Bookkeeping Basics: Part II

Hello, readers! Welcome back to the Hoods Tax & Accounting blog! We’re delighted to be able to share up-to-date information about taxes, savings, and financial literacy—giving you the tools you need to meet your short and long term goals. Whether you’re managing taxes for your small business or wondering how to take advantage of certain tax credits, we’ve got you covered! Our previous post and the first installment of this ‘Bookkeeping Basics’ series introduced the concept of what bookkeeping is, what it's used for, why it’s important and how to begin. From the old “general ledgers,” which used red and black ink, to ultra-modern digital programs, understanding the basics of bookkeeping is an essential part of running any successful small business. As a precursor for accounting, bookkeeping provides an accurate basis for evaluating the health of your business and planning for financial growth. For these reasons, accurate bookkeeping is paramount. 
 
The first part of this series explained the difference between single-entry and double-entry bookkeeping methods. As well, we went through the various types of accounts (i.e. assets, liabilities, revenues, and expenses), as well as their underlying subtypes (e.x. accounts receivable, utilities expense, interest income, etc.). We gave you a few options as far as setting up your accounts (e.g. Excel spreadsheet vs. digital bookkeeping software) along with their corresponding pros and cons. We explained the difference between a debit (Dr) and a credit (Cr) and trust us, it’s not what you think. Finally, we have a few best practices tips concerning bookkeeping to keep your books organized and accurate. Therefore, it’s in your best interest to read our last article (if you haven’t already) before delving into this second part! 
 
Today, we’ll continue our exploration into the world of bookkeeping. We’ll discuss balancing your books, preparing financial reports, then give you a few more best bookkeeping practices. When you’re alone at the computer with a bunch of receipts and numbers, figuring out how to make sense of everything can be overwhelming. Our aim is to showcase how simple bookkeeping can be when you understand the fundamentals. If you begin how you aim to finish, you should establish bookkeeping etiquette early on, as this will ensure later success. If you've been bookkeeping in a messy, roundabout way for years and fear how much effort an overhaul will require, take things one step at a time. We’ll be with you every step of the way!
 
Without further ado, let’s jump in!
 
Balancing the Books
 
This is a phrase many of us have heard thrown around throughout our lives, but what does “balancing the books” really mean? The best way to visualize balancing the books is to envision a scale. Not the scale you step on in the bathroom or the scale your doctor uses to weigh you. In this case, envision what’s called a double-pan balance scale. These types of scales allow you to weigh two things in relation to one another. When you place weights on both sides, the heavier of the two weights will sink lower. If the two weights are equal in mass, then both sides of the double-pan balance scale will appear level. Makes sense, right? 
 
In the same way, when you balance your books, the debits and credits recorded throughout a period (e.g. a quarter, a year) should “match” (which is to say they should correspond. In Part I we discussed the double-entry bookkeeping system. In this system, each transaction is recorded twice. First as a debit, or an increase. Secondly, as a credit, or decrease. For example, if Sally’s lawn company spent $3,000 on a new lawn mower, Sally would record a $3,000 debit in the left-hand side of the Equipment account. Then, Sally would record a $3,000 credit in the right-hand side of the Cash account. Both Equipment and Cash are considered asset accounts and, in this case, Sally has traded one type of asset for another type of asset. 
 
Now, these entries are akin to journal entries. They are a record of the transaction. When you balance your books, you are “posting” these entries into the general ledger in order to extrapolate the final account balances. While most bookkeeping programs will do this math for you (and point out errors in your entries at the time you make them), it’s still important you understand what’s being done. 
 
Continuing the example from earlier, Sally has redistributed her wealth between two different forms of assets in the aforementioned transaction. Thus, her Equipment account will reflect the debit, her Cash account will reflect the credit, but her overall Assets will not change because of this transaction. Now, conversely, if over the course of the month Sally not only purchased a new lawn mower but also needed to pay the firm which markets her services $2,000, the cash account balance and the overall assets would need to be adjusted down by $2,000. 
 
Once you’ve adjusted the balance of each account, you’ll have what’s called an adjusted trial balance. Assuming you’ve done everything right, when you add your company’s liabilities to your company’s equity, you’ll arrive at a figure which is equal to your company’s assets. In short:
 
Liabilities + Equity = Assets
 
Now, equity, if you’re unsure, is the value left over when liabilities are deducted from assets. (Psst! We covered equity in Part I.) This makes the equation, more accurately: 
 
Liabilities + (Assets - Liabilities) = Assets 
 
If you arrive at two different numbers, this indicates a discrepancy in your bookkeeping. You’ll need to comb back over your records, comparing debits and credits and making sure everything is indeed balanced. Once you’ve balanced the figures successfully, you’re ready to close the books and begin compiling financial statements!
 
Yay!
 
Preparing Financial Reports
 
This is one of the most exciting parts of bookkeeping, because this is the stage when conclusions can be drawn based off of the meticulous records you’ve kept. With these financial statements, you’ll be able to assess the health of your business and plan accordingly for future expansion or cutbacks. The three essential types of financial statements are: balance sheets, profit and loss “P&L” statements, and cash flow statements. We’ll provide you with a brief overview of each. 
 
Balance sheets are a snapshot of your books. They showcase the equation at work and include your current assets, liabilities, and equity. You’ll include the balances of your accounts here. When someone looks at your company’s balance sheet, they’ll be able to assess in only a moment the health of your company. Are you in the red? Or, do you have cash reserves which will facilitate expansion? 
 
Profit and loss statements, also referred to as income statements, report on revenues and expenses over a period of time. For example, a clothing company may have grossed $1.2 million in a quarter, but spent $600,000 on materials, shipping, and marketing in the same time span. Therefore, the company’s revenue was actually $800,000. By comparing multiple P&L statements, one can glean the growth (or decline) of a company. 
 
Finally, cash flow statements are a simpler version of a P&L. They focus solely on how much money the company is bringing in and sending out. By evaluating a cash flow statement, you can assess a company’s ability to pay its bills and remain afloat. 
 
Best Bookkeeping Practices
 
Sticking to a regular schedule is key to managing your books. Entering records of transactions can be tedious and time-consuming. Allowing too much time to pass between entries only makes the work unbearable when you finally do sit down. Choose a time every week, two weeks, or month, to input financial information (i.e. invoices, bill payments, revenue, etc.). Keep all of this information in one place and be sure to tackle bookkeeping when your mind is well-rested. Minor mistakes can turn into headaches later. 
 
If you’re unsure about handling the entirety of your company’s bookkeeping, there’s no shame in that! Many successful businesses outsource their bookkeeping needs, as this frees up time and mental energy. Just make sure you invest in a trusted professional to handle your bookkeeping! 
 
 
Thank you for reading the second part of the Bookkeeping Basics series! We hope we’ve demystified bookkeeping, at least a bit. Tune in for the third part of the series, where we’ll be answering commonly asked bookkeeping questions! As always, we’re happy to be able to provide you with the most relevant, up-to-date tax information for you and your family. From savings plans to tax credits to business acumen, the Hoods Tax & Accounting blog is your one-stop shop for everything you need. We offer tax preparation, bookkeeping, payroll, and QuickBooks services. If you have any questions or are interested in a consultation, please reach out! We do offer virtual consultations over Zoom, as part of our effort to accommodate everyone in these trying times. We look forward to hearing from you! Until next time, thank you for reading!