What Are The Basics Of Bookkeeping?
Bookkeeping is the process of recording all financial transactions made by a business. Bookkeepers are responsible for recording, classifying, and organising every financial transaction that is made through the course of business operations. Bookkeeping differs from accounting. The accounting process uses the books kept by the bookkeeper to prepare the end of the year accounting statements and accounts.
Very small businesses may choose a simple bookkeeping system that records each financial transaction in much the same manner as a chequebook. Businesses that have more complex financial transactions usually choose to use the double-entry accounting process.
Millions of small business owners and startup entrepreneurs are masters at creating great products and services, building effective teams and winning over customers. Many of them, however, would probably flunk basic bookkeeping.
As the business owner, if you don’t understand the different types of “accounts” your bookkeeper uses to organise your finances, measuring the success (or failure) of your efforts will be futile.
Being adept at digital marketing, for example, isn’t enough if you don’t have a clear financial picture of your business and run headlong into cash flow problems.
You wouldn’t go to the doctor and ask only to have your legs checked. You want a comprehensive exam! It’s the same with the financial aspects of your business. You need to know everything about your business’s finances, not just your bank account balance. As small- business writer Joshua Adamson-Pickett explains, it not only helps you make solid decisions now and plans for your company down the road, and efficient bookkeeping system saves time. Notably, it prepares you for government audits and helps prevent fraud.
What is bookkeeping?
Simply put, bookkeeping is the recording of a business’s financial transactions. Any transaction with financial implications needs to be recorded by a bookkeeper. Sounds fairly simple.
However, for the novice, the introduction of bookkeeping-specific vocabulary and the rules that govern proper bookkeeping processes can be overwhelming.
Bookkeeping is the process of keeping track of every financial transaction made by a business firm from the opening of the firm to the closing of the firm. Depending on the type of accounting system used by the business, each financial transaction is recorded based on supporting documentation. That documentation may be a receipt, an invoice, a purchase order, or some similar type of financial record showing that the transaction took place.
The bookkeeping transactions can be recorded by hand in a journal or using a spreadsheet program like Microsoft Excel. Most businesses now use specialised bookkeeping computer programs to keep books that show their financial transactions. Bookkeepers can use either single-entry or double-entry bookkeeping to record financial transactions. Bookkeepers have to understand the firm’s chart of accounts and how to use debits and credits to balance the books.
Methods of bookkeeping
Before you begin bookkeeping, your business must decide what method you are going to follow. When choosing, consider the volume of daily transactions your business has and the amount of revenue you earn. If you are a small business, a complex bookkeeping method designed for enterprises may cause unnecessary complications. Conversely, less robust methods of bookkeeping will not suffice for large corporations.
With this in mind, let’s break these methods down so you can find the right one for your business.
Single-entry bookkeeping is a straightforward method where one entry is made for each transaction in your books. These transactions are usually maintained in a cash book to track incoming revenue and outgoing expenses. You do not need formal accounting training for the single-entry system. The single-entry method will suit small private companies and sole proprietorships that do not buy or sell on credit, own little to no physical assets and hold small amounts of inventory.
Double-entry bookkeeping is more robust. It follows the principle that every transaction affects at least two accounts, and they are recorded as debits and credits. For example, if you make a sale for $10, your cash account will be debited for $10, and the same amount will credit your sales account. In the double-entry system, the total credits must always equal the total debits. When this happens, your books are “balanced.”
Using the double-entry method for bookkeeping makes more sense if your business is large, public, or buys and sells on credit. Enterprises often choose the double-entry system because it leaves less room for error. In a way, it ‘double-checks’ your books because each transaction is recorded as two matching but offsetting accounts.
Cash-based or accrual-based
The next step is choosing between a cash or accrual basis for your bookkeeping. This decision will depend on when your business recognises its revenue and expenses.
In cash-based, you recognise revenue when you receive cash into your business. Expenses are recognised when they are paid for. In other words, any time cash enters or exits your accounts, they are recognised in the books. This means that purchases or sales made on credit will not go into your books until the cash exchanges.
In the accrual method, revenue is recognised when it is earned. Similarly, expenses are recorded when they are incurred, usually along with corresponding revenues. The actual cash does not have to enter or exit for the transaction to be recorded. You can mark your sales and purchases made on credit right away.
Both a cash and accrual basis can work with single- or double-entry bookkeeping. In general, however, the single-entry method is the foundation for cash-based bookkeeping. Transactions are recorded as single entries which are either cash coming in or going out. The accrual basis works better with the double-entry system.
How to record entries in bookkeeping
Generating financial statements like balance sheets, income statements, and cash flow statements help you understand where your business stands and gauge its performance. For these reports to portray your business accurately, you must have properly documented records of your transactions. Keeping these records as current as possible is also helpful when reconciling your accounts.
Recording transactions begins with source documents like purchase and sales orders, bills, invoices, and cash register tapes. Once you gather these documents, you can record the transactions using journals, ledgers, and the trial balance. If you are a very small company, you may only need a cash register. The information can then be consolidated and turned into financial statements.
A cash register is an electronic machine that is used to calculate and register transactions. Usually, cash registers are used to record cash flow in stores. The cashier collects the cash for sale and returns a balanced amount to the customer. Both the collected cash and balance returned are recorded in the register as single-entry cash accounts. Cash registers also store transaction receipts, so you can easily record them in your sales journal.
Cash registers are commonly found in businesses of all sizes. However, they aren’t usually the primary method of recording transactions because they use the single-entry, cash-based system of bookkeeping. This makes them convenient for very small businesses but too simplistic for enterprises.
The journal is called the book of original entry. It is the place where a business chronologically records its transactions for the first time. A journal can be either physical (in the form of a book or diary), or digital (stored as spreadsheets, or data in accounting software). It specifies the date of each transaction, the accounts credited or debited, and the amount involved. While the journal is not usually checked for balance at the end of the fiscal year, each journal entry affects the ledger. As we’ll learn, it is imperative that the ledger is balanced, so keeping an accurate journal is a good habit to keep. This form is useful for double-entry bookkeeping.
A ledger is a book or a compilation of accounts. It is also called the book of the second entry. After you enter transactions in a journal, they are classified into separate accounts and then transferred into the ledger. These records are transcribed by accounts in the order: assets, liabilities, equity, income, and expenses. Like the journal, the ledger can also be physical or electronic spreadsheets.
A ledger contains a chart of accounts, which is a list of all the names and number of accounts in the ledger. The chart usually occurs in the same order of accounts as the transcribed records.
Unlike the journal, ledgers are investigated by auditors, so they must always be balanced at the end of the fiscal year. If the total debits are more than the total credits, it’s called a debit balance. If the total credits outweigh the total debits, there is a credit balance. The ledger is important in double-entry bookkeeping where each transaction changes at least two sub-ledger accounts.
The trial balance is produced from the compiled and summarised ledger entries. The trial balance is like a test to see if your books are balanced. It lists the accounts exactly in the following order: assets, liabilities, equity, income, and expenses with the ending account balance.
An accountant usually generates the trial balance to see where your business stands and how well your books are balanced. This can then be cross-checked against ledgers and journals. Imbalances between debits and credits are easy to spot on the trial balance. It is not always error-free, though. Any miscalculated or wrongly-transcribed journal entry in the ledger can cause an incorrect trial balance. It is best to look out for errors early, and correct them on the ledger instead of waiting for the trial balance at the end of the fiscal year.
The next, and probably the most important, step in bookkeeping is to generate financial statements. These statements are prepared by consolidating information from the entries you have recorded on a day-to-day basis. They provide insight into your company’s performance over time, revealing the areas you need to improve on. The three major financial reports that every business must know and understand are the cash flow statement, balance sheet, and income statement.
The cash flow statement
The cash flow statement is exactly what its name suggests. It is a financial report that tracks incoming and outgoing cash in your business. It allows you (and investors) to understand how well your company handles debt and expenses. By summarising this data, you can see if you are making enough cash to run a sustainable, profitable business.
The balance sheet
The balance sheet reports a business’ assets, liabilities, and shareholder’s equity at a given point in time. In simple words, it tells you what your business owns, owes, and the amount invested by shareholders. However, the balance sheet is only a snapshot of a business’ financial position for a particular date. It must be compared with balance sheets of other periods as well. The balance sheet allows you to understand the liquidity and financial structure of your business through analytics like current ratio, asset turnover ratio, inventory turnover ratio, and debt-to-equity ratio.
The income statement
The income statement also called the profit and loss statement, focus on the revenue gained and expenses incurred by a business over time. There are two parts in a typical income statement. The upper half lists operating income while the lower half lists expenditures. The statement tracks these over a period, such as the last quarter of the fiscal year. It shows how the net revenue of your business is converted into net earnings which result in either profit or loss. The income statement does not focus on receipts or cash details.
Bank reconciliation is the process of finding congruence between the transactions in your bank account and the transactions in your bookkeeping records. Reconciling your bank accounts is an imperative step in bookkeeping because, after everything else is logged, it is the last step to finding discrepancies in your books. Bank reconciliation helps you ensure that there is nothing amiss when it comes to your money.
Easy But Vital Bookkeeping Practices You Should Follow
For any beginner, bookkeeping can seem overwhelming, but it doesn’t need to be. You’ll start on the right foot by following these easy yet vital bookkeeping practices.
- Please Don’t Leave it Last Minute: Keep dates and deadlines in mind while creating reminders, so you’re not doing the books the night before. Do it earlier to avoid mistakes and spend less time looking for crucial information.
- Keep Records Nice and Tidy: Cluttered records with endless bits of paper will make it a nightmare to do the books with valuable information all over the place. Keep them organised, so you know exactly what to look for without wasting time.
- Store Your Receipts: If you store receipts through software, it means you’ll finally get that paperless office you’ve wanted. Everything is in one place, and if there’s ever an investigation, all of the information related to expenses will be available within your software or app via attachments. So, you’ll always be compliant.
- Keep business, and Personal Finances Separate: To help you do the books much faster, think about keeping your business and personal finances separate. So, you won’t need to look through personal information for business-related finances and vice versa.
Useful Tips on Learning Bookkeeping at Home
To get started, you don’t need to search for the cheapest bookkeeper around, even if you’re a complete newbie. You work hard for your money so the last thing you want is giving a big chunk to the taxman and then another hefty slice to a bookkeeper for tasks you can do by yourself.
To get started, here are some useful tips on how you can learn bookkeeping at home:
- Get Familiar With Bookkeeping Terms and Phrases: Remember that glossary we told you to bookmark? Now is an excellent time to sit down, read and understand the terms and phrases. It’ll give you a better idea of what to expect and what things mean in bookkeeping.
- Do Your Research: Look for resources online through Google and find some helpful blogs that are regularly updated to keep you in the know.
- Take Advantage of Tutorials: To get to grips with bookkeeping, head over to HMRC for some extra help. Believe it or not, they do offer some free resources from webinars to tutorials and even workshops for you to attend.
- Use a Bookkeeping App: The best way to learn is to get hands-on in your own time and use a bookkeeping app that’s both easy to use and understand. No formal degrees, no qualifications. Just look for one that has useful features you’ll need and not packed full of ones you’ll probably never use.
All of these are a great place to start for any beginner. However, as simple as it might seem on paper, it’s important you recognise when the beast becomes too big. When this is the case, you should know to pick the right time to hand things over to a professional.
Now that you have plenty of helpful information to get started as a beginner, it’s probably the perfect time to make the process even simpler by using your very own checklist…
What Do You Need to Set Up Bookkeeping for Your Business?
One of the first decisions you have to make when setting up your bookkeeping system is whether or not to use a cash or accrual accounting system. If you are operating a small, one-person business from home or even a larger consulting practice from a one-person office, you might want to stick with cash accounting.
If you use cash accounting, you record your transaction when cash changes hands. Using accrual accounting, you record purchases or sales immediately, even if the cash doesn’t change hands until a later time, Sometimes firms start their business using cash accounting and switch to accrual accounting as they grow.
If you are going to offer your customers credit or if you are going to request credit from your suppliers, then you have to use an accrual accounting system.
You also have to decide, as a new business owner, if you are going to use single-entry or double-entry bookkeeping. Single-entry bookkeeping is much like keeping your check register. You record transactions as you pay bills and make deposits into your company account. It only works if your company is relatively small, with a low volume of transactions.
If your company is larger and more complex, you need to set up a double-entry bookkeeping system. Two entries, at least, are made for each transaction. At least one debit is made to one account, and at least one credit is made to another account. That is the key to double-entry accounting.
Companies also have to set up their computerised accounting systems when they set up bookkeeping for their businesses. Most companies use computer software to keep track of their accounting journal with their bookkeeping entries. Very small firms may use a basic spreadsheet, like Microsoft Excel. Larger businesses adopt more sophisticated software to keep track of their accounting journals.
Lastly, the business must set up its chart of accounts. The chart of accounts may change over time as the business grows and changes.