The Basics of Bookkeeping

By Rhys Whittard

 

At its core, bookkeeping is defined as the recording and classification of all financial transactions in a business. Transactions can range across various documents and files including invoices, sales receipts, bank statements, mileage and many others. A bookkeeper is then responsible for taking these documents and ensuring the business’s general ledger remains in balance. 

Before I cover the details of what bookkeeping is, it is essential to establish the difference between accounting and bookkeeping. Many people make the mistake of assuming the two are the same and the terms are interchangeable. In reality, bookkeeping is one piece of the larger accounting puzzle. As mentioned above, bookkeeping is recording transactions along with posting the appropriate debits and credits, producing invoices, and preparing financial statements. In comparison, accounting uses the data produced via bookkeeping to develop insights regarding the financial side of a business and therefore plan and forecast the future. This includes reviewing financial statements, strategic tax planning, preparing adjusting entries, analyzing the organizational cost structure, and understanding the impact of financial decisions.

Now that the difference between these functions has been established, bookkeeping can be further divided into three topics: the Accounting Equation, Debits and Credits, and Cash versus Accrual Accounting (while the terms accounting is mentioned here, these items are also key pieces of bookkeeping). 

The Accounting Equation

Firstly, looking at the accounting equation, this is the global system of tracing transactions. It does not matter if you are operating a small local restaurant or running a multinational corporation; the accounting equation remains the same. Specifically, “Assets = Liabilities + Owner’s Equity”. 

Essentially what a business owns must be equal in value to what it owes plus its retained earnings. Assets is a term used to represent all that is owned by the business. This includes accounts such as cash, inventory, accounts receivable, equipment, land, and many others depending on relevance to the business or industry. Assets are then separated into current and long-term assets. A current asset can be sold or liquidated in under 12 months, and a long-term asset is greater than 12 months. 

Contrary to assets, Liabilities are what a business owes. Common accounts include accounts payable, bank loans, and salaries payable. They are also separated into current and long-term liabilities. The same rules apply as to assets: current liabilities are owed within 12 months, long term are owed in a period greater than 12 months. 

Finally, Owner’s Equity is what remains once the assets pay off liabilities. It can also be referred to as shareholders’ equity depending on the structure of the business. However, it all represents what the owners of the business have rights to. Common accounts found here are retained earnings and different types of stock. Overall, this equation defines all financial positions in a business.

Debits and Credits

Next, it is important to understand debits and credits. They represent the inflow and outflow of value in a business. Specifically, debits record value increasing in an asset or an expense account. For example, if you are paid $500 for a product, you debit your “cash” asset account for $500. Debits also record value decreasing in a liability or equity account. So if you pay off a loan with $750, you debit the account representing the outflow. Debits are always recorded on the left side of a ledger.

In comparison, credits represent the outflow of value in asset and expense accounts. Returning to the $500 example, you must credit the inventory account as there is an outflow of $500 worth of product. A credit can also be used to record an increase in value in a liability or equity account. So if you take out a loan at $750, you must credit the corresponding liability account. Credit values are always recorded on the right side of the ledger. 

One final key piece of information regarding debits and credits; they must always correspond. For every debit, there is a credit of equal value. This is what ensures the accounting equation is always true.

Cash versus Accrual Accounting

Finally, I am going to touch on cash versus accrual-based accounting and bookkeeping. 

The key difference between the two is when the business recognizes revenue and expenses. When a business uses the cash basis, transactions are recorded when cash is received or paid. This process is much simpler than the accrual basis as accounts receivable and payable are not used, and an owner can have a stronger understanding of how much money they have. However, it does create problems. The cash basis often leads to an overstatement of business health. An owner can become distracted by a large value in the cash account when in reality a large sum of money is owed. 

In addition, the cash basis does not align with Canadian accounting standards and therefore cannot be used unless the business is a fisher, farmer or self-employed commission agent. The accrual basis records transactions as soon as they occur, whether or not any cash has been received. This method is more complex than the cash basis but ultimately allows owners to have a more complete understanding of where the business stands. This is also the method required by Canadian standards. 

Finally, if you ever plan on taking your business public or scaling at an extremely fast rate, accrual basis is a must. 

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