One of the things that I enjoy doing as a CPA is helping business owners understand their books and bookkeeping. I’m going to begin posting a series of bookkeeping tips that past clients have found helpful. If you have a question about something, let me know. You are probably not the only person with the question, and after I help you, I may be able to add another tip.
If you have a business, you keep books. I know that some business owners run everything just using a checkbook and a notepad. Other business owners use spreadsheets. Still other business owners use some form of accounting software. How you manage your business is up to you. The important thing is that whatever approach you use, it allows you to keep track of what is happening in your business. Your record keeping system should help you figure out where your money comes from and where it is going. Since this article is about accounting, we’ll use the terms revenue and expense.
Before getting too far into this topic, it is probably a good idea to cover two simple concepts. The first is the accounting equation. It is easy to remember, and if you are a business owner, you know it already even if you don’t know what it is called.
Assets = Liabilities + Equity
Most businesses start when the owner invests money and property that he or she already has or borrows money. Then as the business begins operations it starts having revenues and expenses.
Assets = Liabilities + Equity + Revenues – Expenses
One of the secrets of accounting is that everything ties back to the accounting equation.
The second concept is the accounting cycle. Accountants like to organize things by creating arbitrary cycles. In business, these cycles are typically quarters and years. You may find it helpful to use some other period such as a week or a month. The accounting cycle is simply the steps that are used to organize and report financial activity within a business. The first step in the accounting cycle is to analyze and categorize a transaction. All that means is figuring out how to classify a financial activity. Was it a purchase? Was it a sale? Did the business borrow money? Depending on the complexity of your record keeping system, there could easily be eight, nine, or more steps. For our purposes, we’ll keep it simple. Adjusting entrees and closing temporary accounts are beyond the scope of this discussion.
- Analyze and record transactions
- Assign the entrees to accounts
- Prepare financial statements
You probably have a few questions. The most common question is, “What is an account?” The easiest answer is that an account is a category for transactions of similar types. For example, accounts might include sales or expense, and they would group transactions by whether goods were sold to a customer in exchange for payment or were purchased from a vendor. Accounts also categorize “things” such as assets like inventory or supplies, or debt. Businesses try to have accounts that represent all major types of business activities. The accounts themselves are organized by type: Asset, Liability, Expense, Revenue, and Equity. The types should be familiar now that you know about the accounting equation. The listing of accounts by type is called the chart of accounts.
Now that you know about the accounting equation and the accounting cycle, and you have been introduced to the chart of accounts, it is time for the first two tips.
- Your chart of accounts should look like your business.
- Simple is better.
What does it mean to say that the chart of accounts should look like your business? It simply means that you should have accounts that match the types of transactions that you are likely to have. For example, all businesses need revenue and expense accounts. If you are a simple service business, you might only need your cash accounts, a service revenue account, and miscellaneous expense accounts. If you purchase goods for resale, then you need a purchases account and an inventory account as well. If you manufacture products, then you may need raw materials, work-in-process, and finished goods inventory accounts. If you are required to collect and remit sales taxes, then you may need a sales tax payable account. If your business has employees, then you will need accounts for payroll and payroll taxes.
This is not as confusing as it seems. When you start planning your bookkeeping or accounting system, first think about your business processes. Then build your system around what you actually do.
The second tip is that simple is better. Avoid the temptation to have lots of accounts. Many business owners start out with too many accounts. This is easy to do if you confuse products with accounts. In my business, I work with individuals, small businesses, and not-for-profits. The products I provide are accounting services, consulting, and tax preparation. It might be tempting to have an account for each type of product and each type of customer. That is nine sales accounts! If I were a very large accounting firm with lots of employees and thousands of customers, I might find it useful to be able to analyze my sales activity that way. As a small business, however, I do not need to do that. Having nine sales accounts would make my books more complex and not provide any useful information. Business owners also tend to make their expense accounts too complex. Consider office supplies. Most business owners have a single office supplies account. However, other business owners have separate accounts for paper, file folders, pens and pencils, and more. It’s possible that those business owners need that detail. It is more likely that they don’t. Whenever you add an account there is a tradeoff between making your books more complex and the benefit you receive from the extra account. Keep in mind that it is possible to have too few accounts. I once had a client that had three loans: a loan from a family member, a bank loan, and money that he loaned the business. The business owner lumped all three loans into a single loan account. To further complicate matters, payments were simply recorded as loan payments without regard to the principal and interest component.
Remember when you are setting up and managing your books, they are a tool for you. The only reason to do anything is that you want to be able to see what is going on within your business. Your books help you track what you purchase and sell. They help you see your sources and uses of cash, and they help you keep track of the investments you make in the business.
Whether you are just starting out and creating a set of books or you are reorganizing your books, remember:
- Your books should look like your business.
- Simple is better.