Bookkeeping is the recording of the financial records of a business in an accounting or bookkeeping system. (For this article, these terms may be interchanged.) Bookkeeping is the most essential part of the business’s financial records; It forms the foundation of accountants and other financial professionals’ work. It is also used to get loans, and investments, calculate taxes and determine how the business performs. Any work the accountant or other financial professionals do cannot be relied upon if you have bad data. They are using the books you’ve provided them.
Bookkeeping brings your financial data together in a way that can be easily digested and reviewed.
Having good bookkeeping processes in place allows you to understand how things are going and how to make adjustments before things go wrong. Unfortunately, many small businesses avoid bookkeeping as a nuisance that has to be done for taxes to be filed. They don’t pay attention to their finances regularly, which is a mistake.
There isn’t a lot of value to bookkeeping at the end of the year. What good is it finding out something went wrong 12 to 18 months after it happened? Regular, up-to-date bookkeeping backed by robust financial processes and controls will allow you to pivot when needed and eliminate minor problems before they become big.
Cash Basis vs Accrual Basis
Bookkeeping can be done in either of these accounting bases or a blended methodology.
A cash basis only records transactions when the cash changes hands. For instance, if you receive a bill from a supplier, it isn’t recorded in the books until it is paid. When paid, it debits an expense and credits the bank account.
Accrual-based accounting records transactions when they occur, not when they are paid. That same bill from a supplier will be entered into accounts payable and recognized as an expense based on the date of the bill. When it is paid, it debits accounts payable and credits the bank.
In Canada, corporations generally must keep records in an accrual-based system.
Modern accounting is based on the concept of double-entry bookkeeping. All entries have two sides to them – a debit and a credit. This concept has been around since the 13th century. Make sure that your bookkeeping system uses double-entry bookkeeping. Some software out there doesn’t, yet calls itself bookkeeping software.
Chart of Accounts
This is part of the underlying architecture of your accounting system. It is a list of accounts (aka categories) that includes all your assets, liabilities, equity, revenue and expenses. Each account has its natural balance – a debit or a credit.
All bookkeeping can be thought of in terms of a journal entry. Each journal entry has two sides: a debit and a credit. Modern bookkeeping systems, such as Quickbooks Online and Xero, use modules and tools to make the product more user-friendly for the layperson. They hide the debits and credits of journal entries behind the scenes. If you’re using accounting software, it is essential to use the tools they provide you in the manner intended, or you may not have accurate books and records.
Debits are on the right side of a journal entry. Accounts that should typically have a debit balance are assets and expenses. A credit balance in one of these accounts could signify a problem. A credit balance will appear as a negative in an asset or expense.
Credits are on the left side of a journal entry. Accounts that should typically have a credit balance include liabilities, equity and revenues. Similar to the previous section, a negative or debit balance in an account that should be in a credit position indicates a problem.
What is Equity?
Although most business owners know what assets, liabilities, revenues and expenses are, the equity section is sometimes not really understood. The total equity is the book value of the business.
We won’t be breaking down the items in the equity section or discussing business valuation for this article.
General Ledger and Sub-ledgers
Your accounting records all enter your General Ledger eventually. However, tracking all your accounts and transactions in a single ledger is overwhelming. That’s where sub-ledgers come in. Sub-ledgers are a portion of your general ledger that tracks a specific group of items. For instance, accounts receivable and accounts payable are kept in a sub-ledger. Each sub-ledger may have its own sub-ledgers. For example, a single customer’s records are a sub-ledger of the accounts receivable sub-ledger. Although the general ledger’s debits and credits must balance, sub-ledgers often do not.
Financial Statements and Reports
Accounting software comes preloaded with various reports that can be used by management. Understanding the difference between a financial statement and financial information is important. According to CPA Canada, reports that come directly from your accounting system and documents that support transactions are financial information. A CPA reviews and brings together the financial information to create financial statements. There are three main types of financial statements.
Audited Financial Statements
Audited financial statements are produced by licensed public accountants. They are typically the highest level of assurance work that accountants perform. The accountants must follow Generally Accepted Auditing Standards and test a sample of the transactions recorded in the books to ensure accuracy. They will also review larger and riskier transactions to ensure they are appropriate. They will discuss with your financial team how the books are kept to understand the basis of accounting and will also learn about the financial controls you have in place.
Audited financial statements are accompanied by an audit letter. This discloses the auditor’s opinion to a reader of the financial statements. An unqualified audit opinion is a good thing. This means they didn’t find any problems with how the books and records were kept.
Since audited financial statements are the highest form of assurance work, they are often the most expensive to ask for and the most intense on your accounting department’s time and stress levels. These will often start in the low five figures.
Reviewed Financial Statements
Reviewed financial statements are the next level of assurance work. Again, this work must be completed by a licensed public accountant. They perform similar work to an auditor but with less strict testing requirements. If you are working with a lender or other third party that is asking for audited financial statements, find out if reviewed statements will be sufficient. These often cost a lot less.
Compiled Financial Statements
Compiled Financial Statements are relatively new. You may have heard of Notice to Reader Financial Statements in the past. CSRS 4200 is the new standard that took effect for year-ends after December 14, 2021. It replaces section 9200, which governed Notice to Reader Financial Statements.
Similar to Notice to Reader Financial Statements, Compiled Financial Statements offer no assurance to the reader whatsoever. The responsibility for the underlying financial information is solely the responsibility of management. The accountant has a discussion with management to gain a basic understanding of the basis of accounting, which must be disclosed in a note to the financial statements. They also find out who the audience for the statements will be and ensure that a third party can request additional information from management.
Many accountants’ offices out there are late in adopting this new standard.
Check your Accountant
If you’re unsure of your accountant, you probably shouldn’t be working with them. If you are working with an accounting office, it’s probably a good idea to ensure they are working above board. There are a lot of accountants out there who don’t operate ethically.
To check on your accountant’s qualifications, you can go to the provincial governing body to check. CPA Ontario’s database allows you to look up members, firms and licensees.
The balance sheet is a snapshot at a point in time of the net book value of the business (which can be quite different from the value when selling a business). It shows your assets on one half of the balance sheet and liabilities and equity on the other. In other words, the debits and credits are always equal, which makes it balanced.
Most business owners focus on the income statement, also known as the profit and loss statement. It shows the business’s performance over a period of time, outlining the revenues, expenses and net income. At the end of a period, the activity from the income statement is closed out to retained earnings in the equity section of the balance sheet.
It is common for the net income on the income statement to be less than the cash left in the bank account at the end of the year. This is because cash is used to purchase assets that appear on the balance sheet, not just to pay for expenses that appear on the income statement.
Cash Flow Statement
The cash flow statement shows where your cash is coming from and where it is going. There are two formats it can take:
The direct format of the cash flow statement shows exactly where the cash came from and where it went. It does not reconcile cash-based and accrual-based accounting. For instance, it will show cash collected from customers, which won’t necessarily match sales. It won’t capture sales that are made but not collected at the period end.
The indirect format of a cash flow statement reconciles the accrual-based accounting system with the actual cash that moved around. It is divided into three main sections: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
Cash flow statements are vital to understanding where your cash is coming from and where it’s going.
Management can regularly pull many other reports from a good, up-to-date bookkeeping system. These reports can be vital to management’s understanding of who they need to collect from, who they need to pay, and where they need to adjust. Other reports are frequently used in management accounting.
Management accounting is where things get exciting (yes, accounting can get exciting!) It covers a wide range of topics, including budgeting and forecasting; supporting decision-making through financial analysis and modelling; performance management; cost management; and much more.
Management accounting identifies management’s needs and helps develop systems to collect and analyze the data that management needs to steward the business into a successful future. There is much more to discuss, but several articles will need to cover it.
How is Your Business Doing?
If you can’t answer this question with confidence within a few clicks of the mouse, perhaps it’s time to think about how well your bookkeeping system is serving your business. Feel free to reach out to us if you need help. If we aren’t the best fit, we’ll try to find the right home for you.