Bookkeeping Basics

Bookkeeping is important, but it can seem a bit intimidating. To make it as accessible as possible for someone just getting started in business, this overview breaks the topic down into three sections. The first section explains the essential records that must be maintained by all businesses. The second section describes the basic procedures and systems that are needed for effective financial management. The third section lists key internal controls that should be put in place to keep everything on track.

As an entrepreneur, you need a system that will enable you to monitor the progress of your business, keep track of income and expenses, and prepare accurate tax returns. The financial records that you maintain must be complete, accurate and timely. How do you accomplish all of this? Well, ultimately, you'll learn by doing, but there's absolutely no need for you to reinvent the wheel when it comes to financial matters. Here are some strategies for starting off on the right foot:

• Get advice about systems and procedures from an accounting professional (more about CPAs and bookkeepers below).
• Pick up a reference paperback or two. There are a number of good titles currently available, including Keeping the Books by Linda Pinson.
• Consider enrolling in a seminar. Many community colleges and university extension programs offer a financial workshop for entrepreneurs. The title is usually something along the lines of "Accounting for Non-Accountants."
• Visit the Internal Revenue Service site at www.irs.gov and download the PDF file for publication 583, entitled "Starting a business and keeping records." It is a good overview of basic bookkeeping and tax issues for entrepreneurs and it explains the documentation that is needed in order to resolve any tax-related questions. It's illegal to misrepresent or under-report your business activity, even if it is done accidentally. Keep in mind that much of your financial activity will involve other people—vendors, clients, banks, et cetera. At the end of the year, many of them will be reporting their side of the transactions to the government. Your returns must match those amounts. By keeping good business records, you are creating something called an audit trail, meaning a chain of references that makes it possible to trace information about transactions back through your accounting system.

Business Records

OK, so what are the basic business records that you need to maintain? They include the following:

Client invoices

Keep a copy of all invoices that you have sent to clients. A chronological listing of all the invoices that you have generated during the year is called your sales journal. When each invoice is added to the sales journal, it is officially recorded as business income for the month in which it was issued. While you are waiting for client payments to arrive, the open items are called your accounts receivable, which is carried on your books as a business asset. To track the due dates on the open client invoices, you should periodically prepare an aging report, which sorts the unpaid items into columns based on how long ago they were issued, such as 0 to 30 days, 30 to 60 days and so on. When you receive payment, write the payment information on your copy of the invoice and then move it to a file marked paid. Set up a separate paid file for each year. The contents of the file should be arranged alphabetically by client name.

Vendor invoices

When your business is new, some vendors may require you to pay for materials or services on a C.O.D. basis. Most, however, will extend credit to you. Activity will be charged to your account and the vendor will later send a bill to you in the mail. Be sure to go through your incoming business mail on a daily basis. Some of the bills that you receive will relate to client projects and some will be for general operating expenses. Before you post them to your books, review all incoming bills for accuracy and match them to any packing slips that you've accumulated or any purchase orders that you've issued. A chronological listing of all the bills that came in during the month is called your purchases journal. Each purchase that you make will be identified by expense category. Each posting should be based on an original invoice. Do not record purchases based on monthly statements (except for statements that relate to business credit cards, in which case the statement itself serves as the invoice). If you see an unidentified entry on a month-end statement from a vendor, ask them to provide you with a copy of the invoice that you are missing.

Until you pay the bills, the open items are referred to as your accounts payable. The total will appear on your financial statements as a business liability because it represents money that you owe to creditors for services or goods already received. Keep all unpaid bills in a file that is arranged by due date. Most firms also summarize unpaid bills by periodically preparing an aging report (as described above). When you eventually send your payment to the vendor, be sure to indicate on the face of the check which invoice is being paid. Write your check number, date and payment amount on the bill itself and move it to a paid file for the year, arranged alphabetically by vendor name.

Business bank account information

Even though you may be operating a one-person company, it's best to keep the financial activity of the business separate from your personal finances. At the end of every month, reconcile each business bank account statement and keep it in your files along with the cancelled checks themselves (or the digital check images on paper provided to you by the bank). Contrary to popular belief, reconciling a bank statement is not useless busy work—it's an important process. It brings your records and the bank's records into agreement at the end of each banking period. You need to make sure that each deposit went into the right account and that all checks cleared for the correct amounts. It's an opportunity to correct any mistakes that you find and to record any month-end bank charges or service fees. At the end of the reconciliation process you will know exactly which items have cleared the bank and which are still pending.

Disbursements journal

Just as in your personal life, much of your company's financial information will come from the checkbook. In a business it's called a check register and it's usually in a larger format. However, the essential purpose is the same—to maintain a running record of transactions for a specific bank account, including all checks written and all deposits made. Some businesses have multiple checking accounts, so they have multiple check registers. The payments that you make are called disbursements. The disbursements journal for your company is a combined listing of all payments from your various accounts within a particular period of time. Most of your disbursements will be payments for vendor invoices that are sitting in your open accounts payable, but others may be for new purchases that you have decided to pay for immediately. The activity is listed chronologically, with the amount and the name of the payee. Each disbursement is also identified by type so that you can run totals for each category at the end of each month.

Receipts journal

The deposits that you make are called receipts. Your receipts journal is a chronological listing of all money that has come to the business within a certain period of time. It's often called the cash receipts journal but most of the money that you receive will be in the form of checks sent by clients in payment of invoices that you have been carrying in your open accounts receivable. The receipts journal identifies each payment by date, amount and source, along with an indication of what it was for.

Time-keeping records

For your own internal management purposes, design services being provided to clients will be measured in terms of the amount of labor involved. This means that a design business must track all project time very carefully. There are different ways of doing this. Usually, the hours worked by each person will be captured initially on a daily timesheet, then later posted to the individual projects. A manual project tracking system will involve folders, binders or large envelopes called job dockets. For each project, you need to maintain a running total of the time and materials that have gone into it.

Daily diary for recording business mileage

Any business use of your personal car must be recorded in a simple diary with the date of the trip, the purpose, and the number of miles driven. While you're at it, it's easy to record client entertainment expenses (such as meals) and travel expenses (such as tolls and gasoline) in the same diary.

Schedule of fixed assets

You must maintain a separate listing of all furniture, fixtures, equipment and computers purchased during the year (along with any leasehold improvements or automobiles). This list must include all physical assets with a value of more than $100 and a useful life of more than one year. For tax purposes, you need to calculate depreciation for these items in order to reflect the fact that they will slowly decrease in value over time. The original purchase price will be recorded on your books as an asset. Then, each year, a small portion will be moved to expense. Your accountant will maintain a depreciation worksheet to calculate the annual depreciation amounts reported on your company's tax returns. However, if the original purchase price of an item is less than $100, it will not be depreciated. The full purchase amount will be treated as a direct operating expense in the period of its purchase.

Tax returns

You must keep copies of all tax returns filed by the business, whether they are local, state or federal. For most businesses, this will include such things as corporate business taxes, employer payroll taxes, state sales or excise taxes and local business taxes. If you have employees, you must also maintain detailed employee compensation records. The easiest way to take care of this is to sign up with an outside service to process your payroll. It may be an independent payroll company or a department within your bank. If your business is new, the payroll service will handle the paperwork necessary to receive a federal EIN (employer identification number) and a state EIN. These numbers are necessary for your firm to be able to file payroll tax returns. If you sign a power of attorney form, the payroll service will not only calculate your payroll and print checks for your employees, but it will also file all necessary payroll tax returns on your behalf and prepare all required tax deposits. This is a very helpful service because it means that you won't inadvertently miss any deposit deadlines. You must of course coordinate with your payroll service so that there are adequate funds in your bank account when each payroll is processed and when each tax deposit is due. These periodic deposits will include all tax amounts that have been withheld from employee checks plus your employer payments for Social Security, Medicare, and unemployment taxes. (For a more detailed discussion of income tax requirements for independent contractors and small businesses, please see "Income Tax for Freelancers.")

Other business records

Before you launch your business, you must do some local research in order to determine what licenses are required by the city or county where you are located. Most local licenses must be renewed annually, and you may also be required to prominently post all current licenses in your place of business. You must also keep copies of all insurance policies, leases and signed contracts. Be sure to retain any important business correspondence as well, whether physical or electronic. Your correspondence may later be needed to answer questions that come up, to document your intentions, and to serve as evidence in any dispute or lawsuit.

Retention schedule

As you can see, quite a variety of items will be accumulated by your business. You need a good filing system to keep track of everything. From time to time you may be tempted to clean house and get rid of older items. Be very cautious about this! Legal requirements for records retention vary for different types of documents. For example, federal and state laws require that all cancelled checks be retained for at least three years. In contrast to this, it's recommended that all tax returns should be retained permanently. When you are first launching your business, you should consult with an attorney to develop a formal retention policy for your company. To avoid any potential problems, you may be advised that the easiest approach for freelancers and small design firms is simply to keep everything. In a small business, your accumulated files will not take up too much space. If your desk or filing cabinet does eventually become a bit crowded, older items can always be moved to offsite storage.

Business Procedures and Systems

In addition to keeping proper records, good financial management involves setting up and following the right procedures. You must also record all activity when it happens. Procrastination will only create an intimidating backlog of paperwork, and in the meantime it's all too easy to forget important details about a transaction or lose receipts and supporting documents. Here are some recommendations for good procedures in a number of key areas:

Billing cycle and process

Make the process of issuing invoices to your clients as easy as possible, and be very consistent about the way that you do it. As a businessperson, you'll learn that it's best to send out a fairly steady stream of invoices so that, later on, client payments will come in at a steady pace as well. Don't wait until the end of the month to do one big batch of invoices. You should also avoid waiting to do just one invoice at the end of a big project. Whenever possible, get an up-front deposit and then break up the balance of a large project into a series of progress billings.

Recording client deposits

When you do receive client deposits, retainers or advance payments, make sure that you record them correctly on your books. These up-front amounts must be shown as liabilities until your services are actually performed. It's not yet your money—you might have to refund some or all of it if the projects are cancelled. In the meantime, keep these amounts in your bank account—don't spend them on other things.

Efficient collections

When you send an invoice, you need to make it as easy as possible for the client to pay you. If your client is a large company, your invoice will probably be reviewed by several different people. To simplify the approval process, make each invoice self-explanatory. Include the project name and number, the name of your primary client contact and any necessary client requisition or purchase order information. You may also want to add the date of the signed contract for the work and some indication of which phase or billing milestone is covered by this particular invoice. With corporate clients, it also helps to submit each invoice in duplicate—an original for them to keep in their files and a remittance copy to return to you with payment.

After you've sent an invoice, follow up at the end of the month with a statement of account—a printed list of all open items. It's a reminder and a chance to compare records. If the client sees an invoice listed on the statement that they do not have in their system, they will ask you to provide another copy. As the due date approaches, phone the client's bookkeeper or accounts payable department to verify that the invoice has indeed been scheduled for payment. If it has not, you may need to provide additional information or ask your primary client contact to intercede to get the paperwork back on track. Be persistent, but always friendly and professional—don't be difficult or threatening in any way because that could damage the ongoing relationship. Keep notes of what you are told about the status of each invoice and follow up regularly until you receive full and final payment.

At the beginning of a new client relationship, you may want to establish an initial credit limit for the account, and perhaps obtain a credit report to see what their relationships have been like with other suppliers. You should also include a clause in your contract that gives you the ability to charge interest on any late payments (a typical interest rate for this is 1.5 percent per month). Over time, track each client's payment history so that you have a clear picture of who pays you on time and who does not. Most design firms also calculate the overall collection period for the entire business, meaning the average number of days it takes to collect accounts receivable from all clients (calculated from the point of billing to the point of collection).

Vendor relationships

Your company needs to establish a good payment history with each one of its vendors. This will require good cash management. Keep track of when payments are due and manage your cash so that you can pay them on time. If you come up a bit short, call the vendor and work out a payment schedule—perhaps a series of small checks over a longer period of time. These are important relationships for your business. Keep the lines of communication open. When preparing vendor payments, it's best to do a small batch of checks each week, rather than saving things up for the 15th or the end of the month. When you begin a relationship with a vendor who is an individual, such as a freelance designer, be sure to have him or her fill out an IRS Form W-9 ("Request for Taxpayer Identification Number"). The tax ID number will usually be a personal Social Security number. At the end of each year, add up the amounts that you have paid to each freelancer and prepare a Form 1099-MISC ("Miscellaneous Income") that shows the total and the tax ID that was given to you. You must provide the completed form to the individual by January 31. (Again, copies are sent to the government as well.)

Business banking relationship

Choose your bank carefully. You need one that specializes in providing services for small businesses. Your relationship will start with checking and money market accounts. It will gradually expand to include such things as credit lines, equipment loans and payroll processing. Get to know the banker assigned to your account. He or she can be a great source of business advice. Plan on having a sit-down discussion with this person at least once a year.

Rainy day reserves

One of your financial goals should be to gradually build up reserves. Think of this money as your rainy-day fund protection against unexpected events. Once it's in place, you'll sleep much better at night. For most companies, a reasonable goal is an amount equal to two or three months worth of operating expenses, including payroll and rent. (This reserve must be in addition to any client deposits that you may be holding, and it should not include any equity lines that have been extended to you by the bank.) You'll want the funds to be generating interest income, but not tied up for long periods of time. Place the money in short-term investments that are easily accessible.

Master calendar

At the beginning of each year, compile a master list of all tax-filing deadlines, payroll processing days, renewal dates for leases and insurance policies. (This is sometimes referred to as a corporate calendar.) Depositing taxes on time is especially important because tax authorities charge penalties and interest on all late tax payments.

Payroll cycle

Your payroll processing must happen like clockwork. As you go through the year, regular payments to yourself and other team members must be absolutely dependable. This requires you to manage your cash flow in such a way that there is always enough money in the bank on payday. At the end of the year, your outside payroll service will provide you with annual totals by individual. They will prepare a printed IRS Form W-2 that shows gross earnings, itemized deductions and net pay. Your employees need these in order to prepare their own personal income tax returns so, by law, you must distribute them no later than January 31. (Copies are sent to the government as well.) When you add an employee to your payroll, there are some initial hiring requirements that you need to be aware of. Each new employee must fill out a Form I-9 ("Employment Eligibility Verification") to prove that he or she is legally eligible to work in the U.S. This form is available for download as a PDF file from the U.S. Citizenship and Immigration Services site at http://uscis.gov. Each new employee must also fill out an IRS Form W-4 ("Employee's Withholding Allowance Certificate") in order to notify you of his or her personal income tax filing status and withholding allowances. After that, employees can give you a new Form W-4 anytime their tax situation changes.

Financial software

You'll find that it's a lot easier to track your finances using software than it is to do everything manually. Currently, the two most commonly used financial applications in the United States for small, Macintosh-based creative firms are MYOB and Quickbooks. Both are quite user-friendly. Your initial use of either application will probably focus on the check register. Over time, you'll become familiar with additional functions. These general financial applications will let you do some limited analysis of income and expense by individual client project. However, as your firm grows you will eventually find it necessary to implement a more robust system at the project level. You'll need software that can handle detailed project estimates and schedules, provide comparisons of estimated amounts and actual amounts for individual tasks, and help you to track resources and deadlines. When selecting and setting up any kind of financial software, you'll want to get advice from an accounting professional.

Accounting professionals

Accounting is not just the preparation of tax returns. For proper set up of your financial system, including procedures, files, software and reports, you'll need guidance from a Certified Public Accountant (CPA). A CPA is a person who has been licensed by a state to practice the specialized profession of public accounting. Most creative firms work with an outside CPA. Very few are large enough to need a CPA on staff. It's important for your system to be adequate and reliable and in compliance with GAAP (generally accepted accounting principles). Accounting is the overall process by which financial information is classified, recorded, summarized, and interpreted. It has to do with business systems, rules and methods. Bookkeeping is a sub set of accounting. The focus of bookkeeping is on the recording process. On a daily basis, source documents are reviewed, coded, entered into the system, and filed. A bookkeeper is the person with primary responsibility for properly recording figures into the accounting records. This takes some experience, but it is primarily a clerical role and does not require a state license. New design firms sometimes have their bookkeeping done by an outside service. As the company grows, however, it becomes necessary to bring it in-house.

Double-entry bookkeeping

So, how exactly do bookkeepers do what they do? Your financial activity will be recorded using an approach that is called double-entry bookkeeping. This has been the standard approach to financial management for a very long time—it was first developed in Italy during the Renaissance. The fundamental characteristic is that it's a self-balancing system based on the assumption that all transactions consist of an exchange of one thing for another. This means that every financial transaction has two sides—at least one account must be debited and at least one account must be credited, and the totals for each side must be equal. This is what keeps the books in balance. For example, buying supplies will increase your expenses and decrease your cash. Here is how the debits and credits work for different types of transactions:

Chart of accounts

The internal accounts that you use for tracking your financial activity will be assigned names and code numbers. A list of these is called your chart of accounts. The accounts are grouped into ranges of numbers to indicate their relative positions within your company's financial statements. The standard chart of accounts varies from industry to industry. For a design firm, it usually looks like this:

Balance sheet items 

Profit and loss activity from operations 

Profit and loss activity that is not related to operations 

In setting up individual accounts, it's always best to be as specific as possible. Avoid describing anything as miscellaneous. At the end of each month, your bookkeeper will prepare a list of the ending balances in all accounts. This list of dollar amounts is called the trial balance. It is prepared to verify that the debits and credits for the month were posted properly. If it's in balance, then financial statements can be prepared. The net profit or net loss produced by your business each month will be the amount by which total revenues exceed total expenses (or vice versa). This overall profit or loss is often referred to as the bottom line. (For more information about the preparation and use of financial statements, please see the article "Financial Management.")

Cash-basis vs. accrual-basis

There is another accounting concept that you need to be familiar with. For government reporting purposes, your business has a choice of two different accounting methods: cash-basis or accrual-basis. In accrual-based accounting, all income is counted when it is earned and all expenses are counted when they are incurred, regardless of when the actual cash is received or paid. This means that on your financial statements, you will be recognizing project activity in the month where the work itself took place. As mentioned earlier, your invoices to clients are recorded as sales and then tracked as open accounts receivable. Your purchases from vendors are recorded as expenses and then tracked as open accounts payable. This is in contrast to cash-basis accounting, where income and expenses are not counted until the actual cash changes hands. Cash payments tend to happen long after the fact, which can distort your view of monthly activity and indicate ups and downs that are quite misleading. For this reason, accrual-based financial statements present a more accurate picture. For internal management purposes, most design firms track monthly activity on an accrual basis. At the end of the year, your outside CPA will analyze whether or not there would be a tax benefit in calculating the business tax returns using the cash method. If so, the CPA will convert just the year-end balances into the alternate format.

Internal Controls

As your business grows, some of your employees will become involved in financial matters. This represents a very important transition for your business. You need good procedures and internal controls to prevent simple mistakes, but also to deter such things as theft, embezzlement, kickbacks or fraud. It is much less likely that these things will ever take place if you are proactive in taking preventative measures. Smart business practices include the following:

Careful staffing

• Be cautious when hiring new employees who will have financial responsibilities. Candidates for these positions must have solid financial skills as well as honesty and integrity. Verify the professional experience of each candidate and speak with past employers. It's important to conduct diligent background checks.
• If you are transferring or promoting a current employee into a financial position, be sure that he or she has the necessary skills and aptitude. A good receptionist or a good traffic manager will not necessarily make a good bookkeeper.
• Delegate slowly and maintain close supervision of all employees with financial responsibilities. While you are evaluating the quality and accuracy of their work, you must also strive to maintain good morale. Like all employees, those involved in financial management will be happier and more productive when paid a competitive wage and treated fairly, and when their individual efforts are acknowledged and appreciated.
• You should require some cross training among your employees so that they can fill in for each other when needed. With that as a basis, you should also require mandatory vacations for your financial employees. This will give you a chance to verify that everything is being accounted for correctly.

Setting limits

• Limit the number of people who can sign business checks, and place a dollar limit on each person's authority. Above a certain amount, transactions should come to you for additional review and a second signature.
• You should establish dollar limits for other types of decision-making as well. For example, purchase orders above a certain amount should require a second signature.

Other measures

• It's a good idea to separate purchasing authority from payment authority. The person who identifies and negotiates with vendors should not be the same person who later writes them a check.
• Each time a check is drafted, it should come to the signer with supporting information attached. For example, a large vendor invoice would typically be matched to a purchase order and a packing slip. These may be needed to answer any questions before the check is signed.
• Envelopes from the bank should be opened first by the owner of the firm, especially those containing account statements and canceled checks. Quickly review the contents before passing them on to the bookkeeper for reconciliation. Look through statements for any unusual activity. Look at the names, amounts and signatures on the canceled checks to make sure that there have been no changes or forgeries.
• Avoid cash transactions in your business. Do this by using checks or charge cards for all activity so that there is a clear paper trail. Avoid writing any checks to "cash." Avoid having a petty cash fund on hand—it's much too easy to lose track of when and how the currency is spent.
• Finally, have your CPA do a periodic audit of the company's books. Many people are under the impression that audits are only conducted in connection with tax disputes, but the term audit refers to any professional examination of your company's financial records. The purpose of an audit is to gauge the accuracy, appropriateness, and consistency of your company's accounting practices.