What is bookkeeping and why is it important?
Bookkeeping is the process of recording your company’s financial transactions into organized accounts on a daily basis. It can also refer to the different recording techniques businesses can use. Bookkeeping is an essential part of your accounting process for a few reasons. When you keep transaction records updated, you can generate accurate financial reports that help measure business performance. Detailed records will also be handy in the event of a tax audit.
This guide will walk you through the different methods of bookkeeping, how entries are recorded, and the major financial statements involved.
Methods of bookkeeping
Before you begin bookkeeping, your business must decide what method you are going to follow. When choosing, consider the volume of daily transactions your business has and the amount of revenue you earn. If you are a small business, a complex bookkeeping method designed for enterprises may cause unnecessary complications. Conversely, less robust methods of bookkeeping will not suffice for large corporations.
With this in mind, let’s break these methods down so you can find the right one for your business.
Single-entry bookkeeping
Single-entry bookkeeping is a straightforward method where one entry is made for each transaction in your books. These transactions are usually maintained in a cash book to track incoming revenue and outgoing expenses. You do not need formal accounting training for the single-entry system. The single-entry method will suit small private companies and sole proprietorships that do not buy or sell on credit, own little to no physical assets, and hold small amounts of inventory.
Double-entry bookkeeping
Double-entry bookkeeping is more robust. It follows the principle that every transaction affects at least two accounts, and they are recorded as debits and credits. For example, if you make a sale for $10, your cash account will be debited for $10 and your sales account will be credited by the same amount. In the double-entry system, the total credits must always equal the total debits. When this happens, your books are “balanced.”
Using the double-entry method for bookkeeping makes more sense if your business is large, public, or buys and sells on credit. Enterprises often choose the double-entry system because it leaves less room for error. In a way, it ‘double-checks’ your books because each transaction is recorded as two matching but offsetting accounts.
Cash-based or accrual-based
The next step is choosing between a cash or accrual basis for your bookkeeping. This decision will depend on when your business recognizes its revenue and expenses.
In cash-based, you recognize revenue when you receive cash into your business. Expenses are recognized when they are paid for. In other words, any time cash enters or exits your accounts, they are recognized in the books. This means that purchases or sales made on credit will not go into your books until the cash exchanges.
In the accrual method, revenue is recognized when it is earned. Similarly, expenses are recorded when they are incurred, usually along with corresponding revenues. The actual cash does not have to enter or exit for the transaction to be recorded. You can mark your sales and purchases made on credit right away.
Both a cash and accrual basis can work with single- or double-entry bookkeeping. In general however, the single-entry method is the foundation for cash-based bookkeeping. Transactions are recorded as single entries which are either cash coming in or going out. The accrual basis works better with the double-entry system.
How to record entries in bookkeeping
Generating financial statements like balance sheets, income statements, and cash flow statements helps you understand where your business stands and gauge its performance. For these reports to portray your business accurately, you must have properly documented records of your transactions. Keeping these records as current as possible is also helpful when reconciling your accounts.
Recording transactions begins with source documents like purchase and sales orders, bills, invoices, and cash register tapes. Once you gather these documents, you can record the transactions using journals, ledgers, and the trial balance. If you are a very small company, you may only need a cash register. The information can then be consolidated and turned into financial statements.
Cash registers
A cash register is an electronic machine that is used to calculate and register transactions. Usually, cash registers are used to record cash flow in stores. The cashier collects the cash for a sale and returns a balance amount to the customer. Both the collected cash and balance returned are recorded in the register as single-entry cash accounts. Cash registers also store transaction receipts, so you can easily record them in your sales journal.
Cash registers are commonly found in businesses of all sizes. However, they aren’t usually the primary method of recording transactions because they use the single-entry, cash-based system of bookkeeping. This makes them convenient for very small businesses but too simplistic for enterprises.
The journal
The journal is called the book of original entry. It is the place where a business chronologically records its transactions for the first time. A journal can be either physical (in the form of a book or diary), or digital (stored as spreadsheets, or data in accounting software). It specifies the date of each transaction, the accounts credited or debited, and the amount involved. While the journal is not usually checked for balance at the end of the fiscal year, each journal entry affects the ledger. As we’ll learn, it is imperative that the ledger is balanced, so keeping an accurate journal is a good habit to keep. This form is useful for double-entry bookkeeping.
The ledger
A ledger is a book or a compilation of accounts. It is also called the book of second entry. After you enter transactions in a journal, they are classified into separate accounts and then transferred into the ledger. These records are transcribed by accounts in the order: assets, liabilities, equity, income, and expenses. Like the journal, the ledger can also be physical or electronic spreadsheets.
A ledger contains a chart of accounts, which is a list of all the names and number of accounts in the ledger. The chart usually occurs in the same order of accounts as the transcribed records.
Unlike the journal, ledgers are investigated by auditors, so they must always be balanced at the end of the fiscal year. If the total debits are more than the total credits, it’s called a debit balance. If the total credits outweigh the total debits, there is a credit balance. The ledger is important in double-entry bookkeeping where each transaction changes at least two sub-ledger accounts.
Trial balance
The trial balance is produced from the compiled and summarized ledger entries. The trial balance is like a test to see if your books are balanced. It lists the accounts exactly in the following order: assets, liabilities, equity, income, and expenses with the ending account balance.
An accountant usually generates the trial balance to see where your business stands and how well your books are balanced. This can then be cross-checked against ledgers and journals. Imbalances between debits and credits are easy to spot on the trial balance. It is not always error-free, though. Any miscalculated or wrongly-transcribed journal entry in the ledger can cause an incorrect trial balance. It is best to look out for errors early, and correct them on the ledger instead of waiting for the trial balance at the end of the fiscal year.
Financial statements
The next, and probably the most important, step in bookkeeping is to generate financial statements. These statements are prepared by consolidating information from the entries you have recorded on a day-to-day basis. They provide insight into your company’s performance over time, revealing the areas you need to improve on. The three major financial reports that every business must know and understand are the cash flow statement, balance sheet, and income statement.
