What is Bookkeeping?
Bookkeeping is a method of recording all the financial transactions of your business. At its most basic, it’s the process of keeping track of your income and expenses, but it can involve much more.
No matter what type of bookkeeping system you choose, every financial transaction has to have a corresponding document, such as an invoice, receipt, or purchase order, proving that the transaction took place.
Bookkeeping is an essential process for any business, no matter how big or small. Whether you’re an independent operator selling homemade products or a massive corporation, bookkeeping is the first step in the accounting process.
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Bookkeeping vs. Accounting
Most people tend to confuse bookkeeping and accounting, especially in a small business. Bookkeeping is a smaller part of the larger accounting process. Accountants will use the financial records to summarize, analyze, and interpret the business’s financial situation at the end of the year.
Keeping accurate records during the year makes accounting much easier. If every transaction is already classified and has the supporting documentation, compiling the end-of-year report doesn’t require extensive audits and extra work.
Examples of accounting financial statements include:
- Balance sheet
- Income statement
- Cash-flow statement
Many small businesses only produce these financial statements once a year, but frequent reporting can also help you evaluate your business growth and make adjustments as needed.
Why Bookkeeping is Vital for Your Business
It’s easy to forget to keep books when you run a small business. There are so many things competing for your attention. However, bookkeeping is an essential tool for small business owners and offers plenty of benefits to help your business grow.
Bookkeeping allows you to keep track of your revenue over time, giving you a broad idea of whether your business is profitable or not. Regular reporting can help you identify when your profitability lowers, allowing you to course-correct and improve profitability in the future.
There are many ways to track profitability, depending on your needs. Some can help measure efficiency, while others identify your profit margins. Some of the most commonly used profitability measures include:
- Profit margin
- Return on equity
- Gross margin ratio
- Return on capital employed
- Return on assets ratio
Knowing how effectively your business converts capital expenditures into revenue or whether you’ve got a good profit margin can help you identify weak spots in your business and address these, improving revenue and overall profitability.
Prepare for Tax Season
Instead of scrambling to find the relevant information, having a good set of books ensures that you’re ready for tax season. You can even calculate your taxes in advance, massively simplifying the tax filing process.
Accurate small business bookkeeping also has extra benefits for your tax profile. Accurate records mean that you correctly label every expense, allowing you to take advantage of all potential deductibles.
It’s your responsibility as a small business owner to provide accurate financial information about your business to your employees and potential investors. Most modern bookkeeping programs include numerous reporting tools, including graphs, charts, and many other visual aids to clearly outline your financial position.
These easy-to-understand charts are usually much more informative than traditional financial statements. They’re an excellent way to communicate your business financials to people who may otherwise struggle to make sense of complex financial reports.
Improved Financial Management
Accurate books ensure that you’re aware of your company’s revenue streams and expenditures. This information is essential for financial planning to avoid unnecessary expenses, especially if you’re not making enough to cover costs.
Bookkeeping and financial statements will help you deal with current financial problems and plan for the future.
Knowing your business’s current financial situation can be invaluable. Financial statements can show you who owes you money, who you owe money to, and other important operational information. Having this information on hand will assist you in prioritizing repayments and avoiding late payments while also giving you a clear picture of your cash flow. By making an informed decision, you’re more likely to help your business succeed and grow rather than relying on intuition and good luck.
Evaluate Business Performance
There’s a lot more to running an effective business than revenue and income. Accurate records and regular financial statements can help you decide whether you’re effectively using your resources and where you can adjust for improved performance.
Even better, you can evaluate your current performance over that of previous years. You can see whether you’ve improved in certain areas and which areas need more work.
Overall, bookkeeping and the financial records derived from those books can help you get a good sense of your business health. It’s easy to lose sight of the big picture, especially as you focus on day-to-day business activities. Regular reviews of your book can help you see the bigger picture.
What Financial Records Do You Need to Keep?
Keeping accurate financial records can help prevent problems in the future. Ideally, you want to keep a record of all business transactions. Examples of records include:
- Investment statements
- Tax returns
- Bank statements
- Credit card statements
How you store and organize your documents is another consideration. The traditional method consists of a filing cabinet and folders for each document type. You can also make digital copies and store them in the cloud. These digital copies have the added advantage of being more secure and more accessible from a range of devices.
According to Canadian law, you need to keep financial and tax records for six years. If you use an offline method, you can safely dispose of older documents using a licensed document shredding company.
We recommend using both digital and paper archives to store your documents. This practice adds an extra layer of security should something go wrong, either on the digital end or in the real world. Many small business owners find that using online organization systems keeps their records updated and organized.
Important Bookkeeping Considerations
One of the simplest ways to start bookkeeping is to set up a separate business account. Mixing personal and business finances often leads to confusion. Try to choose a business-friendly bank account by comparing various banks and their offerings.
Keeping your receipts, invoices, and other financial documents is only the first step of bookkeeping. Apart from several different accounting methods, you’ll also need to decide whether you want to work manually or with an automatic bookkeeping system.
The best way to decide on a bookkeeping system is to evaluate your business and how it operates. Do you have time to input every transaction into a spreadsheet manually? Are you primarily cash-based, or do you often receive delayed payments? Understanding how you operate will ensure that you choose a bookkeeping system that works for you.
Cash or Accrual
Your first consideration should be to choose a cash-based or accrual-based method of bookkeeping.
In the cash-based method, you record a transaction when money physically changes hands. In accrual-based bookkeeping, you record the transaction on the date you receive an invoice or charge for a service, whether money flowed in or out of your business.
The main benefit of the cash method is that it’s simpler to reconcile with your bank statement. Since you record the transaction when you move money around, you search for the same date on your bank statement to ensure accuracy.
However, the cash method also has some drawbacks. It can offer a misleading picture of your business. For instance, if you decide to pay a utility bill early or have a late payment, it can lead to a large expense one month and nothing the next month. This type of transaction would suggest that this expense isn’t regular, while in fact, it is.
The accrual method offers a much more accurate picture of your business. The only tricky part is that you have to search for transactions when reconciling your bank statement and books. However, if you’re planning to grow your business, it’s the preferred method of bookkeeping.
The good news is that you can transition between the cash and accrual methods as your business develops. No bookkeeping method is permanent, and while adjusting to a new method can be a challenge, it’s completely possible with an accountant at your side.
Manual or Online Bookkeeping
If you run a small business, you likely use a manual form of bookkeeping. In this method, you have to manually enter every transaction into the books, whether on pen and paper or online. It’s a very hands-on system but is susceptible to human error and can become incredibly time-consuming as your business grows.
Most small business owners have moved to online bookkeeping programs. These programs automate much of the bookkeeping process, especially if you link your business credit card or mobile payment app. The program will automatically track every transaction and will organize it accordingly.
Setting up accounting software can be intimidating for some. However, taking the time to set up your software properly is vital to ensure accuracy later on. If you automate everything correctly initially, you can relax and trust the data you get.
Once your business starts growing, you’ll find it impossible to keep up with manual bookkeeping. You could hire a dedicated bookkeeper or accountant, but it may be a better option to move to an automated, online system instead.
Single-Entry or Double-Entry Bookkeeping
Single-entry bookkeeping is the simpler form, where you record each transaction once. In double-entry bookkeeping, an entry gets recorded twice. While it may seem counterintuitive initially, double-entry bookkeeping is the gold standard, as it paints a more realistic picture of your business’s financial position.
For instance, if you sell a product, you’ll record it once as an income and a loss to your inventory. Entering it twice ensures accuracy. Double-entry bookkeeping is essential for larger companies that need to conform to accounting principles.
If you run a small side business, single-entry bookkeeping is probably sufficient. However, the moment your business becomes your sole source of income, or you decide to incorporate, you’ll need to switch to the double-entry method.
Last In, First Out/ First In, First Out
If you have inventory, you have the option of two accounting methods: Last In, First Out (LIFO), and First In, First Out (FIFO). These two methods aim to determine the current worth of your stock as accurately as possible.
In a LIFO system, you assume that your most recent products will sell first. For instance, in clothing stores, the most popular items are those that are currently trending. This method produces an accurate picture of your inventory’s value if the cost of buying or producing inventory changes between items. It ensures that you can gauge the overall health of your business at the current date.
An important thing to note about LIFO is that it can lower your net income during times of inflation as the cost of the latest inventory increases. Given this, both the Canada Revenue Agency and International Financial Reporting Standards don’t allow LIFO as the method for inventory valuation for tax purposes.
That doesn’t mean that you can’t use LIFO. If you work in a volatile industry, it’s an excellent way to determine costs versus income on a more recent reporting period, rather than relying on costs six months ago. Even if you don’t use LIFO on your external financial reporting, it’s a good option for internal reporting.
FIFO works similarly to LIFO, but it assumes that the oldest goods you bought are the ones you sell first. It’s the most accurate model for most retail businesses since it mimics the flow of products through most businesses.
While the CRA tends to assume that FIFO is more accurate, it can sometimes fail to reflect volatility. It tends to compare current revenues with older costs that can result in distorted profit margins.
The best situation for FIFO is when you have a rapid, constant inventory turnover that ensures that the costs incurred are recent enough to reflect current market conditions.
Important Accounting Terms
To properly understand the accounting process, you’ll need to know a few financial terms. These may seem intimidating at first, but the principles behind them are often relatively simple. Knowing these terms can help you communicate more effectively with your accountant, ensuring that you have a good idea of what’s going on in your business.
Generally Accepted Accounting Principles
Generally Accepted Accounting Principles, or GAAP, refers to a standardized set of accounting rules. They offer guidance on best practices to ensure accuracy in your financial records.
If you’re doing your bookkeeping yourself, look at various ways to adhere to GAAP standards. These standards outline how to standardize your chart of accounts, correctly classify your assets, choose the right bookkeeping system, and implement a three-way matching system to prevent double payments on invoices.
Adhering to GAAP does more than ensure compliance with the CRA. These practices ensure that your financials are accurate and that your work is on par with accounting professionals. If your business goes through an audit, complying with GAAP will speed up the process and help establish the reputability of your financial methods.
Your Accounts Receivables include all unpaid invoices. This ledger’s main function is in an accrual bookkeeping system, where you need to know how much money you’re due to receive, even if it hasn’t cleared in your bank account yet.
Not only does an Accounts Receivable ledger entry help identify future income, but it’s also a good way to track paying customers against those who still haven’t paid. It can also offer insight into your business. The accounts receivable turnover ratio will show how many times per year you collect on your receivables. The higher the ratio, the better.
Similarly, Accounts Payable is an expense account that tracks what you owe others. These creditors can be suppliers, rent, business insurance, and any other costs that you incur.
When you compare your Accounts Receivable versus Accounts Payable, you can estimate your net income and profit margin. A low ratio indicates a narrow profit margin, which indicates poor business health. Knowing this ratio can help you plan for ways to improve your profit margin in the future.
The recommended way to improve this ratio is to reduce your Accounts Payable. Reducing your overhead costs is one way to do that—shopping around for a better rate on your employee health insurance could help!
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Having accurate books allows you to get the most out of your annual tax return. Many business expenses are deductible, but small business owners fail to take full advantage of them due to poor small business bookkeeping. Some of the expenses you can claim include:
- Property tax
- Entertainment costs
- Office supplies
- Insurance fees
The CRA has a page with a complete list of deductible business expenses. It’s a good idea to create specific accounts for each of these expenses, allowing you to file them as soon as they happen. Following this process ensures that you don’t miss any opportunity to claim a business expense.
Another advantage of good bookkeeping is that you can stay ahead of the curve on your tax payments. Having your records on hand means that you can calculate your tax before tax season and prepare accordingly.
When you start paying above a certain threshold for tax, you may have to pay tax in quarterly installments instead of an annual sum. It’s essential to know how much tax you’ll owe to comply with this requirement when you reach the minimum tax threshold. You’ll appreciate having quarterly financial statements that make filing easier.
Small Business Bookkeeping Tips
Small business bookkeeping is all about adopting good habits early. It’s very easy to neglect your financials until the last moment, which can lead to late nights and lots of stress and confusion. These bookkeeping tips can help ensure that your books remain accurate without you having to put in too much effort.
Whether you decide on manual or automated bookkeeping, it’s vital that you record every single transaction. These transactions include any income, no matter the source, as well as all your business expenses. Having a dedicated business account can simplify the process, though you’ll still need to keep records documenting every transaction.
When it comes to business expenses, record every transaction as if you’re about to face an audit. Keep a calendar to record meetings with clients so that you can show why you have a lunch expense on a certain date. If you buy fuel using a business account, make sure to log your mileage and trip history to prove that it was for legitimate business.
Don’t Overdo Your Expense Accounts
When it comes to expenses, it can be easy to over-granulate certain expenses. For instance, you may have four to five separate categories for vehicles, including fuel, repairs, insurance, and parking. However, you’ll need to decide if this information is really that important or whether you can consolidate everything into a single category.
Planning your expense accounts is a delicate balance between having enough information and justifying the effort involved. Every business is different—you should always consider the reason you have a separate account for a particular expense.
Working with an Accountant
As a small business owner, it’s up to you to decide whether you want to manage your books yourself or hire outside help. If you have a small business with a couple of transactions per month, then there’s no reason to pay for an accountant or bookkeeper. However, as your business grows, the need for a dedicated bookkeeper will grow as well.
Having financial records is the foundation of any successful business because, among many other benefits, it allows you to quickly identify areas where you can cut costs, such as business and health insurance.
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