By Meredith Wood, Fundera
You have a business to run and customers to impress. You don’t have time to learn everything about accounting.
But you should take time to learn the most important stuff. Because tax penalties can really hurt your company. In 2013, the IRS slapped U.S. businesses with nearly $7 billion in penalties.
To ensure you don’t get penalized, here are six accounting terms to learn before it’s time to fill out your taxes.
1. Accounts receivable and accounts payable
Billie Anne Grigg, a leader in the bookkeeping field, sums it up nicely: “Accounts receivable is money owed to you. Accounts payable is money you owe to others.”
Why is this important during tax season? Because accounts receivable are assets on your balance sheet (see point 5), while accounts payable are liabilities. It’s an important detail in your income and expenditures.
2. Accrual accounting method
You need to know your accounts receivable and accounts payable, as it’s vital to keeping accurate financial records. If you use the accrual method to file your taxes, it’s even more crucial. Basically, under the accrual accounting method, you record expenses and revenues to the IRS when they occur, rather than when you receive or spend the money.
For clarity, consider this example: Your company completes work for another company in December, but doesn’t receive payment until the next year. That income may still need to be reported on the previous year’s tax forms, depending on whether you use the accrual method or cash method (which brings us to term 3).
3. Cash basis accounting method
With cash basis accounting, you record expenses and revenues to the IRS when you spend or receive money, rather than when transactions occur. If cash flow is something you need to actively manage, this may be your preferred accounting method.
Either way, you’re going to have to choose how you measure your profit. For instance, if you run an LLC with a partner, you’re going to have to fill out Form 1065. Before you even begin recording your income and expenses, you’re asked about your accounting method: cash, accrual, or other.
4. Profit and loss statement (P&L)
Also called your income statement, a P&L statement calculates your revenue against expenses to get your gross income. Obviously, there is a lot of detail that goes into this. But it comes in handy for understanding how your business is doing. You also need to have P&L statements when you apply for loans.
When you look at an IRS form for filing business taxes, whether you run a partnership, LLC, or corporation, you’ll see having a clear P&L statement makes mistakes less likely. For instance, if you own a farm, you’ll have to fill out Form 1040, Schedule F. Part one calculates your revenues, part two calculates your expenses, and part three calculates your income using the accrual method to arrive at an accurate number for profit.
5. Balance sheet
Think of the balance sheet as a snapshot of your company’s financial health. It details your company’s assets (what you own), liabilities (what you owe), and equity (net capital).
A balance sheet provides an idea of where you stand at a given point in time, while an income statement provides financial info for a given period of time. It’s not just a good data sheet to have, you must maintain a balance sheet for an S corporation (it’s actually a part of the tax form). LLCs have to maintain one so payouts to owners and shareholders can be distributed accurately, and it’s also on the tax form (Schedule L).
Every business has to pay taxes. But why pay more than you’re supposed to? Deductions, or reductions of taxable income (usually because of expenditures), lower how much you have to pay the government.
You may be thinking that calculating deductions is just like calculating business expenses, but there are more things you can deduct. Look at Form 1120S (for S corporations). There are other things you can deduct that you haven’t considered, like:
- Depreciation: Items decrease in value over time. Think of things like equipment, vehicles, and technology. The loss in value can be deducted.
- Bad debts: If another business went bankrupt and isn’t going to pay an invoice, that’s a bad debt. While you may want to scream about that, perhaps the fact that that money can be deducted from your income can provide a little relief.
- Dividends: Do you distribute company earnings to shareholders on a regular basis? Deduct that.
- Employee benefits: Do you offer medical insurance and 401K match? Those are company expenses that can be deducted from your income. You can even deduct your health insurance (you’re the boss).
While it may seem like deductions can get shady, the truth is that these expenses impact your company’s income and cash flow. Don’t pay extra tax on money you technically didn’t earn. Just be honest with what actually constitutes legitimate deductions.
Doing your business taxes right
By knowing these accounting terms, you have the tools to optimize the tax filing process and maximize savings. If you feel professional tax help and/or tax software can ensure you file properly, take advantage of those resources
What it comes down to is you making sure your taxes are filed effectively. This way, you’ll have more money and time to focus on what matters: your business.
About the Author
Meredith Wood is the head of content and editor-in-chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident finance advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more.