No matter what your business is, you can be sure that bookkeeping is one of the most important parts of it. Ultimately, the purpose of every business is to make a profit, and if you want to know whether or not you have, and if so, how, then you need a comprehensive overview of your financial transactions.
To some, bookkeeping may sound like a simple matter of addition and subtraction, while to others, it will seem like a bewildering puzzle. The reality is somewhere in between, and while bookkeeping may not be as easy as adding sales on top of expenses, this guide aims to provide you with everything you need to know to start looking after your own bookkeeping.
What is Bookkeeping?
Before diving into detail on how to do it, we first need to ensure that we are clear about the definition of bookkeeping. Although they are quite similar and often confused, bookkeeping is clearly distinct from accounting, and the two terms should not be used interchangeably. .
While bookkeeping can be defined as the identification, measurement, and recording of financial transactions, accounting is the analysis, interpretation, summarisation, and communication of their significance. Unlike accountants, bookkeepers do not require any specific qualifications, and are not tasked with making business decisions based on the numbers. They are there purely as a reliable record keeper, like an independent observer.
If the difference in their roles is still unclear, imagine a woman working as the top advisor to the EU on climate change. She will be highly qualified and have degrees in her field, just as an accountant would. Her job is to look at all the data across the EU, interpret what it means for the current and future state of the climate, and advise policymakers on the steps they need to take to tackle climate change. However, she is not going out and reading thermometers or emptying rain gauges. Those tasks do not require degrees and the people carrying them out will not be making decisions based on what they see, they are simply making a record. These are the bookkeepers.
Types of Bookkeeping
There are two main types of bookkeeping, and although the one that suits you best will probably become clear quite quickly, it is worth understanding both.
The first of the two is single-entry bookkeeping, which is essentially reserved for very small, very straightforward businesses with few employees. Single-entry bookkeeping means that any transactions that occur are only recorded once. It includes a column for incoming funds, and one for outgoing funds. The sum total can then be reconciled against your bank records. Single-entry bookkeeping is best suited for sole-traders or businesses that deal exclusively in cash.
The alternative is to use double-entry bookkeeping, which as the name suggests, means that every transaction is recorded twice. Under this system, there are five main accounts. We will look at these in more detail in the next section, but they are as follows:
Each of these accounts can then be sub-categorised into smaller accounts e.g. Assets could be broken down into Cash Assets and Equipment Assets. Each account then has two columns: one for debit on the left, and one for credit on the right.
A debit entry will increase the total of an asset or expense account, but decrease the total of a liability or equity account. Conversely, a credit entry will decrease asset and expense accounts, but increase liability and equity accounts.
When using the double-entry system, every entry into a credit column of one account must be accompanied by an entry into the debit column of another. This is where we get the phrase “balance the books”, as just like a set of scales, any change on one side must be matched by a change to the other.
To understand why credits and debits must be matched, let’s use the example of purchasing some new equipment for €1,000. If you pay with cash, you will make your credit entry under the “Cash Assets” account, as you are taking €1,000 away from that, and once it is spent, it is no longer an asset of yours. However, you do now own some equipment worth €1,000, which could potentially be sold, so the value of your “Equipment Assets” account would increase, meaning a debit entry of €1,000. If you were to take out a full loan to fund this investment, you would need to credit (increase) your liabilities account, and debit (also increase) your equipment assets account.
Clearly, the single-entry system of bookkeeping is far more straightforward, but also more limited. While it may work for some, the overwhelming majority of businesses would need to use the double-entry system to properly manage their finances.
Chart of Accounts
The five categories of accounts mentioned above (Assets, Revenue, Expenses, Liabilities, Owner’s Equity) make up what is referred to as the Chart of Accounts. The purpose of a chart of accounts is to segment and categorise all financial transactions in a logical manner, so that every possible transaction that could take place has a designated spot in which it should be recorded. This will reduce the amount of time and work it takes to maintain your records, and will make it much easier for them to be reviewed by others in future, such as during and audit or loan application.
Anything that increases that value of your business is considered an asset, whether it is physical cash, or an item with monetary value. After value, the key feature in determining whether or not something can be classified as an asset is ownership. A business that owns the premises on which they operate can count that as an asset, as they have the option of selling it for cash. A business that leases their space cannot count that as an asset, as they ultimately have no way to exchange it for cash.
Expenses are defined as any costs incurred during the ordinary course of business. This refers to any expense that can be legitimately claimed is necessary for the business to function, such as rent, utility bills, and wages. Certain employee benefits, such as health insurance or annual bonuses, can also be counted as expenses as, although they are not technically required for the business to function, they are legitimately associated with it.
Revenue refers to any income that comes from the sale of a good or service. This includes payments that have been received, as well as those that have not. Both cash and credit sales would fall under this category.
The “Liabilities” account is probably the one where most people can get a little confused, so make sure you understand what should and should not be considered a liability. In the most literal terms, a liability is any money that you owe to another party. The easiest example of this is a bank loan, where borrowing €5,000 would be recorded as a credit in your Liabilities account, and as a debit in your Cash Assets account. This means both accounts increase by €5,000, as you now have that much in cash, but also owe that much to the bank.
The main reason people can get confused about liabilities is because so many of these financial transactions overlap with expenses. An electricity bill is a perfect example of this. You have already used the electricity, so you need to pay for it. Between the time you receive the bill and actually pay it, it is technically a liability, as it is money you owe to someone else. But since this is a recurring, relatively predictable cost, the payment of which is rarely disputed, it is counted as an expense. The same can be said of unpaid wages.
Owner’s equity is the final category in the chart of accounts, and probably the one that you will change least frequently. It is a record of any money or assets that the business owner has personally invested into the business. Although it is basically a record of how much the business owes the owner, it is not categorised as a liability because the owner is the very last person to receive any payment in the event that the business shuts down.
Owner’s equity can be calculated by subtracting any withdrawals the owner has made from the deposits they have made. This number is then added to the net income of the business (or subtracted from the net loss), and the final figure is the amount of money the owner is legally allowed to walk away with when leaving the business.
Reconciling the Accounts
Occasionally, you will need to reconcile your accounts, which means comparing the records you have been keeping in your book against your bank and credit card statements. This is done to ensure that the transactions recorded in your book have occurred as stated, and that all the numbers match up correctly. How often you decide to reconcile your books is up to you, and is probably a judgement best based on the volume of transactions you deal with. However, you want to avoid going too long without reconciling, as not only will it be more difficult if you allow a large number of transactions to build up, but it also makes it more difficult to identify where any discrepancies may have taken place.
Closing the Books
Once you have reconciled your accounts, you have the option of closing your books. This is effectively a way of grouping all transactions within a set period together and determining whether you have made a profit or a loss. This will allow you to analyse and judge the success of that period in isolation. This is usually done on an annual basis, but can also be used to look at specific timeframes, such as the summer season. Once your books have been closed, both the revenue and expense accounts go back to zero.
To do this, you first need to create a new account called “Income Summary”, which will only be used temporarily to create your retained earnings report, which is the amount of income from the preceding period that can be carried into the next, after dividends have been paid out.
Once you have your temporary account ready, you need to empty your revenue account. If you had €1,000, which would be marked in the credit column, you would do this by debiting the revenue account and crediting the income summary account, both by €1,000.
Repeat this step in reverse to balance your expense account. So if your expenses totalled €100, which would be marked in the debit column, you need to credit the expense account €100 and debit the income summary by €100.
Your income summary should now have a number in both the debit and credit columns. Take the debits from the credits, and the final figure is your retained earnings. If your revenue exceeds your expenses, this will be a positive number, or a net profit. Using the example above, you would take €100 from €1,000, and arrive at a figure of €900 profit. This will be marked in the credit column on your income summary account, so the final step is to move it to retained earnings by debiting the income summary €900, and crediting your retained earnings account by the same amount.
Now that the books have been closed, you can begin the next reporting period with a clean slate. Moving forward, this will make it easier for you to analyse your figures and gain a better understanding of how your business model functions overall.
What follows is a list of some of the most common terms you will encounter when doing your own bookkeeping. Many of these terms appear quite similar, but have distinctly different meanings, so ensure you familiarise yourself with the list in full.
Accounts receivable: Outstanding payments owed to you by customers who have already availed of your goods and/or services.
Accounts payable: The amount of money you owe others for goods and/or services that have been delivered or used.
Accrued Expense: Any expense that has not yet been paid.
Balance Sheet: A summary of a business’s assets, liabilities, and equity of owners and shareholders.
Capital: The financial assets necessary to maintain operation of the business, usually equity or debt.
Cash Flow: The amount of money that moves both in and out of a business during a set period of time.
Credit: An accounting entry that increases a liability or equity account, but decreases an asset or expense account.
Current Assets: Assets that are expected to be converted to cash within a year.
Debit: An accounting entry that increases an asset or expense account, but decreases a liability or equity account.
Expenses: Any costs incurred during the running of the business.
Equity: The net value of your business, calculated by deducting liabilities from assets.
Fixed Assets: Assets intended for long-term use and not expected to be converted to cash within a year.
Fixed Expenses: Regularly scheduled expenses, such as utility bills.
General Ledger: A full record of all financial transactions throughout the history of the company.
Liabilities: All debts and financial obligations incurred during the running of the business. Can be either current (expected to be paid within a year), or long-term.
Net Profit/Loss: The final profit or loss a business makes after all expenses have been paid.
Operational Expenses: An expense that is necessary for the business to operate, but not in the production of the goods or services themselves e.g. Insurance.
Variable Expenses: The opposite of fixed expenses, those that will change from transaction to transaction.