You had a great idea for a business, decided on a business structure, got a business license, and maybe you’ve even made a few sales. Congratulations! Now you’re probably thinking about what you’ve successfully managed to avoid thus far: bookkeeping. It might be very low on your growing list of what you want to learn how to do for your business, but putting a bookkeeping system in place now will save lots of headaches in the future (ahem, tax time) and will help you have a clear financial picture on how your business is performing.
It may seem daunting, especially if you don’t know a thing about accounting, but you got this! We’re going to walk you through the steps to get yourself set up and be able to maintain your books while doing what you set out to do: run your business.
There are 7 steps to set up a bookkeeping system for your small business which we will discuss in detail. Here are the steps:
- Open a Business Bank Account
- Determine Period and Accounting Method
- Understand Bookkeeping Basics
- Decide to DIY, Use Software, or Hire Someone
- Set Up Your Taxes
- Keep Good Records
Step 1: Open a Business Bank Account
When you’re launching your business, it’s possible that you haven’t gotten around to opening a new bank account yet, so you’re paying business expenses and possibly depositing cash made from sales into your personal bank account. This is okay, but the first thing you’ll want to do is open a separate bank account specifically for your business. You are required to have a separate business account if your business is registered as an LLC, S-Corp, or Corporation. Sole proprietors are not required to have one since business taxes flow through to the sole proprietor’s personal taxes, but it will be so much more helpful for bookkeeping purposes. You won’t want to look through your bank statements and peel apart your personal transactions and business transactions every month!
Another benefit of having a separate business bank account is that it helps your chances of obtaining business loans because it shows the seriousness of your business. Also, even if your personal credit isn’t the strongest, you can start off your business account on the right foot by making payments on time and building good credit.
Things to take into consideration when deciding what banks to use are convenient location (or robust online banking if you don’t need one with brick-and-mortar locations), fees, lending options if you might want a loan, and special offers for opening a new account.
Step 2: Determine the Period and Accounting Method
First up, decide on what you want your tax year to be. A “tax year” is simply a period of 12 months in which you record revenues and expenses and keep records. You default to a calendar year and most companies stay with it because it’s the easiest and you don’t have to request a change with the IRS.
Sometimes it makes sense to have a tax year something other than a calendar year (called a fiscal year), like if you have a seasonal business that makes most of its sales during the holidays. To change from a calendar year to a different fiscal year, you can apply via Form 1128, Application to Adopt, Change, or Retain a Tax Year.
Next, you need to choose your accounting method to arrive at how you will calculate income and expenses. Your options are cash basis and accrual basis. Here’s how they work:
Cash basis is recording revenue when received and expenses when paid. For example, if you own a jewelry business and you sell a bracelet for $50 in October and send an invoice to your customer and they pay it in November, you would record the $50 revenue in November because that’s when you received the cash. It works the same way for expenses. If you purchased some beads for $20 from your supplier in October, they gave you an invoice, and you paid it in November, you would record the $20 expense in November because that’s when you paid it.
Most small businesses, especially sole proprietorships, use the cash basis because it is the simpler of the two when it comes to bookkeeping. Any company is permitted to use the cash basis unless the business is a tax shelter or if average annual gross receipts for the 3 preceding tax years were over $25 million. IRS.gov
Accrual basis is recording revenue when earned and expenses when incurred. We’ll use the same jewelry business example. If you sell a bracelet for $50 in October but don’t receive the cash until November, the revenue will still be recorded in October because that’s when the revenue was earned. If you purchase some beads for $20 from your supplier in October but you don’t pay your supplier until November, you record the expense in October because that’s when it was incurred. This accounting method introduces the use of Accounts Payable and Accounts Receivable. Any business is free to use the accrual basis of accounting. The benefits of using an accrual basis is it gives you a clearer picture of money earned and spent during a specific time period (because paying and receiving cash might happen in a different period), and it conforms to Generally Accepted Accounting Principles (GAAP).
Step 3: Understand Bookkeeping Basics
I get it. You’re a business owner, not a bookkeeper. Why do you need to know this stuff? The truth is, there are many ways to outsource your bookkeeping, which we’ll discuss in the next section, but it benefits you as a business owner to understand how it works so you can analyze the financial health of your business. Knowing how much money you have to spend or how much you need to earn to meet your goals will only benefit you. You don’t need to take hours-long courses or read books on bookkeeping, but having a general high-level understanding will help. I’ll keep it brief; I promise!
What is bookkeeping? It’s the process of keeping track of every transaction made by your business. Since these transactions are affecting different accounts, bookkeepers need to have a chart of accounts, which is an index of all the company’s financial accounts. Each account in the chart of accounts has a number associated with it so that the transactions can be assigned to that account number. When a transaction happens, such as making a sale, at least two accounts are affected. If you sell a $50 bracelet and your company uses the cash basis, your revenue account goes up by $50 and your cash account goes up by $50. If you buy $20 of supplies, your inventory account goes up by $20 and your cash account goes down by $20. When these transactions are recorded, they are recorded as debits and credits depending on the type of account, and a bookkeeper needs to understand how to use debits and credits in order to keep the books balanced.
Since transactions are recording the activity of your business into accounts, we can see the total of this activity on financial reports. The most important one for a small business is the income statement, commonly referred to as the P&L (which stands for profit and loss).
An income statement is a snapshot of your revenue and expenses. Revenue minus expenses equals net income or net loss, so you can use this financial statement to see how much your business made or lost during a period (typically a month), and you can also compare monthly income statements to see trends in sales and expenses. This report is especially important to business owners because you need to report your business income and expenses for income taxes.
A balance sheet shows assets, liabilities, and owner’s equity. Assets include cash, inventory, and anything else you use to operate your business. Liabilities are anything your business owes to outside parties, like debt. Owner’s equity consists of the money you put into your business to start it, plus any retained earnings (net income that you reinvested into your business). The balance sheet’s namesake refers to the fact that assets equal liabilities plus owner’s equity. So, if your total assets are $100, your total liabilities plus owner’s equity will equal $100. Understanding all of that, the balance sheet shows that “assets, or the means used to operate the company, are balanced by a company’s financial obligations, along with the equity investment brought into the company and its retained earnings”.
Step 4: Decide to DIY, Use Software, or Hire Someone
If you want to do the bookkeeping yourself, you can start off by keeping a simple spreadsheet of your expenses and income. If you’re savvy with Excel, you can set this up yourself. If not, there are templates that you can purchase so all you have to do is enter in your transactions and everything is calculated for you. You can purchase these on Etsy (yes, really!) or hire a freelancer on Fiverr or Upwork to make one for you if you want it a bit more customized. They are easy to use and it’s all you need when starting out.
If you want something more detailed and streamlined, you can use bookkeeping software like Quickbooks or Xero. After a little bit of training and practice, these are great tools to keep track of your finances and they create financial reports like the balance sheet and P&L for you. There are more software options than Quickbooks and Xero, but they are the most popular and easily integrate with other technology you might use, like payroll or bill-paying apps. They both offer several tiers so you can pick what you need. In 2020, Quickbooks starts at $10 a month and goes up to $40 a month. Quickbooks also has a payroll add-on for $39 a month plus $2 per employee. Xero starts at $9 a month and goes up to $70 a month.
If you’d rather not deal with bookkeeping at all, you can always outsource! You can outsource to a freelancer, who is someone you can pay to do your books remotely. They will manage all of your bookkeeping, including entering transactions into software and providing financial reports. Freelance bookkeepers charge either per hour or per month and how much they charge you typically depends on how many transactions they will need to enter. Average hourly rates are $20-$50 per hour. You can find them on those freelance websites like Fiverr or Upwork, and you can also find freelance bookkeepers that are certified in a certain software on the software’s website, like Quickbooks ProAdvisors or Xero Advisors.
If you have an office and would like to hire a bookkeeper to work on-site, you could always hire one as an employee. The average cost of a full-time bookkeeper is $40,000, but you need to take employment taxes and benefits into consideration. The benefit of having an on-site bookkeeper is that they’re “closer to the action” and can easily ask questions about transactions as they come up.
In addition to having bookkeeping help, you might want to consider hiring a CPA to do your taxes. The CPA will take all the financial reports for the year that your bookkeeper created and use them to report your income and expenses for your taxes. If you are required to report your taxes quarterly, your CPA can take care of that for you as well. They will also be helpful for answering tax-related questions. CPAs typically start at $125 per hour and you can find them via referrals, freelancing sites, local organizations such as the Chamber of Commerce, or Linked In.
Step 5: Set Up Your Taxes
You have a system in place! You decided on either hiring help or doing the books yourself. Now, it’s time to consider the inevitable: taxes. The types of taxes you will need to consider are income tax, employment tax, and sales tax.
All businesses need to file an income tax return. Pass-through entities, like sole proprietorships, partnerships, and S-Corporations have their business income taxed at the owner’s individual tax rates via their personal taxes on Form 1040 Schedule C. C-Corporations will pay income taxes at the corporate rate, which is 21% for 2020.
If you expect to owe at least $1,000 in taxes for the year, you need to estimate and pay quarterly taxes. To calculate your estimated tax, you will need your adjusted gross income, taxable income, taxes, deductions, and credits for the year. You can use Form 1040-ES to help you determine your estimated tax. You can pay quarterly estimated tax online using the due dates given by the IRS. If you do not make the quarterly payments, you can get hit with penalties.
Since you are a business owner, you are self-employed so you will need to pay self-employment taxes. There are exceptions, such as having net earnings less than $400 or working for a church. Self-employment tax consists of Social Security and Medicare taxes, and the 2020 rate is 15.3% (12.4% for social security and 2.9% for Medicare). Self-employment tax is reported on Schedule SE of Form 1040. If you have employees, you are responsible for paying half of the 15.3% for each employee. The other half is withheld from the employee’s paycheck. Some good news: you can deduct the employer-equivalent portion of your self-employment tax from your adjusted gross income (which affects your income tax). Also, if you file a Form 1040 Schedule C, you may be able to claim the Earned Income Tax Credit. IRS.gov
Sales tax is a bit more complicated since it is levied at the state level and varies by state. Chances are if you sell something to customers whether in person or online, you will have to pay sales tax, which is a tax imposed on the sale of goods and services. The tax is collected by the customer when a sale is made and is remitted by you, the seller, to the government. The sales tax percentage varies by state but averages around 6.25%.
Step 6: Keep Good Records
Recording transactions in your books is all well and good, but these transactions don’t mean much without supporting documentation. The IRS recommends documents that you should keep, and electric documents are now supported, so you don’t have to keep a shoebox of receipts! The IRS has varying periods of limitations for different types of documents, so your best bet is to keep all supporting documents since the beginning of your business just in case.
The types of documents you should keep depend on the type of business activity. Support for gross receipts includes cash register tapes, deposit information, receipt books, invoices, and Forms 1099-MISC. Support for purchases and expenses include canceled checks or other proof of payments/ETFs, credit card receipts and statements, and invoices. You need certain support for assets like machinery and furniture, and employment taxes. You also need to substantiate any deductions you take for travel, entertainment, and gifts, so certain documentation is required for those. The IRS has several publications where you can find exactly what records you need, or you can always ask your CPA.
If you’ve followed the 6 steps outlined above, you have a solid bookkeeping plan in place for your business! It may seem overwhelming, but there are endless resources out there for you to learn how to do it yourself, and there are lots of people out there willing to do it for you. Either way, having a good system in place will help keep your business tax-compliant and allow you to know your company’s financial health.