Before technology, ledgers were kept for the various types of accounts. There were the balance sheet ledgers for cash, receivables and fixed assets. There were ledgers related to the sales and the various expenses of the company. These ledgers were piled on top of each other and brought to the owner. This looked like a pile of library books, thus the term ‘books’.
Over time, and because of some historical economic turmoil, the government and governing boards implemented rules related to how businesses presented their financial information – ‘books’. So before you begin, you need to understand the difference between accrual and cash accounting. In addition, you will benefit in understanding the difference related to tax purposes.
As I stated above, there are four different sets of accounting books. Most really small businesses only use one set and by default related to simplicity and cost, this set is tax based. But often tax based accounting did not truly reflect the economic value the business earned in a year. When a company is really small in terms of volume of business activity, the financial difference between the tax set and a more accurate set is minimal. But when a company exceeds a million a year in sales and/or the volume of actual transactions increase to several thousand per year, it does become beneficial to develop another set of books. This leads to the second reason for accounting.
The second reason for accounting is to provide accurate information to the business management team via a feedback loop for analysis and decision making. The key is to make changes to continuously improve the financial performance of the company. This is where the cost of an additional (more accurate) set of books is less than the value the additional set brings to management. So what are the various sets of books that a business can use? Let’s find out.
Generally Accepted Accounting Principles (GAAP)
This is considered the absolute Cadillac of a set of books. Because of laws and prior economic failures related to reliance on false information, the Securities and Exchange Commission requires all publically traded companies to use GAAP based accounting to report their financial performance. GAAP is established by a board – Financial Accounting Standards Board (FASB) – of individuals educated, trained and experienced in accounting. This board has established eight concepts and over 120 standards. In addition, there are pronouncements, updates and exceptions related to certain industries etc.
The key to GAAP books is that there is a method to compare one company to another and it is considered fair. In GAAP the accountants use more advanced forms of accounting related to the following areas:
There is a lot more and many of the rules are generally not applicable or cost prohibitive for even regional companies to implement. Therefore, many really small businesses rely of a simple tax set of books.
As a small business owner, you often hear of how everyone has ‘two sets of books’. Well, this is because many businesses develop a more formal set of books along with the required set of tax books. The Internal Revenue Code requires all businesses to file an annual tax return. So many of your very small operations stick to a single set of books and just simply comply with the tax code in the design and recording of the information. There are two different forms of tax books, they are accrual and cash basis formats.
One of the benefits of tax basis accounting is the Section 179 deduction. Many small businesses that invest into large capital purchases throughout the year take advantage of a special one-time deduction called Section 179.
But the most likely reason for a tax set of books relates to the value derived in reduced taxation over the larger corporate forms of business. Almost all small businesses take advantage of the pass-through form of taxation. If you are not aware of what this means, I encourage you to read more about this significant benefit with the following articles:
- Types of Business Entities– introduces the reader to the sole proprietorship, partnerships, corporations and limited liability companies
- What is a K-1? – introduces the reader to this reporting process used by pass-through entities and the IRS to assigned income, expenses, and credits to the investors/owners of businesses.
- What is an S-Corporation? – explains the various tax attributes and requirements related to this form of business operation.
- Partnerships – introduces the reader to the basic principles related to this form of business relationship
A tax set of books is the only legally required set of accounting books for a small business. I strongly encourage those of you with operations of less than $500,000 per year to simply stick to this form of accounting. There is really no need or valuable benefit to have a second set of books. The cost for the second set of books will most likely exceed any benefit derived. However, as you grow and prosper, it is time for you to create a second set of books. Since true GAAP accounting requires a degreed accountant and often a Certified Public Accountant to prepare, many businesses create a version somewhere between accrual tax and GAAP. This is referred to as ‘Other Comprehensive Basis of Accounting’ or OCBOA. The following section explains this in more detail.
Other Comprehensive Basis of Accounting (OCBOA)
This is by far the most common set of books found in business. You need to remember that there are only about 20,000 publicly traded businesses in the United States but there are many more small businesses that are not publicly traded. These small businesses are not legally mandated to prepare their books in accordance with GAAP. So many make adjustments to reflect the economic activity that is more in line with how the business actually does perform.
Some will use accrual accounting related to some activities and traditional cash accounting related to others. There is a multitude of different depreciation methods used including accelerated depreciation. But mostly, the accounting function practices bookkeeping based on what generally transpires in economic activity at the business. Nobody sits down and actually goes through all the FASB standards and makes sure the business is in conformance. You don’t have to. Pretty much everyone keeps it simple so management can get informative financial reports. Many business owners get some guidance from their CPA in modifying their accounting processes and reporting formats to better reflect what is happening in their business.
At the end of the year, the CPA generally takes the trial balance provided by the accounting department and he converts the information to a tax set of books. What is interesting is that in the world of small business, the business has its own set of books and the CPA has the tax set of books. Thus the saying that every business has at least two sets of books.
There is one final variation of accounting books. These are the books related to particular industries. My next section explains this variation and why they exist.
Many industries use a customized form of accounting to better reflect the economic transactions that occur in their business. They start out by modifying their chart of accounts to reflect the particular industry. Examples of industries that use their own standards include:
- Mining – use depletion accounting to determine income
- Banking – the equity section is highly leveraged and most banks have to comply with very rigid state laws
- Multi-Family Housing (Real Estate) – use two sets of accounts for the balance sheet to reflect restricted assets and unrestricted (traditional) accounts. In addition, the income statement (profit and loss statement) reflects grouping of fixed and variable costs.
- Energy Services – generate a multi column based income statement to reflect generation and distribution of energy. This is mostly related to the mandates issued by many state governments. Furthermore, because many are publicly traded operations, the financial statements reflect very highly customized standards as set forth by FASB.
- Hospitals, Medical Facilities, and Non-Profits
Some industries incorporate a third form of accounting to use in their books. So in addition to tax and accrual accounting, some production based operations use managerial accounting (commonly called cost accounting) to reflect the economic activity during the production process.
So there are various sets of books in accounting and depending on the legal status, tax issues and industry the business owner determines the best set of books to use. So what do you do? Which set of books is going to serve you the best? Let’s explore this question.
Best Method for Small Business
Right off the bat, I’m going to tell you that if you are a really small operation as with any one of the following variables (you only need one), I would encourage you to keep it simple and just work with a tax set of books.
- Less than 5 employees including yourself
- Less than $500,000 a year in sales
- Less than 2,500 transactions per year (about 200 per month)
- Less than $50,000 in inventory
- No state restrictions
- Privately held
This will keep your accounting costs low and the level of bookkeeping simple. I can’t imagine how the benefits of some other form of accounting will offset the associated cost to implement additional accounting procedures which means a second set of books.
But, hopefully you will grow and prosper. If true, then most likely you’ll set up a second set of books. They can work as the main set, use your existing tax books, and at year end the CPA or if you have the knowledge, just make the tax adjustments to generate the tax set of books. In general, what happens is that you need to start implementing certain types of accrual adjustments such as for revenue and the associated expenses (cost of goods sold) and make modifications to the balance sheet. This is a good thing because you want your financial reports to better mimic the actual economic activity the business is operating within.
As you grow even more and add departments, more personnel, or get involved in various types of compensation including accrued payroll, you’ll need to adjust the books. What this means is that as you grow, your books will begin to move towards GAAP style books or industry specific. This is the natural progression of accounting in business. So don’t start out with a high end complicated set of books, this will not help you and it will cost an excessive amount of resources (time, money, facilities) to generate. Keep it simple and start out small. If you need to, get some advice from a CPA. Or contact me via the ‘About the Author’ page down in the footer section and send me an e-mail. I’ll be glad to assist. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.