Introduction to small business bookkeeping

If you are an aspiring accountant, the concepts that we will cover in this section will be familiar to you. However, if you are brand new to bookkeeping, make sure you grab a notepad to take notes, and a cup of coffee to stay alert. In this section, we will discuss the following: money coming into your business; money going out of your business; inventory and fixed asset purchases; the money you owe (liabilities); how to properly track everything using the chart of accounts; the two accounting methods; and double-entry bookkeeping.

One of the benefits of using QuickBooks to manage your books is that you don't need an accounting degree to learn how to use the software. However, you should have a basic understanding of how bookkeeping works and of what's happening behind the scenes in QuickBooks when you record transactions. As we walk through how to record transactions in QuickBooks, we will also explain what is happening behind the scenes, to further deepen your understanding of bookkeeping.

The main areas of your business include the following:

• Money in (sales)
• Money out (expenses)
• Inventory and fixed asset purchases
• Liabilities
• Chart of accounts
• Accounting methods
• Double-entry bookkeeping

Let's discuss each of these areas in more detail.

Money in (sales)

Every business generates sales by either selling products, services, or a combination of the two. For example, a freelance photographer provides photography services for weddings, graduations, and other special events. A retailer that sells custom T-shirts in various sizes and colors provides a product to generate sales.

In general, there are two types of sales: cash sales and credit sales. The primary difference between the two is in terms of when you receive payment from your customer. Cash sales are sales that require payment at the time a product is sold or services have been provided. For example, let's say a customer walks into a T-shirt shop and buys a T-shirt. This sale would be considered a cash sale because the sale of the T-shirt and payment by the customer takes place at the same time.

Credit sales are the opposite of cash sales because the sale and the payment by the customer take place at separate intervals. For example, let's say the freelance photographer spends four hours at a wedding and sends their customer a bill a few days later. This is considered a credit sale because payment will take place sometime in the future after services have been rendered.

For bookkeeping purposes, credit sales are recorded as accounts receivable. Accounts receivable, also referred to as A/R, is the money that is owed to you by customers. We will talk more about how to keep track of your A/R balances later on.

Now that you understand sales, let's take a look at expenses.

Money out (expenses)

The majority of the money that flows out of a business is used to pay for business expenses. Business expenses can be categorized as recurring or non-recurring. A recurring expense is one that repeats, such as rent, utilities, and insurance.

A non-recurring expense is one that is unexpected. For example, if a photographer's camera stops working and they need to spend money to get it repaired or buy a new one, this would be considered a non-recurring expense because it was unexpected.

QuickBooks is designed to help you easily track both recurring and non-recurring expenses. In this book, we will cover how to create recurring transactions in QuickBooks so that you don't have to manually enter them each time they occur. Plus, you will learn how to pay non-recurring transactions by writing a check, making online payments, or paying with a credit or debit card.

Now that you know how to keep track of money coming into your business and money going out of your business, let's see how you should handle inventory and fixed asset purchases next.

Inventory and fixed asset purchases

To keep track of all the costs and quantities for each item that you purchase, you would create a purchase order and send it to your vendor supplier to place an order. When you receive the goods, you would record them in your inventory. As you sell products to customers, you will record the sale in QuickBooks so that your inventory, cost, and quantities can be adjusted in real time.

If you purchase computers, printers, or other equipment for your business, these items are called fixed assets. When you record these items in QuickBooks, they will be categorized as fixed assets. Fixed assets must be depreciated over their useful life.

Liabilities

Many people think that liabilities are expenses, but they are not. A liability can be described as a loan you have with a financial institution, or money that you owe to vendor suppliers, which is also called A/P. The primary difference between expenses and liabilities is that if you were to go out of business tomorrow, you would no longer have to pay expenses. Instead, you would stop making payments for utilities, and you would lay off employees to eliminate payroll expenses.

On the other hand, if you go out of business, you still have to pay your outstanding liabilities. For example, if you have an outstanding loan with a bank, you still have to make your loan payment until it has been paid off. The same would apply for unpaid bills for products and/or services you received. This means you would have to contact the vendor/supplier and notify them you are going out of business in order to make payment arrangements.

Chart of accounts

The chart of accounts is a systematic way of categorizing business financial transactions. Every transaction for your business can be categorized into one of five primary categories: Income, Expenses, Assets, Liabilities, and Owner's Equity.

Here is a brief description of each category, with an example:

• Income: Proceeds from the sale of products, such as T-shirts, or services such as photography or consulting services.
• Expenses: Payments made to maintain daily business operations. This includes, but is not limited to, rent, utilities, payroll, and office supplies.
• Assets: Assets are items that your business owns. For example, the money in your business checking account is an asset, and the inventory that you have on hand is an asset.
• Liabilities: As discussed, liabilities consist of money that you owe to creditors. This includes loans, lines of credit, and the money owed to vendor suppliers (for example, A/P).
• Owner's Equity: Equity is everything that your business owns. For example, any money that you invest in your business is equity.

When setting up your QuickBooks company, you don't have to worry about creating a chart of accounts from scratch. Instead, QuickBooks will create a default chart of accounts, based on the industry your business falls into.

Accounting methods

One of the key decisions you need to make when setting up your books is which accounting method you will use. There are two accounting methods to choose from: cash-basis accounting, and accrual accounting. The primary difference between the two accounting methods is the point when you record sales and purchase transactions in your books.

Cash-basis accounting involves recording sales and purchases when cash changes hands. Let's say a photographer is not paid right away for most of his jobs, but instead, he sends an invoice to the customer that includes a payment due date. Until the photographer receives payment in cash, or by check or credit card, he does not count the photography services as income under the cash-basis accounting method.

Accrual accounting involves recording sales as soon as you have shipped the products to your customer, or have provided services. Going back to our photographer example, the photographer would count the services he provided as income once he completed taking pictures, regardless of when the customer actually pays for the services.

In general, most small business owners will start out using the cash-basis accounting method. However, according to the Internal Revenue Service (IRS), there are certain types of businesses that are not allowed to use this method of accounting.

The following businesses should never use cash-basis accounting:

• Businesses that carry an inventory
• C-corporations (regular corporations)
• Businesses with gross annual sales that exceed $5 million

One of the benefits of using QuickBooks is, regardless of which accounting method you choose, it does not change how you record transactions. As a matter of fact, you can start recording transactions into QuickBooks and decide later on which method you will use. As we will discuss in the chapter on reports, you can run reports for either method (cash or accrual).

Double-entry bookkeeping

You may have heard the term double-entry accounting/bookkeeping. This means that, for every financial transaction that you record, there are at least two entries—a debit and a credit. This ensures that both sides of the accounting equation always remain in balance.

The accounting equation is as follows:

Assets = Liabilities + Owner's Equity

Let's look at the following example.

Let's say a T-shirt owner goes out and purchases $100 in T-shirts from a supplier. He doesn't pay for the T-shirts right away, but the supplier will send him a bill later on. For this transaction, inventory increases by $100 and liabilities increase by $100. Since both assets and liabilities increased, our books remain in balance.

The impact of this transaction on the accounting equation is as follows:

Assets = Liabilities + Owner's Equity
$100 = $100 + $0

Behind the scenes in QuickBooks, the following journal entry would be recorded for this transaction:

Financial Impact	Account	Amount
Debit (Dr.)	Inventory (T-Shirts)	$100
Credit (Cr.)	Accounts Payable	$100

In this section, we have covered the seven main areas of focus for managing the books for your business: money coming into your business in the form of sales to customers; money going out of business for expenses such as office supplies and rent; inventory and fixed asset purchases, and how to record them on your books; money you owe to suppliers and creditors (liabilities); how to manage the chart of accounts; the two accounting methods (cash-basis versus accrual); and how double-entry bookkeeping works.