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A pro forma income statement is a financial report that projects a company’s future income, expenses, and profitability based on specific assumptions or hypothetical scenarios. Unlike traditional income statements, which reflect historical data, pro forma statements provide a forward-looking view. This helps businesses evaluate the potential impact of decisions such as mergers, product launches, or expansion.

Understanding how to create and analyze pro forma income statements is crucial for making informed strategic decisions and managing financial risk effectively. Keep reading to learn more on what a pro forma income statement is, some pros and cons of using them, how to create them, and more.

What Is Pro Forma?

The phrase “pro forma,” derived from Latin, signifies that something is being done for the sake of courtesy or as a matter of convention. In business, a “pro forma” is an example document that doesn’t reflect the current reality of a company’s finances. Instead, the information and projections in the statement are assumptions and estimates rather than actual data.

What Is a Pro Forma Financial Statement?

Generally there are three types of pro forma financial statements. These are:

•   Pro forma income statements (also known as profit and loss statements)

•   Pro forma balance sheets

•   Pro forma cash flow statements

What Are Pro Forma Income Statements?

Before we look at the pro forma income statement definition, let’s first look at what a traditional income statement is. An income statement shows a company’s income and expenses over a given period. It’s used to determine whether a company was profitable or not over that time.

The problem is: Not every period is the rule. There are always exceptions, like when you purchase another business or have to liquidate a large amount of inventory. In these exceptions, a traditional income statement won’t accurately reflect the financial health of your business. That’s where a pro forma income statement is more useful.

How Do Pro Forma Income Statements Work?

Just like you would with a traditional income statement, with a pro forma statement, you’ll include both the income and expenses of your business. The caveat is that you factor in whatever scenario you’ve got that will skew the income statement. In our example above, you might remove the investment cost of the business you acquired, since that large investment would make it look like your business operated at a loss.

Pro forma income statements can also be used to forecast potential revenues based on a particular scenario. Let’s say you take out a small business loan, which will take a toll on cash flow in the short term. If you use the loan to expand or bring new products to market, that could create a boost in revenues down the road, and you can calculate this potential increase in revenues in your pro forma statement.

It’s important to note that pro forma financials aren’t approved for Generally Accepted Accounting Principles. So they should only be used internally to better understand income and expenses over a period with unusual activity.

Recommended: Small Business Balance Sheets

When Do Businesses Use Pro Forma Income Statements?

Under normal conditions where you have no unusual expenses or revenues, you would use a traditional income statement. But if something out of the ordinary occurs, such as purchasing another company, upgrading equipment, or liquidating inventory that hasn’t sold, it might be better to compile a pro forma income statement.

Keep in mind that sometimes when you use pro forma financials, you’re basing your numbers on a hypothetical situation. By removing the manufacturing costs for a product you might decide to stop selling, you’re making assumptions that you’ll sell all the assets involved with that previous product and get revenue numbers back up to what they were.

Because this is a bit of speculation, you can’t share this pro forma statement with investors or shareholders. It’s better used internally to understand how your finances would look if a certain situation occurred.

How to Create a Pro Forma Income Statement

On the surface, the pro forma income statement format looks like a traditional income statement. It includes both revenues and expenses. The difference is that it also factors in the scenario you’re calculating for.

As suggested above, a pro forma income statement might factor in:

•   A large investment for acquiring a business or purchasing high-cost equipment

•   A forecast for a sudden increase in annual business revenues due to a new client

•   The loss of revenue from stopping a product line and liquidating assets

1. Establish Baseline Numbers

You can start with the information recorded in your traditional income statement. You’ll likely alter it for this pro forma project, based on your chosen scenario, but it’s important to know your starting position.

2. Identify Major Changes

Say you were forecasting the impact of stopping a product line. In that scenario, your pro forma statement would show different numbers because you’d get less sales revenue, while also paying out less for raw material and labor. Various other aspects would be affected too. Having projected those effects, you’d see new numbers and then figure out what additional outcomes might follow.

3. Calculate Financial Impact

To continue with this example, if you discontinued a line of products, you’d run the numbers to see the outcome. For example:

•   There’d be a decline in sales revenue — but if you were selling those products at a loss, there might actually be a positive impact on your bottom line.

•   You might anticipate a one-time cash bump from liquidating related equipment. How much tax would you have to pay on the gain from that sale?

Some additional decisions you could make:

•   If there’s less revenue coming in, would you lay off some workers and reduce your payroll? Would you rent a smaller, less expensive office space?

•   Would you take out a loan to help you pay the bills while your business is regrouping? If that’s part of your scenario, remember that cash from small business loans is usually not considered income, while the loan interest is generally a deductible business expense.

4. Account for Multiple Scenarios

You can create as many pro forma income statements as you like; they’re meant to be helpful in making decisions. So if there are different scenarios you’d like to explore, such as different price points for products, these statements can give you a sense of what each potential possibility would bring.

Tools and Templates for Forecasting

Many accounting platforms and software packages now offer tools and templates for pro forma financials. Some allow you to create these documents with your existing accounting software; for example, QuickBooks can generate your documents in pro forma income statement format. You can also get spreadsheet templates from enterprises designed to help small business, such as Score and the Corporate Finance Institute.

Recommended: Small Business Financial Software

Pros and Cons of Using Pro Forma Income Statements

So is it worth it to use pro forma income statements? Here are some benefits and drawbacks.

Because the pro forma income statement is based on a possible scenario, you can use it to make informed financial decisions for your business, such as whether or not to take out a business expansion loan. Just be aware that it won’t accurately depict what’s actually going on with your company, but rather only one possibility. And, again, you won’t be able to use these statements anywhere you’re required to provide GAAP reports.

Pro Forma Income Statement vs. Income Statement

As mentioned, there are similarities and differences between traditional income statements and pro forma statements.

A traditional income statement uses actual numbers for profit and loss based on what has happened in the past. A pro forma income statement looks at different possibilities based on certain scenarios and may use past data to create future projections for profit and loss.

The Takeaway

If your company has unusual activity coming up that can significantly alter a traditional income statement, consider using a pro forma statement to get a better sense of your profits and losses. Likewise, if you’re considering a certain action, such as buying another company, a pro forma income statement can help you make an informed decision.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What’s the difference between a pro forma income statement and an income statement?

A traditional income statement is based on actual numbers, while a pro forma income statement may use projected or hypothetical numbers based on certain scenarios.

What should be included in a pro forma income statement?

A pro forma income statement includes projected revenues, cost of goods sold (COGS), operating expenses, and taxes. It also forecasts gross profit, operating income, and net income based on assumptions about future performance.

What items are excluded from a pro forma income statement?

A pro forma income statement typically excludes non-recurring items like one-time expenses (e.g., restructuring costs, legal settlements) or unusual gains (e.g., asset sales).

How far into the future should a pro forma income statement project?

It’s typical to present three years of pro forma data for readers, investors, and lenders. In general, as the time frame for the pro forma projections gets longer, the predictions are more and more likely to prove inaccurate.

Can pro forma income statements be used for budgeting purposes?

They definitely can. Budgeting is one common reason for generating pro forma income statements, often as part of broader business planning. A pro forma income statement can guide businesses in setting realistic commercial goals and identifying areas for improvement.

Photo credit: iStock/skynesher

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Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

SOSMB-Q225-034

An economic recession is a challenging time for businesses. When it occurs, it means unemployment is rising, spending is decreasing, and businesses may struggle to survive amid all the uncertainty.

The good news is that there are ways to recession-proof your business ahead of an economic downturn. Conducting strategic planning, nurturing customer relationships, and building cash reserves are just a few ways to help your company remain resilient during challenging times. Here is more on how to prepare your business for a recession.

Historical Recession Patterns and Warning Signs

Although recessions can be difficult for everyone, they are a normal part of the economic life cycle. The U.S. has had 34 recessions since 1857, the most recent of which spanned two months in 2020 during the Covid-19 pandemic. Recessions occur when the economy contracts and can be marked by higher unemployment, lower spending, and a decline in industrial production.

Sometimes a recession is defined as two quarters in a row of declining gross domestic product (GDP). GDP is a measure of all the goods and services that the economy produces. The National Bureau of Economic Research (NBER) is responsible for officially declaring a recession. It looks at multiple indicators, including the GDP, retail sales, payroll employment, and personal income.

Some other signals that economists track when predicting a recession are inflation, stock market declines, and a reduction in housing prices. Investors also tend to put more money into gold ahead of an economic downturn, and business spending often starts to go down.

Industry-Specific Recession Vulnerabilities

Some industries are more vulnerable to recessions than others. The retail and hospitality sectors, for example, often feel the pinch first when consumers cut down on discretionary spending. Clothing stores, luxury brands, hotels, and restaurants may lose revenue as people cut back on non-essentials.

Manufacturing companies can also get hit hard due to a decline in consumer demand and a slowing of global supply chains. Both the residential and commercial real estate markets can struggle as home values decline and businesses downsize or shut down locations.

Financial Strategies

Don’t wait until a recession strikes to protect your business. Here are some financial strategies you can use ahead of time to prepare for an economic downturn.

Building Cash Reserves and Emergency Funds

Building an emergency fund can help your business survive during a recession. Ideally, you could save enough cash to cover three to six months’ worth of business expenses. That way, you’ll be able to pay employees and cover other costs if your business slows down temporarily.

When cash flow is strong, focus on building up your cash reserves. An alternative option is opening a business line of credit, which you can draw from as needed. You’ll only pay back the amount you borrow, but you will also have to cover interest charges and any associated fees.

Managing and Restructuring Business Debt

If you owe a business loan or other type of debt, make payments on time to protect and build your credit score. Paying your small business loans and other debts on time will help you build a positive relationship with your creditors. As a result, they may be more likely to renegotiate terms if a business recession hits and you need a new repayment schedule. You might also apply to refinance your startup business loans or other debts if interest rates are low. Refinancing has the potential to save you money and simplify repayment by combining multiple loans into one.

Operational Adjustments

By reviewing your operations, you might find areas where you can cut costs. Evaluate your equipment, facilities, services, staff, and other components of your business to see if you have any areas of waste.

You could negotiate with vendors to reduce costs or switch to a new software that streamlines your invoicing process. Cutting costs could help you through an economic downturn, as long as it doesn’t harm the quality of your services or the satisfaction of your customers.

Diversifying Revenue Streams

Diversifying your business’s revenue streams is another important part of recession planning. You might put more focus on research and development so your company offers a greater variety of products and services, rather than putting all its eggs in one basket.

Economic recessions can create unique opportunities for companies as consumer habits change. During the Great Recession amid the pandemic, for instance, remote work platforms and delivery service-based companies thrived.

Customer Focus

Nurturing your existing customer base is also key for surviving a recession. Not only will you maintain loyalty from your current clients, but they might also attract other customers to your business via referrals, positive reviews, and word-of-mouth.

You could engage with customers through social media or email to stay present in their minds. Make it easy for them to reach you through email, phone, or a social media channel.

Collect feedback whenever possible so you can improve your offerings and best meet customer needs. On the back-end, record details of customers’ purchase history so you can make customized product recommendations and upsells.

Government Resources

During an economic downturn, you may look to the federal or state governments for financial assistance. The Small Business Administration funds various types of business loans. It also offers low-interest disaster loans to businesses impacted by natural disasters.

The State Small Business Credit Initiative (SSBCI) provides capital and technical assistance to small businesses across the U.S. Some states also provide support to local business owners. The Massachusetts Growth Capital Corporation (MGCC) for example, has loan and grant programs to help small businesses grow.

During economic downturns, the government may introduce temporary relief programs. During the Covid-19 pandemic, for instance, the government helped small businesses with the Paycheck Protection Program (PPP) and Employee Retention Credit (ERC).

Planning for Recovery

Recessions don’t last forever, so it’s important to create a recovery plan for your business. Set short- and long-term goals that make sense for your company when the recession ends.

Continue to evaluate your finances, cutting wasteful expenses whenever possible. Maintain strong relationships with your customers, and consider whether the recession has caused customer behavior to change.

If so, you may need to adjust your product offerings, pricing, or business model to adapt to a changed market.

The Takeaway

It’s impossible to predict whether a recession is on its way or how long it will last, but planning for one can fortify your business for tough times. Focus on optimizing certain areas, such as customer satisfaction, marketing, and pricing. Look for areas where you can cut costs without sacrificing quality, and consider refinancing debt for better rates or more manageable repayment terms. By having a strategy in place, you can position your business to survive, or even thrive, during an economic downturn.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

How much cash reserve should my business maintain for a recession?

It can be beneficial to build a cash reserve that would cover three to six months of operating costs to help your business survive a recession.

Should I reduce prices during a recession to maintain sales?

Reducing prices during a recession may help maintain sales, since consumers are probably not spending as much. At the same time, be careful not to devalue your company’s services or products. Factors such as consumer demand and what your competition is doing may also help you tailor your prices during a recession.

What government programs help small businesses during economic downturns?

The Small Business Administration offers business loans and other resources to help small businesses during economic downturns. Some states also offer financial assistance.

How can I retain employees while cutting costs?

If you need to cut costs while retaining employees, start by taking stock of all your business expenses. Figure out how much you’re spending in areas like rent, utilities, inventory, marketing, insurance, and loan payments. Identify areas where you can reduce expenses without having to downsize your staff. Boosting engagement or offering better benefits are also ways to retain employees during challenging times.

Is it better to take on debt or reduce existing debt during a recession?

There’s no one-size-fits-all answer when it comes to debt during a recession. A business may benefit from taking on debt if it needs to increase cash flow, can qualify for a low interest rate, and has a solid repayment plan. On the other hand, reducing debt may be the better option if the company’s revenue is uncertain. Balancing risk with return is key when determining how to manage debt during a recession.

Photo Credit: iStock/Liubomyr Vorona

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Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Small Business Loans
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SoFi receives compensation in the event you obtain a loan, financial product, or service through SoFi’s marketplace. This webpage is owned and operated by SoFi Lending Corp., licensed by the Department of Financial Protection and Innovation under the California Financing Law, license number 6054612; NMLS number 1121636. ((www.nmlsconsumeraccess.org)). This page is NOT operated by SoFi Bank. Loans, financial products, and services may not be available in all states. All loan terms, including interest rate, and Annual Percentage Rate (APR), and monthly payments shown through SoFi’s marketplace are from providers and are estimates based upon the limited information you provided and are for informational purposes only. All rates, fees, and terms are presented without guarantee and are subject to change pursuant to each provider’s discretion. The actual loan terms you receive, including APR, will depend on the provider you select, their underwriting criteria, and your personal financial factors. The loan terms and rates presented are provided by the providers and not by SoFi Lending Corp. Please review each provider’s Terms and Conditions for additional details.

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Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOSMB-Q225-014

If you’re thinking about filing bankruptcy for your small business, you’ll have plenty of questions about what kind of bankruptcy you’re eligible for and what might make the most sense for your business.

This is a big decision to make, with lots of considerations. To help, here are answers to some pressing questions on this fraught subject.

What Are the Different Types of Bankruptcy for Business Owners?

Within the U.S. Bankruptcy Code, the types of bankruptcy for businesses are Chapters 7, 11, 12, and 13.

There are other types, but they’re not for small business bankruptcies. Chapter 9 bankruptcy applies only to municipalities: cities, counties, school districts, and so forth. Chapter 15 bankruptcy rules facilitate international legal processes when bankruptcy proceedings filed in foreign countries involve U.S. financial interests.

You may hear the term insolvency used when talking about small business and bankruptcy. This means a person is unable to pay debts due to lack of funds but may not necessarily be going bankrupt.

Bear in mind that insolvency and illiquidity are not the same thing. A business that is illiquid is generally facing short-term cash flow issues, but would probably be able to access working capital through loans, equity financing, or restructuring company operations.

Recommended: What Is Insolvency?

Chapter 7 vs. Chapter 11 vs. Chapter 13 Bankruptcy

This chart sums up some of the important features of the three most common types of bankruptcy so that you can see them all together.

Key Considerations Before Filing for Bankruptcy

There are many angles to examine before you take the step of filing for bankruptcy. Your particular situation will affect your priorities. Still, the most important issues are likely to be the type and amount of debt you have. You’ll also want to consider your business’s income, assets, and goals.

Thinking these over will help you decide whether to file and, if so, which type of bankruptcy would be best for your predicament. Most individuals file for Chapter 7 or Chapter 13 bankruptcy. Businesses that intend to remain operational generally opt for Chapter 11, with some exceptions.

Assessing Business Viability and Future Revenue

Insufficient revenue or unmanageable debt may mean that your business has begun to falter. The market for your goods and services might have changed, the economy might be slumping, or trends might simply have veered in a direction you didn’t foresee. Maybe you’re suddenly wondering how to file business bankruptcy, even if you don’t go through with it.

Ask yourself these questions:

•   What is the realistic outlook for the business in the near future and in the long term?

•   Is it time to shutter your business altogether and make a fresh start?

•   Or do you want to remain operational while discharging and restructuring your debts?

Take a look at your financial statements for this year and compare them to past numbers. It may be very helpful to analyze the outlook with your accountant and, if warranted, your lenders.

Exploring Alternatives Like Debt Restructuring or Settlement

You may be able to avoid small business bankruptcy by modifying your debt obligations. There are several methods to consider.

Debt restructuring is a common move to ward off bankruptcy. This is likely to be more helpful to you if your company’s loans have high interest rates. The comparatively steep APR on unsecured business loans, for example, means that renegotiating the terms of your loan could make a noticeable difference.

If your main issue is illiquidity, you may be able to free up some cash with a debt consolidation loan that would lower your monthly payments.

Debt settlement is similar but generally involves paying a creditor less than you owe in exchange for wiping the slate clean. Typically you or a representative of your business negotiates with creditors to determine how much of a discount they’re willing to accept. It’s wise to discuss this option at length with your attorney and accountant, who can help you steer clear of unscrupulous, fee-driven debt settlement firms.

If your business’s tax debt is dangerously high, you may want to look into the IRS’s “offer in compromise” arrangement. Eligible taxpayers (including some employers) can negotiate with the agency to settle an overdue tax bill for a smaller sum than what’s owed. If the offer is accepted, the taxpayer can submit a lump sum or agree to a payment plan.

For business owners eyeing a Chapter 7 bankruptcy filing, there is yet another approach to consider. Assignment for the benefit of creditors (ABC) is a state-governed, voluntary alternative process in which a business transfers its assets to a trust, after which they are liquidated to pay creditors. ABC can be quicker and less formal than federal bankruptcy proceedings. This option is available in more than 30 states.

How Bankruptcy Affects Employees and Business Operations

Regardless of whether you choose Chapter 7, Chapter 11, or Chapter 13, small business and bankruptcy can be a painful combination. Businesses heading into bankruptcy often have to contend with employee retention, skittish suppliers, unhappy customers, and more. Here’s some information you may want to consider.

Managing Payroll and Contracts During Bankruptcy

The Bankruptcy Code sets out legal requirements and priorities for managing payroll and contracts during the bankruptcy process.

If the company is going out of business, employees have a priority claim on wages and benefits that were earned up to 180 days before the bankruptcy filing; the allowable amount tops out at just over $15,000. Employers also have an obligation to pay payroll taxes on those wages.

If the company has 100 or more full-time workers, the employer is bound by the federal Worker Adjustment and Retraining Notification (WARN) Act, which requires 60 days of advance notice about layoffs or plant closures. Several states, including California, New York, and Illinois, have their own versions of this law.

Legal obligations during bankruptcy may involve modifying or rejecting contracts with court approval. Companies can either continue or terminate contracts that haven’t been completely fulfilled, including employment contracts.

Continuing the contracts calls for the business to make good on defaults and show it can perform in the future. Termination may allow employees to file damage claims.

Communicating with Stakeholders

If your business is a sole proprietorship, you may not have many stakeholders in the roles of employees and investors. But every business has clients and vendors, and many also have consultants, landlords, lenders, and gig workers. Those people all have at least a small stake in your enterprise. Larger businesses may have thousands of stakeholders involved in the purchase, production, sales, and distribution of their products or services.

Be transparent and humane with your stakeholders as bankruptcy looms on the horizon, corporate communications experts advise. What you tell them will depend on the type of bankruptcy you’ve decided to pursue.

Chapter 11, for example, doesn’t usually mean a company is shutting down, so in talking to worried employees, be specific about how the company will resolve its financial and legal issues and continue to operate.

You may even find someone who’s willing to infuse some capital by investing in your bankrupt company as it reorganizes under Chapter 11.

The main goal in all cases is to demonstrate good faith by addressing and talking over your customers’, partners’, and workers’ concerns.

The Takeaway

When a small business struggles — and sometimes can’t even service its small business loans — it’s understandable that an owner would wonder about filing for bankruptcy. There are at least three types of bankruptcy structures that can be viable ways to protect the business and reorganize financial obligations. It’s very important to choose the type of bankruptcy that fits with your needs and priorities.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Are you personally liable for your business debts?

The answer depends on what kind of business structure your company has. If you are a sole proprietor, you can be held liable for your business debts. If your company is an LLC or corporation, you are generally separated from the company and cannot be held liable. In partnerships, general partners are typically liable, while limited partners typically are not, but this can vary by state.

How will the bankruptcy affect your personal credit?

If your business is an LLC or a corporation, it should be legally separate from you, so the business’s bankruptcy should not affect your personal credit (unless you have signed a personal guarantee). However, if you are a sole proprietor, there is no separation and bankruptcy, which can stay on your credit report for seven to 10 years, depending on what type it is, can lower your personal credit score significantly.

How will this affect your business credit?

If your business survives the bankruptcy, there will still be a negative impact on your business credit score.

What happens if a business files for bankruptcy?

If a business files for Chapter 7 bankruptcy (liquidation), the company’s assets will be sold by a trustee, the proceeds will be disbursed to the creditors, and the business will cease to exist. If the business files for a Chapter 11 bankruptcy, it will be able to keep doing business but will have to pay off some or all of its debts according to a structured repayment plan.

Who can file for Chapter 7 bankruptcy?

Individual people can file for Chapter 7 and so can businesses. Small business owners are able to choose whether to file on their own personal behalf or on behalf of the business.

Who can file for Chapter 13 bankruptcy?

Individuals with a regular source of income. Among small businesses, only sole proprietors can file for Chapter 13, so this is not an option for corporations or LLCs.

Who can file for Chapter 11 bankruptcy?

This type of business bankruptcy is available for individuals, as well as for LLCs, corporations and partnerships.

Photo credit: iStock/elenaleonova

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

SOSMB-Q225-035

Running a business of any size requires at least a basic understanding of small business accounting. Accounting allows you to keep track of expenditures and revenues and manage your company’s cash flow. It also provides insight into your company’s operations and enables you to provide financial information about your business to potential investors and lenders. These basics will get you started.

What Is Small Business Accounting?

Small business accounting is the process of tracking and analyzing your company’s financial information. It can help you evaluate the health of your business, stay on top of necessary administrative tasks, and file your taxes more easily. A solid accounting system also makes it easier to apply for small business financing or bring in outside investors.

Before diving into the basic elements of an accounting regimen, it’s a good idea to familiarize yourself with a few key business accounting terms.

•   Liabilities: A business liability is any type of financial obligation that a business owes to another entity, such as money, goods, or services. They are divided into current (due within one year) and non-current (due after one year or more) and listed on the balance sheet. Accrued expenses are a type of liability.

•   Assets: This refers to any goods or property that add value to the business. Assets can be tangible (like inventory or offices) or intangible (such as patents, trademarks, or even brand recognition). They’re itemized on the balance sheet.

•   Accounts payable: A type of short-term liability, accounts payable is the amount of money a business owes to its suppliers for goods or services purchased on credit. It’s recorded as a current liability on the balance sheet.

•   Accounts receivable: This term refers to the money a business’s customers owe for products or services that have been sold but not yet paid for. It’s listed as an asset on a company’s balance sheet.

•   General ledger: This is a record of all financial transactions made by a business. An entry into this ledger is called a “journal entry.”

•   Equity: This is the value of the business’s assets minus its liabilities and is a measure of the business’s ownership and value.

Recommended: Set Your Small Business Up for Success: Strategies, Best Practices, Insights, and Tips

Small Business Accounting in 9 Steps

Running a basic accounting system for a small business involves a variety of tasks. Some tasks only need to be done once, to get your system up and running, while others you might revisit once a quarter or once a year. Here are nine important steps for small business accounting.

1. Choose Accounting Method

Small businesses typically use cash-basis accounting. It’s a simpler method, as income and expenses are recorded when the money is actually received or spent. This approach keeps cash flow front and center, with no adjustments needed.

Other small companies may prefer accrual accounting, which records transactions when they occur, rather than when the exchange of money occurs. This accounting method is more complex. Accordingly, it can provide a more detailed view of a company’s long-term financial health.

2. Set Up Chart of Accounts

Compiling a chart of accounts, or COA, involves listing the financial account names and numbers in your company’s general ledger. Typically, the COA will identify assets, liabilities, income, and expenses accounts. Some companies have a fifth account, the equity account.

3. Utilize Accounting Software

Today’s small business financial software is equipped to help you with all kinds of accounting tasks, from tracking expenses and sending out invoices to generating various financial reports.

For example, your accounting software may be able to produce a cash flow statement so you can see where money is coming in and where it’s going out. To that end, it can monitor unpaid invoices to help you pursue overdue accounts receivable, and give you automatic reminders to settle up outstanding accounts payable.

Having the information organized and at your fingertips also enables you to make data-driven decisions about budgeting, cost-cutting, expansion, financing, and more.

4. Maintain Bookkeeping

Here are some crucial actions to take to keep your general ledger in order.

•   Record all income and expense transactions.

•   Keep and file copies of your receipts and invoices.

•   Check your balances and stay on top of managing your daily cash to avoid overdrafts.

•   Track upcoming bills. You can create a calendar and enter information for all of your vendors and service providers (like utilities) that need to be paid each month. Note how much is due and when (estimate, if you need to), then log when you actually make the payment.

•   Make payments on time. Be sure not to miss payments on any type of small business loan, as delinquency could harm your business credit score.

Orderly paperwork makes it easy to compile your tax records when it comes time to file. And if you’re ever audited, you’ll have an organized archive with all of those documents at hand.

5. Create Financial Statements

Your small company accounting workflow should involve creating annual financial reports. These reports usually include a balance sheet, income statement, and cash flow statement.

These will give you an overview of your business’s performance, especially by calculating annual revenue and making year-over-year comparisons. The reports can also be helpful for reference at tax time.

6. Manage Payroll and Taxes

If you have employees, you’ll need to stay on top of payroll. It’s important to meet your payroll schedule deadlines, which are typically biweekly. Consider setting up direct deposit if it makes sense with the size of your business. You can also outsource the process to a part-time or contracted payroll manager.

In addition to making sure your employees are paid, making payroll for small businesses involves meeting tax requirements for federal, state, and local jurisdictions.

You’re responsible for payroll tax for your employees and yourself; you typically also need to pay sales and income taxes as part of your small business accounting routine. It’s a good idea to get to know your state’s specific requirements for each type of tax.

Sales tax is required in 45 states, and your local county or city may also collect this type of tax from small businesses. You may qualify for an exemption, depending on your type of business. If not, check each locale’s payment schedule and note it on your calendar.

You’ll want to apply the same process to income tax. The IRS and most state revenue departments collect income tax, with estimated payments due each quarter. Check with an accountant or tax advisor if you’re unsure of how to estimate your income taxes.

Accounting for small businesses includes important annual responsibilities as well. In particular, to avoid penalties and interest, you should file your annual tax return on time. This includes paying any additional sums you owe beyond the quarterly estimated taxes you already paid.

7. Reconcile Accounts

An online accounting system can also help you track your accounts payable and accounts receivable, as well as inventory, so that you can successfully manage your business cash flow.

By tracking and reconciling unpaid expenses versus total sales, you can see at a glance how your business is doing and confirm that your accounts are aligned. If you owe more than you’ve brought in for the month, you’re experiencing a cash flow crunch and will need to take steps to address it. If your total sales amount is more than your expenses, you’re experiencing a surplus.

8. Monitor Financial Performance

You can analyze your financials in several ways to gauge the health of your small business. For example, you might look at your profit-and-loss statement and income statement to get an idea of how well the business is performing.

There are also several accounting financial ratios worth reviewing regularly. Here are three that may be particularly helpful.

•   Gross margin profit ratio lets you see how much profit your business is making after expenses are paid.

•   Debt-to-equity ratio can help you assess whether or not your company is overleveraged (has too much debt compared to equity).

•   Cost of capital evaluates how much your company must pay for funds. It’s a useful metric since it helps you see if your financial decisions are paying off in terms of profit margins. And it’s also something that investors may look at.

Tracking these numbers regularly also reveals long-term trends. It’s wise to compare current financials to those from the previous month, quarter, or year to identify factors that are either hurting or helping your business.

9. Consider Hiring an Accountant

Delegating time-consuming financial duties to an accountant frees you up to focus on the business as a whole. The accountant — typically a certified public accountant (CPA) — can help with everything from setting up a bookkeeping system to preparing financial statements to filing your tax returns.

If you’re wondering how to find an accountant, consider tapping your professional network and local organizations for referrals. Online recommendations via LinkedIn and other social media could also be helpful.

Once you’ve got a few candidates in mind, you can use resources like CPAverify to confirm their credentials.

Recommended: What Is Working Capital & How Do You Calculate It?

Common Mistakes to Avoid

Accounting can be complex and it’s easy to make mistakes. Some of the most common errors are irregular recordkeeping, data entry typos, missing or inaccurate account information, and clerical slipups like misclassifying transactions.

How To Choose the Right Accounting Method for Your Business

When choosing between cash-basis and accrual-basis accounting methods, you’ll want to carefully consider a variety of factors. These typically include the size of your business, your industry’s regulatory demands, legal requirements, your financial goals, and your tax and shareholder reporting needs.

Cash Basis vs Accrual Basis Accounting

As mentioned above, cash accounting is more straightforward. It also offers tax advantages, in that you can delay paying taxes on revenue until you receive payments.

Accrual accounting provides a more accurate financial picture. More importantly, it’s required by law for larger companies, public companies, and those following generally accepted accounting practices (GAAP) or international financial reporting standards (IFRS).

Some Small Business Accounting Solutions

Staying on top of your accounts is a sound business practice, but that doesn’t mean you can’t get some help. Here are some possible moves to consider.

Small Business Accounting Software to Consider

There are numerous free bookkeeping and accounting programs. If you’re willing to pay for your software, you may be able to get more bells and whistles along with the basics.

If you have or know a CPA, it may be worth asking him or her for accounting software recommendations.

Professional Accounting Services

You may not be able to afford a staff accountant, but you may find it worthwhile to hire an accountant on a part-time or consulting basis, particularly if you’re too busy or feel uncomfortable delving into the numbers yourself. As your business grows, you may benefit from hiring a full-time accountant onto your team who can manage complex tasks and provide financial insights for long-term planning.

The Takeaway

Understanding basic accounting for small businesses automatically sets you up for a better chance of success. If you’re just starting out, you may be able to manage all of these steps on your own, especially with the online accounting software available today. As your business becomes more complex, however, it may be time to start outsourcing tasks that are either out of your comfort zone or take up too much time.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Can you do your own small business accounting?

Yes, it’s possible to handle your own small company accounting, especially with the help of accounting software. These tools simplify tasks like tracking income, expenses, invoices, and payroll, making them doable even if you have limited accounting experience. As your business grows, however, you may benefit from hiring an accounting professional to manage complex tasks, ensure tax compliance, and provide financial insights that can help with long-term planning.

What accounting is required for a small business?

Small businesses are typically required to maintain accurate records of income, expenses, assets, and liabilities. This involves tracking your revenue and costs, managing accounts receivable and payable, and maintaining records of any inventory or equipment. You’ll need these records to prepare financial statements, file your taxes, and monitor profitability. Depending on your business structure, certain tax or financial reports may be mandatory, like a balance sheet or income statement.

Which accounting method is most commonly used by small businesses?

Small businesses typically use the cash basis accounting method due to its simplicity. With this approach, income and expenses are recorded only when cash is actually received or spent. This offers a clear view of cash flow without the need to make complex adjustments. However, some small businesses may prefer accrual accounting, which records transactions when they occur and before any money is received or paid out. While this accounting method is more complex, it can provide a fuller picture of a company’s long-term financial health.

Photo credit: iStock/tdub303

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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SOSMB-Q225-030

GAAP (generally accepted accounting principles) is a set of standards that publicly traded businesses in the U.S. must follow when reporting financial information. IFRS (International Financial Reporting Standards), on the other hand, is the accounting standard used in the European Union and other countries around the world.

Both GAAP and IFRS are designed to maintain transparency and consistency in financial documentation and make it easier for investors, creditors, and business managers to make informed financial decisions. While the two systems share similar goals and features, they use different methodology. Here’s what you need to know about U.S. GAAP vs. IFRS.

What Is GAAP?

GAAP is a set of rules and principles that companies in the U.S. must follow when preparing their annual financial statements. GAAP dictates how a company can recognize revenue and expenses, what types of expenses have to be capitalized as assets, and how information needs to be presented to shareholders in an audited report.

Governed by the U.S. Securities and Exchange Commission (SEC) and administered by the Financial Accounting Standards Board (FASB), GAAP was established to provide consistency in how financial statements are created and make it easier for investors and creditors to compare companies apples to apples.

All publicly traded businesses in the U.S. must use GAAP in their financial statements. Auditors who doublecheck these financial documents abide by an analogous set of guidelines known as “generally accepted auditing standards”, or GAAS. (GAAS vs. GAAP can be confusing, but it may help to remember that only GAAP is for accountants.)

While small businesses that don’t get audited aren’t required to use GAAP, doing so could make it simpler to report your company’s financial information. It might also make it easier to get approved for small business financing.

Recommended: Classified Balance Sheet: Definition and Key Components

What Is IFRS?

The International Financial Reporting Standards, or IFRS, is another set of accounting standards, but these are used at the international level. IFRS is standard in the European Union and many countries in Asia and South America, but not in the U.S.

IFRS, issued by the International Accounting Standards Board (IASB), is designed to create a commonality in how businesses in different countries report their accounting. This consistency in accounting language enables investors and creditors to understand a company’s financials and compare one IFRS-compliant company to another IFRS-compliant company, which helps in making investment decisions.

GAAP vs IFRS Compared

There are some commonalities between IFRS and GAAP, but also many differences. Here’s how they net out.

Similarities

Both GAAP and IFRS govern how companies should report their financial information for a given reporting period, such as one quarter or one year. And both systems are designed to simplify financial statements and provide an even playing field for investors to evaluate companies and compare one to another.

GAAP and IFRS also both require companies to issue income statements, balance sheets, cash flow statements, changes in equity, and footnotes. In addition, they both require accrual (vs. cash) accounting, and allow the use of the inventory estimates first-in, first-out (FIFO) and weighted average cost.

Differences

GAAP and IFRS differ in several key areas.

Rules- vs Principles-Based

GAAP goes into much more detail when it comes to accounting and uses fixed rules for calculations, with little room for interpretation. This is to prevent companies from creating exceptions to the rules in order to make themselves look more profitable.

IFRS, on the other hand, sets out principles that companies should follow using their best judgment. It allows for some wiggle room for companies to interpret the principles.

Inventory

While GAAP allows companies to choose the most convenient method when valuing inventory, IFRS does not permit companies to use the last-in, first-out (LIFO) method of calculating inventory. The reason is that some analysts believe the LIFO method does not show an accurate inventory flow and may portray lower levels of net income than is actually the case.

Recommended: Advantages and Disadvantages of GAAP vs Tax-Basis Accounting

Intangible Assets

The way that intangible assets like goodwill or research are recorded differs between IFRS vs. GAAP. With IFRS, intangible assets are only capitalized when certain criteria are met, such as having a definite future financial benefit.

Under GAAP, intangible assets are generally expensed as they are incurred based on their current fair market value with no other considerations required.

Fixed Assets

There are differences in depreciation of fixed assets for IFRS vs. GAAP. Under GAAP, fixed assets (such as property and equipment) are valued using the cost model, which means the purchase price of the asset less any accumulated depreciation.

With IFRS, by contrast, fixed assets are initially valued at cost but can later be revalued (up or down) based on current market value.

Revenue

How you address revenue differs between the two systems. IFRS is based on the guiding principle that revenue is recognized when value is delivered. With GAAP, however, the rules are more specific.

While revenue generally is not recognized until the exchange of a good or service has been completed, GAAP requires the accountant to consider the industry-specific rules regarding revenue recognition. Due to looser rules, the IFRS system may allow a business to report income sooner.

Liabilities

Another difference between GAAP vs. IFRS is how liabilities are classified on the cash flow statement. GAAP classifies them as either current or non-current, with those the company can reasonably repay in the next 12 months considered current, and those that will be repaid later as long-term or non-current.

Certain kinds of redeemable shares get different treatment, too. When they constitute mezzanine financing (a hybrid of debt and equity financing), GAAP-compliant public companies consider them temporary equity. IFRS, which has no “temporary equity” classification, treats them as financial liabilities.

With IFRS, all liabilities (both short- and long-term) are grouped together.

Lease Accounting

GAAP and IFRS standards treat lease accounting differently. GAAP distinguishes between operating and finance leases, while IFRS does not.

Instead, IFRS treats all leases as finance leases, which affects how expenses are reported on the income statement. IFRS splits the operating lease expense into interest and depreciation, while GAAP treats it as a simple rental expense.

In some cases, the difference in the expense calculation may alter financial ratios used by lenders and investors, such as the fixed charge coverage ratio and the net profit margin.

Development Costs

GAAP requires that companies expense most R&D costs when they are incurred. Under IFRS, research costs are expensed but many development costs are capitalized if certain criteria apply. For example, intangible assets developed within the company, such as software or chemical formulas, are generally capitalized and amortized.

Pros and Cons of IFRS

The U.S. hasn’t yet decided to adopt IFRS over GAAP, though with so many other countries around the globe using it, that may happen in the future. However, there are both pros and cons to switching to IFRS.

On the plus side, adopting IFRS would make it easier for U.S. companies to do business with companies overseas. It would also make it easier for investors to compare U.S. and foreign companies.

Another advantage of IFRS is that it is less detailed than GAAP, which makes it easier to implement. It also offers more flexibility, which allows companies to adapt the system to fit their specific situations. Some experts also believe that a focus on principles, rather than rules, captures the essence of a transaction more accurately.

However, there are also downsides to IFRS. Because IFRS is more subject to interpretation, it often requires lengthy disclosures on financial statements. The system’s flexibility can also lead to the manipulation of standards to make an organization seem more financially secure than it is in reality.

Another disadvantage to IFRS’s flexibility is that statements aren’t always comparable (which is the point of having a global standard). Finally, if the U.S. were to adopt IFRS, it would be costly for small businesses to implement the change.

Transitioning Between GAAP and IFRS

Small U.S. companies doing business internationally may feel that they need to decide between GAAP’s rules-based approach or the IFRS principles-centered framework. Each approach has advantages and disadvantages, as discussed above.

However, it’s often debatable whether a business needs to transition from one to the other. Companies have the option of maintaining financial records under both standards.

Key Considerations for Multinational Businesses

When converting to IFRS, executives typically need to address changes in accounting and reporting practices, such as significant new standards for revenue recognition, leases and financial instruments.

The changeover also affects systems, processes, and business plans. Business owners will want to analyze the cost and complexity of adjusting the accounting system for compliance and the time and effort of training employees accordingly.

Impact on Financial Reporting and Compliance

The different accounting treatments will produce financial statements that vary in reported net income, assets, and liabilities. The disparities in reported numbers will affect financial ratios.

Some of the areas of disagreement generally include inventory valuation (FIFO vs. LIFO), categorization of R&D costs, and revaluation of assets.

The Takeaway

IFRS is a standards-based approach that is used internationally, while GAAP is a rules-based system used primarily in the U.S.

There are several differences between GAAP vs. IFRS. The biggest is that GAAP lays out highly specific accounting rules and procedures, whereas IFRS sets out principles that companies should follow and interpret to the best of their judgment.

For small business accounting, you don’t have to follow any specific regulations. However, following GAAP in your financial statements can be useful in certain situations, such as when you’re looking to get approved for financing. Many lenders and creditors often prefer GAAP-compliant statements when they issue loans.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Does the U.S. use IFRS?

No. Public companies in the U.S. must use GAAP (generally accepted accounting principles), though many businesses opt to report their finances under IFRS (International Financial Reporting Standards) as well.

Is GAAP used in the U.K.?

No. Public companies in the UK must use IFRS as issued by the International Accounting Standards Board (IASB) with some limited modifications. However, some companies in the U.K. may also use GAAP to cater to a U.S.-based audience.

Is GAAP or IFRS more conservative?

GAAP (generally accepted accounting principles) is considered more conservative because it is highly detailed and rules-based. IFRS (International Financial Reporting Standards), on the other hand, is principles-based and leaves more room for interpretation.

Which industries are most affected by GAAP vs IFRS differences?

Because they rely heavily on leasing, industries such as retail, construction, and transportation are significantly affected by differences in how GAAP and IFRS standards treat lease accounting.

Pharmaceuticals and software, sectors that spend large sums on research and development (R&D), see contrasting outcomes based on how the accounting system expenses or capitalizes R&D costs.

Can a company use both GAAP and IFRS for reporting?

Yes, a company can use both frameworks by maintaining two sets of books. Employing both may be done as part of a transition from one system to the other. It may also be done indefinitely for statutory reporting or other reasons.

Photo credit: iStock/piranka

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

SOSMB-Q225-031