Keeping the Books: Basic Recordkeeping and Accounting for Small Business

Preface

Thank you for choosing Keeping the Books to use as your guide for learning about recordkeeping and small business accounting. I think you will be pleased with this new eBook edition.

It has been the goal of each edition of this book to give you a clear, concise, and easy-to-understand process to follow as you set up your bookkeeping and work with it throughout the life of your business. I have been working with business owners for many years and most of them have the same problem—they are experts in their industries, but are novices when it comes to working with financials. In fact, many times, the prospect of keeping financial information is so formidable that some business owners avoid it until tax time when they have to come up with the information for the IRS.

Keeping the Books should provide you with a clear, concise, and easy-to-understand process for setting up, understanding, and attending to recordkeeping and accounting. If I have been successful, you should be able to follow that process, customize it for your business, and set up a system that will greatly benefit your company.

Who is this book for?

I frequently get asked who Keeping the Books is appropriate for. It is for all business owners who need to better familiarize themselves with the recordkeeping and accounting processes and their relationship to tax accounting - even those who hire in-house bookkeepers and accountants and/or outside accounting professionals. Keeping the Books is not meant to take the place of accounting software, but should be utilized as a reference guide that will help you to better understand and utilize general records and financial statements.

The purpose of accounting is not just to provide the IRS with information at tax time. Its main benefit is to boost your company’s profitability through periodic financial statement analysis. If you do not understand how to read and utilize profit & loss statements and balance sheets, you are forfeiting one of the most valuable tools at your disposal.

Thank you again for choosing Keeping the Books to help you accomplish your financial goals. I appreciate your confidence that it will help you and wish you success in the operation of your businesses.

Linda Pinson

CHAPTER

1

Recordkeeping Basics

The keeping of accurate records is imperative if you are going to succeed at business. From time to time, I have had students in my small business classes who have wonderful ideas for products or services, but who do not want to be bothered with the details of recordkeeping/accounting. Their businesses are already doomed to failure. This book was written with the assumption that you are starting from scratch and know nothing about small business accounting. I have tried to solve the puzzle for you. By the time you have finished applying the principles in the book, I hope that you will understand how all of the pieces fit together to develop a simple, but accurate recordkeeping and accounting system.

Functions of Recordkeeping

The first, and most important, function is to provide you with information that will help you to see the trends that are taking place within your operation. You will see, as you study this book, that a complete and simple set of accounting records will make it possible to tell at a glance what is happening with your business - which areas are productive and cost-effective and which will require the implementation of changes. The second function of accounting records is to provide you with income tax information that can be easily retrieved and verified.

Who Should Do Your Bookkeeping?

You, the business owner, should be personally involved rather than simply delegating this job to an outsider. Keeping your own books and important records in house will make you doubly aware of what is going on in your business and it will also save you money that can be used to benefit your business in other areas. For example, you may now be able to afford a piece of effective advertising that will generate more sales. Even if time will not allow you to personally do your own bookkeeping and you assign the task to someone else, it will be a major benefit to you to make every attempt to understand how your records are organized and to learn how to read and use them to make decisions in your business.

Do You Need an Accountant?

Absolutely! I do not advocate the elimination of an accounting professional. In fact, end-of-the-year tax accounting requires special expertise and will best be handled by an accountant who can maximize your tax benefits. You will have to decide whether to use a Certified Public Accountant (CPA), Enrolled Agent (tax accountant), or non-certified bookkeeper/tax preparer. The first two are empowered to represent you at an IRS audit.

All accounting professionals are dependent on the financial information that you provide. To ensure the most profitable results for your business, you will need to set up and maintain general records as the source of financial data. You should also work with the accountant to establish a good line of communication and a smooth flow of that data.

Depending on the size and scope of your business, you will have to decide which of the accounting chores you can handle and which ones should be delegated to an expert. For instance, you may be able to do all of your accounting except for payroll, which is very exacting and will probably be more effectively handled by your accountant. You may also decide that you would like to use an accountant at the end of the month to generate your financial statements. In fact, if the scope of your business becomes very large, it may become necessary to turn over your entire accounting operation to an expert. If so, it will still be imperative that you understand the process, so you will be able to use your financial information to make sound business decisions.

Accounting Software

One of the most frequently asked questions is about which accounting software application is the best and easiest to use. There are many accounting software programs on the market today that will adequately take care of your needs. However, if you do not understand accounting basics, you will not know how to input the proper information in order to effectively utilize the software for your business. In the start-up stage of your business, you may best be served by beginning with a few spreadsheets that emulate a manual system. You can always transfer the information into your accounting application when the time is right. At that time, if you are working with an accountant, it will probably be best to use the accounting software application that he or she suggests and one that will easily interface with what is currently being used in that office. Coordinating with your tax accountant may even enable you to work together via Internet transmissions.

Every Business Is Unique

The system you use should be tailored to the needs of your business. Obviously a service-oriented business will not use the same accounts as a retail operation. Because no two businesses will have exactly the same concerns, it is imperative that you set up the right records and accounts. You will have to consider any information that will be used by your particular venture and set up your records according to those needs.

When Does Recordkeeping Begin?

Your business commences as soon as you begin to refine your idea. You do not have to wait until you have a license and are open for business to start with your recordkeeping. In fact, you will do yourself a great disservice if you are not keeping track of financial information at this very moment. Many of your initial expenses are deductible if you have begun to actively pursue your business. A good way to begin is as follows:

• Deductible Expenses

The first thing you should do is familiarize yourself with the expenses that are commonly deductible for a business. When you are doing things that relate to your business begin to think of the costs involved and record them for future use. (See: Chapter 2, Income and Expenses.)

• Diary

Buy yourself a hardbound journal at your local stationers - or start a journal on your computer. Keep a diary of your thoughts and actions related to your new business. If you use a hardbound journal, number the pages, write in pen, and initial any corrections you make. Your journal will serve to protect your idea as well as provide you with a record of your contacts and the information you gather for the future. You can also list any expenses incurred and file away your receipts. Be sure to date all entries.

• Beginning Journal

I like to utilize the last few pages of the journal to keep a record of income and expenses during the planning stages of a business. It need not be complicated. You can set it up like the sample Beginning Journal provided on page 4. On your computer, you can set up a simple spreadsheet of the same type.

Simplicity is the Key

Simplicity is the key to small business accounting. Your records must be complete, but not so complicated that they cannot be read and interpreted.

It will be the function of this book to introduce you to the terminology and forms necessary to set up an accounting system for your business. My goal is for you to clearly understand how a good accounting system works to provide you with the information you need to satisfy tax requirements, examine trends, make decisions, and implement changes that will make your business venture more profitable and rewarding.

Remember: All expenses relating to your new business endeavor should be recorded. A few examples are as follows:

Conference, seminar and workshop fees

Mileage to and from business pursuits

Meals related to business (see tax rulings)

Books, tapes, videos, etc. purchased for business

Office supplies (notebooks, journals, pens, etc.)

Telephone calls relating to business

Professional organizations (dues, fees, etc.)

Materials used for developing your product

Tools or equipment purchased for your business

There are many other business expenses, including those mentioned under the pages on Common Deductible Expenses. A good rule of thumb is that when a purchase or activity seems to have any possible bearing on your business, journalize it, keep receipts, look up tax rulings, and then utilize the information accordingly.

CHAPTER

2

Income and Expenses

Accounting for small businesses is based on one premise. Every transaction that takes place involves: 1. money that is earned by the business, 2. money paid out by the business for ordinary and necessary costs, 3. money infused into the business, or 4. money taken out of the business. Earnings and monies paid for ordinary and necessary costs fall under one of two classifications - income or expenses. Before you set up your accounting system, you need to understand some basic facts about the two terms.

Income

Ordinary business income is money earned by your business in any given period of time. It is made up of monies derived from retail and wholesale sales of products, sales of services, interest income, and any miscellaneous income. Money infused by the business owners as a loan or capital contribution is not earned business income and needs to be deposited separately.

All income must be deposited. Do not mix income with money paid out. Under no circumstance do you use part of the money received as income to purchase goods or services (or spend otherwise) and subsequently deposit the remainder.

Expenses

Ordinary and necessary business expenses are the costs of carrying on a trade or business, and they are usually deductible if the business is operated to make a profit. They include expenses paid by check, cash, or credit card. It should be noted that credit card transactions are recorded as expenses when they are charged, not when the bill is paid. All require careful recording.

Expenses fall into distinct categories:

Cost of Goods Sold (Inventory)

The cost of the merchandise (inventory) sold during an accounting period. Cost of goods sold = beginning inventory + purchases - ending inventory.

Includes material and labor or the purchase price of manufactured goods.

Variable (Selling) Expenses

Those expenses directly related to the selling of your product or service.

Includes marketing costs, production salaries, shipping, research and development, packaging, sales commissions, non office salaries, vehicle expenses, travel expenses, vehicle expense and depreciation, machinery and equipment repairs and maintenance and depreciation, and various other product or service overhead.

Fixed (Administrative) Expenses

These are costs not directly related to your production or rendering of services. They are the type of expenses that all businesses have in common.

These expenses include normal office overhead such as accounting and legal, bank charges, office salaries, payroll expenses, rents, licenses, office equipment and depreciation, office supplies, telephone, utilities, insurance, etc. Administrative expenses are those that generally remain constant if your business suddenly ceases production or services for a period of time.

Other Expenses

Interest Expense

Includes monies paid out for interest on purchases, loans, etc.

Note: Some categories of expense may be divided into both selling (variable) and administrative (fixed). Examples are:

• Utilities. Those used for production as differentiated from utilities consumed in the office, heating, restrooms, etc.

• Telephone. Telemarketing and advertising are selling expenses. Monthly charges and office telephone charges are administrative expenses.

• Freight and Postage. Shipping of your product is a selling expense. Postage used as office overhead is an administrative expense.

The categories into which certain expenses should be placed can be confusing. The important thing to remember is that all expenses must be recorded somewhere. If you erroneously record a selling expense as an administrative expense, it will not carry any serious consequence. However, if you can properly classify expense information, you will have a good basis for analyzing