How do I set up bookkeeping for my small business?

The IRS requires all businesses to keep basic financial records in order to accurately track gross receipts, purchases, expenses, and other transactions. The exact nature of your record-keeping system is up to you, but a well-designed small-business bookkeeping system will keep your financial information in good order, facilitate reporting, and scale with your business as you grow.

Choose Cash or Accrual Accounting

Businesses with revenues under $5 million per year may use either cash accounting or accrual accounting to track how money flows into and out of the business.

• Cash accounting records revenues when the money is received by the business, and expenses when they are paid by the business. This is the same kind of accounting that individuals use when balancing their checkbooks.
• Accrual accounting records revenues when they are earned, which may be long before the customer actually pays the business. Similarly, expenses are recorded when the business incurs them, not when it pays for them.

Set Up a Business Bank Account

A separate bank account for your business is a must-have for businesses of all sizes. Make sure that all business transactions flow into and out of this account, not your personal bank accounts. Similarly, never make personal transactions using your business bank account. We’ve written before about how mixing business and personal accounts can get you into trouble.

Having a dedicated business bank account solves a lot of problems:

• First, you’ll know every transaction in that account is a business-related transaction.
• Second, you can automatically import transaction information from your business bank account straight into your bookkeeping software. Separating your business and personal accounts means you won’t have to waste time separating business- from non-business expenses.
• Third, keeping your business funds siloed away from your personal funds shows the IRS and other authorities that you are serious about maintaining your financial records in a businesslike manner.

Pick a Bookkeeping Software Package for Small Businesses

Technically, a business can manage its books using Excel. Theoretically, they could even do it with pen and paper. But, practically speaking, bookkeeping software is a must for all businesses. Manually typing or writing transactions day after day is a tremendous waste of time and energy, and such a manual approach is also highly error-prone. A basic bookkeeping software package is not terribly expensive and can more than pay for itself in the time you’ll save and the capabilities you’ll gain.

Create a Chart of Accounts

The chart of accounts is a list of the accounts you have set up in your bookkeeping system to track all financial activities. This chart forms the skeletal structure that holds your entire bookkeeping system together. Most bookkeeping software packages will set up a basic chart of accounts for you, based on your entity type. But you’ll likely need to tweak this chart to better match your business’s specific needs. Each account should have an account name, a type (asset, liability, expense, and so on), a description, and a number.

Set Up an Expense Tracking System

If you want to keep accurate records, tracking your business expenses is a must. Transaction receipts generally come in either paper or electronic form. Paper receipts can be stored in something as simple as a shoebox, but it’s much better to keep those receipts organized — whether by date, in alphabetical order, or with some other system. Electronic receipts can live on your computer or in an online storage system, such as Expensify.

Prepare Your Bank Reconciliation Process

Having your transactions automatically imported from your bank is a wonderful time-saver, but it doesn’t eliminate the need for bank reconciliation. This is the process of comparing your monthly bank statement with your business’s Cash account in your chart of accounts, to confirm that both are accurate.

A typical reconciliation process goes as follows:

• Take the bank statement and add any outstanding items, such as checks that haven’t cashed yet. Write the new total at the bottom of the statement.
• Review the bank statement’s transactions to check for any errors. If you find an error, contact the bank immediately.
• Adjust the Cash account within your bookkeeping software to reflect bank-generated transactions, such as service charges and interest payments.
• Ideally, the corrected bank-statement balance and the corrected Cash account balance will now be identical. If not, you’ll need to dig into both the bank statement and the bookkeeping account transactions to figure out what’s causing the discrepancy.

Set Up Your Reporting System

Reports help you assess your business’s overall financial health. Most bookkeeping systems have dozens of reporting options, but most of them won’t be important to your particular business. There are three basic reports that you’ll definitely want to generate and review on a regular basis.

• Balance sheet

The balance sheet takes a snapshot of what your business owns and owes at any particular time. Balance sheets list a business’s assets, liabilities, and equity.

• Income statement

Also known as the profit and loss (P&L) statement, the income statement shows how profitable your business was over a certain period. This statement compares your business’s revenues (the money you made from selling your products or services) to your business’s expenses. If your business had more revenues than it had expenses, it was profitable; if not, it took a loss.

• Cash-flow statement

The statement of cash flows tells you how much actual cash your business received over a certain period. This differs from the income statement because income statements are generally prepared using accrual accounting, so the revenues listed on the statement may still be unpaid. Your business might have enormous income, yet be chronically short of cash to pay the bills.

 

Determine your tax obligations

Tax obligations vary depending on the legal structure of the business. If you’re self employed (sole proprietorship, LLC, partnership), you’ll claim business income on your personal tax return. Corporations, on the other hand, are separate tax entities and are taxed independently from owners. Your income from the corporation is taxed as an employee.

Self-employed people need to withhold taxes from their income and remit them to the government in lieu of the withholding that an employer would normally conduct. For American store owners, you’ll need to pay estimated quarterly taxes if you’ll owe more than $1,000 in taxes this year. Canadians have it a little easier; if your net tax owing is more than $3,000, you’ll be required to pay your income tax in installments.

Calculate gross margin

Improving your store’s gross margin is the first step toward earning more income overall. In order to calculate gross margin, you need to know the costs incurred to produce your product. To understand this better, let’s quickly define both cost of goods sold (COGS) and gross margin.

COGS. These are the direct costs incurred in producing products sold by a company. This includes both materials and direct labor costs.

Gross margin. This number represents the total sales revenue that’s kept after the business incurs all direct costs to produce the product or service.

 

Reconciling Your Accounts

Keep ledgers for all financial accounts. You may have several business bank accounts. For example, small businesses usually have a checking account to pay bills and a savings account to save up money to pay self-employment tax. You should also create a ledger or spreadsheet for each of your major accounts.

Keeping this ledger will allow you to monitor the current state of your business. You won’t have to wait for the monthly bank statement to see if your business is insolvent or thriving.

Reconcile your books. You need to make sure that your monthly recording of expenses is the same that shows up on your bank records. This means analyzing your bank statement and your accounts to make sure the same transactions appear on each.

• Reconciliation is a good way to catch mistakes—yours or the bank’s. If the bank makes a mistake, you can contact them. Share whatever documentation you have (receipts, cancelled checks).
• You can also catch fraudulent activity with reconciliation. For example, an employee might have withdrawn money from the checking account without telling you.
• Perform reconciliation monthly. If you wait too long, it will be harder to reconcile. Also, you won’t catch fraudulent transactions in a timely manner.

 

Maintaining Cash Flow & Improved Financial Management

As a responsible small business owner or bookkeeper, you should be aware of your company’s revenue streams. With accurate bookkeeping, you can tell how much your business is making in terms of income and track your spending to ensure that you have enough cash on hand to cover your business expenses. Proper financial records make it easier for you to analyze the financial state of your firm and determine areas that need improvement.

 

Be prepared for major expenses.

Even with your carefully maintained balance sheet and cash flow reports, it’s hard to predict what will happen in the future. That’s why it’s always a good idea to plan for significant or surprise—or significantly surprising—expenses with a cushion of savings.

Keep a separate emergency fund for your business. Save separate emergency funds for your business and personal life. Both should give you enough cash to cover your expenses for three to six months. For your business, that extra cash can help you cover unplanned large expenses that can’t wait. For example, if you own a copy shop, what would happen if your printer broke down and you had to wait until you saved enough for a new one? Imagine all the business you would lose! But if you had the cash on hand, you could replace the printer and be back to normal in no time.

Don’t go into debt for your business—always pay cash! You’ll have less risk and your business will be profitable faster when you operate without debt. Put whatever you make back in the business, especially in the beginning, and live lean in both your business and personal life. A future without debt is worth it!