The basics of financial accounting for startups

accounting-for-startups

Finance is one of the most basic skills that any business must embrace to be successful, yet, financial know-how, issues, and analysis are often the entrepreneur’s Achilles’ heels.

This article is part of a series on how to think about entrepreneurial finance. While the finance function is much more strategic than just financial accounting, both bookkeeping and accounting are vital to every business’s success. This article will provide you with the basics, as well as the other main benefits of thoroughly knowing your numbers.

What is accounting? 

In a nutshell, accounting is the language of business – a means to summarize the financial picture of a company which then helps us understand future prospects. Accounting answers questions such as what do you own, what do you owe, and how well did you perform last year.

Speaking accounting – your accounting method 

Before you start your accounting, you’ll need to make a few decisions about the structure of your business, like choosing your business entity-type, developing a detailed financial roadmap, choosing an accounting method, and deciding on the initial shape of your accounting system. 

  • Cash basis: most common and where most startups will start. Cash coming in less cash coming out -and that’s your net cash. 
  • Accrual basis: used by most accountants around the world, it’s the industrial standard for GAAP(USA) and IFRS(EU) accounting. You recognize revenues and expenses when they actually occur, not when the cash comes in or goes out.
  • Tax basis: the ‘tax return’, booking different depreciation methods, expenses not deductible – the goal is to minimize tax liability – so you choose methods, and follow the tax law to report the minimum of income in each year. 

As a startup looking to grow, obtain financing, and track talent and investors, you’ll most likely use an accrual basis accounting. And then, you want to speak to a tax person to follow the most appropriate tax methods for your returns. A general misconception for first-timers is that your tax return has to match your internal books, and that’s simply not true. 

Good accounting starts with great systems

Without proper accounting, you can’t figure out your cash runway, budget for another salary, or provide your investors with the proper financials. And if you are seeking fundraising, you’ll need clear financials so that potential investors can make informed decisions about investing in your company.

Although founders don’t need to know in detail the mechanics of a startup, because it’s just not worth the founder’s time, it’s important to know the basics:

Bookkeeping: it’s important to understand that bookkeeping and accounting are not the same thing. Bookkeeping is the process of tracking all financial records, like income and expenses. While accounting is about interpreting those financial records and making sure you pay the right amount of taxes or make strategic business decisions based on your business’s numbers.

Chart of accounts: it is effectively your account listing, it’s all the different buckets that you’re going to classify the accounts into (income, expenses, assets and liabilities).

Trial balance: it’s the chart of accounts with actual Euro or Dollar amounts assigned to each account at a specific point in time.

General Ledger: the general ledger is a basic document where a bookkeeper records the amounts from sales and expenses. The recording act is referred to as ‘posting entries’ to the ledger.

Maintaining a general ledger is one of the main components of bookkeeping, others are:

  • Categorizing expenses
  • Recording financial transactions
  • Posting debits and credits – making journal entries in the proper place
  • Producing invoices
  • Maintaining other historical accounts
  • Completing payroll

Accountant: Accounting turns the information from the ledger into the financial statements that reveal the bigger picture of the business. Business owners will often rely on accountants to help with strategic tax planning, financial analysis & forecasting, and actual tax filing. 

The process of accounting provides reports that bring key financial indicators together, and includes:

  • Reviewing the bookkeeper’s work
  • Preparing adjusting entries
  • Preparing financial statements and other reports
  • Preparing other reports that bring key financial indicators together
  • Prepare your tax filings – income tax returns
  • Aiding the company management with analysis of the impact of financial decisions

Financial Statements: Accounting numbers are summarized into three main financial statements: the balance sheet, income statement and cash flow statement. 

The balance sheet basically summarizes a company’s net worth, at any single point in time.  There is only one equation in accounting: Assets = Liabilities + Equity.

The income statement, or the profit and loss statement, describes the company’s financial performance for any current year: whether they created value or they destroyed it. The “bottom line” as its known (since net income is the last line item on the income statement) is a single “yes/no” answer to whether you succeeded or not.

An important line item in the income statement is the gross profit figure. Gross profit indicates the intake per each product sold, without factoring selling and other support costs.

The cash flow statement shows a firm’s cash transactions, and how much cash was generated/disbursed from various activities: operations, investments, and financing. Since the income statement does not indicate how much cash a firm makes during a period in time, the cash flow statement is constructed to indicate the cash related balances for the fiscal year.

How do you identify what’s important for your company to track?

Once you’ve made the decision on the methods to be used, and before setting up your chart of accounts, you need to think about what’s important to your company. The important question to answer here is ‘what is the bare minimum you can track and that will be helpful to you’ – how much detail do you really need? 

For example, it could be 3 to 4 items: Positive cash flow, very happy customers, happy employees and each new contract to make money. (1) through the accounting system you can check both your cash-basis and accrual-basis accounting –cash flow is a huge issue. Also, on the cash side of it, you have to think planning– project out for a year, 3-5 years, and project cash flow and needs. You have to project out for cash needs. On the revenue side, you have projected cash coming in (with various scenarios like ‘conservative’, ‘moderate’ and ‘optimistic’). The idea is to know months in advance if you need to hold on to cash.

Generally speaking, the first thing you’re going to do is to look at your business and your expenses – take your bank statement from the last few months, see what’s coming through and what are you spending money on.

Secondly, you’re going to look at what your revenue side and figure out what are your different lines of business, and then look at what are your cost of sales or your direct costs associated with the revenue generation. Depending on the industry you’re in, you will set up a certain number of accounts and group them into relevant buckets (relevant to your business) –and that is what’s important to you.

And once you have the numbers which help you decide how to grow your business, you can figure out what will go into the financial and performance dashboards that make it to executive, board and investor meetings.

Tracking things at the right level of detail is a tricky thing at first, and it often depends on the size of the business and the number of transactions that are completed daily and monthly. But remember that all sales and purchases made by your business need to be recorded (posted) in the ledger, and most items need supporting documents such as invoices and bills-of-sale.

Payroll

The main thing about payroll is, if you hire an employee, you need to calculate payroll correctly – not just randomly pay them an amount. It’s recommended to hire a payroll company if you have more than a couple of employees, or if you don’t think you will make payroll payments timely, because the company you hire will make sure to process things on time.

And it’s very important to know that the difference between an employee and a contractor (freelance) boils down to ‘control’. If the individual doesn’t satisfy all the rules to be considered a contractor, that person is by default an employee (this is that straight forward both in the USA and EU). 

It’s important to have independent agreements in place when dealing with contractors or freelancers – i.e. Independent Contract Agreement. You can end up owing a lot of taxes, and penalties for doing this wrong, so make sure to check out the EU and your country’s legislation very closely to avoid problems.

What are the benefits of cloud-based accounting and what are integrations?

Having good management tools from the start is a seriously good idea, check out these European startups that will help you manage your business.

There are also many tools that you might be able to integrate with your accounting system, the main thing is to figure out where the bottlenecks are in your financial and accounting systems. Shopify, Stripe, Bill.com and Expensify, to name just a few, and whatever industry you’re in, there is for sure a solution out there you can integrate into your accounting system –it’s all about automatically coding transactions like revenues and expenses. 

On the accounting end, there are some very easy to use and well-developed software applications available, which help make it easy to manage your company’s accounts, but also make everything clearer for you accountant at the end of the year.

These days, the most common applications run on the web, which means you (or anyone) can access them through a web browser or app on almost any device and while on the go. Some of the better known accounting software currently available includes Freshbooks, Intuit Quickbooks, Xero, Wave, SAGE Business Cloud, Kashoo, Receipt Bank and Holded

Growth and scaling accounting

At the core, the finance function is much more than just taking care of payroll or keeping track of the cash, it also does much more strategic things like determining the company’s unit economics, helping define and track the right KPIs to measure business progress, assess the company’s resources, and figure out how to create enough time to get from one key milestone to the next.

So, your bookkeeper is your basic level within the finance function. This person may have a degree, a certification or just experience. A good bookkeeper should have some good experience and you should vet them well.

Typically, bookkeepers are required to have between two to four years of experience or an associate’s degree, but this can vary a great deal. Often, in a startup scenario, the accountant will act as bookkeeper.

To qualify as an accountant, generally the individual must have a bachelor’s degree in accounting, finance or business administration. Accountants both in the US and Europe are usually eligible to acquire additional professional certifications, which provides an additional quality of work guarantee, and financial assurance.

Accountants usually start as staff or junior accountants and eventually make it all the way up to controller or even CFO. A controller ‘controls’ all the accounting and finances of a company. 

The bottom line

Not having a strong finance team is like flying an airplane with no windows and no navigation system –you are in the air but not knowing exactly where you’re going. And this applies to companies at any stage in their life cycle.

Running a company is very much about following the rules, so try to keep things simple. Do all the standard stuff to help you and others better measure progress, keep things very organized, and at any time, know your financial metrics like the back of your hand – such as cash position, burn rate, and when cash will run out.

Organized financial records and proper balanced finances, coupled with smart financial strategy and accurate tax filing, will contribute directly to the long-term success of your business. Whichever option you choose, investing into your business financials will only help your business grow.

LEAVE A REPLY

Please enter your comment!
Please enter your name here