What Is Bookkeeping? A Small-Business Owner’s Guide
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One of the first challenges new business owners face is managing their business’s bookkeeping. Not only is solid bookkeeping required to file your tax returns each year, but it is also necessary to have the financial information you need to make sound business decisions.
Even with this inherent knowledge about the importance of bookkeeping, many business owners are still confused. What, exactly, is bookkeeping? What is the difference between bookkeeping and accounting? What goes into bookkeeping, and what should you expect from your bookkeeper?
Bookkeeping is broadly defined as the recording of financial transactions for a business. It is part of a business’s overall accounting process. Bookkeeping can be done as frequently as daily or as infrequently as once per year.
Modern bookkeeping was formally established in the late 15th century when Italian mathematician and Franciscan monk Luca Pacioli described double-entry bookkeeping in his book, Review of Arithmetic, Geometry, Ratio and Proportion.
That’s right: “Modern” bookkeeping is over 500 years old. And while the basics of accounting haven’t changed in over 500 years, the practice of bookkeeping has. Bookkeeping was once done manually using actual books called journals and ledgers. Because bookkeeping is based on double-entry accounting, transactions had to be recorded in two separate places (the journal and the ledger). The books then had to be balanced each month — known as a trial balance — before financial statements could be prepared.
In other words, bookkeeping for a business was a full-time job.
The advent of computerized accounting software significantly lessened the tediousness of bookkeeping. Technologies like optical character recognition (OCR) and bank feeds have come just short of fully automating the traditional bookkeeping process. Data entry can now happen as soon as you snap a photo of a receipt with your smartphone. And reconciliations happen almost in real-time through daily bank feed maintenance, making the end-of-month closing process a snap. Now one bookkeeper can manage the bookkeeping for several businesses in fewer than eight hours a day.
Accounting vs. bookkeeping
Many people use the terms bookkeeping and accounting interchangeably. Even though many bookkeepers today do fulfill some traditional accounting roles — like consulting clients on their finances — there is a difference between bookkeeping and accounting.
Bookkeeping is largely concerned with recordkeeping and data management. Bookkeepers make sure the information in the books is accurate and that the books are reconciled each month. In essence, they complete the first step in the accounting process.
Accountants, on the other hand, use the information provided by bookkeepers to summarize a business’s financial position and render financial advice to the business owner. Many accountants also prepare tax returns, independent audits and certified financial statements for lenders, potential buyers and investors.
Accountants typically have at least a bachelor’s degree in accounting, and many go on to become Certified Public Accountants (CPAs) or Certified Management Accountants (CMAs.) Bookkeepers might also have degrees in accounting, but most have either technical certifications or on-the-job experience.
Bookkeeping has its own language, and bookkeepers and accountants sometimes forget business owners might not be fluent in it. The following are some common accounting terms you will encounter when doing bookkeeping or working with a bookkeeper or accountant. This is by no means a comprehensive glossary, but a quick primer:
The accounting equation: The accounting equation is the key formula that keeps your books in balance. That equation is Assets = Liabilities + Equity. You can see the accounting equation in action in your business’s balance sheet.
Assets: What your business owns. Assets include cash, buildings, vehicles, patents and open invoices due from customers (accounts receivable), just to name a few.
Liabilities: What your business owes. Liabilities include credit card balances, amounts due to vendors (accounts payable), loan balances and tax liabilities that have not yet been paid.
Equity: What is owed to the owner or shareholders of the business. Equity includes money paid in by the owner (contributions), money the owner has earned but not taken from the business (retained earnings) and other types of contributions like stock issued.
General ledger: The general ledger is made up of assets, liabilities, equity, income and expenses. These five types of accounts comprise the books for your business.
Chart of accounts: The listing of categories you use to classify your business’s transactions. Think of the chart of accounts as a sort of filing system for your business’s transactions.
Debits and credits: Each bookkeeping transaction has two sides (remember, it’s called double-entry accounting). One side of the transaction is the debit side, and the other side is the credit side. Assets and expenses are increased by debits and reduced by credits. Income, equity and liabilities are increased by credits and reduced by debits.
Accrual basis and cash basis: Accrual basis accounting recognizes income and expenses when they are incurred. Cash basis accounting recognizes income when payment is received and expenses when payment is made. Our accrual vs. cash basis accounting guide can provide more detail.
Reconciliation: The process of verifying the balance of certain accounts (checking, credit cards, loans, etc.) against statements from an outside source, usually a bank.
Income: Money your business earns through sales.
Expenses: Money your business spends on operations and overhead.
Cost of goods: Money your business spends to produce income.
Profit: What your business has earned after cost of goods and expenses are subtracted from income. Profit is not the same as cash on hand.
Common bookkeeping tasks
Bookkeeping means different things to different people. Some bookkeepers focus solely on “write up” work, which basically consists of compiling the books quickly, usually for tax preparation purposes. Other bookkeepers provide “full charge” services and can even serve as a financial controller for your company.
Full charge bookkeeping tasks can be broken down into four broad categories.
1. Data entry
Data entry involves entering your business’s transactions into your bookkeeping system. As mentioned above, a lot of the data entry now happens automatically, either through OCR or bank feeds.
There is more to data entry than just putting the numbers into your software, though. Proper data entry includes:
Source document verification: This is the step that usually gets skipped when doing your bookkeeping solely from bank feeds. Ideally, you want to make sure your data entry comes not from the bank feed, but from source documents like receipts or bills. This ensures that only valid business transactions are being entered into your books. Today’s bookkeeping software allows you to snap a photo of or scan in your source documents, and then OCR technology will extract the pertinent information and do much of the data entry for you. This means you can maintain source document verification while still taking advantage of the time-saving technology of your accounting software.
Accurate classification of transactions: Each entry into your bookkeeping system impacts at least two accounts in your business’s chart of accounts. Proper data entry — or data management if you rely on automation for your data entry — ensures that transactions are being posted to the correct accounts. Accurate classification of transactions enables you to produce financial management reports which can be used to make strategic business decisions.
Accurate identification of transactions: One of the downfalls of some bookkeeping software is that the artificial intelligence behind the software can make mistakes a human wouldn’t make while entering the data. The most common of these mistakes is assigning the wrong payee name to a transaction. You must make sure your transactions are being identified correctly. This is especially important for payments you make to vendors who will need a 1099 Form at the end of the tax year.
2. Office management
Often, office management tasks like customer billing, paying vendors and payroll are considered to be bookkeeping tasks. Although accounts receivable, accounts payable and payroll do impact your books, some of these tasks can be managed by a person in your company other than your bookkeeper. Others — like payroll — can be outsourced to independent companies that specialize in the task.
If your bookkeeper bills your customers or pays your vendors and employees, make sure you have proper checks and balances in place to mitigate the possibility of fraud.
3. End of period closing
Your books should be closed at the end of each accounting period. End of period closing includes:
Reconciling all bank, credit card and loan accounts.
Reconciling accounts payable and accounts receivable.
Making any adjusting journal entries for prepaid revenue or expenses, depreciation or other unusual transactions.
Reviewing the financial statements for accuracy and completeness.
Locking the books so the books cannot be changed after the end of period closing has been completed (optional, but highly recommended).
4. Internal management reports
Only an accountant licensed to do so can prepare certified financial statements for lenders, buyers and investors. However, your bookkeeper can prepare internal management reports for your business.
There are three common internal management reports your bookkeeper can prepare for your business:
Your balance sheet is a snapshot of what your assets, liabilities and equity as of a certain date. It is the accounting equation Assets = Liabilities + Equity in action for your business.
Your income statement (also known as a profit and loss statement or P&L) details your business’s income and expenses for a period of time (a month, quarter, year, etc.). It shows whether your business has earned a profit or experienced a loss.
Your cash flow statement reconciles the income statement to the balance sheet and answers the question, “Where did the cash go?” for accrual basis businesses.
The balance sheet and income statement can be prepared on either a cash basis or an accrual basis (the cash flow statement is always an accrual basis report). Although accrual basis statements are more accurate, many business owners find cash basis reports easier to understand.
Your bookkeeper might also prepare other auxiliary reports for your business, like accounts receivable and accounts payable aging reports. You can use these unaudited financial statements and auxiliary reports to make business decisions based on the information in your bookkeeping system, but they should not be presented as audited, certified or official financial statements.
It’s important to note that not all lenders and investors require certified or audited financial statements. However, it’s still a good idea to ask an accountant to review your bookkeeper’s financial statements for accuracy and completeness prior to submitting them to a third party for consideration. And even if you’re not looking for funding, consider asking an accountant to review your financial statements at least once a year.
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A version of this article was first published on Fundera, a subsidiary of NerdWallet.