A sole trader or a sole proprietor only needs a simple accounting system to manage the business. The accounting process for a sole trader involves recording, analysing and reporting all business transactions. Admittedly a beginner sole trader may have a challenge undertaking the various accounting tasks in his business. But by following fundamental and basic accounting principles, any business owner can build a successful business model.
Methods of Accounting
There are two methods of accounting. The cash basis method involves recording as income the actual cash received and recording as expenses the cash used for operating the business. This method is simple and most suitable for a sole trader with a small business dealing largely with cash transactions. The accrual method involves matching income with expenses even when the actual transaction has not yet occurred. For example, when you have not yet collected money from a customer who is supposed to pay after 30 days or you have not paid for expenses such as paying suppliers later in the month, under the accrual method you would still record the money to be collected as an asset, and the amount to be paid as a liability. This provides a much more current record of where the business actually stands. Sole traders dealing with inventory (stock) are required by HM Revenue and Customs to apply the accrual method.
Taxes are recorded as liabilities in your income and cash flow statements. Sole traders report net income or loss on a HMRC self-assessment tax return; the IRS will deduct income tax according to the amount of business income generated. Other taxes include National Insurance, the rate of which depends on the net income of the business. If, as a sole trader, you hire an employee, you are required to pay NI employer's contributions for them.
Keep separate accounts for business and personal use. A sole trader must open a business bank account to facilitate deposits and withdrawals for the business. Separate accounts enable a sole trader to easily prepare tax returns at the end of the year. Separate accounts also ensure that revenue and expenses are tracked effectively to know if the business is making a profit or a loss. Personal liabilities such as a car should not be included as business expenses or operational costs, as this will negatively affect profit and loss calculations in the accounting books.
Bookkeeping involves recording transactions. The importance of bookkeeping includes identifying expenses and how to enhance business effectiveness, evaluating the business's financial health and identifying major clients and profitable products. Bookkeeping may be done manually or automatically through the use of accounting software. But to do proper bookkeeping, a sole trader must keep records such as invoices, receipts and a record of expenses. Bookkeeping should be done as often as possible, preferably daily or weekly to avoid inaccurate recording of transactions.
Bank reconciliation is the final stage of accounting. Bank reconciliation entails comparing the figures in the bank statement and the closing balance in the cash book at the end of each month. The sole trader takes the previous bank statement balance, adds the payments made that have not yet appeared on the bank statement and subtracts those payments that have been made. The cash book balance and the bank statement balance must be the same for successful bank reconciliation.