Guide to Basic Bookkeeping
MAZUMA MAKES IT EASY
As a small business owner, you have to get used to having a lot of balls in the air at one time. You are probably used to working countless hours and constantly jumping from one thing to another in order to keep afloat. So when you add in something like bookkeeping, it can often feel like an extra headache to even understand it, let alone take care of it every month. That’s why we are presenting the Mazuma Guide to Basic Bookkeeping. Whether you know some basic bookkeeping and you want to learn more, or your level is closer to “what is bookkeeping?” we hopefully have some answers for you. And if you really hate bookkeeping, you can even skip straight to the end, and see how Mazuma can take it off of your hands altogether!
What is Bookkeeping?
What is Bookkeeping?
So let’s start at the beginning: what is bookkeeping?
So let’s start at the beginning: what is bookkeeping? Some would say that bookkeeping feels like taking a small business owner’s brain and pounding nails into it. But when you break it down, it’s just the process of taking individual transactions from bank or credit card records, grouping them using accounting basics, and then adding them all up. It’s that simple!
It’s that tricky little component of “accounting basics” that can create the aforementioned ‘nails.’ But when done properly, the numbers tell a story about your business that you never could have learned without the nebulous, yet tedious task of bookkeeping.
Please note: before we go much further you should understand that the concepts explained in this article are intended to illustrate “cash basis” accounting. There are a multitude of accounting principles and procedures that will not be covered herein because they don’t apply to most small business owners.
The origins of modern day “double entry accounting” go back thousands of years. If you’ve ever walked away from a conversation with an accountant and felt like they were speaking another language, you won’t be surprised to hear that they once belonged to the same industry as lawyers. There was a day when lawyers offered accounting services and accountants offered legal services…as if one subject of over-complicated jargon wasn’t enough!
By the middle of the 19th century, the industrial revolution was growing strong. New limited liability entities— such as corporations — springing up everywhere compelled professionals to find better ways (imagine that… innovative accountants!) to report financial information to shareholders.
This demand for information sparked a development of a set of universal standards that shareholders could use to make investment decisions — what became the basics of bookkeeping; and accounting has never looked back.
So what is bookkeeping as it pertains to us? If you took a look at the financial statements of a large company like Costco, you’d find a long story, told by a hundred pages of footnotes. However, in our world of small business, you don’t have to go that deep to get the critical information you need to run your business well. The end goal of bookkeeping for 90% of the businesses out there is the profit and loss and balance sheet statements. In short, small business bookkeeping is therefore the process of collecting transactions into these common financial statements.
Bookkeeping 101: How Does it Work?
Bookkeeping 101: How Does it Work?
So now let’s get into the nitty gritty: bookkeeping 101.
Let’s start with the most common source document used in the world of business: a bank statement. Somehow we’ve got to get all the transactions listed on that bank statement into a computer program, so that we can categorize and summarize them. There are many different platforms out there that facilitate this…but they usually come down to either typing the information into an accounting software, or importing the information into the software.
After the information has been input into the accounting software, each transaction has specific tags to describe that transaction:
- Payee or Payor
The one tag or label that is needed to complete the bookkeeping process of entering the data is the “category,” which from now on will be referred
to as the “account.” The account is just an additional label you give the transaction to identify what it is. For example, you may be familiar with the “Office Supplies” account, or maybe the “Travel” account. These accounts just add information to your transaction so it can be grouped with other similar transactions. You can also add a “Memo” or “Notes” to your transaction to provide even more information to it, but it’s the account that acts as the primary key for grouping transactions together.
So for example, imagine we have the following list of nine transactions from your bank statement:
Step one is to get the information into your accounting software and then assign them to the relevant account. So what account would you use for each of those transactions? Maybe the following:
Easy as pie! Now that you’ve assigned each transaction to an account in the software, you can generate a profit and loss statement, which would look something like this:
You’ve now seen the magic behind the curtain! Of course, this is a simple example with very few, very simple transactions, but it illustrates the process. As you can imagine, when there’s hundreds or thousands of transactions involving balance sheet accounts, in addition to the profit and loss accounts, things can get pretty hairy.
Why is Bookkeeping Important?
Why is Bookkeeping Important?
So why bother with all this bookkeeping mumbo jumbo?
Why not just monitor the bank account balance like you’ve always done? There are four really good reasons to go through the hassle of learning the basics of bookkeeping, or at least finding a way to keep a good set of books.
If you were asked how much you spent eating out last month, could you give a good answer by just looking at your credit card or bank statement? Or what if the question was about your marketing efforts — how much did you spend on marketing last year, and was it worth it? Or maybe a more important question, what did you spend your marketing dollars on, and did it produce the return you were looking for?
This is just the beginning of the information that becomes available to you when you have a set of books. When you’re asking yourself these questions it may not be a big deal, but what if a bank or investor has questions and all you have for an answer is a blank stare? Not good. This leads us to the next reason why bookkeeping is important.
The reality is that if you don’t have a Profit and Loss and Balance Sheet for your business, there is no way to communicate the value of your business to outsiders. A bank will not loan you money if they don’t know what’s going on inside your business. An investor, other than your mom, won’t give you a dime without some evidence that their dime could produce more pretty coins after giving it to you. Hence the hundred page financial statements produced by large businesses every year — they need to explain everything that’s going on inside their business to the shareholders, in order for those shareholders to feel ok about them using their money.
Now you may not have plans to take on investors or even borrow money from a bank, but is there any possibility that you’d want to sell your business down the road? If so, historical financial statements are an absolute requirement.
GOOD DECISIONS AND BUDGETING
By staying organized and having a record of performance to analyze, you actually know more about your business. And you know what they say, ’good inspiration is based on good information.’ You may be endowed with an entrepreneur’s gut that leads you everywhere you want to go in business, but how much more powerful would you be if you merged that “gut feel” with a mind full of knowledge about your business? Am I going to invest a thousand dollars in advertising this month? Will this new piece of equipment be worth it in the end? Can I afford to hire an employee? These are decisions that are a little too risky to make without good information at your fingertips.
Financial statements represent activity, as of a certain period of time. Each month, quarter, or year becomes a benchmark by which you can measure your progress.
And even better than looking backward is the new found ability to look forward and budget for the future. With enough historical information to review, you can identify trends and project those into the future. How powerful is that?
“When performance is measured, performance improves. When performance is measured and reported, the rate of improvement accelerates.”
– Thomas S. Monson.
Holding yourself accountable to predetermined benchmarks and budgets will greatly increase your chances of success. And if success is not in the deck of cards for you, measuring yourself will make you aware of pending failure much sooner!
TAXES AND REGULATORY COMPLIANCE
It’s that unfortunate certainty these days: death and taxes. If you don’t have your small business’ bookkeeping done, the tax return becomes difficult
to prepare with integrity. You’ll most likely pay too much or too little taxes without solid financial statements to use as the basis for the numbers you put on the forms. For a small business, tax rates can make all the difference. Who wants to go through life wondering if they’re going to get slammed with a huge tax bill, just because they weren’t sure if their tax return was right?
At the risk of beating a dead horse, the idea of budgeting must be mentioned here again. Especially for a small business, tax is something you want to pay as little of as possible — which is not against the law! But the taxes that you end up having to pay should be budgeted for; if you can’t avoid them, plan for them. Without good bookkeeping records, you won’t even have the chance to see the IRS freight train coming!
Where to Start?
Bookkeeping for Dummies
Where to Start?
Bookkeeping for Dummies
Now that we’ve flown over this bookkeeping concept at the 10,000 foot level, let’s turn this theory into practical, basic bookkeeping steps you can take to get it done! So let’s go over some of the first steps to take, before a deeper dive into the basics of bookkeeping.
STEP 1: CHOOSE ACCOUNTING SOFTWARE
The days of keeping your books outside of a computer program are long gone. Accounting software is not only very cheap, but will be necessary to keep you on track with your bookkeeping. A spreadsheet is the next best alternative, but unless you are extra “spreadsheet savvy” — and are willing to put in a lot of extra time developing your own system — you won’t get the functionality or reports you need. So, search the market for accounting software and you’re sure to find something that fits your needs. But next up, you’ll have to actually learn how the software works.
As a typical small business owner, you have an unfortunate disadvantage… you’re not only facing the accounting/bookkeeping learning curve, but
the accounting software learning curve too! But rest assured, the curve associated with learning the principles of bookkeeping are much steeper than the curve with the software, especially if you’re somewhat capable on a computer.
Just one word of warning however: accounting software is notorious for lulling you into a sense of security and assurance that you’re doing everything correctly, when in fact you’re often not! They’ve made it so “user friendly” that you feel like it’s all going fine, only to find out when you send it over to your tax professional that it’s all wrong. This is another thing that makes understanding the basics of bookkeeping valuable.
All that said, find a software that has a free trial and see how it goes. If it doesn’t go well, look for an affordable outsourced accounting service that will take care of it for you.
STEP 2: SET UP YOUR CHART OF ACCOUNTS
As you recall from our demonstration of putting together a profit and loss statement, you need to specify “accounts” that you can categorize your transactions within. Your accounting software will most likely have a default chart of accounts all ready for you to use, but you should tailor these to your own needs. Remember, these are the labels you’re going to see on your profit and loss and balance sheet statements — they should be labels that make sense to you, and give you the understanding you’re looking for.
Feel free to create your own accounts, but don’t get too detailed. Your own custom accounts can be very helpful, but they can get out of hand very quickly. For example, a few different accounts to isolate sales from various marketing channels might make sense, such as:
One Time Sales
However, it’s easy to go overboard, especially when tracking expenses. It’s very common to see overly complex charts of accounts in new businesses because they start out wanting to track every little thing, but they end up not being able to step back and summarize the results. For example, the following accounts may be too detailed:
Office Supplies – Paper
Office Supplies – Envelopes and Stationary Office Supplies – Printer Ink
Office Supplies – Stamps
Office Supplies – Other
Travel – Rental Car
Travel – Flights
Travel – Parking
Travel – Other
Hopefully you see how that begins to be unnecessary detail. Combining all the office supplies together is probably more beneficial than knowing how much you spent on stamps during the month. So a word to the wise: summarize as much as your management style is willing to allow for. Doing so not only helps you comprehend your reports quicker, it also saves time when coding transactions; it’s a lot quicker to pick from a list of 15 accounts than it is to pick from a list of 100 accounts.
STEP 3: UNDERSTAND THE TYPES OF ACCOUNTS
So far, all of the accounts referred to in this article were profit and loss accounts. However, as you will come to find out, balance sheet accounts are an important piece of the puzzle. We will go into the differences between a profit and loss statement and a balance sheet in detail soon, but for now, just know that income and expense accounts belong to the profit and loss statement, while assets and liability accounts belong to the balance sheet. So you won’t ever see the following accounts on a profit and loss statement:
- • Cash (Asset)
- • Inventory (Asset)
- • Credit Card (Liability)
- • Loan (Liability)
These balance sheet accounts all represent balances for an amount owned by you (an asset) or an amount owed by you (a liability). You will need to set up a cash (representing your business bank account) or a credit card account in order to begin entering transactions. The default chart of accounts will most likely contain these accounts already, you can rename the defaults to reflect the actual name of your account.
STEP 4: SET UP VENDORS AND CUSTOMERS
Most accounting software allows you to setup vendors and customers as you go, but it may be more convenient to add all the details about your customers and vendors at the beginning. As you recall from our Nine-Transaction Example, there was a “Payor/Payee” column, or in other words “Customer/Vendor” column. The software likes you to preset the customers and vendors so it can report on them, and so it can remember what account you categorize their transactions to.
If you’ve got a list of customer or vendor information in a spreadsheet, for example, you’ll probably be able to import it into the software and save them all at once.
STEP 5: START ENTERING DATA…SLOWLY
Once the chart of accounts is set up, you can go ahead and begin entering transactions. Most modern accounting software allows you to “link” your bank accounts and begin automatically downloading your transactions…DON’T DO THAT YET! It is smarter to enter your first transactions by typing them in yourself. This is an extremely valuable learning opportunity, so take it slow. Enter in 5 transactions, then view your profit and loss statement. Enter in 10 more transactions, then view your profit and loss statement. View the balance sheet also and see what’s happening to your bank balance as you go along. This process will allow you to really connect the dots between what you enter in the system and how it shows up in your reports.
By taking it slow and understanding what’s happening as you take the first baby steps, you allow the basic bookkeeping concepts to sink in. If you link your bank account and import a hundred transactions all at once, you’re likely to be confused right off the bat and not understand what’s going on. Also, sometimes the bank linking and transaction importing process can be complicated in itself — no need to put your brain through that. Get at least the first month done by hand, and then if you’re feeling great about everything, go ahead and find more efficient ways to get the data in the system.
What is Profit and Loss Statement?
What is Profit and Loss Statement?
We briefly covered the nuts and bolts of a profit and loss statement in our Nine-Transaction Example. Let’s walk through it piece by piece, using a typical Mazuma profit and loss statement:
Header – This is the header of your profit and loss statement:
On the first line you’ve got your company name, “Example Company”.
The second line is the name of the report, “profit and loss statement”, which means the same thing as Income Statement.
The third line indicates the date ranges which are being reported. In this example, we are reporting figures that represent the month of June, and figures that represent January through June.
Income – This section displays the sales or income that was generated by your business for each of the two time periods:
We’ve set up two income accounts in our chart of accounts. Remember that if you have set up an account but haven’t coded any transactions to it yet, it probably won’t show up on your profit and loss statement report.
The column titled “Month” is the total income that was received during June.
The column titled “YTD” is the total income that was received from January through the end of June, it stands for “Year to Date.”
The titles of these columns can vary, and of course the timeframe you’re reporting on will vary, but this is a common presentation.
Expenses – This is the expense section of your profit and loss statement:
Similar to the Income section of the statement, we have the list of expense accounts, and two columns with amounts totaled at the bottom. Within the month of June, you paid $125 for your Mazuma Accounting fee, $100 for Insurance, $1,000 for Rent and so on. The Total Expenses you paid out in June was $2,255, while you’ve paid a total of $13,530 for the January through June period of time. Nice to know, huh?
Net Profit or Loss – This last section is the “bottom line,” as they say, telling you whether you made money or lost money:
In this case, our total income, minus total expenses, results in a nice net profit of $9,745 for June and $58,470 for your YTD total. In the case where total expenses exceed total income, we would have a net loss and the bottom line number would be negative.
Let’s put all our sections together and see how it looks:
Looks great! Now you can move on to asking yourself, “Is that as profitable as I want to be?”, “What can I do to be more profitable?”, “What are my numbers going to look like for the rest of the year…will I make enough money to buy that new car I’ve been eyeing lately?”
Stacking these numbers up month by month becomes a powerful tool now at your disposal.
What is Balance Sheet?
What is Balance Sheet?
Now you’re getting into some deep water!
But don’t worry, most of the balance sheet is actually fairly simple to understand, because we inherently comprehend what assets and liabilities are. These are concepts we deal with in our daily personal lives, whether we run a business or not. It’s the mysterious equity section that often muddies the water. Let’s break the balance sheet down into sections and step through it:
Header – This is the header of your balance sheet:
Looks very similar to the profit and loss statement, right? However, you’ll notice that the third line looks a little different. This subtle change in verbiage actually represents a huge concept that differentiates the balance sheet from the profit and loss statement.
Recall that the profit and loss statement was presented as a “period of time,” showing transaction activity that occurred between a beginning and ending date. The balance sheet on the other hand presents balances in accounts “as of” a specific date.
So instead of representing a period of time, the balance sheet represents a snapshot in time. In this example, we are looking at the balances in specific accounts on June 30 and on May 31. Let’s move to the asset section and it will start coming together.
Assets – This is always the first section of the balance sheet and contains all the assets that belong to the business:
So now we know that on June 30th, the company had $5,050 in their checking account and $500 of equipment on hand. We also can see that the truck that was purchased cost $30,200. The balance of the Work Truck account did not change from May to June, which makes sense because once the truck is purchased, you don’t end up buying a little more truck…or selling a piece of your truck from month to month. But your cash balance is very likely to change, because businesses are spending and receiving cash all throughout the month.
We can also see that the business purchased equipment for $500 in June. Our balance sheet tells us that the business owns a total of $35,750 in Assets at the end of June and $34,225 at the end of May. If we have more assets than we owe in liabilities, we are what is known as solvent, which is a good thing! Let’s find out if that’s the case by looking at the next section of the balance sheet.
Liabilities – The next section of the balance sheet is always liabilities. This section represents amounts, or balances, that the business owes other people or other businesses:
These balances show us that the company has a balance of $2,025 on their credit card as of June 30th. Looks like they made a payment on the truck loan, which brought the balance down to $26,000, and that there was no payment made to Dad on that loan. Total balance due, aka Total Liabilities, was $34,025 as of June 30th and $35,100 as of May 31st.
With total liabilities being so close to the total assets, the company is walking the fine line of being solvent, however, that doesn’t mean they aren’t making good money.
As we saw in the profit and loss statement above, the company earned $9,745 in June alone, and $58,470 for the whole year. So where is all that money going? It’s not sitting in their bank account, and it wasn’t used to pay down the credit cards or loans, where could it have gone? This leads us to our final section of the balance sheet.
Equity – The equity section of the balance sheet reflects the historical profitability of the company, as well as the transactions that occur between you — the owner — and the company itself. It is quite honestly the most complicated section of the basic financial statements, so don’t freak out if it doesn’t all make sense. Let’s take a look:
These accounts illustrate a few elements that can be useful to you:
First, the owner contributions and owner distributions accounts are exactly what their names suggest: the cumulative amount the owner put IN to the company, and the cumulative amount the owner has taken OUT of the company.
That idea of “cumulative” is important to remember, these balances reflect “inception to date” figures, or the total amount that the owner put in or took out, since the beginning of the business.
Second, the net profit line item is the year-to-date net profit. If you look back at the profit and loss statement we reviewed above, you’ll notice the net profit under the YTD column matches this total in the equity section.
Lastly, the retained earnings account represents the cumulative net profit from all prior years. So in this case, the retained earnings figure indicates that company generated $30,000 of net profit during all years prior to January 1st of the current year.
So again, the net profit line shows the profit generated this year, and the retained earnings line shows the profit generated for all time prior to this year. Pretty cool, huh?
Here comes the part where you find out why it’s called a “balance” sheet… wait for it…it balances! If you add up total liabilities ($34,025) and total equity ($1,725) it equals $35,750. And what do you know? That happens to match the total assets number. The world is in order for an accountant when total assets = total liabilities + total equity.
You should certainly be proud of yourself if you’ve made it this far! You have traversed the treacherous set of principles that make up the fundamental world of double entry accounting. Okay, you may not be ready to take the CPA exam, but as you work repeatedly with these concepts in your business, you’ll find them becoming more and more familiar. You may eventually even be able to casually tell your friends…“Yeah, I know what’s goin’ on with my books.” Try not to get too cocky though…
Analysis and Budgeting
Analysis and Budgeting
So now what?
You know a bit about financial statements and understand the basics of bookkeeping, but how does this knowledge help you in your business? With a basic understanding of accounting, you can begin to use financial statements to help you budget and analyze what’s going on in your business — and thus make better decisions about the future.
Let’s look at a set of monthly financial statements, January through April:
As you can see, things are headed in the right direction for this company. Revenue is going up and so is net profit; that’s what we like to see! Now if you were just staring at the bank account balance at the end of each month, you might be able to tell that things are going well, simply because you’re not running out of money. But how much more can you understand about how this business has performed this quarter, when you have these figures to analyze? Tons!
Focusing on the income section, we can see that the new subscriptions are the main driver in our increased net profit. Google Ad income is actually dropping off, but we are more than making up for it in recruiting subscribers.
• What does that mean?
• Where should we be focusing our efforts?
• Do we want to spend our time getting Google Ad Income back up?
• Or would we be better off just focussing on subscribers?
If this was your business you’d now be well equipped to answer those questions.
Now let’s analyze the expense section. Things are trending pretty steady overall, except for our marketing costs. We’ve increased our marketing spend substantially since January, especially in March.
• Was that marketing investment worth it?
• It seems to have increased our subscriber count. Did it increase our subscriber count as much as we hoped it would?
• What do we think would happen if we increased our marketing spend beyond the peak $2,500?
• Are there other marketing avenues that might give us a bigger bang for our buck?
Again, lots of questions surface that can be answered when you have this insight into your business.
We’ve briefly touched on the simple analysis that can be done when viewing a set of monthly profit and loss statements. How can monthly statements help us with budgeting? Well, if you boil budgeting down to its most fundamental principles, it’s about trends (things you can’t always control) and behavior (things you can control).
Consider your personal or family budget, there are both trends and behavior affecting how much money you have each month. A trend of sickness in your home may cause a few more doctor visits and medical bills than you were expecting. Things you can’t control pop up here and there, but that doesn’t mean you can’t try to plan for them.
Conversely, behavior — things you choose, and can thus control — will also impact your family budget. For example, if you choose to eat out every night instead of cook at home, you’ll likely spend much more on food during the month. That’s a behavior that can be changed and would affect the balance in your bank account at the end of the month.
Business is the same, trends in the economy, your competition, or even among your vendors can alter your ability to generate revenue or afford to provide your service. Those trends are often out of your control, but by looking ahead, you may be able to have a contingency plan in place.
Behavior also affects business the same way it does the family budget. You get to choose whether to hire an extra employee or pick up the slack yourself, choose whether to fly first class or coach, choose whether to hire a marketing firm or learn how to manage an ad campaign on your own. There’s obviously no ‘right’ answer to those questions — it depends on your situation and what you believe is best.
But whatever trends you’re facing, and whatever behavioral choices you make, you have the ability to look ahead and at least make a good guess
at the financial consequences. Because we know what happened January through April, we can make up our own profit and loss statement (in Excel for example) for May based on any scenario. What types of industry or economic trends might impact your business? How could you change your behavior to positively impact your Net Profit? Pull up a spreadsheet and start plugging numbers into your own profit and loss statement as you explore those questions.
Mazuma Makes it Easy
Mazuma Makes it Easy
Perhaps you have finished reading this and you still feel overwhelmed when it comes to bookkeeping. Well, lucky for you, we want to help you with that! Mazuma is a certified bookkeeping and tax accounting service that aims to be a one-stop-shop for bookkeeping, taxes, and any accounting advice that you need. Unlike many software providers that require you to still plug in information yourself, Mazuma is a full service accounting solution. All you have to do is link your bank accounts or upload your statements. It’s as easy as that! So whether you are looking to get the best small business tax rate, or you just want peace of mind that your finances are in order, find a plan that fits you today.