Bookkeeping and Its Basic Purpose
2 of 12 in Series: The Essentials of Accounting Basics
Bookkeeping, when done properly, gives you an excellent gauge of how well your business is doing. Bookkeeping also provides financial information throughout the year so you can test the success of your business strategies and make course corrections to ensure that you reach your year-end profit goals.
Bookkeeping can become your best system for managing your financial assets and testing your business strategies, so don’t shortchange it. Take the time to develop your bookkeeping system with your accountant before you even open your business’s doors and make your first sale.
Choosing your accounting method
The two basic accounting methods you have to choose from are cash-basis accounting (also called just cash accounting) and accrual accounting. The key difference between these two accounting methods is the point at which you record sales and purchases in your books:
If you use cash accounting, you record transactions only when cash changes hands. For example, you don’t record a purchase from a vendor until you actually lay out the cash to the vendor.
If you use accrual accounting, you record a transaction when it’s completed, even if cash doesn’t change hands. For example, you record a purchase from a vendor when you receive the products, and you also record the future debt in an account called Accounts Payable.
Understanding assets, liabilities, and equity
Every business has three key financial parts that must be kept in balance:
Assets include everything the company owns, such as cash, inventory, buildings, equipment, and vehicles.
Liabilities include everything the company owes to others, such as vendor bills, credit card balances, and bank loans.
Equity includes the claims owners have on the assets based on their portion of ownership in the company.
The formula for keeping your books in balance involves these three elements:
Assets = Liabilities + Equity
Introducing debits and credits
To keep the books for your business, you need to revise your thinking about two common financial terms: debits and credits. Most non-bookkeepers and non-accountants think of debits as subtractions from their bank accounts. The opposite is true with credits — people usually see these as additions to their accounts, in most cases in the form of refunds or corrections in favor of the account holders.
Debits and credits are totally different animals in the world of bookkeeping. Because keeping the books involves a method called double-entry bookkeeping, you have to make a least two entries — a debit and a credit — into your bookkeeping system for every transaction. Whether that debit or credit adds or subtracts from an account depends solely upon the type of account.
You can’t just enter transactions in the books willy-nilly. You need to know where exactly those transactions fit into the larger bookkeeping system. That’s where your Chart of Accounts comes in; it’s essentially a list of all the accounts your business has and what types of transactions go into each one.