Keeping records is crucial for the successful management of a business. A comprehensive recordkeeping system makes it possible for entrepreneurs to develop accurate and timely financial reports that show the progress and current condition of the business. With the financial report you can generate from a good recordkeeping system, you can compare performance during one period of time (month, quarter or year) with another period, calculate trends and plan for the business's future.
Every entrepreneur enters the business world with personal assets in terms of skills, interests, education, training, experience and ability. Some entrepreneurs are strong salespersons. These entrepreneurs possess excellent people skills and hands-on product/service knowledge that generate revenue for the firm. Some entrepreneurs are more management and detail-oriented. They like organizing, developing policies and procedures and recordkeeping.
For a business to be successful, its owner must possess a good blend of these skills: sales, customer service, management and recordkeeping. The sole proprietor must assume all the responsibility; but if the business has more than one owner or employee, it has the advantage of bringing sales, customer service, management and detail-oriented persons together to cover all aspects of the business.
The purpose of a good recordkeeping system is to provide management information to use in operating the business. Because cash flow and profitability are closely tied to financial analysis, it is vital that the entrepreneur understand the external and internal financial factors that affect business. The recordkeeping system provides the foundations for monitoring and measuring the progress of the business. It provides a blueprint for fiscal control by monitoring and measuring sales, costs of goods sold, gross profits, expenses and taxes. The entrepreneur should be involved in setting up the recordkeeping system and the chart of accounts, which includes elements that are critical in managing the day-to-day operations of the specific business.
Many business finance professionals recommend that all entrepreneurs be knowledgeable about basic recordkeeping practices. The entrepreneur who decides to purchase a manual or computerized recordkeeping system, or has a bookkeeper or accountant, still needs to understand the basic premises.
The following is a simplified lexicon of basic recordkeeping that demonstrates how to set up your own accounting system.
A journal is a book for recording business transactions in chronological order. A simple method of recordkeeping is to use 13-column paper for journals. You derive the information for each journal entry from original source documents, such as receipts for cash paid or received, checks written or received, cash register tapes, sales tickets, etc. The information appearing on these documents must be analyzed to determine the specific accounts affected and the dollar amounts, then the proper journal entry is recorded.
A transaction is entered in a journal before it is entered in ledger accounts. Transactions are entered into the journals by date, amount, description and account to which the transaction has been assigned. For example, when rent is paid, the journal entry would be made in the cash disbursement journal under the accounts of cash and rent. A journal is also called the book of original entry.
Different journals are used for different source documents. Cash coming into the business (cash sales, bank loans, interest income) is entered in chronological order in a cash receipts journal. Cash going out of the business (expenses: rent, insurance, payroll, purchases,) is recorded in a cash disbursement journal. The checkbook is the source for recording disbursements.
All disbursements should be made by check from a business account that is separate from your personal bank account. This provides an audit trail in case of an IRS audit. Sales and Purchases on credit are entered into a sales journal and purchases journal, respectively. These journals are the original entry for the accounts receivable and accounts payable. A payroll journal is used to show employee gross wages, taxes/other deductions withheld and net wages. It also shows the employer's share of FICA, Medicare and unemployment taxes. A general journal is used for miscellaneous entries and adjustments such as depreciation and inventory.
The accounting system is built around a list of account names called a chart of accounts and is organized under the categories of assets, liabilities, owner's equity, revenue or income, cost of goods sold (for a business that sells a product), operating expenses and other income/expenses. The accounts you keep are tailor made for your particular business.
Assets are things of value owned by a business including cash, receivables, investments, buildings, land, equipment, vehicles, etc.
Liabilities are those amounts the business owes the creditors. They include payables, notes, loans, mortgages, etc.
Owner's equity or capital (sometimes called net worth) is the investments of the owners and the accumulation of profit or losses for the business since it began. It is also the difference between Assets and Liabilities.
Revenue or income is the money that came into the business from the sale of goods and services. Income is measured for a period of time.
Cost of goods sold is the cost of the product being sold by the business. A service type business will not have a cost of goods sold.
Operating expenses are the daily expenses in running a business. For example, rent, advertising, insurance, etc.
Other income/expenses are not daily necessities or a required part of the business operation. However they are a part of doing business such as interest income and expense.
At the end of each month, all transactions are totaled and only the total of each account is posted to the general ledger on three-column paper. The general ledger is a cumulative (year to date) book that contains the individual accounts maintained by the business and shows the balances in each account.
Financial statements (Balance sheet and income statement) are prepared using the account balances from the general ledger.
The balance sheet is a financial report as of a specific date that lists the assets, liabilities and owner's equity of a company. It is a "snapshot" of the business at a point in time.
The income statement or profit and loss statement (P&L) is the financial report that shows if the business had a profit or loss. It is the Revenue minus the Expenses.
The basis of your business's recordkeeping/accounting system is the chart of accounts, a listing by account name and account number that defines the business. Most recordkeeping systems, whether manual or computerized, begin with a generic chart of accounts. The problem with using an unmodified generic chart of accounts is that the standard account numbers are not specific to your business. Each business should have a unique chart of accounts that reflects the operation and market niche of that specific business. Suggested charts of accounts may be modified to better reflect the actual assets, liabilities, sales, costs and expense accounts of the specific business. This requires owner/manager participation in developing and defining the chart of accounts for the specific business operation.
Each account should have a name and number that identifies and defines it. An account must tie to a specific type of business transaction. If you define the types of business transactions that your business will record, this will tell you how to set up the name and numbering sequence of each account that you will need to record, monitor and measure your business transactions.
The numbering system is quite flexible. There are three digits for each category. The first digit 1 defines that the type of account, i.e. assets, liabilities, equity, revenue, etc. The second two digits allow up to 99 accounts to define the account structure. If 100-199 is assets, then 100 would be cash, 105 might be petty cash, 110 accounts receivable, 120 Inventory and 130 Deposits such as sales tax.
It is a good idea to allow skips in the numbering sequence
so you can add additional accounts later,
without having to revise the entire numbering sequence.
CHART OF ACCOUNTS
|400 Sales Revenue|
|100 Cash||405 Sales Returns/Allowances|
|105 Petty Cash||410 Over/(Under)|
|110 Accounts Receivable||420 Miscellaneous|
|130 Deposits (Sales Tax, Rent)||
|500 Merchandise Purchases|
|150 Furnitures/Fixtures||510 Purchase Discounts|
|160 Machinery/Equipment||520 Inventory Variance|
|180 Accumulated Depreciation||
600-699 GENERAL EXPENSES
|610 Depreciation, Furniture/Fixtures|
|200 Accounts Payable||615 Depreciation, Vehicle|
|210 FICA/Federal Income Tax Payable||620 Electricity|
|220 State Income Tax Payable||625 Insurance|
|230 Salaries Payable||630 Interest|
|240 Federal Unemployment Payable||635 Maintenance/Repairs|
|250 State Unemployment Payable||640 Payroll Expense|
|260 Sales Tax Payable||645 Rent Expense|
|280 Notes Payable, Long-term||665 Telephone|
700-799 CLEARING & SUMMARY ACCOUNTS
|300 Owner's Equity*||701 Income Summary|
|320 Owner's Withdrawal*|
|* Sole proprietorship recorded differently with partnership or corporation.|
Anything of value that is owned by or legally due the business. Examples include cash, accounts receivable, inventory and prepaid insurance.
All the debts of a business and all the claims creditors have on the business' assets, i.e. amounts owed to suppliers, short and long term loans, taxes and mortgage balances.
Owner equity/net worth
The difference between assets and liabilities. Or the difference between what the business owns and what it owes.
The dollar amount of services rendered or goods sold. In addition to actual cash transactions, revenues include sales and services sold to customers on credit.
The costs of doing business.
* Revenue and expense accounts fit in the accounting equation by being part of owner' equity. They are temporary accounts. At the end of the accounting period, expenses are subtracted from revenue. The result is the profit or loss for the period.
Single vs double entry recordkeeping
Now you have laid out the blueprint for your recordkeeping, monitoring and measurement systems. There are some other considerations that will affect your recordkeeping functions. One consideration is whether to use single entry or double entry recordkeeping.
Single entry is a simple listing of cash receipts and checks paid out. It is not a debit/credit system. It records monies received in a cash receipts journal (cash in) and monies paid out in the cash disbursements journal (cash out). From these two listings, a simple profit and loss statement and cash flow statement can be developed. The single entry can be kept manually on a notepad or journal with columns labeled with your chart of account numbers.
Because the double entry system is more sophisticated, an understanding of bookkeeping principles is needed to implement it. A small business with a limited number of transactions and employees can get by on a single entry system, either manual or computerized. All businesses require accounts receivable controls, accounts payable controls and pricing policies. For larger businesses with employees, with different departments or with inventory to manage, it is wise to implement a double entry recordkeeping system because it affords checks and balances.
Another consideration is whether you use cash basis or accrual basis accounting for recordkeeping and reporting purposes. According to the United States Internal Revenue Service (IRS), a business is allowed to use either method, or a hybrid. According to standard accounting procedures, whatever method you choose for your first fiscal year must be used in following fiscal years. Consistency is necessary for correct reporting.
Cash basis recordkeeping
Cash basis recordkeeping is a simple concept. You only record sales when you have actually received the monies/revenue. You only record expenses at the time you actually pay them. This is cash in and cash out in its purest sense.
Accrual basis recordkeeping
Accrual basis recordkeeping is also a simple concept. You record all items/services you sell, whether or not the sale is cash or credit in the current fiscal period. If credit, the remaining balance will be recorded as receivable in the current fiscal period. Accounts receivable are the accrual. You have sold the item and it is recorded as sold for XXX number of dollars. However, you have not received all the cash. The customer is to pay you at a future date. The amount due is the receivable amount. You have accrued, but not received the revenue.
The same principle is used with all expenses. You record the expenses the business has incurred in the current fiscal period, not just the expenses you have paid in full. Payroll is an example of an accrued expense. On December 31, you might owe $2,500 in wages and $800 in payroll taxes; although they have not yet been paid, you owe them. You can accrue these expenses with a recordkeeping entry and use them in the current fiscal year against your income tax. The same may be done with equipment or inventory purchased on credit.
If you produce, purchase or sell merchandise for income/revenue, you must use an accrual or hybrid method for purchases and sales. This is because you must take inventories into account in figuring your taxable income.
Remember that if you use a cash recordkeeping system for income/revenue, you must use a cash system for expenses. If you use the accrual method for income/revenue, you must use the accrual method for expenses.
There are advantages and disadvantages to each method. The obvious advantage to cash accounting is that it is simple to understand and the easiest concept to apply. If you received or paid cash (cash in/cash out), it counts as a revenue or an expense in the current fiscal year; there are no accruals. A disadvantage of cash basis accounting is that it can be difficult to get an overall view of the business’s exact financial position. The records do not show all the revenue or expenses the business has incurred at the close of the fiscal year.
The primary advantage to the accrual accounting system is that it gives the owner/manager a more accurate picture of the actual financial performance of the business. The larger and more complex the business, the more important accrual accounting is as a management tool. The disadvantage of the accrual method is that the concept is more complex to understand and to apply. The entrepreneur must know and understand what revenues or expenses are not recorded in the books at the end of the fiscal period and make the entries to record income/revenue and expenses the business has incurred but not yet received or paid.
On the following pages are examples of a cash receipts journal (cash in) and a cash disbursements journal (cash out) as examples of a cash recordkeeping/accounting system. These are the basic journals required to record the transactions of any business. From these two journals a simple profit and loss statement can be made on a monthly basis for management understanding and control of a small business.
The chart of accounts and journals may be either a manual system using columnar pads or a computerized system. Entrepreneurs should master a manual system before using a computerized system.
(click here for cash receipts journal and cash payment journal samples)
A simple manual or computerized recordkeeping/accounting system works well for a small business that is a sole proprietorship with a small payroll and very little inventory. However, if a business has a large payroll, inventory, accounts receivable, or accounts payable, a computerized system may be better. Entrepreneurs should understand a manual accounting system very well before changing to a computer system. Computerized recordkeeping/accounting systems consist of linking word processing, spreadsheet and database programs. The following is a more comprehensive discussion of some aspects of a computerized system.
Accounts receivable computer module
An accounts receivable computer module assists in the management of a large number of customer accounts. It keeps a running record of all charges and payments. Its advantages include the capability of sorting your customers by sales categories, the automated production of customer statements, the capability to do aging analysis of your accounts receivable and the ability to add reminder messages on customer statements for overdue accounts. An automated system gives a business more efficient and effective management and control of customer charge accounts. A similar manual system is labor intensive and costly.
Payroll computer module
A payroll computer module can assist in the timely and accurate management of the payroll function. It keeps a running record of all payroll deductions per individual and cumulative totals of payroll taxes the business has withheld and must pay. Its advantages include automated check writing and payroll records, ease in applying updates or changes in tax laws, ease in issuing W-2 forms to employees and ease in issuing W-3 forms to the Social Security Administration. Electronic transfer of payroll data will be required by the IRS in the future.
Inventory control computer module
An inventory control computer module can assist in the management of sales, pricing, costing and ordering of inventory. This is quite important on serial numbered items or high cost items, where inventory turnover is crucial to the cash flow of the business. Its advantages include ease in applying price increases; availability of current and accurate cost information for sales personnel; and automated reports on items to order, low sales or obsolete items, high sales items and out-of-stock items. A computerized inventory control system assists you to oversee and manage a large number of diverse units in inventory. Inventory control can be done manually, but the computerized system saves you time that can be used to analyze your total inventory and make informed purchasing and sales decisions.
Accounts payable computer module
An accounts payable computer module assists in the management of payables and cash flow. A computerized accounts payable system can help you keep track of what is due when. It enables you to have an overview of the aging of your accounts payable by the day, week and month. This enables you to pay your bills on time, but not before they are due. With a computerized system you can look 30 days into the future and see how much cash the business will need to meet payables. This assists you in making the best use of cash flow to meet the needs of the business and still pay creditors on a timely basis.
From the beginning, expect to prepare and/or maintain many of the following reports/journals/schedules:
Cash reports - daily/weekly/monthly
THERE IS NO SUBSTITUTE FOR GOOD RECORDS
NOTE: These materials are designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the authors are not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Completion of these materials does not ensure success in business.
- From the book, Entrepreneurship: Changing the Odds
Copyright © Curators of the University of Missouri, March 1998, for the Missouri Enterprise Development Focus Team, University of Missouri Extension.
- Reviewed/updated by Russell Wyrick, business specialist, MO SBTDC 2/25/08.