maintenance and security.Office expenses – such as computers, licenses, stationary.Inventory and materials – such as your stock, raw materials, equipment.Business insurance – such as property insurance, public liability, employer's liability insurance.Subscriptions – such as professional memberships and trade bodies. 
This is by no means an exhaustive list. Check out GOV.UK for more information. In addition to this, there are also quite a few expenses that are commonly missed as they are easily confused with personal expenses. These include:
    Digital marketing – paid social media ads, website hosting fees, software.Business travel – hotels, flights, petrol, rental cars.Home office – WiFi, work mobile phone, equipment.Business meals and coffee.
To access this tax relief you just need to provide a record of your expenses to HMRC which accurately details every business cost, all of which can be easily done through Ember. You must claim this tax relief within four years of spending the money on the expense.Alternatively, if you operate as a sole trader then you can complete a self-assessment form at the end of the tax year.Tracking your expenses may seem time-consuming, but with Ember, you can organise your expenses into separate tabs within the app and record your costs in just a couple of clicks. 

Identify payment gateways & invoicing

The payment gateway is the method by which you receive payment for your goods or services. Depending on the nature of your business, whether you are a service provider, a brick-and-mortar business, or an e-commerce business, your payment gateway may vary slightly.  

Service provider

It is not uncommon for service providers to operate on a freelance basis and rarely work with clients in person. Regardless of whether you work in person with your clients, it is still important to provide an invoice for your sales so that you can track your accounts receivable (money owed to your business) and income.Ember enables you to create, send and record your invoices all in one handy place ensuring that your clients receive an accurate invoice in a timely manner. 

E-commerce business

As an e-commerce business, you have several different options to choose from as your payment gateway. Some e-commerce platforms such as Shopify already have a payment gateway integrated, alternatively, you could use a third-party payment option such as PayPal, Worldpay, and Stripe to take payment. These are connected to your chosen bank provider, which is connected to Ember where you can conveniently track all of your sales.

Brick & mortar business 

If you run a brick & mortar business and operate out of a storefront, then the payment gateway may look slightly different. You could invest in a Point Of Sale (POS) system, or register a dedicated card reader. However, this can be quite costly, especially when you add in credit card fees. Alternatively, you can now use apps that allow you to accept payments through your phone or tablet. This is much more cost-effective and convenient for many small businesses. The app will connect to your chosen bank provider, which can then be connected to Ember, allowing you to track all of your sales and income.

Invoices

An invoice is a document between a buyer and seller that verifies the products or services being provided and details the total bill sum to be paid. These can all be created, sent, and recorded within Ember. As invoices are the foundation of your small business accounting, you want this process to be smooth, fast and accurate. By automating your invoice systems, you have the security of knowing that your customer will automatically receive their invoice. 

Identify, understand and adhere to relevant tax obligations 

As we've identified, your tax obligations as a business depend on a variety of things, including your business structure, whether or not you have employees and how much profit you make. First of all, you need to identify which tax applies to you. Use the tax breakdown above to help identify which tax obligations might be relevant to you and your business. Secondly, familiarise yourself with it so that you understand what you are paying for and why. Ember offers expert advice from qualified accountants, who will happily guide you through these areas should you need it.Thirdly, sit back and relax knowing that Ember shows your real-time tax position, submits tax returns directly to HMRC, and sends handy notifications before your next tax bill is due. Knowing your real-time tax position, based on your salary and dividends, enables you to know which tax brackets you're in, and exactly how much you should be paying.

Create payroll systems

With Ember, you get a record of your employees (and their wages), what you owe to pensions and HMRC, as well as monthly reports and payroll obligations, all in one simple solution. Remember if you want to pay salaries (for yourself or employees) you must register the company as an employer. Depending on your business structure, how you pay yourself might look slightly different.

Sole trader

If you operate as a sole trader, then technically all profits that you earn are yours. Keep in mind that what you decide to take as a salary is taxable. It is really important to keep a record of this, as you are personally liable for your tax bills. If you do not pay your tax then you are putting your personal assets at risk.

Limited company

As a limited company, this is slightly different. By operating as a limited company you are fundamentally paying yourself as an employee of the company. Yourself and your business are legally two separate entities. If you pay yourself below the personal allowance then you are exempt from paying tax. However, if you pay yourself above this then you will have to pay tax and will need to set up PAYE to do so. For more information on how to do this, visit GOV.UK.

Dividends

Download Ember 

Welcome to the age of empowerment, where you can regain control of your accounting! With Ember, you can access all your accounting solutions right from your pocket. You can use Ember on your desktop and through an app on your phone, all for a fraction of the cost of an accountant.Long gone are the days when you had to hire an accountant to do your small business accounting. Download the app today for a month completely free of charge or get in touch for a demo to try for yourself.

Glossary: Key Accounting Terms

One of the biggest obstacles when it comes to accounting is the language that surrounds it. To make things clearer, we have put together a glossary of terms you will come across, with clear definitions. For more terms related to contracting in the UK check out our other blog post on "confusing contractor terms explained".
AssetsA resource with economic value that can be converted into cash if needs be. These include everything that your company owns, both tangible and intangible.
Burn rateThis refers to how quickly your business spends cash.
CapitalThe money available to cover daily operational costs and to fund future growth.
Costs of goods sold (COGS)/ cost of salesThese are any costs involved in acquiring or making the products that you sell.
DepreciationThis is the decrease in your asset's value over a period of time.
EquityThis is the money invested in your business by the owners.
Fiscal yearA year-long period that may or may not correlate with the tax year, but you can use it for financial reporting and budgeting.
Gross profitYour sales minus the cost of goods sold (COGS).
Gross profit marginYour sales minus the costs of goods sold (COGS), represented as a percentage to show business sustainability over time.
Net assetsThe value of your assets minus your liabilities.
Net marginHow much profit you've made after removing all costs. This is often represented as a percentage.
Net profitYour profit after deducting all costs and expenses.
Operating profitYour profit before any interest and taxes are removed.
RevenueYour total income before any costs or expenses are removed.
ShareholdersAn individual or other business that owns a share in your business.
Working capitalThis is the measure of your company's liquidity, operational efficiency, and short-term financial health.
Daniel Hogan
Daniel HoganCOO & Co-Founder

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