it, most entrepreneurs and business owners don’t know the first thing about
double-entry bookkeeping, and they don’t want to know.
For larger companies, that doesn’t matter: you just hire a specialist. But in the early days, you may not be able to afford full-time help. Even if you go to an accountant to help you prepare your annual tax return, you need to know the basics of how to keep your books in order throughout the year.
Why does it matter? Because good accounts are the basis of a good business. If you don’t have an accurate grasp of your financial situation, your plans will be based on little more than guesswork. Investors or lenders will also want to see well-organized finances before they commit to funding your business.
So in this tutorial, you’ll learn the basics of keeping your business accounts in order. We’ll go through the fundamentals of double-entry bookkeeping, and explain how to set up a chart of accounts, balance the books, and prepare financial statements.
By the end, you won’t be a fully qualified accountant, of course. It’s a complex area, and you’ll still need to hire a pro to help you wherever possible (and we’ll give tips on that too). But you will at least have a basic grasp of how to keep a set of business accounts. You’ll be armed with some practical steps you can take to make sure you’re recording the right things, and will be able to keep your business on solid financial ground.
Step 1: Understand Double-Entry Bookkeeping
Don’t skip this step!
Double-entry bookkeeping may not seem like the most interesting topic, but it’s vital to understand how it works. Most businesses these days use accounting software instead of physical books, but the principles are still important to grasp. We’ll keep it simple, and use examples to make everything clear.
First, what’s the purpose of double-entry bookkeeping?
The point is to give you a rounded picture of where your money is going, and to help you avoid making mistakes. Every transaction is recorded in at least two places. It makes sense, because every business transaction is an exchange of one thing for another. The double-entry system shows exactly how that exchange took place, and what the results were.
Let’s look at an example.
Say you run a café, and spend $500 on a crate of the finest coffee beans. If you look only at your cash balance, it would seem as if you’ve lost $500, because your account has gone down by that amount. In reality, of course, that coffee has a value—you’re adding it to your supplies (inventory), and will use it to brew drinks to sell to customers. So in the double-entry system, you’d make two entries:
Cash account: - $500
This records both the loss of cash and the gain in inventory, giving you a more accurate picture of what’s happening in your business.
As you can see, the principle is quite simple. However, a lot of the confusion with double-entry bookkeeping comes from the terminology. In everyday life, we’re used to thinking of debits as decreases and credits as increases. In the accounting world, it’s more complicated than that. So for this tutorial, to keep things simple, we’re going to talk about increases and decreases rather than credits and debits.
Step 2: Set Up a Chart of Accounts
If you want to have a rounded picture of how your business is doing, you’ll need to set up several different accounts. What that means is that for each key area of your business, you track each transaction that affects it, and adjust the balance accordingly.
In the café transaction above, for example, we added $500 to the inventory account to reflect the addition of the crate of coffee. We’d keep that account constantly updated, so that every time we either buy new supplies or use them up, we adjust the balance. That way we know exactly how much we have on hand at all times. We do the same with the cash account.
Aside from cash and inventory, here are some other key accounts to track, according to SCORE:
- Accounts Receivable (money due from customers).
- Accounts Payable (money you owe to others).
- Sales (the revenue you make from selling products/services).
- Purchases (supplies you buy for your business).
- Payroll Expenses (staff salaries and other costs).
- Owners’ Equity (the amount you or other owners put into the business).
- Retained Earnings (the profits you’ve accumulated).
Depending on how much detail you want to go into, you can create all sorts of different accounts tracking various aspects of your finances. For example, you could split that “Inventory” account into sub-accounts tracking coffee beans, food and other items.
For larger companies, the number of accounts can multiply rapidly, so it’s essential to set up a chart of accounts from the start: basically a list of all the accounts you maintain, with a number for each one. You can view a sample chart of accounts here.
Step 3: Balance the Books
You’ve probably heard about companies balancing (or in some cases failing to balance) the books. In this step, we’re going to look at exactly what that phrase means, and how you can balance your own books effectively.
Let’s return to that café example from Step 1. We bought $500 worth of coffee beans. The next step, of course, is to grind them up, brew some lattes and cappuccinos, and sell them to customers. We do that, and our happy customers pay us $750 in revenue. Let’s see how you’d record that in your accounts.
First of all, we’ve received $750 in cash, so the cash account increases by $750. But we’ve also used up $500 of inventory, so the inventory account needs to decrease by $500.
So far, so good. But what about that $250 that’s left over? Well, that’s profit for your business, so it gets added to the “retained earnings” account. Here’s how it looks:
Cash account: + $750
Retained earnings: +$250
This is a simplified example, of course. We’re not looking at the cost of the milk and sugar for making those lattes, or labor costs, or any of the other things that in reality would eat into that $250 profit.
But this simplified example illustrates a key concept: whatever entries you make in your accounts, the books must balance afterwards.
What that means is that the following equation must always hold true:
Assets = Liabilities + Equity
When we added $750 to the cash account and removed $500 from the inventory account, we created an imbalance—assets increased by $250, but there was no corresponding entry on the other side of the equation. By adding $250 to retained earnings (part of the “equity” category), balance was restored. Our assets increased by $250, and our equity increased by $250, so the equation still works.
Your goal as a business owner is to make sure that the “accounting equation” always holds true, that the books always balance. In practice, however, mistakes happen. Professional bookkeepers regularly create trial balances, and if they can’t get the books to balance, they go back through the accounts and make adjustments to any errors that were made.
The most important thing is that the books balance at the end of every accounting period (say monthly or quarterly). That’s when you put everything together into the financial statements.
Step 4: Prepare Financial Statements
In a previous series of tutorials, we looked at the key financial statements a business prepares: the balance sheet, income statement and cash flow statement.
The information for those statements comes directly from the accounts we’ve just been looking at. The accounting equation we covered in Step 3, for example, is reflected in the structure of the balance sheet, which totals up all the assets on one side, and all the liabilities and equity on the other, and ensures that they always balance out.
As for the income statement, that uses the accounts we looked at in Step 2, like the revenue, expenses, and cost of goods sold. And the cash flow statement is based primarily on the cash account, while also pulling in information from other accounts to show where all that cash went.
So on a regular basis, you’ll draw all of the information from your different accounts together, and create a full set of financial statements. The balance sheet is a snapshot of your company at one particular time, whereas the income statement and cash flow statement show the changes over a particular period.
How often should you go through this process? Public companies are required to produce financial statements for shareholders on a quarterly and annual basis. If your company has investors or lenders, they may also tell you how often they expect to see them. If not, you’ll need to decide what makes sense for your business—you may want a monthly snapshot of how you’re doing, or you might decide, particularly if your firm is very small, that you don’t need formal statements so frequently.
Step 5: Get Help When You Need It
The examples we’ve looked at in this tutorial have been very simple. In practice, keeping accurate accounts can be a complex process, especially as your business grows. A single transaction can involve multiple entries in several different accounts, and when you have hundreds or even thousands of transactions to record, it can quickly become overwhelming.
But still, a time will probably come when you need to hire a professional. Even when you use software, it’s easy to make mistakes. And the time it takes to enter all that information could probably be better spent elsewhere.
Although you’ll often hear the terms “accountant” and “bookkeeper” used interchangeably, they actually have different functions. A bookkeeper handles the day-to-day tasks of recording transactions and making sure everything is represented correctly. An accountant focuses more on the big picture, producing high-level financial statements and helping you with things like filing taxes and securing financing.
You can start by employing a bookkeeper and accountant part-time or on a freelance, hourly basis, and progress from there. When your business grows to have more than 30 employees, or more than $1 million in revenue, it’s probably time to consider hiring full-time staff.
Bookkeeping is a complex area, and there's a lot more to learn. But this tutorial has given you the basic tools you need to be able to keep accurate records, and ensure your business is in a good state of health.
You’ve learned how to record simple transactions using double-entry bookkeeping, and how to set up an accounting system that makes sense for your business. You’ve seen the link between day-to-day bookkeeping entries and the overall financial statements like the balance sheet and income statement. And you’ve learned what type of help you need, and when.
So start getting your books in order, using your preferred accounting software (or old-fashioned ledgers if you prefer). Be sure to keep all your receipts and order records in a well-ordered filing system, so that you can go back and verify anything you need to. And keep making sure those books balance on a regular basis.
One more important thing to decide for your company is exactly when and how you record each transaction. There are two main approaches: cash and accrual accounting. We’ll look at what those terms mean, and how the choice affects your business, in a future tutorial.