Step 1: Separate your business and personal expenses
The first step to mastering your business finances is pretty simple: get a business bank account and separate your business and personal expenses.
Why? Liability is one big reason. If you’re running a corporation or an LLC and there isn’t sufficient distance between your personal and business finances, there’s a chance that you could be held personally liable for any debts incurred by your business.
Mixing together personal and business expenses in the same account can also result in unnecessary stress when you need to file taxes or do your bookkeeping. It could mean a business expense gets lost in your personal account and you miss out on an important deduction. Or it could mean your CPA spends more time doing your taxes. Either way, you end up losing money.
Step 2: Choose a bookkeeping system
There are two main bookkeeping methods: single-entry and double-entry bookkeeping.
Under single-entry, journal entries are recorded once, as either an expense or income. Assets and liabilities (like inventory, equipment and loans) are tracked separately. If you’re just starting out, are doing your books on your own and are still in the hobby stage, single-entry is probably right for you. It’s simple, fast and good for really basic bookkeeping. Double-entry is more complex, but also more robust, and more suitable for established businesses that are past the hobby stage.
Under double-entry bookkeeping, all transactions are entered into a journal, and then each item is entered into the general ledger twice, as both a debit and a credit. Most accounting software today is based on double-entry accounting, and if you ever hire a bookkeeper or accountant to help you with your books, double-entry is what they’ll use.
Step 3: Choose an accounting method: Cash or Accrual
You have another important decision to make when setting up your bookkeeping: whether to make your accounting process cash or accrual based.
Under cash accounting, you record transactions only once money has exchanged hands. If you bill a customer today, those dollars don’t enter your ledger until the money hits your bank account. Many small businesses opt for the cash basis of accounting because it’s easy to maintain, doesn’t require you to track receivables or payables, and tells you exactly how much cash you have on hand at any given point in time.
Using the accrual accounting method, you record income when you bill your customers, in the form of accounts receivable (even if they don’t pay you for a few months). Same goes for expenses, which you record when you’re billed in the form of accounts payable.
Generally speaking, accrual accounting is better for larger, more established businesses. It gives you a more realistic idea of your business’ income and expenses during a period of time and provides a long-term view of the business that cash accounting can’t provide.
Step 4: Choose the right tools
Every transaction you make needs to be categorized when it’s entered in your books. This helps your bookkeeper catch more deductions, and will make your life easier if you get audited.
The way you categorize transactions will depend on your business and industry. Generally speaking, your transactions fall into five account types—assets, liabilities, equity, revenue, and expenses. Individual line items are then broken down into subcategories called accounts. In our ice cream shop example, some accounts in your ledger might be “revenue-ice cream sales”, “expenses-ice cream ingredients”, etc.
These days, you’ve got three options when it comes to bookkeeping tools.
You could go with one of dozens of popular cloud accounting solutions, like QuickBooks, Xero or Wave. These tools can be powerful if you know what you’re doing. However, if you don’t have a lot of bookkeeping experience (or don’t have time to learn), they could stress you out more than they help you. Especially if your accountant ends up telling you you’ve been using them incorrectly for the past year.
Step 5: Make sure your transactions are categorized
Every transaction you make needs to be categorized and entered into your books. This helps your bookkeeper catch more deductions, and will make your life easier if you get audited.
Remember: an unmarked receipt for lunch at a restaurant might not mean much to you six months later. Was it a client lunch? Did you treat your employees after a successful quarter? Properly categorizing and recording your transactions can help you avoid doing all of this extra investigative work later.
If you’re going to be doing your own bookkeeping, it’s worth talking to a pro when you set up your system to make sure the accounts you create align with your industry standards and CPA expectations.
Step 6: Choose a system for storing your documents
At tax time, the burden is on you to show the validity of all of your expenses, so keeping supporting documents for your financial data like receipts and records is crucial.
Diamonds may be forever, but the ink on your expense receipts is not. Since the IRS accepts digital records, it’s smart to use a cloud-based system like Dropbox, Evernote, or Google Drive so you never have to deal with smudged receipts. You can also use apps like Shoeboxed, which are specifically made for receipt tracking.
Step 7: Organize your deductions
The IRS’ golden rule on deductions is that they must be both ordinary (a common expense in your field) and necessary to your business. For example, pens would be an ordinary expense for a writer, but a $900 pen might not fall into the category of “necessary.”
But even if an expense is ordinary and necessary, you may still not be able to deduct all of it on your taxes. Just because you do most of your work from your dining room table doesn’t mean that you can deduct your entire monthly rent. Luckily, the IRS has put together a comprehensive guide on business deductions that you can consult if you’re ever unsure about a deduction.
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