Before we jump into the basics, we think it’s important to define what bookkeeping is and what bookkeepers do. While bookkeeping and accounting are similar, bookkeeping actually lays the basis for the accounting process. Bookkeeping is the process of recording and organizing a business’s financial transactions, and a bookkeeper records transactions, sends invoices, makes payments, manages accounts, and prepares financial statements. From the cash you have on hand to the debts you owe, understanding the state of your business’s finances means you can make better decisions and plan for the future.
Now that we have our topic defined, let’s get into the basic steps to managing your small-business’s bookkeeping.
1. Set up and manage accounts
A key difference between business bookkeeping and personal budgeting is in the handling of accounts.
But what is an account, exactly? A bookkeeping account doesn’t refer to an individual bank account. Rather, an account records all financial transactions of a certain type—for example, sales or payroll.
Each account falls under one of five types:
- Assets: Cash and resources owned by the business (e.g., accounts receivable, inventory)
- Liabilities: Obligations and debts owed by the business (e.g., accounts payable, loans)
- Revenues or income: Money earned by the business, usually through sales of products or services (e.g., sales, interest income)
- Expenses or expenditures: Cash that flows out from the business to pay for some item or service (e.g., salary, utilities)
- Equity: Value remaining after liabilities are subtracted from assets and that represents the owner’s held interest in the business (e.g., stock, retained earnings)
Bookkeeping begins with setting up each necessary account so you can record transactions in the appropriate categories. You likely won’t have exactly the same accounts as the business next door, but some accounts are more common than others. The table below shows some frequently used small-business accounts and their types.
How to set up bookkeeping accounts
Knowing the accounts you need to track for your business is one thing; setting them up is another. Traditionally, charts of accounts were recorded in a physical book called the general ledger, or just ledger.
Today, most businesses use computer software to record accounts, but the file is still referred to as the ledger. Here are three methods for creating a general ledger:
- Spreadsheet software (e.g., Excel)
- Desktop accounting software (e.g., QuickBooks Desktop)
- Cloud-based software (e.g., Xero)
Or you can pay a company to manage your accounts and ledger for you. These companies are typically called outsourced accounting service providers or virtual accounting service providers because they do your bookkeeping on your behalf.
Step 2: Record every financial transaction
You’ve created your set of financial accounts—now it’s time to record what’s actually happening with your money.
Most bookkeeping is done using the double-entry accounting system, which is sort of like Newton’s Third Law of Motion, but for finances. Newton’s law states, “for every action (in nature), there is an equal and opposite reaction.”
Likewise, in double-entry accounting, any transaction in one account requires an equal and opposite entry in another account. It isn’t physics, but for managing a business, it’s just as important.
You can technically use a single-entry system for small-business bookkeeping, but we don’t recommend it unless you run a small business with minimal financial activity. Single-entry bookkeeping is simpler and faster than dual-entry, although it provides only a limited picture of your business’s finances. This makes it challenging to produce important financial documents, such as balance sheets.
In the double-entry bookkeeping system, you’ll record two entries for each transaction: a debit (Dr) and a credit (Cr). Debits and credits are recorded as journal entries in the ledger. The debit is usually recorded first (on the left), followed by the credit (on the right).
A debit doesn’t necessarily mean cash is flowing out; likewise, a credit isn’t necessarily money you’ve earned. The type of account defines whether a transaction either debits or credits that account.
It’s crucial that each debit and credit transaction be recorded correctly and in the right account. Otherwise, your account balances won’t match, and you won’t be able to close your books.
To record a transaction, first determine the accounts that will be debited and credited. For example, imagine you’ve just purchased a new point-of-sale system for your retail business. You paid for the $2,000 system in cash.
The transaction will affect two accounts: cash (an asset account) and equipment (also an asset account). Because you’re decreasing your cash and increasing your equipment, you would record a $2,000 debit (on the left) in for the equipment account and a $2,000 credit for the cash account (on the right).
Note that journal entries don’t include specific details about the item, vendor, or biller; you just track debits and credits by account.
Step 3: Balance and close the books
The last step in basic bookkeeping is to balance and close the books. When you tally up account debits and credits—often at the end of the quarter or year—the totals should match. This means your books are “balanced.”
You have been recording journal entries to accounts as debits and credits. At the end of the period, you’ll “post” these entries to the accounts themselves in the general ledger and adjust the account balances accordingly.
For example, if over the course of the month your cash account had $3,000 in debits (increases) and $5,000 in credits (decreases), you would adjust the cash account balance by a total of $2,000 (as a decrease).
Follow this method to adjust the balances for each account in your ledger. At the end of this process, you’ll have what’s called an “adjusted trial balance.” When you combine account types, the adjusted balances should meet the accounting equation:
Assets = Liabilities + Equity
If the two sides of the equation don’t match, you’ll need to go back through the ledger and journal entries to find errors. Post corrected entries in the journal and ledger, then follow the process again until the accounts are balanced. Then you’re ready to close the books and prepare financial reports.
Step 4: Prepare financial statements
Creating financial reports is a crucial task of bookkeepers and the bookkeeping process. Summarizing the flows of money in each account creates a picture of the financial health of the company that business owners use to make decisions about the future.
Here are some common financial reports created in bookkeeping:
- Balance sheet: This document summarizes your business’s assets, liabilities, and equity at a single period of time. Your total assets should equal the sum of all liabilities and equity accounts. The balance sheet provides a look at the current health of your business and whether it has the ability to expand or needs to reserve cash.
- Profit and loss (P&L) statement: This report is also called the income statement. It breaks down business revenues, costs, and expenses over a period of time (e.g., quarter). The P&L helps you compare your sales and expenses and make forecasts.
- Cash flow statement: This statement is similar to the P&L, but it doesn’t include any non-cash items such as depreciation. Cash flow statements show where your business is earning and spending money and its immediate viability and ability to pay its bills.
Bookkeeping software helps you prepare these financial reports—many in real-time. This can be a lifeline for small-business owners who need to make quick financial decisions based on the immediate health of their business. Read below for more details about getting help with your bookkeeping by using accounting software.
By now, you’ve probably realized that bookkeeping can become a complicated process, which means mistakes are bound to happen. But learning ahead of time how you can make the process easier and avoid common bookkeeping mistakes can set you up for success.
- Stick to a schedule: Our primary bookkeeping advice? Create and stick to a regular schedule. At least once a week, record all financial transactions, including incoming invoices, bill payments, sales, and purchases. And make it a priority to close your books at least every quarter.
- Track every receipt and transaction: It’s a major mistake not to record every transaction—even for minor purchases. Even one missed receipt can throw off your balances and keep you from being able to balance your books. Make it a habit to record everything.
- Don’t be wishy-washy with your accounts: As your business grows, the number of accounts you track will grow too, which can get complicated. It may be tempting to record the inflow or outflow of money in the same accounts each time, but improper categorization can lead you to mismeasure your finances.
- Store records properly and securely: Proper record keeping for small businesses makes the process easier and keeps you compliant with the law. You never want to waste time chasing down last month’s missing invoice, and you certainly don’t want to find yourself in trouble with legal requirements. Visit SBA.gov to find out more about how small businesses can stay legally compliant.
- Don’t go it alone: Unless you’re specially trained in accounting principles, bookkeeping can be a challenging task. So consider getting help—whether by hiring a bookkeeper, outsourcing to an accounting service, or using accounting software.
Hiring a bookkeeper
If you need help with your small-business bookkeeping, you should hire an accountant or bookkeeper, right? Well, although there are plenty of highly trained, professional bookkeepers, the cost to hire one is too high for many small businesses. While it may be too expensive to bring a bookkeeper on payroll, there are other great ways to outsource your bookkeeping. Companies like Phoenix Management offer affordable bookkeeping and quick service. In addition you can browse for virtual accountants as there are many services online. Depending on your business, make sure to research the best options for you.
Whether you take on your small-business bookkeeping yourself or get help from an expert, understanding the basics will help you better manage your finances. You’ll save time chasing receipts, protect yourself from costly errors, and gain valuable insights into your business’s potential. Getting a handle of your bookkeeping as early as possible in your business’s
inception will insure that you don’t run into financial or legal issues and your business succeeds.