What Is Bookkeeping?

The textbook definition of bookkeeping is the routine, systematic method of retrieving financial information, categorizing that information, inputting it into an accounting system, and generating reports which are used by decision makers.

That’s a mouthful!

More simply, bookkeeping is the recording of past financial data which is used to make future business decisions.

You might still have questions surrounding, what is bookkeeping and how your business can benefit from it.

Bookkeeping helps your business remain compliant with accounting and tax rules so you can avoid unnecessary penalties and fees.

The facts are bookkeeping is complicated. There are hundreds of accounting rules that you legally must follow. Not only that, but your business and individual tax returns depend on the information in your bookkeeping records. And, no one wants to be on the IRS’s bad side.

In addition to the legality piece, bookkeeping helps you make better business decisions.

Have you ever thought about expanding your business? Of course, you have! Most business owners would love to grow their business to the next level. But the reason why the majority do not is that they are unsure as to the how? How can you grow your business?

The answer is in your bookkeeping.

For many of you, you know this already. Bookkeeping helps with filing your taxes. It helps with organizing your financial information. And it helps you make key decisions. The problem is you don’t know what exactly a bookkeeper does and therefore, don’t know what you should look for in a bookkeeping service.

After a little research, you’ll come across a few different bookkeeping companies. Though they talk about their services on their website, it may still be difficult to decipher what exactly a bookkeeping company does.

Bookkeeping can be broken down into 6 steps. A bookkeeping service is responsible for the first 4 steps. This is where their accounting knowledge is utilized and the compliance piece of your business is taken care of.

The last 2 steps are your responsibility. As stated before, bookkeeping is there to help you make decisions.

Below we discuss each step in detail and the benefits of using a bookkeeping service.

Steps of a Bookkeeping Service

1: Gather Source Documentation

Bookkeeping starts with a business transaction.

A business transaction is the buying or selling of products or services. There is always evidence of a business transaction, i.e. source documentation.

Source documents are original records containing details of a transaction. Examples are an invoice, sales order, or a receipt. All of these documents have a date, buyer/seller, amount, and product/service provided. This is the information your bookkeeper needs to start the bookkeeping process.

In today’s online world, most people don’t keep up with physical copies of all of their source documents. Instead, they rely on their bank statements to tell the story.

In most cases, bank or credit card statements have all of the information needed to substantiate a business transaction.

Your bookkeeper will need access to all of your business’ bank and credit card statements. Granting access to your monthly bank statements happens in 1 of 2 ways.

1. You can manually send (usually electronically)
2. Granting your bookkeeper access to your online banking

With the first option, the con is you have to remember each month to download your statements and send to your bookkeeper. Some business owners prefer this method for security reasons.

The second options you “to forget” since your bookkeeper and log in and retrieve this information themselves. If security is your concern, most banks allow you to grant an accountant type access to a user. Meaning, the user cannot change or make any transactions. Instead, he or she can only view information.

With whichever option you choose, keep in mind that cash transactions are not recognizable using bank statements alone. In this case, you would have to retain the physical receipt or recall the purpose of the cash transaction and communicate that to your bookkeeper. Your bookkeeper can then correctly classify those types of transactions.

As a tip, it’s good practice to use credit or debit cards to make and receive all payments. This way, your bookkeeper can rely mostly on your bank statements to classify transactions.

Step 2: Categorize Your Transactions

Have you ever tussled around your desk and been greeted with a boatload of receipts? And being completely clueless about what they were for?

Understanding what is bookkeeping is understanding that every transaction needs to be classified into a specific category. It is the core of the bookkeeping process.

Your bookkeeper will categorize your transactions depending on its business purpose.

There are 5 main categories that transactions fall into:

1. Assets
2. Liabilities
3. Equity
4. Revenue
5. Expenses

Each one of these categories can be broken down further into subcategories. For example, you could have a subcategory for inventory which would fall under the asset main category.

The first step of categorizing is identifying which main category a transaction belongs to.

Assets are defined as resources that have some future economic benefit. For example, cash would be an asset. It is a resource and can be used in the future to benefit your business.

Liabilities are future obligations. Examples are a payroll liability or a loan from a bank.

Equity is ownership interest. Equity increases with revenue and capital contributions. Equity is decreased with expenses and distributions.

Revenue is generated by the sale of products or services.

Expenses are the costs incurred to generate revenue. Expenses could be cost of goods sold or supplies.  

Most bookkeepers will use an accounting software to help with the organization and classification of transactions. Bookkeeping is no longer a pencil and paper process.

Step 3: Reconciling Your Transactions

A good bookkeeper will correctly classify your transactions. A great bookkeeper will reconcile your transactions to make sure everything is accounted for.

The idea of reconciling is simple. It is the process of matching all of your transactions on your bank statements to what is in your accounting software.

When your bookkeeper is dealing with hundreds or even thousands of transactions, it can be easy to double count a transaction or two. Or accidentally miss one.

But reconciling helps to catch all errors.

He or she starts with the beginning balance on your statements (which should match what’s in your accounting program) and checks line by line that every transaction is accounted for.

Step 4: Preparing Financial Statements

The last step for a bookkeeper is to prepare financial statements.

The process of adding, classifying and reconciling your transactions provide the inputs for your financial statements. 

There are 3 main financial statements that should be prepared: the balance sheet, income statement, and cash flow statement.

Balance Sheet

The balance sheet is also known as the statement of financial position. It contains asset, liability and equity transactions.

What makes the balance sheet unique from the other financial statements is its balancing component. Assets on the balance sheet must equal liabilities plus equity. If not, your balance sheet is out of balance!

Income Statement

The income statement is also known as the profit and loss statement. It contains revenue and expense transactions. The income statement tells you how profitable you are during a certain period.

Cash Flow Statement

The cash flow statement has 3 components: cash from operations, cash from financing and cash from investments.

The cash flow statement shows how transactions from the balance sheet and income statement affect your cash account.

Have you ever heard the saying cash is king? Well, it is true. Investors and creditors want to know if you have cash on hand. Without cash, your business is not sustainable.

Steps for Business Owners

Step 1: Read Your Financial Statements

So your bookkeeper prepared your financial statements. Now what?

Digging into the details of your company’s financial statements may not sound appealing, even for the most financially savvy business owner.

However, businesses succeed or fail based on what their financial statements are trying to tell them. Therefore, it is critical for you to understand your financial statements and take advantage of the insight it’s giving you.

In order to read your financial statements, you should understand how they are structured.

Structure of the Balance Sheet

Remember the balance sheet must balance. The assets are listed first and liabilities and equity are listed last.

Assets are ordered in terms of liquidity or how long it will take for the asset to convert to cash. For this reason, cash is always the first asset you will see on the balance sheet, followed by other current assets (accounts receivable, inventory).

Long-term assets are listed after the current assets (i.e. equipment). Fixed assets, like equipment, take into consideration depreciation, a contra asset, that would reduce the asset side of the balance sheet. Think of depreciation as the amount of an asset that has been “used up”.

The liabilities section is listed similarly to assets. Current liabilities appear before long-term liabilities. Current liabilities are debts due within 12 months. Common accounts listed under current liabilities are accounts payable, wages payable and credit cards. Common accounts listed under long-term liabilities are bank loans, car loans, and capital leases.

The equity section is listed last on the balance sheet. It shows the ownership in the business. It is sometimes referred to as the “book value” or net worth of a business since its value equals assets minus liabilities. Also, retained earnings is a section within equity. Retained earnings are the dollar amount of earnings reinvested in the business.

Structure of the Income Statement

The first component of the income statement is revenue (a.k.a. the top line). It is the dollar amount of product or service sold at a given time. The revenue section may be broken down further into specific types of income based on products or services.

The next item is the cost of goods sold or cost of sales. These are the direct expenses associated with selling your products or services.

Examples are inventory costs and labor.

The difference between the revenue and cost of sales is gross profit.

The other expenses of the business are listed below the gross profit.

“The bottom line” of the income statement is the net income. It is the amount after subtracting all of the expenses of the business. It answers the question, “what is the profit or loss of the business?”

Structure of the Cash Flow Statement

The cash flow statement tracks the cash coming in and going out of your business. These cash inflows and outflows are broken into 3 categories: operating, financing and investing.

Cash flows from operations is the cash activities related to performing the regular, ongoing activities of your business. Activities like selling products or services would be considered cash flows from operating activities.

Cash flows from financing relates to capital raising activities of your business. So if your business borrows money from a bank, that is considered a financing activity. When your business starts repaying the loan, that is a financing activity. Financing activities don’t just relate to loans but equity funding too. So if your business issues stock to investors, that too is a financing activity.

Cash flows from investing relates to the gains and losses from your business’ investments. If your business invests in the stock market, that is considered an investing activity. When your business buys stock in another company, that is an investing activity.

Step 2: Make Decisions

One of the most important purposes of bookkeeping is to help you make better, more profitable decisions.

Every day, business owners are faced with decisions concerning all areas of their business. Answering the age-old question, “How can I make more without spending more?”

You now have gained familiarity with the 3 most common financial statements. Now, it’s time to learn how to use these statements to make well-informed business decisions.

The balance sheet outlines your company’s assets, liabilities, and equity.

As such, the balance sheet can be used to gauge the liquidity and sustainability of your company.

Let’s take an example of a company who has $1,000,000 in net income.

Their balance sheet shows 3 months of income in accounts receivable.

Knowing this information, the owner might decide to shorten the collection period to have more cash on hand.

Next, the income statement tells you the operating performance of your company. It lists out the revenues and expenses and spits out a profit or loss.

However, the income statement tells you a lot more than that. The details of the income statement can help you focus on the strengths of your company and improve on its weaknesses. You’re able to see which product/service lines are performing better and how much you are spending in each area.

The cash flows statement tells you how much cash your company has on hand and whether or not it’s staying afloat. It shows if your business is able to pay its debts as they come due which is a component potential lenders and investors are interested in. If your operating cash flow has decreased, then you might reassess some of your operating costs or pricing.

What to Look for in a Bookkeeping Company

Not all bookkeeping companies are the same. Some work hard on your financials, ensuring you receive the most accurate financial statements every single month. Others use shortcuts, that could result in improper treatment of your transactions and lead to higher tax bills or even penalties.

If you are considering hiring a bookkeeping company to handle all of your bookkeeping needs, consider the following when narrowing down your choices.

Education. The person you have doing your books should have some level of formal accounting education. The reason being is that he or she will have a greater overall understanding of business. Not only organizing your financials but being able to point out issues and offer solutions.

Experience. Education is not enough on its own. Your bookkeeper should have practical experience. Experience is not one dimensional. A bookkeeper with 30 years of experience doing a restaurant’s books does not necessarily correlate as a good fit for your business. Consider the depth and quality of a bookkeeper’s experience, not just the quantity of years.

In House Bookkeepers. Some bookkeeping companies outsource your accounting work in order to cut costs. However, that compromises your financial data since people you did not hire would have access to it. Consider bookkeeping companies who perform their work in-house.  This way, you know exactly who is managing your financial information every day.

Customized Services. No two businesses are the same. Your business is unique and requires different bookkeeping solutions. Maybe you need help with managing accounts payable or need help sending invoices to customers. Make sure you work with a bookkeeping company that tailors their services to your needs.

Now That You Know What Is Bookkeeping…

Now you should have a better understanding of what bookkeeping is and how bookkeeping can help your business.

If you find that you lack the time or knowledge to do your own bookkeeping, consider LYFE Accounting for your bookkeeping needs. We provide you with the financial statements you need to make smart, profitable decisions.