If you recently started a small business or are looking to improve your business’s financial management, the next step is developing a comprehensive bookkeeping system.

That can seem like a daunting prospect, especially if you don’t have the knowledge or experience to record financial transactions and translate them into usable records and reports, but with a good understanding of the basics, it doesn’t have to be.

Let’s take a closer look at what every Canadian small business owner needs to know about bookkeeping to ensure sustainable business growth.

What is Bookkeeping?

Bookkeeping is a process that involves the systematic recording of financial transactions that occur between your business and other parties on a day-to-day basis. Even though bookkeeping occurs within the spectrum of business accounting, there are several differences between these two processes.

In essence, bookkeeping involves identifying, measuring, and recording all financial transactions, while accounting involves interpreting and analyzing financial data to make critical business decisions.

The bookkeeping process also doesn’t include drawing up financial reports, such as an income statement or balance sheet. The preparation of financial reports is one of the steps in the accounting cycle. However, in some cases, experienced bookkeepers may generate financial reports as part of their activities.

The most common bookkeeping tasks include:

• Making deposits
• Issuing invoices
• Paying accounts
• Recording journal entries for all payments and receipts
• Filing a source document for every journal entry
• Posting the journal entries to the general ledger
• Drawing up trial balances and cash flow statements
• Carrying out bank reconciliations
• Compiling payroll records
• Filing tax returns

Bookkeeping may involve the making of profit or loss projections. However, when it comes to long-term analyses, you need the services of a qualified accountant.

The Importance of Bookkeeping

Thorough and accurate bookkeeping is critical to the survival of any business, including yours.

Accurate Financial Data Tracking

Keeping an accurate record of incoming and outgoing funds is critical to ensure that you base your financial decisions on valid information. A comprehensive record-keeping system becomes crucial with the introduction of asset management, investments, loans, and taxes.

Maintaining a Healthy Cash Flow

With proper financial recording and reporting, you have all the information you need to keep track of your business’s revenue streams and ensure that you have cash available to cover all expenses.

Thorough Financial Data Reporting

Accurate and up-to-date bookkeeping will enable you to report critical financial data to your business’s stakeholders, including employees, trade associations, customers, and suppliers. Robust bookkeeping programs that translate your financial data into visual elements, such as graphs and charts, will also make it easier to demonstrate your business’s growth potential, attract investors, and gain funding.

Evaluate Your Business Performance

Incorporating sound bookkeeping into your accounting cycle allows you to gauge your business’s performance better. You’ll also be able to determine the profitability of individual operations and pinpoint inefficiencies, such as high shipping or group benefit costs.

By gaining insights into your business’s current performance, you can evaluate your growth strategies and plan successfully to ensure profit generation and sustainable business growth.

Building a Chart of Accounts for Your Small Business

A chart of accounts is a framework for organizing all your business’s financial data and keeping it ready for when you draw up financial statements. In other words, your chart of accounts is an index you use to identify transactions as you post them to your general ledger. Setting your business’s chart of accounts should also be the first step in developing your business’s bookkeeping system.

The accounts on your chart depend on your business activities. For example, an online service business typically doesn’t have a shipping or inventory account. However, you should include accounts that your business doesn’t have now but may add in the future, such as salaries and wages.

Ideally, your chart of accounts should have a numbering system with a code for each account category. Account categories include:

• Assets
• Liabilities
• Positive owner’s equity (income)
• Negative owner’s equity (expenses)

Below, we take an in-depth look at each of these categories.

Assets

An asset is any tangible or intangible property that a business owns, such as buildings, stock, vehicles, a patent, or a license. A business can have two types of assets:

• Current assets: Items of value you expect to turn into cash within a year, such as cash in your business bank accounts, accounts receivable, and inventory
• Fixed assets: Tangible property for long-term business use, for example, equipment, buildings, land, vehicles, and software

Your bookkeeping system should account for depreciation, which is the gradual reduction in the value of a fixed asset over time. Even though the accumulated depreciation account represents a business loss, it is a method for allocating the cost of an asset over its functional lifespan.

Depreciation is a contra asset account, not an expense, and you should include it under the asset category. Accumulated depreciation also appears on the balance sheet as a gross fixed asset reduction.

Liabilities

A liability is a debt obligation or legal responsibility. Examples of ordinary liabilities include vehicle loans, mortgages, accounts payable, income taxes payable, and salaries or wages payable. Like assets, liabilities fall under two categories:

• Current liabilities: Financial obligations your business must repay within a year, for example, accounts payable and credit lines
• Long-term liabilities: Loans or other forms of debt with a repayment period of more than a year, for example, a mortgage or bond

Note the difference between an expense and a current liability. For example, wages are an expense account. However, wages payable is a current liability account as it represents the accrued income your employees earned but haven’t received.

Another example: a mortgage is a fixed liability, the interest on the mortgage is an expense, and interest payable on a short-term loan is a current liability.

Owner’s Equity

Owner’s equity is the portion of a business’s total asset value that owners can claim. You can calculate your business’s owner’s equity by deducting the total liability value from the total asset value. This calculation is the accounting equation (Equity = Assets – Liabilities).

Let’s look at a practical example of how owner’s equity works. In the event of liquidation, you will use the total asset value to pay off all existing liabilities. You, as the business owner, will then own the remaining assets. In simplest terms, your owner’s equity is your business’s net assets.

The owner’s equity accounts of sole proprietors and partnerships include:

• Capital (an account representing the owner’s initial investments)
• Withdrawals (transfers to the business owner for private purposes)
• Sales revenue

Partnership equity accounts include:

• Member’s capital
• Owner’s distributions
• Sales Revenue

As a business grows and attracts investors, its owner’s equity becomes more complex, with accounts such as:

• Common stock
• Treasury stock
• Paid-in capital
• Dividends
• Retained earnings

However, as a small business owner, the only accounts you need to add under owner’s equity include capital and withdrawals. Subcategories under equity include income and expenses.

Income

The income your business realizes includes sales revenue from day-to-day operations and rent, dividends, and interest from business investments. Accounts that typically fall under this category include:

• Sales revenue, the main income your business generates from the sale or provision of a product or service
• Sales discounts or early payment discounts your business grants to customers
• Sales returns and allowances representing merchandise returns or original selling price deductions
• Accounts for other forms of income, including rent, interest, or dividends
• Supplier discounts

When you add income accounts to your chart of accounts, note that sales discounts, sales allowances, and sales returns are not expense accounts. Instead, these accounts are contra-revenue accounts. That’s why they fall under the income category.

Contra-revenue accounts are gross revenue deductions due to customer behaviour, resulting in net revenue, and they appear near the top of the income statement, below the cost of goods sold.

Expenses

The Canadian Revenue Agency (CRA) defines business expenses as the costs your business incurs while conducting operations to generate profits. For example, meals and entertainment can be a business expense if you took a potential client out to dinner. Similarly, a portion of your personal vehicle’s expenses is a tax-deductible business expense if you sometimes use it for business reasons.

To determine which expense accounts apply to your business, consider the CRA list of operating expenses. Examples of everyday expenses small business owners incur include:

• Costs of goods sold (COGS) is the direct cost to produce the products or services your business sold
• Professional accounting and legal fees for advice, services, and consulting
• Advertising and marketing expenses
• Trade or commercial membership fees, annual license fees, and business taxes
• Routine commercial insurance premiums on real estate, equipment, tools, and machinery
• Interest on business loans and bank charges
• Labour and material costs to repair or maintain all business property
• Office expenses for consumable items such as stationery, stamps, and paper
• Salaries, wages, and employer’s contributions, including TFSA and health insurance contributions
• Business start-up costs
• Motor vehicle expenses, including fuel, toll fees, and routine maintenance costs
• Business or office rental costs

Cost of goods sold, or cost of sales, is a business expense referring to the cost of producing or purchasing the goods that your business sold. However, you record COGS under the income or sales category on the income statement.

Develop an expense account for each of the above expenses that apply to your business.

Single-Entry vs. Double-Entry Bookkeeping

After developing your business’s chart of accounts, the next step is to decide whether you will implement the single-entry or double-entry bookkeeping system.

Single-Entry Bookkeeping

With single-entry bookkeeping, you record transactions once in a cash book as an expense or an income. In other words, single-entry bookkeeping aims to record cash coming in and cash going out. Each transaction entry will typically also include details such as the transaction description, value, and date.

With single-entry bookkeeping, there are three transaction types:

• Cash transactions
• Taxable income
• Tax-deductible expenses

Single-entry bookkeeping is straightforward and doesn’t require complex accounting software. Service-based businesses often use this bookkeeping system as they don’t have to record inventory transactions, which require more robust bookkeeping solutions.

Double-Entry Bookkeeping

With double-entry bookkeeping, you enter two entries per transaction: a debit entry and a credit entry.

The double-entry method takes place on the basis of accrual accounting using the five account categories: income, expenses, assets, liabilities, and owner’s equity. Single-entry accounting only uses income and expenses.

When recording a transaction, how do you know which accounts to debit and credit?

In essence, a debit represents money flowing into an account, while a credit represents money flowing out of the account.

• When an asset account or expense account increases, you debit the account.
• When an income account, liability account, or owner’s equity account increases, you credit the account.

Let’s look at practical examples of double-entry bookkeeping and the effects of transactions in owner’s equity:

Kelly owns a business selling second-hand books. Her business bank account has a balance of $5,000, and her inventory is worth $500. When Kelly started the business on 1/1/2020, she took out a business loan of $1,000.

In the above example, Kelley’s equity in her business = total assets ($5,000 + $500) – total liabilities ($1,000) = $4,500.

Recording an Asset Purchase

On 03/01/2020, Kelly bought more inventory at $400. Let’s see how she would record this transaction using the double-entry method:

She pays for the inventory from her business bank account, which is a current asset. In this case, she credits her cash account with $400. She needs to debit her inventory account $400, as this is the corresponding value increase, and inventory is a current asset.

Now, Kelly’s owner’s equity in her business = total assets ($4,600 + $900) – total liabilities ($1,000) = $4,500. As you can see, Kelly’s equity remains the same.

Recording an Expense

On 04/01/2020, Kelly appoints a shop assistant for a month and pays her $500. In this case, there is an expense increase and an asset decrease. When recording the transaction at the end of April using the double-entry system, Kelly needs to debit an expense account (wages) by $500 and credit an asset account (cash) by $500.

What is the effect of this transaction on Kelly’s equity in her business?

Equity = total assets ($5,500 – $500) – total liabilities ($1,000) = $4,000. In this case, the expense of $500 reduces Kelly’s equity in her business by $500.

Recording a Current Liability

What happens if Kelly doesn’t pay her shop assistant’s wage by the end of April?

In this case, there is no payment from the business’s cash reserve, but there is an increase in Kelly’s total liabilities. Kelly would credit the liability account (wages payable) when recording the event at the end of the month. However, according to the accrual method, the expense pertains to April, and Kelly has to debit wages, an expense account.

If Kelly doesn’t pay the wage at the end of the month, her equity = total assets ($5,500) – total liabilities ($1,000 + $500) = $4,000. The increase in liability of $500 reduces Kelly’s equity in her business by $500.

Recording Cost of Goods Sold

To explain the double entry for the cost of goods sold, let’s look at how Kelly treats a single transaction.

On the 5th of May, Kelly sells a book with a $10 cost of sale for $50 to a customer.

1. The transaction reduces her inventory account by a value of $10 and increases the expense cost of goods sold by $10. Note that the expense cost of goods sold only applies when Kelly sells the book.
2. The transaction increases her sales revenue account and her bank account by $50 each.

Which accounts does she debit, and which ones does she credit?

Inventory is an asset, and its value decreases, which means that Kelly should credit her inventory account with $10.

The cost of goods sold account is an expense account, and its balance increases, which means Kelly would debit the cost of goods sold account with $10.

The sale revenue is an income account, and its balance increases, which means Kelly credits it with $50.

The cash account is a current asset that increases with the sale, which means Kelly needs to debit the account with $50.

The effect of the sale on Kelly’s equity in her business = total assets ($5,500 + $50 – $10) – total liabilities ($1,000 + $500) = $4,040. Note the $40 increase in Kelly’s equity. This $40 is her profit, which equals sales revenue minus the cost of goods sold expense.

The Difference Between the Cash and Accrual Accounting

The difference between the cash and accrual accounting methods is significant in bookkeeping and involves the timing of recording income and expenses in your accounts.

Cash-based accounting only recognizes a transaction when there is an exchange of cash. You only report revenue in your income statement if your business received the cash in your bank account. Similarly, you only record expenses if the cash leaves your bank account.

The cash method is straightforward, as it doesn’t take the time you delivered the service, sent the invoice, or signed the contract into account. Small business owners often select this accounting method to ensure they stay on top of their cash flow management. Cash-based accounting is also acceptable for tax purposes, provided that your business remains below the prescribed revenue threshold.

With accrual accounting, you record the transaction when it takes place and not when there is a cash exchange. In other words, with this method, you report revenue when your business earns it, and you report expenses when your business incurs it.

For example, if you sell goods to a customer on credit in July and your customer pays the account in September, you will report the income in July.

Many business owners prefer the accrual system, as it clarifies the relationship between revenue and expenses, providing you with insights into your business’s profitability.

The Bookkeeping Process

Once you’ve developed your chart of accounts, decided on an entry system, and selected an accounting system that fits your business’s financial situation, you can start implementing the bookkeeping process.

The bookkeeping cycle consists of the following steps:

• Identifying and recording transactions in a journal
• Posting the transaction to the relevant accounts in the general ledger
• Calculating the trial balance at the end of the accounting period
• Creating a worksheet to ensure the equal entries of debits and credits
• Making necessary adjustments through journal entries

Depending on your business’s financial situation, the bookkeeping process may also include drawing up financial statements, such as the income statement, balance sheet, statement of changes in equity, and cash flow statement.

Take the Stress Out of Tax Season

One of the most significant benefits of a responsive bookkeeping system is that it makes tax compliance more manageable. When the time comes to report your business’s income and expenses to the CRA, you don’t have to pull all-nighters to find source documents or go through six months’ bank statements.

A complete bookkeeping system will also ensure that you don’t miss tax-deductible expenses, which means you minimize your tax obligation.

Bookkeeping Methods

Suppose you have a service-based business and use a single-entry bookkeeping system with the cash-based method. In that case, you can record your business transactions manually using a simple Excel spreadsheet. Some businesses still use pen-and-paper journals and ledgers to record their transactions.

However, cloud accounting software will provide you with a more comprehensive and flexible bookkeeping solution for inventory, payroll, and expense tracking. Using accounting software is also best if you use the accrual method.

Financial programs automate various processes to save you time, and you can customize your process to fit your business’s unique financial situation and transaction recording needs.

Reduce Your Overhead with GroupEnroll

While there are more advanced aspects of financial management, we hope we’ve provided you with a better understanding of bookkeeping basics for small business owners in Canada. At GroupEnroll, we always aim to help business owners find the optimal solutions to grow their businesses.

We can also help you find the best group insurance coverage for your employees at the best possible price to reduce your overhead. To learn more, send us an email at [email protected], or complete our quick quote form. We’re located at 10 Great Gulf Drive, Unit 5, Vaughan, ON, L4K 0K7.