How to Set up Small Business Bookkeeping

Bookkeeping is keeping records — keeping the books — of business activities, such as what the business buys and sells. The aim is to tell the owner how much profit (or loss) the business is making, what it owns (its assets), and what it owes (its liabilities).

The “books” of a bookkeeping or accounting system are accounts, journals, and ledgers. An account records financial transactions of a certain type (e.g., rent, stationery, sales, etc.) or for a certain person or entity (ABC Corp). Ledgers are simply a group of accounts. Journals record the business activities that have an economic aspect.

Some journals are specialized and deal with just one type of transaction, for example, the cash book. Similarly, some ledgers are subsidiary ledgers that hold accounts of one type (e.g., amounts owed by customers who bought on credit), called accounts receivable (AR). But there’s always one main ledger, which is known as the general ledger (GL) that will have the totals from subsidiary ledgers. This makes the GL a complete record of every economic event affecting the business.

Most times, the business activity will have some documentary evidence, such as an invoice or check, which is referred to as a source document.

Here’s what the accounting cycle — the bookkeeping system in operation — looks like:

1. Enter (record) each source document in a journal
2. Post the entries to a ledger
3. Prepare a trial balance
4. Make adjustments
5. Prepare financial statements

A trial balance is a listing of balances in the GL. It has that name because it provides the first indication of possible errors in the system. Why? Because of the concept of double-entry.

Double-Entry

Most modern bookkeeping systems are “double-entry” systems, based on the idea that every benefit a business receives has a cost. Consequently, every transaction requires two entries, a debit and a credit. The convention is that debits represent what is owned, while credits indicate what is owed. Debits are also used to record expenses, and credits are used to record revenues.

If all goes well when recording transactions, the total dollar value of debits and credits should be equal. This is the purpose of a trial balance: a listing and total of all debits and credits in two columns.

What Does a Bookkeeper Do?

A bookkeeper’s job is to maintain accurate records and ensure the books balance (i.e., that the total dollar values of debits and credits are equal). Although the number of debits and credits may be different, the dollar totals must be equal. Additionally, the debits and credits relating to every transaction must be posted to the right accounts. A bookkeeper needs some accounting knowledge to analyze each transaction and categorize it appropriately.

Bookkeeping can be done on a cash basis or an accrual basis. Under cash basis bookkeeping, revenue and expenses are recorded when cash is actually paid or received. Under accrual basis accounting, revenue is recorded when it is earned and expenses are reported when they are incurred.

Cash Basis Accounting

While accounting on a cash basis is simple, it omits many business transactions, such as buying on credit, since there is no cash component. And it provides no way to track assets, liabilities, or equity. This can give a distorted picture of business operations. Additionally, cash basis accounting does not conform to Generally Accepted Accounting Principles (GAAP). Nevertheless, the IRS allows cash basis accounting, and some businesses may find that it better suits their activities.

Accrual Basis Accounting

In accrual basis accounting, revenues are recognized when a sale is made, even though no cash is received. Conversely, expenses are recognized when a cost is incurred even if it’s not paid for yet. Accrual basis accounting does conform to GAAP.

Accounts are the basic building blocks of an accounting system, and a chart of accounts links all of the accounts into a system. The chart of accounts is a listing or index of all the accounts appropriate to a particular business, grouped normally into five categories: assets, liabilities, equity, revenue, and expenses. Equity is the owner’s stake in the business.

There are three basic financial reports that an accounting system produces — a balance sheet, an income statement, and a statement of cash flow.

• The balance sheet provides a financial picture of a business at a particular point in time.
• The income statement and cash flow statement show the flow of resources over a period of time.

These three statements are historical since they relate to the past.

Balance Sheet

The balance sheet shows the financial position of a business. It’s a snapshot of a business, taken at a particular point in time, typically at month-end or year-end. A balance sheet is usually arranged to reflect the accounting equation (Assets = Liabilities + Equity) with assets on one side and liabilities and equity on the other side.

Income Statement

The income statement or statement of profit and loss summarizes business revenue and expenses. It is, perhaps, the most important financial statement since it shows whether or not the business is making a profit. While preparing the income statement, great care must be taken not to confuse cash receipts with revenues or cash expenditures with expenses. A proper income statement depends on accrual accounting.

Cash Flow Statement

A statement of cash flow keeps track of a business’s liquidity position. It usually has three sections, devoted to cash flows from operations, investing, and financing. Each section shows the surplus or deficit contributed to the closing cash balance.

Cash flows from operations include the cash component of transactions that determine net income or profit. The cash flow statement actually begins with net income (net profit) as its top line. Thereafter, adjustments are made in each section to show how adjustments in thaincomet section affect the closing cash balance. Consequently, the statement of cash flows shows the link between net income and the closing cash balance.

Bookkeeping systems treat a business as a separate entity, distinct from its creditors, customers, and owners. Even if, legally, a business is regarded as simply an extension of an individual’s activities (like a sole proprietorship), it is regarded as different and separate from its owner(s) for accounting purposes. There’s a common-sense reason behind this approach. It is easier to determine if a business is successful if its activities can be isolated and measured.

Also, when it’s time to file a tax return, every single expenditure would have to be reviewed to be categorized either as a business or personal expense. Unless meticulous records were kept, this could prove difficult since the reason for many expenses will be forgotten.

Get a Business Checking Account

All businesses need a bank account to receive payments from customers and to make its own payments. All business-related cash transactions should go through the business bank account, and you should not use the account for personal transactions as much as possible.

Since about three-quarters of cash transactions are made electronically, you can link a business checking account to a merchant services account or a payment processor. This allows payments to be made by debit and credit cards, as well as through the Automated Clearing House (ACH).

You can also link a business checking account to your business bookkeeping system (i.e., your accounting software). This allows transactions in the bank account to be reconciled easily with the cash book, your record of cash receipts, and payments.

Use a Business Credit Card

A business credit card is one way to increase financing options for a small business. Unlike loan financing, where the money is advanced right away and then repaid by installments over a period of time, a business credit card provides a revolving line of credit. A credit limit is set, and funds can be drawn down and repaid as the situation demands. Interest is charged if the balance is not paid in full each payment cycle.

It’s usually a trite easier to qualify for a credit card than a loan. However, credit card interest rates are generally higher than loan rates. As with personal credit cards, business credit cards can be used as a tool to build good credit.

Accounting software is the modern version of the age-old bookkeeping system. It has a distinct advantage over traditional systems — the only manual entries usually required are inputting source documents. Other entries, such as the postings to ledger accounts and the generation of financial reports, are done automatically.

Originally, many accounting software systems required a small business owner to purchase or license the system, which could then be downloaded. Now, many accounting systems are available in Software-as-a-Service (SaaS) versions. You access the software through a web browser or specialized app, and the service charges a monthly subscription fee for its use.

There are many advantages to hiring a professional accountant. Doing so enlists the services of a professional who will be up-to-date with the latest guidelines and rules. You may be able to do the books yourself, but an accountant will take less time, since they are a great deal more familiar with the issues.

Bookkeeping may be done most cost-effectively in-house. But, a professional is best for producing the financial statements from the system, in a way that will pass review from the IRS, bankers, auditors and other parties that you may wish to show them to.

Even if you use accounting software, it’s a good idea to hire a professional to review the reports produced. A pro can also help analyze the information with accounting ratios and he will be able to provide guidance based on his experience with other businesses similar to yours.