Why you need to understand the basics of accounting
You may be thinking, “I’m a freelancer, not an accountant!” (Well, unless you are an accountant, in which case you probably don’t need my help).
And it’s true that you don’t need a degree in accounting to run your own business. However, having some accounting knowledge can help you keep an eye on your money, maintain tax compliance, and communicate with your bookkeeper or accountant (if you want to go that way), among other benefits. You can access a full list of accounting terms here [Link to Accounting Terms article], but first, I encourage you to read on to get the basics you need to orient yourself to the financial side of your business.
Whether you use accounting software or not, you need a system. As long as humans have had assets, we have kept accounting records. Even the ancient Mesopotamians are known to have kept accounting records. However, we now have record keeping options beyond the papyrus scrolls the ancient Romans used. Today, we can use pencil and paper, spreadsheets like Excel or Google Sheets, or any number of accounting software products available in a range of prices—from, well, free to quite costly.
I am going to be completely transparent here. I favor the software option, and you’ll see why.
You will need to keep records as a freelancer. You are a business owner. All business transactions need to be recorded somewhere. Did you pay your bills this month? Did you get paid? Where are your receipts? (What’s that noise? That’s the sound of the IRS knocking….)
You will need to record any payments you make to vendors or any business-related bills you pay. You will need to track any payments you have received, too. In order to bill clients, you may need to show how you spent your time on a service or product and how much time. You will probably need to note when a job has been completed.
First of all, let’s get your banking squared away
Personal banking should be kept completely separate from your business banking. Don’t mix. Open a separate account for your business and conduct all business transactions from there. You can set up your bank accounts to transfer funds from your business to your personal accounts, as needed (such as to pay yourself a salary).
More importantly, you can easily track your business income and expense transactions if you have separate accounts; if you don’t, quarterly and end-of-year tax time will be challenging. The good news is that if you use accounting software, you can typically set it up to import, categorize, and reconcile transactions almost automatically.
None of this is particularly difficult, but it can be overwhelming at first.
Your top priority as a business owner is bringing in money, right? In accounting terms, accounts receivable refers to the payments owed to you and your business for any products or services you have provided. These are part of your assets. This will be important later when we talk about the balance sheet.
Invoicing is a term you probably know already. Or, you might know it as “a bill” you either send (or, unfortunately, all too often receive). The invoice states the goods or services provided. the amount of money due for the goods or services, and when payment is due, plus any special terms, such as discounts, credit balances, and so forth.
To bill accurately and receive all the money you have earned, you will need to keep careful records. Noting when a job is completed and when you have received the payment is essential. You don’t want to forget to bill for a project—or overbill a client. You want to be aware if the client has failed to pay or is slow to pay. The more projects you have going at any given time, the more challenging keeping up with accounts receivable becomes.
It’s important to track time spent on a project and the cost of that project to you. You will want to track receipts for any purchases you make related to the project (this is important when tax time comes, too). Transparency is key for good customer relations.
Paying your bills
We all have to pay the bills, and in accounting terms, those fall into the category of accounts payable, which is the money your business owes to creditors. These are your liabilities. They can be short-term liabilities, such as utility bills, payments for office supplies, and rent, or they can be long-term liabilities, such as loans or credit card payments that are spread out over time.
Again, these need to be tracked and recorded carefully. If you’re spending more than you’re bringing in, you will want to make some adjustments.
Some expenses can be deducted come tax time. For example, you will want to see if you can deduct any utilities or your internet if you work from home. Do you keep a separate phone for business? Did you have capital expenditures like a new computer or printer? (Capital expenditures are fixed assets like equipment needed for your business or buildings, etc.) Keeping your receipts allows you to make applicable deductions come tax time.
Monitoring your cash flow
Basically, cash flow refers to money coming into your business and money going out of your business. Cash flow is not the same as profit. It is possible to have a profitable business that simply runs out of cash. When you have no cash, you can’t pay for the things you need to run your business, such as supplies or maybe even electricity. So, rather than finding yourself doing origami in the dark, it’s important to keep an idea on cash flow!
Of course, you want a positive cash flow—more money coming in than going out. And the only way to accomplish this is to track it, whether you do so by spreadsheet, accounting software, or the services of a bookkeeper or accountant.
The taxman cometh
Or not. It’s better to head that off.
Paying taxes is the least painful when you plan ahead for it. A general guideline you will see is to plan to pay approximately 30% of your income in taxes. Again, records are important here. Keep copies of everything. Every transaction for your business should be scrutinized to see if it can help to lower your tax liability: supplies, software, website expenses, capital expenditures, utility bills, business-related training/professional development, travel, etc. Keep receipts.
Preparing to file taxes
Here is where you might want to seriously consider hiring a professional (if you haven’t already decided to take this road). Accounting software can also help you prepare for tax filing—although, unlike an accountant, it won’t actually file taxes for you.
For tax purposes, you will need to consider your business structure. As a freelancer, your business is most likely a sole proprietorship. In this case, you pay taxes for your business on your personal tax return by filing a Schedule C form with your Form 1040 Individual tax return. However, you may be in a Partnership or you may have formed a limited liability company (LLC), in which case, your business is probably growing, and it is time to get serious about hiring a professional to do your taxes and/or investing in some accounting software. You may still be able to file a Schedule C if you choose to recognize your business as a disregarded entity, but you should also examine with a tax professional any advantages to filing Form 1065 instead.
If you want to hire an accountant or bookkeeper to do your taxes, you can save money by being organized and mindful of the time they will spend on your taxes. Presenting them with everything they need to get your taxes squared away in a timely, efficient manner is money saved. Therefore, it’s really important keep up with your bookkeeping, preferably on a daily basis but weekly at the very least.
Some accounting basics
So, we’ve touched on some accounting terms here: accounts receivable, accounts payable, invoicing, cash flow, etc. Let’s pull those together to form a bigger picture and discuss some additional accounting concepts you might find it helpful to know.
Let’s start with the balance sheet. This is a summary report that shows your business’s assets (what you own), liabilities (what you owe), and equity (how much you would have if you up and sold off everything and paid off your debts) at a specific point in time.
The balance sheet represents this equation:
Assets = Liabilities + Equity
If you are looking at a balance sheet, there are two sides to it. On the left side, assets will be listed. On the right side will be liabilities and equity (equity can refer to owner’s equity or shareholders’ equity, but let’s keep this simple).
These two sides should be equal in amounts or in balance.
This is called double-entry accounting. Each transaction will impact at least two accounts.
Here’s an example: Let’s say you borrow $1,000 from the bank. Thus, your assets (cash) increase by $1,000 (meaning you now have $1,000 in cash that you didn’t have before). But, your liability (what you owe) is also increased by $1,000.
Now, let’s say you decide to advertise your business. You spend $500 of your cash on it. Your assets have decreased by $500 (you spent it!) and so has your equity (you don’t have that $500 anymore).
Three core financial statements
The balance sheet is one of the three core financial statements in accounting. The other two are the cash flow statement and the income statement. Cash flow, as we covered earlier, refers to money coming into your business and money going out of your business.
Again, cash flow is not the same as profit. Instead, it is the income statement that shows your profit and loss. It is calculated this way:
Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)
Or, to simplify:
Net Income = Revenue – Expenses
The General Ledger
In accounting, this information comes from the General Ledger (GL), which is the record of all of a business’s financial data and transactions. Think of the GL as the foundation for the double-entry accounting system.
The GL comprises all the accounts in your bookkeeping system and presents them in a comprehensive, cohesive way. As a new freelancer, you might begin your new venture with as few as 10 or so accounts (bank, asset, income, expense, and/or liability), but as your company grows, you’ll add accounts to reflect how you are doing business.
Some of the accounts you create should have a subsidiary ledger (e.g., accounts receivable), so that you can see detail at a more granular level. You can be as simple or as detailed as you want with your account structure. A good accounting software will also help you maintain the GL and set up appropriate accounts for your business.
The importance of good accounting software
Not sure if accounting software is for you? Afraid of taking on an extra expense? The good news is that accounting software doesn’t have to break the bank. Your options range from free offerings to very affordable to pricey. We have a round up of the best accounting software for freelancers here.
It’s worth the investment, though, as long as it doesn’t undermine the financial health of your business. Accounting software can help with many of the key tasks we have identified in this article:
- Keeping records
- Tracking accounts receivable
- Tracking accounts payable
- Tracking expenses
- Creating quotes and estimates
- Tax preparation
- Bank transactions (typical automated import and sync)
- Reporting, including cash flow, profit and loss, trial balance (to verify your numbers), aged payables and receivables
In addition, most modern accounting software is cloud-based, so you can access your accounts anywhere. If working on the go on your mobile phone is important to you, look for software with robust mobile app functionality.
If you do your research, you can often find accounting software that provides bookkeeping or accounting services for an additional fee, which is a big help come tax time.
You might also consider how scalable the software is, meaning whether it can grow with you (if growing your business is a goal!). It’s important when looking for software so consider not only the features you need now but what you might need in the future. To find out about some of the best options available to you, read our Best Accounting Software for Freelancers and Contractors [link to article] and Best Accounting Software for Small Businesses [link], in which we review specific accounting software available to you.
You don’t need to know a lot about accounting to use accounting software effectively. Sure, it’s good to know some basics, but you can learn as you go, too.