A sole proprietorship’s accounting needs are somewhat different from those of other kinds of business entities. Since the owner is regarded as being inseparable from the business, it is not necessary to keep a separate set of accounting records. However, keeping track of business activities is necessary so that you can assess whether they are profitable.
Keep track of all your financial transactions separately from your financial activity when performing bookkeeping for a sole proprietorship. Then, enter this data into spreadsheets or a bookkeeping program.
In comparison to more complex types of organizations, a sole proprietorship typically produces lower levels of revenue and lower levels of expenses. Therefore, starting with the bare minimum of accounting record keeping that is based on the cash flows into and out of a bank account may make sense. This entails doing little else besides keeping separate cash receipts and cash disbursement journals. Since only an income statement can be produced using this system, it is referred to as a single-entry accounting system.
The variety of sole proprietorships reflects the variety of their owners and operators. While some are businesses that generate income, others are laborers of love that allow their owners to express themselves while also making enough money to cover their expenses. Depending on whether an entrepreneur is primarily interested in making money or whether financial success is a secondary priority, different sole proprietorships have different financial objectives. Despite these variations, a sole proprietorship’s financial management should strive to separate its business and personal finances to produce transparent financial statements and reduce the likelihood of a challenging audit.
How Important Accounting Is:
The process of maintaining records and gathering data about the financial health of your small business is known as bookkeeping. When preparing presentations and proposals for stakeholders like bankers and investors, as well as when filing tax returns, you need this information. Additionally, you require bookkeeping data to comprehend how your business is performing. The story that the numbers reveal can help you understand how to increase the profitability and efficiency of your company.
Most sole proprietorships are closely held companies, and many of them are run entirely or primarily by their owners. You might or might not be equipped to handle the bookkeeping duties that your sole proprietorship requires. Even if you hire someone else to handle your bookkeeping, you should still become familiar with the data distilled in your accounting reports because these records offer priceless information.
Because it is simple to lose perspective when you are so closely involved in your company’s operations, small proprietorships must become familiar with their bookkeeping and accounting information. Positive customer feedback may make you happy, but until you look at your financial statements, you won’t know whether your business is profitable.
Selling an independent contractor:
Your financial records will offer an invaluable record that a potential buyer can use to judge your sole proprietorship’s financial performance if you decide to sell it. It will be simpler to disclose the information that a potential buyer needs if you keep thorough records and arrange them clearly and logically. Your financial and administrative diligence will also reflect favorably on your managerial abilities and your capacity to put in place systems that a new owner can easily take over.
Information on sole proprietorship accounting:
Many sole proprietors aren’t even aware that they are operating sole proprietorships, according to the Small Business Administration. This is because unless you have formally established a business entity like a corporation, LLC, or partnership, any independent business activity—from freelance writing or farmers market vending to raking leaves—is classified as a sole proprietorship.
The IRS treats your income as coming from a sole proprietorship business if you work independently even if you don’t apply for a business license.
A sole proprietorship business cannot be legally or financially separated from the person who owns and runs it. After operating costs are deducted from gross revenue, any profits made by your sole proprietorship are considered personal income. After deducting costs from operating income, your sole proprietorship business may experience a loss, which may be used to offset any earnings you have received from other sources.
Banking for sole proprietorships:
You are not required by law to keep a separate bank account for your business if you operate as a sole proprietor. But unless your business is as straightforward and straightforward as a freelance gig with a small number of clients, it is a good idea to do so. Having a separate bank account makes it much simpler to track and organize your business activities if your sole proprietorship business incurs multiple types of expenses, such as rent, materials, and payroll. Establishing a trustworthy bookkeeping system that records all business revenue and expenditures that pass through your personal bank account is crucial if you don’t have a separate bank account for your sole proprietorship.
In addition to being necessary for submitting income tax and excise tax returns, this information enables you to run your company profitably by enabling you to comprehend the financial activity of your company.
Accounting Procedure for a Sole Proprietorship:
Track your earnings. If your revenue is derived from a single source, like an online platform, then this is straightforward. When you have multiple revenue streams, like wholesale and retail sales or e-commerce and a physical location, it becomes more difficult. Keep ongoing records of all your business revenue in either case.
- Observe your spending. If all your purchases go through the company bank account, this is straightforward. If you use several payment methods, such as cash, checks, credit cards, and automatic payments, it becomes more difficult.
- Create procedures to ensure that purchases don’t slip through the cracks in either case.
- Use a spreadsheet or accounting software. This is your chance to put all the data you’ve gathered so you can see the big picture. If you’re using a spreadsheet, create columns for various types of income and expenses. The categories are integrated into your accounting organizational system if you use a bookkeeping program, which prompts you to create a chart of accounts.
- Review the data you have. By using your bookkeeping data in this way, which is referred to as “management accounting,” you can improve your bottom line.
Accounting for a sole proprietorship has peculiarities:
It is particularly crucial to know where your finances end and your business finances begin, and vice versa, because sole proprietorships are closely held businesses. If your sole proprietorship operates outside of your home, two examples of transactions that are not recorded in accounting are mileage to and from work and areas of your home that are not used for business if you operate a home office.
Business miles traveled for purposes other than commuting and the proper use of your home for business purposes are two examples of transactions that should be recorded in your sole proprietorship accounting.
Keep track of all your car expenses and mileage for non-commuting business trips. Then, expense a portion of your expenses that is equal to the proportion of miles you drove for your sole proprietorship. You can also use the standard mileage rate, which is updated by the IRS for each new tax year.
You must determine both the total square footage and the square footage of the area you use exclusively for your business if your sole proprietorship business uses an office or shop in your home. The rent or mortgage payment can then be adjusted to a corresponding percentage and written off as an expense for your business.
As part of your individual 1040 income tax return, IRS form Schedule C must be filled out if you operate your business as a sole proprietorship. Both the field for total revenue or gross receipts and the form that lists your expenses by categories like rent, labor, materials, advertising, depreciation, and office expense are included in Schedule C.
Because they represent the different kinds of expenses that most businesses incur, most of these categories ought to neatly correspond with the ones you have established for your bookkeeping system.
The form also has a section where you can list specific costs associated with your company that might not have been covered by the broad list of categories, like booth costs for a farmers market booth.
The bottom line of Schedule C displays your net income after deducting all business expenses from all business revenue, just like the bottom line on your profit and loss statement. You owe personal taxes on the number of sole proprietorship earnings if this number is positive.
Schedule C and Sole Proprietors:
The Internal Revenue Service considers every self-employed person to be a business owner. The IRS automatically treats you as a sole proprietor if you have business income but haven’t set up an entity for your company. In this case, you report your business’s profits and losses on Schedule C of Form 1040. You can compute your net business profit or loss on Schedule C, which is then transferred to your individual 1040 tax return.
Expenses on Schedule C:
Most of your business-related expenses can be written off as a sole proprietor on Schedule C, Part 2. Advertising, travel, supplies, licenses, and depreciation of business assets are all deductible expenses. Meals and entertainment expenses may be listed, but the IRS only permits you to deduct half of the total cost of such expenses. The home office deduction may allow you to deduct a portion of your rent and utility costs if you work from home. However, you are only eligible for the home office deduction if you regularly and solely use a portion of your home for work.
Loss of Income for Cash Basis:
It may or may not be necessary to include lost business income in Schedule C. If you operate your company on a cash basis, as most business owners do, there is no need to list lost income. It is simple to deduct the costs incurred to provide the goods and services. If your company doesn’t receive the money it is owed, there is no income to report on Schedule C; you can report the income once it is received.
Income for Accrual Lost:
Schedule C might need to include lost income if your company uses accrual accounting. The amount can be deducted as a bad debt along with other business expenses if the company recorded income in its accounting records but doesn’t anticipate ever receiving the payment. You must first make a reasonable effort to collect the income before you can claim a bad debt. You can record the payment as income when it comes in if your company ever receives the money that is owed.
What Sets a Bookkeeper Apart from an Accountant?
Bookkeepers do not audit financial statements or file tax returns, in contrast to certified public accountants. Also not required is an accounting degree for bookkeepers. Bookkeepers are not permitted to prepare tax returns or sign as paid preparers unless they are certified public accountants (CPAs).
Since there is no attempt to track assets or liabilities, fixed assets, inventory, and other items are not formally tracked in separate journals.
Accounting for Taxes as a Sole Proprietorship:
A separate form is used to itemize the main categories of revenues and costs incurred by the business in addition to the owner’s tax return, which serves as the conduit for reporting taxes for sole proprietorships. Since there is no distinct business entity, there is no separate tax return for the company.
Restrictions on Accounting for Sole Proprietors:
This accounting system’s main drawback is a lack of accounting records that can be converted into a set of financial statements that can be audited.
If a sole proprietorship owner wants to raise money for their company, the lender will probably demand audited financial statements, which calls for the upgrading of the accounting records in the order listed below:
- Create a legal business entity.
- Switch to a double-entry bookkeeping system and the accrual basis of accounting.
- Have a CPA audit the resulting financial statements.
This represents a significant increase in complexity over the fundamental accounting system for a sole proprietorship described in this article.