I love modern accounting software. Companies like Intuit and Xero have demystified accounting for a whole wave of business owners who want to keep their own books. They both do a great job of morphing the mechanics of debits and credits into easier to understand concepts like creating a new bill or invoice. Funnily that same feature (hiding away the underlying accounting) is what gets most users into trouble - there are very few “best practices” built into the system to keep users from making mistakes.
As much as we try to step around it, some accounting principles are still helpful to know before doing your own bookkeeping. Today we will explore some of those principles and practices so that you can feel confident when posting a transaction of any kind to your books.
This is something that people often have trouble understanding, and it’s no wonder because it can seem complicated. Basically, there are two fundamentally different methods of recording transactions:
You might already be confused. That’s okay. The main distinction is that under accrual accounting we do not record transactions as revenue or expenses based on when the money enters or leaves our hands. For example, if you are using the accrual method and you pay someone today for consulting work they will complete next month, you would record that as a prepaid expense (asset) today and then move it to the correct expense category (consulting expense) next month after the service is performed. The opposite would be true for revenue if you were the consultant. You might take the cash for the consulting fee today, but it won’t be recorded as revenue until you complete the service next month. This little distinction is really all you have to remember. These two situations embody the revenue and expense principles, which are two of five main pillars of basic accounting.
Whether you know it or not, you are required by the IRS to choose which method you use, and it has to stay that way unless they approve you changing it. I highly recommend using the accrual method as it is the foundation of all modern accounting and financial reporting. It might be a little more complicated to get familiar with, but it will be worth it in the long run, and a lot of the rest of these principles assume you are using it.
Whichever method or treatment you choose to apply to a particular transaction, continue doing it the same way every time. If you realize you’ve made a mistake later, it will be much easier to find and fix transactions that were all recorded the same way. When I was managing accounting teams in-house, I would tell my fellow accounting coworkers, “it is fine to be wrong sometimes, but try to be consistently wrong.” It will make life easier for you and any other people you bring in to manage your books.
For example, maybe there is a daily recurring transaction for supplies, but you’re not really sure what they are. Choose an account to put it in and keep putting them in the same account until you get the direction you need. Then make sure to move the old transactions, and put them in the correct account going forward.
Let’s say you are in the lawn mowing business, and you need a new truck to help haul equipment. You find a nice used one for around $10,000 and purchase it. At the end of the month, you are wondering where to put that truck in the books. You paid cash for it, so you might think it would be an expense...but it isn’t. It is an asset, and needs to be capitalized.
You may have heard that word before, but not know what it means. Capitalizing a purchase just means that you will record it as an asset on your balance sheet instead of an expense on your income statement. How do you know which is which? Well, the IRS is kind of murky when it comes to making this determination. It ultimately depends on whether the purchase has a useful life of at least one year and whether it exceeds the capitalization threshold you set for your business.
That threshold is tied to the concept of materiality (i.e. is the transaction financially material?). The IRS lets you decide what dollar amount threshold is material to your business. For instance, you could say anything over $1,500 is material and needs to be recorded as an asset, but if you were a multi-billion dollar company that threshold would probably be too low. Clear as mud? You’re not alone. The decision of what dollar amount to use is something I advise you to ask your CPA. They will have a much clearer perspective on what other companies your size and in your industry are using, and that’s what you pay them for. In the end, whichever threshold they tell you is the one to use going forward.
This one is easier than the others, and its name is a giant clue as to what it requires. The matching principle states that you should record expenses in the same period as the revenues to which they are related. For example, taking our lawn mowing example from above, if your company mowed 100 lawns in January, then you need to record the payments to your employee for mowing those lawns in the same month. This is only true under the accrual method of accounting, but we already went over why you should be using that method anyway.
After all, it makes sense that you would want to see the true profit for that month based on also having taken out the expenses related to that month. Over time, using this principle will give you deeper insights into your business’ average monthly income, seasonality, and ways to improve profitability. It is near impossible to glean any kind of granular insights beyond your bank balance without using the matching principle. The data are just spread over too many periods to make sense.
This is a pet favorite of mine. I love logging into a set of books, and seeing all of the available fields for a transaction filled out. When keeping your books, it is important to fill out each field offered to you with as much detail as you can. For example, if you are entering a vendor bill, make sure to fill out the name, date, amount, and leave a detailed description of what services the bill covers. If you can upload a PDF of the bill, do it. The more data the better.
There are two reasons this is important. First, you don’t know who will need this data down the line. You could outgrow doing your own books, have a cleanup project that requires someone else to look through transactions, or have to remember yourself what happened a year ago when you entered that transaction. In any of those cases, time and money will be saved in direct correlation to the amount of data connected to the transaction in question. The second reason is audits. It could be an audit before a large financing you are going through, or and IRS audit, but either way having the data attached will make your life much easier, and give the auditors more comfort that you aren’t hiding anything. The less data and support they have, the deeper they dive as the suspect there might be other material information missing from your books. It is best to take a couple extra seconds while your brain is fresh and do it right the first time. As a wise person once said, “if you don’t have time to do it right, when will you have time to do it again?”
For answers to questions you have about this or related topics, schedule your free consultation today.
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