You can’t keep books unless you know how you want to go about doing so. The two basic accounting methods you have to choose from are cash-basis accounting and accrual accounting. The key difference between these two accounting methods is the point at which you record sales and purchases in your books. If you choose cash-basis accounting, you only record transactions when cash changes hands. If you use accrual accounting, you record a transaction when it’s completed, even if cash doesn’t change hands.
For example, suppose your company buys products to sell from a vendor but doesn’t actually pay for those products for 30 days. If you’re using cash-basis accounting, you don’t record the purchase until you actually lay out the cash to the vendor. If you’re using accrual accounting, you record the purchase when you receive the products, and you also record the future debt in an account called Accounts Payable.
Every business has three key financial parts that must be kept in balance: assets, liabilities, and equity. Assets include everything the company owns, such as cash, inventory, buildings, equipment, and vehicles. Liabilities include everything the company owes to others, such as vendor bills, credit card balances, and bank loans. Equity includes the claims owners have on the assets based on their portion of ownership in the company.
The formula for keeping your books in balance involves these three elements:
Assets = Liabilities + Equity
Much of bookkeeping involves keeping your books in balance.
To keep the books, you need to revise your thinking about two common financial terms: debits and credits. Most nonbookkeepers and nonaccountants think of debits as subtractions from their bank accounts. The opposite is true with credits – people usually see these as additions to their accounts, in most cases in the form of refunds or corrections in favor of the account holders.
Well, forget all you thought you knew about debits and credits. Debits and credits are totally different animals in the world of bookkeeping. Because keeping the books involves a method called double-entry bookkeeping, you have to make at least two entries – a debit and a credit – into your bookkeeping system for every transaction. Whether that debit or credit adds or subtracts from an account depends solely upon the type of account.
Don’t worry. All this debit, credit, and double-entry stuff may sound confusing, but it will become much clearer as you work through this chapter.
You can’t just enter transactions in the books willy-nilly. You need to know where exactly those transactions fit into the larger bookkeeping system. That’s where your Chart of Accounts comes in; it’s essentially a list of all the accounts your business has and what types of transactions go into each one. Book I Chapter 2 talks more about the Chart of Accounts.
Recognizing the Importance of an Accurate Paper Trail
Keeping the books is all about creating an accurate paper trail. You want to track all of your company’s financial transactions so if a question comes up at a later date, you can turn to the books to figure out what went wrong.
All your business’s financial transactions are summarized in the General Ledger, and journals keep track of the tiniest details of each transaction. You can make your information gathering more effective by using a computerized accounting system, which gives you access to your financial information in many different formats. Controlling who enters this financial information into your books and who can access it afterwards is smart business and involves critical planning on your part.
The granddaddy of your bookkeeping system is the General Ledger. In this ledger, you keep a summary of all your accounts and the financial activities that took place involving those accounts throughout the year.
You draw upon the General Ledger’s account summaries to develop your financial reports on a monthly, quarterly, or annual basis. You can also use these account summaries to develop internal reports that help you make key business decisions. Book I Chapter 3 talks more about developing and maintaining the General Ledger.
Small companies conduct hundreds, if not thousands, of transactions each year. If every transaction were kept in the General Ledger, that record would become unwieldy and difficult to use. Instead, most companies keep a series of journals that detail activity in their most active accounts.
For example, almost every company has a Cash Receipts Journal in which to keep the detail for all incoming cash and a Cash Disbursements Journal in which to keep the detail for all outgoing cash. Other journals can detail sales, purchases, customer accounts, vendor accounts, and any other key accounts that see significant activity.
You decide which accounts you want to create journals for based on your business operation and your need for information about key financial transactions. Book I Chapter 4 talks more about journals and the accounts commonly journalized.
Every business owner needs to be concerned with keeping tight controls on company cash and how it’s used. One way to institute this control is by placing internal restrictions on who has access to enter information into your books and who has access necessary to use that information.
You also need to carefully control who has the ability to accept cash receipts and who has the ability to disburse your business’s cash. Separating duties appropriately helps you protect your business’s assets from error, theft, and fraud. Book I Chapter 5 covers controlling your cash and protecting your financial records.
Most companies today use computerized accounting systems to keep their books. You should consider using one of these systems rather than trying to keep your books on paper. You’ll find your bookkeeping takes less time and is probably more accurate with a computerized system.
Using Bookkeeping’s Tools to Manage Daily Finances
After you set up your business’s books and put in place your internal controls, you’re ready to use the systems you established to manage the day-to-day operations of your business. You’ll quickly see how a well-designed bookkeeping system can make your job of managing your business’s finances much easier.
If your company keeps inventory on hand or in warehouses, tracking the costs of the products you plan to sell is critical for managing your profit potential. If you see inventory costs trending upward, you may need to adjust your own prices in order to maintain your profit margin. You certainly don’t want to wait until the end of the year to find out how much your inventory cost you.
You also must keep careful watch on how much inventory you have on hand and how much was sold. Inventory can get damaged, discarded, or stolen, meaning that your physical inventory counts may differ from the counts you have in your books. Do a physical count