Siri: Define ‘bookkeeping’
Bookkeeping is the process of tracking all of your company’s financial transactions, usually by entering them into accounting software or a physical set of “books.” It lets you see exactly where your business is spending money, where your revenue is coming from, and which tax deductions you’ll be able to claim.
Why bookkeeping matters
We’ll start with our five favorite reasons.
1. You need it to do your taxes
You need to know your net profit in order to do your taxes, and to figure that out, you need to know your total income and expenses. And the only way to know that for sure is to have accurate, up-to-date books.
2. It tells you where your money is going
Getting your books together and producing financial statements is the only way to gauge the financial health of your small business.
Are sales up? Are your shipping costs too high? Will you have enough money next month to cover payroll? Is cash flow increasing or decreasing? The only way to know for sure is to start bookkeeping.
3. It ensures that you don’t miss out on tax deductions
Keeping an accurate, up-to-date set of books is the best way to keep track of tax deductions (expenses that you can deduct from your taxable income).
The more information (and supporting documents) you can give your CPA at tax time, the more deductions you’ll be able to legitimately claim, and the bigger your tax return will be.
The IRS also has pretty stringent recordkeeping requirements for any deductions you claim, so having your books in order can remove a huge layer of stress if you ever get audited.
4. You need it to borrow money
If you need to borrow money from someone other than friends and family, you’ll need to have your books together. Doing so lets you produce financial statements, which are often a prerequisite for getting a business loan, a line of credit from a bank, or seed investment.
Lenders and investors want a clear idea of your business’ financial state before giving you money. They can’t do that without looking into things like revenue, cash flow, assets and liabilities, which they’ll search for on your balance sheet, income statement and statement of cash flows.
5. It helps you catch errors quickly
If you wait until the end of the year to reconcile or get your financial transactions in order, you won’t know if you or your bank made a mistake until you’re buried in paperwork at tax time. Regularly organizing and updating your books can help you catch that erroneous overdraft fee today, rather than six months from now, when it’s too late to bring up.
The first seven steps of a bookkeeping process
We’re making it sound easier than it is. When you’re stuck in the minutiae of reconciling your transactions, this won’t feel like “seven easy steps”.
But for the sake of explaining the basics of bookkeeping, here are the first seven steps you’ll need to walk through to get your bookkeeping machine humming.
Step 1: Separate your business and personal expenses
The first step to mastering your business finances is pretty simple: get a business bank account and separate your business and personal expenses.
Why? Liability is one big reason. If you’re running a corporation or an LLC and there isn’t sufficient distance between your personal and business finances, there’s a chance that you could be held personally liable for any debts incurred by your business.
Mixing together personal and business expenses in the same account can also result in unnecessary stress when you need to file taxes or do your bookkeeping. It could mean a business expense gets lost in your personal account and you miss out on an important deduction. Or it could mean your CPA spends more time doing your taxes. Either way, you end up losing money.
Step 2: Choose a bookkeeping system
There are two main bookkeeping methods: single-entry and double-entry bookkeeping.
Under single-entry, journal entries are recorded once, as either an expense or income. Assets and liabilities (like inventory, equipment and loans) are tracked separately. If you’re just starting out, are doing your books on your own and are still in the hobby stage, single-entry is probably right for you. It’s simple, fast and good for really basic bookkeeping.
Double-entry is more complex, but also more robust, and more suitable for established businesses that are past the hobby stage.
Under double-entry bookkeeping, all transactions are entered into a journal, and then each item is entered into the general ledger twice, as both a debit and a credit.
Most accounting software today is based on double-entry accounting, and if you ever hire a bookkeeper or accountant to help you with your books, double-entry is what they’ll use.
Further reading: A Relatively Painless Guide to Double-Entry Accounting
Step 3: Choose an accounting method: Cash or Accrual
You have another important decision to make when setting up your bookkeeping: whether to make your accounting process cash or accrual based.
Under cash accounting, you record transactions only once money has exchanged hands. If you bill a customer today, those dollars don’t enter your ledger until the money hits your bank account.
Many small businesses opt for the cash basis of accounting because it’s easy to maintain, doesn’t require you to track receivables or payables, and tells you exactly how much cash you have on hand at any given point in time.
Using the accrual accounting method, you record income when you bill your customers, in the form of accounts receivable (even if they don’t pay you for a few months). Same goes for expenses, which you record when you’re billed in the form of accounts payable.
Generally speaking, accrual accounting is better for larger, more established businesses. It gives you a more realistic idea of your business’ income and expenses during a period of time and provides a long-term view of the business that cash accounting can’t provide.
Step 4: Choose the right tools
Every transaction you make needs to be categorized when it’s entered in your books. This helps your bookkeeper catch more deductions, and will make your life easier if you get audited.
Six months later, an unmarked receipt for lunch at a restaurant might not mean much to you. Was it a client lunch? Did you treat your employees after a successful quarter?
The way you categorize transactions will depend on your business and industry. Generally speaking, your transactions fall into five account types—assets, liabilities, equity, revenue, and expenses. Individual line items are then broken down into subcategories called accounts. In our ice cream shop example, some accounts in your ledger might be “revenue-ice cream sales”, “expenses-ice cream ingredients”, etc.
These days, you’ve got three options when it comes to bookkeeping tools.
You could go with one of dozens of popular cloud accounting solutions, like QuickBooks, Xero or Wave. These tools can be powerful if you know what you’re doing. However, if you don’t have a lot of bookkeeping experience (or don’t have time to learn), they could stress you out more than they help you. Especially if your accountant ends up telling you you’ve been using them incorrectly for the past year.
Your could also do everything via spreadsheet, using tools like our free Excel Income Statement Template
Finally, if you want someone else to do your bookkeeping for you, you could sign up for a cloud-based bookkeeping service like Bench. We’ll do your bookkeeping for you, prepare monthly financial statements, give you expense reports with actionable financial insights, and we’ll even file your taxes for you when the time comes. It’s a one-stop shop.
Step 5: Make sure your transactions are categorized
Every transaction you make needs to be categorized and entered into your books. This helps your bookkeeper catch more deductions, and will make your life easier if you get audited.
Remember: an unmarked receipt for lunch at a restaurant might not mean much to you six months later. Was it a client lunch? Did you treat your employees after a successful quarter? Properly categorizing and recording your transactions can help you avoid doing all of this extra investigative work later.
If you’re going to be doing your own bookkeeping, it’s worth talking to a pro when you set up your system to make sure the accounts you create align with your industry standards and CPA expectations.
Further reading: How to Categorize Business Transactions
Step 6: Choose a system for storing your documents
At tax time, the burden is on you to show the validity of all of your expenses, so keeping supporting documents for your financial data like receipts and records is crucial.
Diamonds may be forever, but the ink on your expense receipts is not. Since the IRS accepts digital records, it’s smart to use a cloud-based system like Dropbox, Evernote, or Google Drive so you never have to deal with smudged receipts. You can also use apps like Shoeboxed, which are specifically made for receipt tracking.
If Bench does your bookkeeping, you can also upload and store as many digital receipts and documents as you'd like in the Bench app.
Step 7: Organize your deductions
The IRS’ golden rule on deductions is that they must be both ordinary (a common expense in your field) and necessary to your business. For example, pens would be an ordinary expense for a writer, but a $900 pen might not fall into the category of “necessary.”
But even if an expense is ordinary and necessary, you may still not be able to deduct all of it on your taxes. Just because you do most of your work from your dining room table doesn’t mean that you can deduct your entire monthly rent. Luckily, the IRS has put together a comprehensive guide on business deductions that you can consult if you’re ever unsure about a deduction.
Further reading: The Big List of Small Business Tax Deductions
Step 8: Make bookkeeping a habit
If you’re a busy small business owner with a million things to do, it’s easy to let bookkeeping fall by the wayside. One way to avoid that is to make it a habit.
Try setting aside and scheduling a ‘bookkeeping day’ once a month to stay on top of your financials. Use that day to enter any missing transactions, reconcile bank statements, review your financial statements from the last month and make any major changes to your accounting or bookkeeping.
If you’re months or years behind, you might want to get a bookkeeper to do some catch-up bookkeeping for you (Bench can help with that).
DIY vs. professional bookkeeping
Most small businesses will either do their books themselves or outsource the work to a professional. Here how to choose which method is best for you.
The DIY approach
If your business is a side project with a limited budget, you can probably get by going the DIY route. You might still consider consulting with a CPA or bookkeeper at the beginning, just to make sure you’re doing everything right. But most businesses in the hobbyist stage can get by using either a simple spreadsheet (like our free Income Statement Template) or one of the many accounting or bookkeeping software solutions on the market.
Outsourcing to a professional
If bookkeeping keeps getting pushed aside as your business starts growing and you simply can’t find the time to get your books in order every month, you should consider hiring a professional to help you.
Our bookkeepers here at Bench can do your books for you entirely online. We’ll also give you easy-to-use software to produce financial statements, keep track of your daily expenses, and help make tax time a breeze.
