Accounting for a sole proprietorship
/How to Account for a Sole Proprietorship
The accounting for a sole proprietorship differs somewhat from the requirements for other types of business entities. It does not require a separate set of accounting records, since the owner is considered to be inseparable from the business. Nonetheless, you should maintain records for business activities, in order to judge whether these operations are generating a profit. The basic accounting steps required are as follows:
Create a chart of accounts. This is a listing of the categories into which you want to record your revenues and expenses. For a smaller business, this may be quite a small listing - perhaps a couple of dozen accounts, such as revenue, cost of goods sold, rent, utilities, and office expenses.
Record your business transactions. Assemble your receipts and record them within the appropriate account. This may be done on an electronic spreadsheet, or perhaps on a simple accounting software package, such as Quickbooks.
Create an income statement. At the end of the reporting period, print out an income statement, which is a summarized listing of your revenues and expenses, as well as any resulting profit or loss.
The Level of Complexity Required
A sole proprietorship tends to generate smaller amounts of revenue and incur lower levels of expenses than more complex types of organizations. Consequently, it can make sense to start off with the most minimal accounting record keeping that is based on the cash flows into and out of a bank account. This means maintaining a separate cash receipt journal and cash disbursements journal, and little else. This is considered a single entry accounting system, since it cannot be used to produce a balance sheet, only an income statement.
A single entry system is most suited to a cash basis accounting system, where revenues are recorded as cash is received, and expenses are recorded as payments are made. There is no attempt to track assets or liabilities, so there is no formal tracking of fixed assets, inventory, and so forth in separate journals.
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Tax Reporting for a Sole Proprietorship
The tax reporting for a sole proprietorship flows through the owner's personal tax return, with a separate form used to itemize the major classes of revenues and expenses incurred by the business. There is no separate tax return for the business, since there is no separate business entity.
Limitations of Sole Proprietorship Accounting
The main limitation of this accounting system is that there are insufficient accounting records to be translated into an auditable set of financial statements. If the owner of a sole proprietorship wants to obtain funding for his or her business, the lender will likely require audited financial statements, which will require the following sequence of actions to upgrade the accounting records:
Form a business entity.
Switch to the accrual basis of accounting, using a double entry bookkeeping system.
Have the resulting financial statements audited by a CPA.
This represents quite an upgrade in complexity from the basic accounting system outlined in this article for a sole proprietorship.