Businesses use bookkeeping to manage and keep track of financial transactions – what the company has, what it’s spent and what it owes – in order to make informed financial decisions. In this article, we’ll do a deep dive into bookkeeping basics and practices.
What is bookkeeping?
Bookkeeping is the recording of all financial transactions that a business is involved in. It essentially creates a systematized accounting record that allows company owners to determine if their business is profitable or not, and in some cases, if their company is ready for expansion. Business owners can use this record, also referred to as their ‘books,’ to identify the challenges affecting their business’ financial health and address them as soon as possible.
Every time money is involved, companies need to ensure that every move is recorded, even if the money has not yet changed hands. Bookkeeping also records transactions that are not in monetary form, like when two companies trade services instead of paying each other.
In general, bookkeepers ensure that all transactions are logged in the books every time they take place so that decision-makers can see how the business is performing.
Bookkeeping vs. Accounting
Bookkeeping is an essential part of the accounting process. It is the act of recording all transactions, invoices, payments, income, and all other vital financial data.
Think of bookkeeping as the primary tool that accountants use. Once a company’s financial transactions have been recorded and compiled, accountants analyze that information and report it to the banks, the company’s investors and its owners.
Accountants interpret what the numbers mean and make recommendations for future business decisions. They determine what kind of data bookkeepers should collect for tax and presentation purposes.
Types of Accounts
“Accounts” refers to the different types of financial transactions that bookkeepers keep tabs of.
Here we’ll break down the basic types of accounts:
Assets are anything that a company owns that has monetary value. This includes equipment, products, stocks, and vehicles. Essentially, it’s everything the company uses to generate income.
Assets are not always material items. Patents and copyrights fall under assets, along with anything that the company has a legal right to receive, such as tax refunds or accounts receivable. The company’s checking account and prepaid expenses like subscriptions or insurance paid in advance are also recorded as assets.
Here’s a quick breakdown of the standard assets groupings:
Current assets include the existing cash in the company’s bank account, and its inventory. This also pertains to money that is immediately available, as well as everything that will quickly turn to cash.
Investments are both tangible and intangible items that are expected to generate income or grow in value in the future. They come in the form of holdings, like mutual funds or municipal bonds, real estate, and retirement savings accounts like 401(k)s and IRAs. These are assets that are not necessarily used to increase immediate profit, but rather generate wealth for future use.
Companies that have extra cash may choose to invest their money so they can earn even more down the line. With these longer-term earnings, a business can build asset reserves or put them towards expansion so it doesn’t have to seek funding from external sources.
All properties, equipment, and furniture are classified under fixed assets. These are long-term assets that a company acquires to produce goods or provide services. They are also assets that the company uses to support its daily operations, such as delivery vehicles and office equipment.
Intangible assets have no physical form but still have monetary value to the company, such as trademarks, patents, or copyrights.
Liabilities are assets the company owes and needs to pay sometime in the future. Also referred to as ‘payables,’ liabilities can either be current or long-term depending on the agreement with the person or entity the company owes something to. For some concrete examples, liabilities are recorded every time a company takes out a bank loan, uses its corporate credit card or purchases goods from suppliers that are payable in the future.
Here’s a quick breakdown of the standard liabilities groupings:
Anything a company owes that’s due within a year is considered a current liability. This includes paying off credit card expenses that cover the business’ electricity and purchasing inventory from partners.
Long-term liabilities are any financial obligations that are due in more than one year. This includes startup, car, or mortgage loans.
Taxes are also considered liabilities. They accumulate every time there is a recorded transaction. Here are some of the most common tax liabilities bookkeepers should take note of:
- Sales tax payable
- Withholding tax payable
- Federal Insurance Contributions Act (FICA)
- Federal and state unemployment insurance
- Property tax
- Franchise tax
- Gross receipts tax
- Self-employment tax (Social Security and Medicare)
Revenues are the money a business earns by selling its products or services. It’s the gross income figure that companies need to bring in to account for the time and effort of running their operations.
In the profit equation, businesses usually start by deducting the expenses and costs from revenues. A positive result means that the company is profitable. A negative result means the company sustained a loss.
Businesses need to use a considerable amount of their revenue to pay their expenses and compensate their employees. Successful companies find ways to create big gains while keeping their costs low. This allows them to maximize their revenue to fund future projects and improve customer experiences.
The company’s expenses are the costs of operating the business, from overhead to advertising. Almost all expenses are tax-deductible, so knowing what the expenditures are will go a long way in managing the business’ tax bills.
Expenses are mandatory obligations that companies have to pay no matter how much revenue they generate, like rent, electricity, or gas if they rely on vehicles. What business owners need to remember is that these expenses can be deducted from their tax obligations.
It’s always best to file and store all receipts and invoices beforehand to lower the taxes. Remember that every dollar of expense means income reduction. The reduction of income translates to lower taxes.
Equity is everything that’s left when liabilities are subtracted from assets. It represents how much of the company belongs to the rightful owners. In the balance sheet, which is a snapshot of the business’ assets and liabilities, bookkeepers use this calculation: Assets minus liabilities equals the owner’s equity (asset – liabilities = equity).
Simply put, equity is the ownership of an asset used in the business. First-time entrepreneurs typically put their personal assets into the company to build their equity account, and leave those personal assets there for a long time. Those who plan to expand their business leave some of their profits as part of equity and don’t take them out as soon as they’re earned, so they can continue to grow in value.
When a company decides to do its own bookkeeping in-house – as opposed to outsourcing to a bookkeeping firm – the owner needs to determine whether he or she will use the single-entry or double-entry bookkeeping method. What’s the difference?
1. Single-entry bookkeeping
With the single-entry bookkeeping method, business owners enter every transaction only once in their books. When customers pay a sum, that transaction is recorded under ‘asset’ only. This method is preferable for new businesses that don’t have inventory or often engage in cash transactions.
This bookkeeping method is not for large organizations. Since single-entry bookkeeping only records one entry for every transaction, this will not monitor inventory, accounts payable, and accounts receivable.
2. Double-entry bookkeeping
Organizations that need to monitor the movement of their assets and liabilities should opt for double-entry bookkeeping. With this method, bookkeepers record two entries for every transaction: credit and debit. Double-entry bookkeeping ensures that the books are always balanced and error-free.
For example, let’s say a business owner owes $20,000 to a creditor. Under debit, bookkeepers should log an increase of $20,000 to their cash account, and the liability account must also be increased by $20,000.
Cash Basis vs. Accrual Accounting
Recording every business transaction can be done through a cash basis or accrual basis accounting. The main difference between the two is the timing of when the transactions are recognized and recorded.
1. Cash Basis
Cash-based accounting is similar to single-entry bookkeeping, where transactions are not recorded until cash exchanges hands. This method does not record accounts payable and accounts receivable since it records transactions only when cash is paid.
Cash basis accounting is commonly used for personal purposes or by small business owners with no complex accounting requirements. It is easier to manage, but is less accurate than accrual accounting in terms of illustrating a company’s financial health. This is because cash-based accounting only puts on record the physical money a business receives or spends, and not future transactions that are agreed upon in present time. Investors might assume the business is profitable when in fact, it has already burned through cash for accounts payable.
2. Accrual Basis
Accrual accounting, on the other hand, recognizes all transactions even before payments have been made. It covers accounts payable and receivables.
Through the generally accepted accounting principles (GAAP), the Internal Revenue Service requires the accrual basis of accounting because this method spreads out the up-to-date revenue and receivables, therefore showing the company’s profitability most accurately and transparently. This method is the current practice in corporate bookkeeping.
Compared with cash basis, the accrual method records the sales and expenses at the time they occur. The timing of the actual payments is important when recording transactions, on top of the amount. This also captures the company’s exact profitability, since all revenues are recorded as soon as they’re earned, even if the cash has not landed in the company’s bank account yet.
Here’s a diagram comparing cash vs. accrual accounting:
Recording of Financial Reports
Financial reports need to be prepared so accountants can make informed decisions. Three basic financial reports serve as the lifeline of the business: the balance sheet, the profit and loss statement, and the cash flow statement – all of which will give decision-makers a timely picture of the business’ financial ins and outs.
1. Balance sheet
A balance sheet summarizes the business’ assets, liabilities, and equity at any period. It gives a clear picture of the business’ financial health.
The basic accounting equation for determining whether the books are “balanced” is:
Assets = liabilities + equity
This formula balances what the business owns (assets) against what it owes (liabilities and equity).
Here’s an example. A new business has a balance sheet that looks like this:
0 = 0 + 0 (no assets = no liabilities + no equity)
The business then borrows $20,000. In doing this, it receives a cash asset but also gains a liability (debt). In other words, the company has that $20,000 of cash to use as it pleases, but it also owes $20,000 because the money was borrowed. Since its liability ($20,000) is equivalent to its assets ($20,000), the company’s equity is zero.
Here’s the formula for this specific instance:
$20,000 = $20,000 + 0
By keeping a timely record of the balance sheet, business owners can easily decipher if the company is no longer able to keep up with its dues, such as overhead costs. It will also show how the company’s value grows over time.
2. Profit & loss statement
The profit and loss statement – also known as the income statement, earnings statement, or operating statements – provides a summary of the company’s revenues and all the costs incurred within a given period. It tells whether the product or service price is too low or if the business is spending too much on the packaging.
The income statement tells whether the business is profitable or not. It elaborates which products are generating more sales or which operational costs are no longer necessary.
In the profit and loss statement, three accounts usually appear: revenue, cost, and expenses. Revenue always comes first because it’s the business’s gross profit or total sales. The standard equation for profit and loss is basically:
Net profit or Net loss = Revenues – costs – expenses
Should the company decide to use the cash basis accounting method, bookkeepers only need to include the business’s actual sales. Otherwise, the sale should not be included. On the other hand, users of the accrual accounting method should indicate all accounts payable and receivable.
3. Cash flow statement
At every end of the accounting period, say, quarterly or annually, cash flow statements should be created. This statement tells business owners where their money went, where it came from, and if the business is still keeping afloat period after period.
Cash flows are usually generated using accounting or bookkeeping software, but they can also be done manually. When creating a cash flow statement in the traditional way, bookkeepers should cover the same period as when reporting the profit and loss.
This statement begins with the ending cash balance from the previous period. Then, three sections need to be tracked: operating, investing, and financing activities.
- Operating activities – covers day-to-day transactions, i.e., revenues and expenses.
- Investing activities – all long-term assets, such as bonds or stocks. This also includes fixed assets and property refurbishments.
- Financing activities – records the movement in equity contributions.
It’s essential to monitor the company’s cash flow statement because it will tell whether the business is making enough money to support its operations.
If the business is doing well enough to pay off its operating activities, it is most likely to survive. If the company’s source of funds is coming from selling assets or bringing in the owner’s personal funds, the company might not live long.
Bookkeeping ensures the business’ long-term success
Whether you hire an in-house accountant or bookkeeping professional, or appoint an outside firm to do the job, it’s essential to keep accurate bookkeeping records so you can prevent financial errors. Remember that miscalculations can take a toll on the business’ financial health, and even lead to closure if not managed well. No degree is needed to be a bookkeeper, but using bookkeeping and accounting software will make the job easier and more accurate.