Part V: Managing Your Money

Chapter 17
Keeping Books and Records

In This Chapter
Accounting basics
Accounting software
Recordkeeping requirements
Taxation and tax forms
Hiring accounting professionals
Working with bookkeepers and accountants

Introduction
Ed Apperson seemed like a nice guy and a good bookkeeper, but he is now serving a 10-year prison sentence for embezzling hundreds of thousands of dollars from small businesses.
At first, he wrote company checks to himself under a different name. Later, he took on a partner and gave him blank documents to create forgeries. If an employer got wise, Apperson moved to another business and assumed a new identity. He hid his thefts by handing his employer false financial statements. Incredibly, he said that few owners asked to see the bank statements and none looked at the canceled checks.
Unfortunately, stories like this one are common. In most cases, the business owner could’ve prevented this kind of theft by understanding and monitoring the business’s accounting system.
The more involved you are in the creation and management of your accounting system, the better it will function. And the earlier you get a reliable system up and running, the better prepared you’ll be for growth. A study by researchers at the Stanford Graduate School of Business found that “firms that acted quickly to institute formal mechanisms such as operation budgets, cash budgets, and financial monitoring systems...had higher growth rates in terms of revenues and head count. They also had greater and more rapid increases in valuation at successive rounds of venture capital funding.”
Accounting Basics
Many entrepreneurs are bored or intimidated by accounting, so they put off learning about the nuts and bolts for as long as possible. Although this attitude is understandable, it’s also dangerous. You must have a reliable accounting system if you hope to succeed.
The IRS and other government agencies require businesses to track financial data and to retain supporting documents for their tax returns. But an even better reason to keep accurate records is that you need this information to run your business from day to day.
Accounting also helps you understand how to make your business run better from one year to the next. For example, it lets you make financial forecasts and then track your business’s actual performance. That way, you can compare your forecast to what actually happened. You can also compare this month to last month, or this year to last year. What did you do right? What did you do wrong? How can you improve?
Having the answers to these questions at your fingertips can be a powerful advantage.
…
As a fitness professional, self-discipline is practically my religion. I’m always challenging my clients and myself to work harder, smarter and better.
Before I opened my own gym, if you’d asked me what my best qualities were, I would’ve told you I was careful and detail-oriented, not afraid of challenges, and always looking for ways to improve myself.
So when I think about how careless I was, and how badly I messed up, it’s really embarrassing!
Maria Benitez is a certified aerobics instructor and personal trainer. Up until a couple of years ago, she worked as an independent contractor at a popular gym chain in Miami, Florida.
After getting divorced, she took three months off to travel through Eastern Europe with a couple of friends. During that time, she thought a lot about what her next step would be. Her career had been going well, but she had a nagging feeling that she was capable of doing something more interesting and fulfilling.
By the time she got back to the United States, she had decided she was ready for a bigger challenge.
I’d talked with enough people to know that most of them were not thrilled with the local fitness clubs. Most of them were super crowded and loud, and a few of them were places where women didn’t necessarily feel comfortable.
But even at the nicer places, you sometimes feel like you’re just another hamster on a wheel. My clients wanted personal attention from an actual expert, and they were willing to pay more for that level of focus. I was sure lots of other people felt the same way.
All in all, starting my own gym was a no-brainer. I had years of experience and great references. I had a degree in exercise science and an enthusiastic client base. What else could I possibly need? How hard could it be?
Like I said, it’s embarrassing to think about how naive I was.
…
Cash or Accrual Accounting?
The accrual method of accounting records revenue and expense when the activity occurs, regardless of whether any cash has changed hands. The cash method records revenue when cash comes in, and expense when cash goes out.
Suppose your business provides a service in December and your client pays the bill in January. Using the accrual method, you would record the transaction in December, when you did the work and your client contracted the debt. Using the cash method, you would record it in January, when you got paid.
Accountants usually prefer the accrual method because it provides a more realistic picture of a business’s performance over time. If you sell $3,000 in merchandise this month, but you won’t get paid until next month, cash accounting will understate your revenue. And if you stop paying your bills and start selling your office furniture online, the cash method might make your situation look pretty good. After all, more cash is coming in than going out!
Accrual accounting is tricky, though, so small-business owners usually prefer cash accounting, at least during the startup phase.
When filing your business’s first tax return, you can use either method unless the IRS requires businesses of your type to use one or the other. Once you’ve made your choice, changing your accounting method usually requires IRS approval.
If your business maintains an inventory, you may be required to use the accrual method. For IRS purposes, “inventory” refers not just to goods stored for sale, but also to any raw materials used in manufacturing those goods. Certain types and sizes of business are exempt from these regulations. If you’re not sure which method to use, talk to your accountant or consult IRS Publication 538.
It’s also common for eligible small businesses to use the cash method for some transactions and the accrual method for others, depending on what type of information they need. The IRS will accept this approach provided you follow certain guidelines:
The accounting method must clearly show your business’s income, which means that it must treat gross income and expense the same way in each year.
If you use the cash method to report your income, you must also use it to report your expenses.
If you use the accrual method to report your expenses, you must also use it to calculate your income.
You must use the same method to calculate your taxable income that you use to keep your books.
Calendar Year or Fiscal Year?
You must also select an accounting year for your business. The calendar year runs from January 1 through December 31.
A fiscal year is an accounting year that ends on a date other than December 31. Businesses typically choose a fiscal year when their business is seasonal. For example, if you run a food cart that sells milkshakes, you will probably do most of your business in summer. If you wish to use a fiscal year, be prepared to explain this decision to the IRS. This is a good point to discuss with your tax advisor.
Generally, sole proprietorships, partnerships and S corporations—all of which pass profit and loss through to the owners’ personal tax return—must use a calendar year unless they get permission from the IRS to use a different method. In the case of partnerships, this can become tricky because individual partners may use different tax years. You will probably need professional help to assess your options.
Double-Entry Bookkeeping
As we learned earlier, assets are valuable things your business owns, such as cash, accounts receivable, inventory, equipment and vehicles. Liabilities are debts that your business owes, such as utility bills, loans, accounts payable, payroll and taxes.
Your total assets depend on how many liabilities you have. For example, if you have $1,000 cash but you owe $500 of it, you really only have $500. Your total assets also depend on your owner’s equity, which is the amount you have invested in your business. Accountants use the following equation to express these relationships:
Assets = Liabilities + Owner’s Equity
This equation is the basis of double-entry bookkeeping, which in turn is the basis of accounting.
Chart of Accounts
Double-entry bookkeeping divides business transactions into different types of accounts. These accounts reflect the type of transactions your business makes. Therefore, they vary depending on the type of business you run.
The group of accounts that applies to your business is called its chart of accounts. The chart of accounts consists of balance sheet accounts (Assets, Liabilities and Owner’s Equity) and income statement accounts (Income, Expenses, Gains and Losses).
Income and expense accounts close at the end of each tax year. Asset, liability and owner’s equity accounts remain open for the life of the business.
Depending on your type of business, you might need accounts for special expenses and services. The chart of accounts for a large business may contain dozens of accounts, each of which may be subdivided by department, location, customer or other parameters. Although you may not need many accounts at your current stage, it’s best to set up your chart of accounts with growth in mind. Your accountant or bookkeeper can help you with this.
Debits and Credits
Suppose you take a clean sheet of paper and write Accounts Payable at the top. Then, you draw a vertical line down the middle to divide it in half.
Now, you can record increases to that account on one side of the paper and decreases on the other side. Accountants call amounts on the left side of the vertical line debits, and amounts on the right side credits. When you enter a number on the left side of an account, you debit that account. When you enter a number on the right side, you credit it.
Accounts Payable
Debit | Credit
Every business transaction affects at least two of your accounts, each of which has a debit column on the left and a credit column on the right. When you record a transaction, one account is debited, meaning that the transaction amount is entered on the left side of the sheet. And a corresponding account is credited, meaning that the transaction amount is entered on the right side of the sheet.
For every transaction, your debits must equal your credits. Suppose your business buys a new computer for $2,000 on account. Your assets have increased, so $2,000 goes on the debit side of your Computer page. Your liabilities have increased because you owe $2,000, so this amount goes on the credit side of your Accounts Payable page. Thus, you have recorded $2,000 on a left side and $2,000 on a right side.
Computer |  | Accts. Payable
Debit | Credit | Debit | Credit
$2,000 |  |  | $2,000
See how the $2,000 entry is on opposite sides of the two accounts? This ensures that when you record transactions, your debits (left sides) will equal your credits (right sides). That’s why this system is called double-entry bookkeeping.
Now, suppose that instead of buying your computer on account, you spent $500 of your own money and borrowed the remaining $1,500. In this case, you would record a $2,000 debit to Computer, a $1,500 credit to Accounts Payable and a $500 credit to Owner’s Equity.
This is a good place to remember the accounting equation:
Assets = Liabilities + Owner’s equity
And compare it to our computer example:
Computer = Loan + Personal funds
or:		$2,000 = $1,500 + $500
or:		$2,000 = $2,000
As you can see, the number on each side of the “equals” sign is the same, so the equation is balanced.
For most people, the most confusing thing about the double-entry system is that “debit” and “credit” don’t mean “decrease” and “increase.” Whether a debit is an increase or a decrease depends on the type of account. For assets and expenses, a debit is an increase and a credit is a decrease. For liabilities, equity and revenue, a debit is a decrease and a credit is an increase.
This may seem strange at first, but it makes more sense when you consider that in financial terms, an increase to a liability account is the opposite of an increase to an asset account. If we defined both increases in the same way, the two sides of the equation wouldn’t balance.
Balancing the Books
After each day’s transactions, you can check to see if your credits equal your debits. If they don’t, you know there’s a mistake somewhere. For example, if you record a $1,000 debit to Computer and a $100 credit to Accounts Payable, this mistake will show up when you try to balance the books.
But if you mistakenly record a $100 debit to Computer and a $100 credit to Accounts Payable, the system won’t catch the error. The same holds true if you forget to record the transaction, or you record it twice. The only mistakes the system reveals are those that leave the books out of balance.
Debits and credits can get complicated, especially for businesses with many accounts. Fortunately, inexpensive accounting software can organize, calculate and report them automatically.
Journals and Ledgers
Business transactions tend to be very repetitive. Sales happen daily, bills get paid every month, payroll is weekly or biweekly. This means you must enter the same debits and credits over and over again.
Accounting systems use journals and ledgers to simplify this process. Sales, cash disbursements and other transactions are recorded daily in the journals. Each month, the journals are totaled and posted in the appropriate ledger.
Here are examples of these journals. You can customize them to fit your needs.
Sales Journal
The Sales Journal lists sales on account; cash sales are listed in the Cash Receipts Journal (see below). Note that including the invoice number creates a trail; if you want to find out more about one of these sales, you know which invoice to examine.
Sales Journal |  |  | Page 2
Date | Customer | Invoice | Amount
1/11 | Jayco, Inc. | 535 | $1,200
1/12 | Davis Glass | 536 | 2,800
Cash Receipts Journal
This journal is used to record cash receipts; sales on account are recorded in the Sales Journal. You can set up columns to represent typical sources of cash for your business. Our example includes columns for cash sales, receipts from credit customers, and miscellaneous receipts.
Cash Receipts Journal |  |  |  |  |  | Page 2
Date | Cash | Sales | Accounts Receivable | Customer | Other | Description
1/4 | 1,100 |  | 1,100 | Ajax Co.
1/5 | 125 | 125
1/16 | 55 |  |  |  | 55 | Rebate
Purchases Journal
The Purchases Journal records purchases of inventory and supplies on account; cash purchases are recorded in the Cash Disbursements Journal (next page). Some businesses record inventory purchases in an Inventory account rather than the Purchases account.
Purchases Journal |  |  |  |  | Page 5
Date | Supplier | Invoice | Accts Payable | Purchases | Supplies
1/9 | Ajax Co. | A1034 | 725 | 725
1/9 | Offices | 237 | 122 |  | 122
Cash Disbursements Journal
The Cash Disbursements Journal is similar to a check register, but it provides more detail. Again, you can include a column for any frequently used account.
General Journal
The General Journal record debits and credits for transactions that don’t belong in one of the special journals. These transactions are entered in the order in which they occur. Many small businesses leave this task to their accountants.
General Ledger
Details from all other journals are fed into the General Ledger, which is the source of key financial documents such as income statements and balance sheets.
A General Ledger entry for Cash might look like this:
Cash |  |  |  | Account No. 101
Date | Ref. | Debit | Date | Ref. | Credit
1/4 | CR2 | 1,100 | 1/7 | CD7 | 437
Notice the account number 101. To reflect entries in the Cash Receipts and Cash Disbursements Journals (above), $1,100 has been added to the debit side and $437 to the credit side of the Cash account. The “CR2” reference shows the source of this debit by referring us to page 2 of the Cash Receipts Journal, while CD7 refers us to page 7 of the Cash Disbursements Journal.
Every account receives a unique account number, which gets listed in the chart of accounts. It’s best to use systematic account numbers, like this:
Account Type | Beginning Number
Assets | 1
Liabilities | 2
Owner’s Equity | 3
Revenues | 4
Expenses | 5
This numbering system can help you create special reports. Let’s suppose Wages Expense has the account number 520. Now, let’s extend that number to indicate location and department. Suppose your business has an Albany location with the code number 05, which includes a repair department with the code number 12. In this system, 520-05-12 would indicate wages paid to employees in the Albany repair department.
Although the journals and the General Ledger contain the same numbers, they are organized differently, allowing you to find information readily. To see how a particular transaction was recorded, you can consult the appropriate journal and find the transaction by date. To see what happened to a single account over time, you can turn to that account page in the General Ledger.
Business Checkbooks
As we’ve said more than once, it’s essential—and in some cases, legally required—to keep your business and personal finances separate.
It’s equally important to use your business checking account for expenses and receipts. Your receipts should be deposited daily, and the source of these funds should be documented. All paid business expenses should be documented clearly in your checkbook, and should include the amount, payee, date and purpose. A carbonless checkbook that makes a copy of each check can simplify this process. Alternatively, you can use a computer-based checkwriting system that will update your records automatically.
At the end of each month, you should reconcile your account to make sure your accounting records agree with your bank statement. This will help you catch errors—whether on your part or the bank’s—and ensure that you don’t overlook bank charges and other expenses that may not appear in your business records.
…
When I opened Luna Gym, it was all about my passion for fitness. And that kept me busy. I had appointments to keep and exercise plans to write. I had to be totally focused on my clients. It wasn’t enough to be there physically; I had to be there mentally. That’s what my clients pay me for, right? But of course there are safety issues, too. You can’t fall asleep on this job!
The point is, I couldn’t afford any distractions. That’s why I hired Margaret as my general manager.
Margaret Bennett was in charge of everyday managerial tasks, including overseeing the counter staff and keeping the gym’s books. Margaret wasn’t a bookkeeper, exactly, but she claimed to have a lot of experience with accounting in addition to office management. Plus, she “loved numbers.” That sounded ideal to Maria, who didn’t like numbers much at all.
Maria wasn’t completely hands-off. She handled the gym’s marketing efforts, which mainly consisted of offering introductory membership rates and online coupons every few months. Just about everything else, she left to Margaret.
I knew my management style was super casual. But that seemed like a good thing. So much of the day, I was pushing people and pushing myself. I know it’s not healthy to be “on” all the time, so I wanted to save my energy and adrenalin for the times I needed it.
And as far as I knew, my system was working out great. The space was exactly what I’d dreamed. I had nice kids working the counter, my clients seemed happy, things were good. I was even thinking about opening a second location over in the Design District.
So yeah, I wasn’t running my business exactly by the book. But I figured, “Hey, the bills are getting paid.”
Except that they weren’t.
…
Accounting Software
Your accounting system should help you collect data, record them, classify and summarize them, and report them in the form of financial statements.
Accounting software makes this task easier, but it’s no substitute for knowledge of best practices in accounting. To get the most out of accounting software, you have to understand what you’re putting into it and why. It’s like a calculator: It can speed up tasks, but it can’t run your business. Having software that can calculate economic order quantity is a godsend, but only if you understand what EOQ is, and how to gather the information it requires.
When you choose an accounting system, you need to commit to understanding what it does and learning how to use it correctly. You also need to commit to training your employees. Don’t make the mistake of giving them a 400-page manual and telling them to get busy! Forcing new software on employees in this way rarely works out well.
Before you buy a system, consider how long it will take to get the appropriate people truly proficient. When you buy a program, it’s natural to want to get it up and running that afternoon. But instead, you need to set a sensible, realistic roll-out date that will allow the transition to happen smoothly.
Problems with your accounting system can be fatal to your business, so don’t roll out a new system until you’re confident it will work. You should also maintain a temporary backup system in case anything goes wrong.
Accounting Modules
Accounting systems consist of modules for specific journals, ledgers and tasks. Larger firms might have a whole department for each of these modules. Others may assign a different bookkeeper to each module. In addition to the General Ledger, basic modules include:
Accounts payable. This module tracks amounts owed to vendors, as well as payment terms and vendor information. In many systems, this module allows you to issue checks to vendors.
Accounts receivable includes debits for all sales made on account and credits for all payments received. It typically offers billing, payment processing and collections functions. It should also create aging reports, which show how long each customer typically takes to make payments.
Inventory management modules usually track stock on hand, reorder quantities, lot tracking and back orders. They can also calculate cost of goods sold.
Payroll modules typically track each employee’s work hours, as well as paid leave benefits, tax withholdings and related matters. They usually allow you to issue checks or make direct deposits as well. Payroll accounting can get very complicated, so many small-business owners prefer to outsource this function to a payroll services provider.
Purchasing modules issue purchase orders to vendors and track the status of orders. These capabilities are often merged with inventory management.
In addition to these basic functions, accounting systems may have specialized modules such as electronic payment processing, project accounting, warehouse management or job costing.
What Do I Need?
The type of accounting system you need depends mainly on your type of business. Some firms may require industry-specific software in order to capture necessary data while complying with legal requirements.
It also depends on your resources and growth plans. At the high end of the spectrum, you can get an enterprise resource planning (ERP) system that not only provides robust accounting capabilities, but also integrates them with virtually every other business activity, from customer management to product development. These systems are very powerful, but they also tend to be expensive and complicated. Using them correctly requires a level of training, discipline and coordination that smaller businesses often lack.
Alternatively, you can look for a flexible system that provides core functions but also allows you to add specific modules. This option includes cloud-based systems with multiple service tiers, which allow you to upgrade your subscription as you grow. Provided the core system works well, this can be a great way to scale up your accounting system gradually.
At the low end, you can get programs that handle basic tasks well, but lack flexibility and scalability. If you opt for one of these programs, you will almost certainly need to replace it once you grow. This can be a disruptive process, and you always run the risk of losing data when migrating to a new accounting system, so it’s wise to weigh the lower sticker price against the extra costs you may incur when it’s time to upgrade.
When assessing your options, start by thinking about every single thing your business needs to do. Will you and your employees access your system outside the office? Then you’ll probably want a cloud-based system. Are you selling digital downloads in Europe? Then you may need currency conversion and the ability to calculate VAT. Will you sell to government agencies? Then you’ll need software that complies with Defense Contract Audit Agency (DCAA) requirements.
Consider whether you have any unique needs that will require customizable software. For example, do you want to create different invoice templates for different types of customers? If so, you’ll need a system that offers this capability.
Finally, drill down to the smaller details, like issuing quotes, scanning barcodes or processing returns. Once you know what your system needs to be able to do, you’ll be in a better position to make your decision.
If possible, get input from your accountant as well. No matter how well a system seems to meet your needs, it’s likely to be a source of grief if it doesn’t work seamlessly with your accountant’s system.
Choosing Accounting Software
Here are some important criteria for choosing accounting software:
Compatibility. Will your computer be able to run this program? What are its hardware requirements?
Cost. Will you buy a desktop product to run onsite, or pay a subscription fee for a cloud-based system? Are there installation fees? What are the training costs? Is tech support free? Will you be charged by amount of use, number of users, service level or a combination? If you need to switch or upgrade, what additional costs are entailed?
Ease of use. How steep is the learning curve? Can an average user figure the program out without getting a PhD in math? How long will it take you and your employees to become proficient? Does the interface resemble those of familiar programs like Word and Excel, or will users need to learn totally new ways of doing things? Watch out for cramped and cluttered screens, non-intuitive navigation, and confusing jargon. Pick a program that’s easy on your eyes, your brain and your fingers.
IRS compliance. The IRS requires that electronic records reconcile with your books, records and tax returns. Also, they must “provide enough detail to identify the underlying source documents,” and have controls that ensure accurate results and prevent unauthorized changes to your business records. To learn more, visit www.irs.gov/businesses/automatedrecords.
Compliance with accounting standards. Historically, accounting standards have varied by country. In a globalizing world, differing accounting standards can cause serious problems. The primary divergence is between International Financial Reporting Standards (IFRS), which is used in many foreign countries, and Generally Accepted Accounting Principles (GAAP), which is used in the United States. If you will be operating abroad, you may need to conform with IFRS. As of this writing, the United States is working toward convergence with the IFRS system; stay on top of new developments, and ask your accountant how they will affect your business.
Scalability. At the very least, your accounting system should be able to grow with your business. Ideally, it should help you grow by making it easy to cope with new needs and requirements. When you’re in a hectic growth period, the last thing you want to do is learn to use a new interface, rework your accounting procedures, or migrate huge amounts of crucial accounting data to a new and untested system. If you’re planning for a certain level of growth within a year or two, make sure your system will still meet your needs.
Flexibility. Can the program easily be customized to suit your needs? Does it integrate seamlessly with other business applications, as well as email and word processing programs? Is it compatible with your accountant’s system? Does it allow you to share information easily between a variety of devices? Can you customize templates, files and labels?
Access. Do you need to access your accounting data from a single office, or from multiple offices? Will employees access the system from mobile devices? If so, what features will they access?
Security. What security standards, authentication measures and permission levels are in place to prevent unauthorized access to your data? Do security measures comply with industry standards and laws for your type of business? If it’s a cloud-based system, what encryption standard does it use?
Backup and data recovery. How often are your data backed up? If data will be stored in the cloud, where are the servers located? What security and disaster recovery measures are in place at this site? What data recovery measures are in place? How reliable are they, and how long do they take? Are there multiple restore points? What happens if you switch providers? How easy is it to get your data back? Will it be in a format you can use right away?
Help. What type of training is available? Does the program have a reliable help utility or online user forum? Is the manufacturer popular enough that it’s likely to stay in business and offer support over the long term?
The most important thing you can do is try out the system you’re evaluating. Free trials and online tutorials are the best way to get a feel for a system’s pros and cons. Of course you’ll want to read lots of software reviews, and get recommendations from fellow entrepreneurs. But that’s no substitute for hands-on experience.
…
One day, Maria went through her mail and saw an envelope that said “Final Notice.” When she opened it, she was amazed to learn that one of her equipment lessors was threatening her with repossession!
She tore open the rest of her mail and found that almost every other bill was past due. How on earth had this happened? What was Margaret thinking?
She decided she’d worry about Margaret later. First, she needed to pay every single one of her overdue bills.
Sadly, that wasn’t an option. When Maria looked at her bank statement, she saw that she didn’t have enough money to pay next month’s rent, let alone five overdue bills.
I didn’t have any idea what was going on. I knew I’d been making money. But where was it? I assumed Margaret had messed things up and it was all a misunderstanding, but I also knew that it could be something worse than that. You read stories about business owners who hire a crook, and one day the person takes everything and leaves. You don’t think it can happen to you. But you never know.
When I wasn’t worrying about that, I was worrying about practical stuff. How am I going to keep my doors open, let alone open a second location? Will I be able to get financing, or is my credit totally ruined?
It was my business, and it was my money and reputation on the line. But when I needed answers to these questions, I realized that I didn’t know where to look for them. If you need proof that I was on the wrong path, there it is.
Maria confronted Margaret, who explained that Luna Gym had “the cash shortages you’d expect at a new business.” She blamed these problems partly on the economy and partly on Maria’s inexperience, even though it was clear that Margaret had been keeping only the most basic of records, had reconciled the gym’s checking account only once in six months, and had neglected to pay several crucial bills.
When Maria pointed this out, and questioned Margaret’s qualifications, Margaret got angry and quit on the spot. “Good luck,” she said as she stormed out. “You’ll need it.”
…
Internal Controls
Your accounting system must have internal controls to protect business assets and help you comply with laws and regulations. Internal controls vary by business, but here are some basics:
Authorization. Make sure the appropriate person authorizes purchases and sales. You must clearly state to vendors, banks and other business partners what authority you have given to which employees.
Segregation of duties. Authorization, recordkeeping, reconciliation and custody activities should be performed by different people.
Physical controls include padlocked doors, safes, and personnel identification cards. Blank checks and other documents should be prenumbered and locked away when not in use. Cash should be deposited daily. Software access should be protected by passwords and limited to authorized personnel.
Tickler systems help you keep track of current bills and orders. This could be a red folder for current orders, or software that produces a daily report of due bills.
Audit trail. A trail of evidence should link amounts in the books with source documents.
Monitoring and review. Look for variances, excessive costs and other red flags. Identify and remedy weak spots in your controls. A yearly review of your system by a CPA is a good idea.
Recordkeeping Requirements
No matter what size your business is, keeping good records is crucial. Studies show that most business failures result from poor recordkeeping. In many cases, the owners didn’t know they were out of money until their checks started to bounce.
The uses of financial records include:
Budgeting and planning
Managing cash flow through timely collections and payments
Tracking and managing costs
Setting business goals and measuring progress toward them
Preparing financial statements
Applying for loans and negotiating terms
Distinguishing between taxable and nontaxable income
Tracking tax-deductible expenses
Preparing tax returns
Defending your tax return in the event of an audit
Preventing theft and embezzlement
Proving compliance with applicable laws
Supporting your case in a lawsuit or other dispute
Proving ownership of physical or intellectual property
What Records Should I Keep?
Which records you must keep for tax purposes depends on your business type. At a minimum, your recordkeeping system must document your business transactions—including your income—as well as your deductions.
Documenting Income
Gross receipts are the income you receive from your business. In most cases, this is the money you get from selling your product. Supporting documents include:
Cash register tapes
Bank deposit slips
Receipt books
Invoices
Credit card sales slips
Forms 1099-MISC
Documenting Expenses
Expense records should show the amount, purpose and payee for each expense. Supporting documents include:
Check register
Canceled checks
Receipts
Cash register tapes
Bank statements
Credit card charge slips and statements
Invoices and bills
Payroll records
Petty cash slips
A petty cash fund lets you make small purchases—like a box of paperclips—without having to write checks. This fund should consist of a small, fixed amount (e.g., $100). Whenever you make a payment from this fund, a petty cash slip should be attached to the receipt. At the end of each month, compare the unspent petty cash to the total petty cash slips and make sure they add up to the starting balance. For example, if you have $25 in unspent cash, your slips should equal $75. Once you’ve confirmed that the amount is correct, you can restore the fund to its full amount by writing a business check for $75 to “Petty Cash.” Last, the petty cash slips should be entered into the Cash Disbursements Journal.
Documenting Operations
Important legal, historical and management documents may include:
Emails and other correspondence from customers, vendors, partners, employees, lenders, investors and regulators
Contracts and leases
Telephone records
Market research data and surveys
Licenses and permits
Copyright, trademark and patent info
Nondisclosure agreements
Shipping documents
Maintenance and repair records
Customer feedback and complaints
Employee records and files
Time cards
Withholding certificates
Inspection records
Project management files
Accident and injury reports
Documentation for appliances, software and equipment
Material Safety Data Sheets (MSDSs)
Records Management
A records management plan should start with a complete inventory of the records you need to keep, based on the following considerations:
Tax and legal requirements
Accounting and budgeting
Marketing and customer management
Historical and informational needs
Format
Next, you need to decide how to store your data. On the one hand, digital files save space, and they’re easier to search and back up. On the other, they’re vulnerable to system failures. Creating digital files can also be labor intensive; digitally scanning every business receipt takes a lot more time than sticking them in a folder.
Regulators will usually accept electronic documents provided they meet standards for legibility, integrity and accessibility. If digitizing a document would affect legibility or integrity, keep the original.
Records dealing with employees—such as those required by OSHA, the Department of Labor or U.S. Citizenship and Immigration Services—may have special requirements and restrictions. Check with the relevant agencies to make sure your recordkeeping system is in compliance.
Access
Which employees should have access to which records? Your sales team will need access to customer data, but they probably don’t need access to your payroll records. Also, regulations may require you to restrict access to employee and customer data. For example, OSHA requires you to limit access to employee injury and illness records.
Setting access policies also entails thinking about how records will be named, grouped and organized. Does the record need to be filed by date? By customer name? By account type? By number? Whatever the case, it’s essential to use a consistent numbering, naming and filing system.
Record Retention Times
The IRS generally requires you to keep records for three to seven years. Other agencies may have different requirements, most of which will relate to employee issues or environmental protection.
Here is a sample list with suggested retention times. Your accountant can help you modify this list to fit your needs.
Type of Record | Retention Time
Bank and credit card statements | 7 years
Business asset records | 7 years
Business licenses | Until expired
Cash register tapes | 3 years
Check registers | Permanent
Canceled checks | 7 years
Deeds, titles and title insurance | While you own the property
Employee records | 10 years
Employment tax records | At least 4 years
Financial statements | Permanent
General ledger | Permanent
General journal | Permanent
Inventory records | 7 years
Invoices | 3 years
Payroll records | At least 3 years
Property, plant and equipment | Permanent
Purchase orders | 3 years
Receipts (tax-deductible) | 10 years
Receipts (high-cost buys) | Life of the asset
Receiving reports | 3 years
Tax returns | Permanent
Time cards or tickets | 3 years
Travel expense records | 7 years
Utility bills | 3 to 6 years
Disposal
Disposing of outdated paper documents makes it easier to store and search your records. Furthermore, the size of your archive can add to your legal costs if you’re involved in legal proceedings, as lawyers may have to sift through these documents one by one during the discovery process.
When compiling your list of records, make sure to note how they should be disposed of. What can go in the trash, and what needs to go in a shredder? Is ordinary deletion good enough for electronic records, or is secure deletion required?
Security
Will your records be in a password-protected database searchable by content and metadata? Or will they be alphabetized in a folder stored in a locked filing cabinet?
As we noted in our section on continuity planning, you must have a backup system in place for all vital records, so you can get back on your feet quickly in the event of theft, fire and other disasters. But beyond that, records stored on site should be kept under good environmental conditions.
Creating Your Plan
As you can see, record management can get very complicated. That’s why it’s a good idea to create a plan that lists the records you store and explains how, where and for how long they’re stored. If a certain person is in charge of a certain type of record, that information should appear in your plan as well. You should also include any regulations that apply; if the IRS or OSHA has specific requirements for documents of a given type, the description of those documents should include this information.
Last, detail any management tasks the files require, ranging from weekly or monthly backup to disposal.
If all of this is too complicated, you can hire a file management firm to handle most of these tasks. This can be a good option for business with sensitive data, as a reputable service provider will understand and meet all relevant security regulations.
The standard warnings about cloud-based services apply here: Always research firms very carefully before entrusting your valuable data to them!
…
I was so worried. Before all this stuff happened, I assumed that even if my records weren’t all neat and tidy, at least they were complete and accurate. I had actually been planning on organizing them for a while, so I’d be prepared to get financing for my second location.
That’s what records were for me—something you might need in the future. I didn’t understand how important they were to keeping my business on track day to day. Now I was learning—maybe too late—that if you’re not taking care of things in the present, your future plans aren’t likely to work out.
One of the first pieces of equipment Maria had purchased was a computer check-in system. It had cost her almost $7,000, and it was supposed to record members’ visits, membership dues, accounts payable and other vital information.
Had Maria taken the time to be thoroughly trained on the system (or to train her front desk manager), it would have been a valuable tool. It had lots of customizable features, and her monthly service contract included staff training and customer support. But she had failed to use either.
Worse, her front desk staff had rarely entered information into the system. Most of them worked at the check-in desk as a result of barter arrangements band had not been trained on the system. Often, Maria would pass the front desk and realize that the computer hadn’t even been turned on.
Maria could see that she’d made some serious mistakes. How many others would she discover? And how would she know where to look for them? Clearly, she needed help from an expert.
Her first move was to hire Celia Cruz, a CPA and freelance financial planner, to help get her books in order. Celia happened to be a member of the gym, so Maria negotiated a deal for her time: Celia would receive a lifetime membership and would be kept on retainer for a monthly fee of $250.
Now, with Celia’s help, she was ready to find out how things stood with Luna Gym.
…
Taxation AND TAX FORMS
Businesses typically have to pay sales taxes, property taxes, federal income taxes, state taxes, payroll taxes, licenses and fees. It can be overwhelming to sort through all the tax requirements. It’s also far too much information to present in this book, so this is another area where you will need help.
Sales Tax
Depending on your location and sales volume, you may need to deposit sales tax payments monthly, quarterly or annually. Some businesses may be required to prepay estimated sales taxes. Contact your city, county or state tax authority to learn more.
Estimated Quarterly Tax
Sole proprietors, members of partnerships, and S corporation shareholders who expect to expect to owe $1,000 or more in taxes normally have to pay estimated quarterly taxes by filing Form 1040-ES, Estimated Tax for Individuals. To learn more, see IRS Publication 505, Tax Withholding and Estimated Tax.
Corporations that expect to owe $500 or more in taxes must file Form 1120-W, Estimated Tax for Corporations. Your state government may also require estimated tax payments.
Payroll Taxes and Forms
Payroll taxes are imposed on employees and employers. Employees pay state and federal income tax, as well as Social Security and Medicare taxes mandated by the Federal Insurance Contributions Act (FICA). Employers pay federal unemployment tax (FUTA) and also contribute to FICA taxes. The timing of deposits for payroll taxes is based on the amount due. To learn more, see IRS Publication 15 (Circular E), Employer’s Tax Guide. Federal tax deposits must be made through the Department of Treasury’s Electronic Federal Tax Payment System (EFTPS).
It’s a very good idea to create a separate bank account for withholdings. This way, you can make sure you avoid spending them. Alternatively, your payroll service can make these payments.
The IRS treats part-time and temporary workers the same as full-time employees for withholding, FICA and FUTA purposes.
Note that even if you outsource payroll functions to an outside contractor, you are legally responsible if that contractor fails to comply with IRS regulations on payroll tax reporting and payments.
Withholding
Our income tax and Social Security systems are on a “pay as you go” basis. Companies and individuals do not wait until income tax returns are due to send in the tax owed. Instead, the government collects the money throughout the year.
For employees, this is usually done by employers. The employer withholds taxes from the employee’s paycheck and forwards them regularly to the government. The penalties for failing to make timely tax payments are high! Do not consider money withheld from employees as available to meet other business debts.
Each of your employees must fill out and sign Form W-4, Employee’s Withholding Allowance Certificate, which specifies how much tax you will withhold from each paycheck. You must keep this form with your employee records and be able to provide the IRS with a copy on request.
Withholdings—along with total wages, tips and other compensation—are shown on Form W-2, Wage and Tax Statement, which you must provide to each employee by January 31 and to the IRS by February 29. If a W-2 is returned to you as undeliverable, the IRS requires you to keep it on file.
Social Security and Medicare Taxes
Social Security and Medicare taxes pay for a wide range of worker benefits, including retirement benefits, disability benefits, hospital insurance benefits and survivor benefits. Employers must deduct a percentage of these taxes from employee wages and make an additional payment of their own. These taxes are reported on Form 941, Employer’s Quarterly Federal Tax Return, or Form 944, Employer’s Annual Federal Tax Return. To calculate Social Security and Medicare withholdings and payments, see IRS Publication 15.
Self-Employment Tax
The self-employment tax is a Social Security and Medicare tax for individuals defined by the IRS as self-employed. Sole proprietors, members of a partnership, and members of an LLC must pay this tax by filing Schedule SE. For more information, see IRS Publication 334, Tax Guide for Small Business.
Federal Unemployment Tax (FUTA)
FUTA taxes cover unemployment compensation for workers who lose their jobs. This tax is paid solely by employers, and is reported on Form 940, Employer’s Annual Federal Unemployment Tax Return.
Affordable Care ACT (ACA)
If you provide your employees with a self-insured health plan, you must provide Form 1095-B, Health Coverage, to each covered employee by January 31. You must also send these forms to the IRS by February 29 (paper) or March 31 (electronic), along with Form 1094-B, Transmittal of Health Coverage Information Returns.
Independent Contractors
Payments of $600 or more to independent contractors who provided business services must be reported to the contractor and to the IRS on Form 1099-MISC. This form is also used for royalty payments of $10 or more. The IRS will use this informational return to confirm that the contractor reports this income in her own tax return.
The contractor must receive this form by January 31. You must provide all 1099s along with transmittal form 1096 to the IRS by the end of February if you submit it on paper, and by the end of March if you submit it electronically. Your state taxing authority may have a separate deadline.
Other Taxes
Many states also impose accident insurance or workers’ compensation taxes on the employer. There may also be county or city taxes, as well as taxes supporting public transportation, emergency response, water treatment, education and other necessities. Check with your state or local tax authority, or your accountant, to learn more.
…
The next day was not exactly a great one for me. I met up with Celia first thing in the morning to go through all the paperwork. At first, Celia tried to put a positive spin on things, saying we didn’t know if the situation was all that bad, and that I should wait to panic.
Then we looked, and it really was bad. We had to dig through all the drawers and files, and we found papers and receipts and bills stuffed everywhere. We had to go through them one by one. There were unopened bills, unsent membership renewals, random ledger pages with entries but no dates. I mean, it was just a disaster area. And all I could think was, how could all of this have been going on right under my nose? I was supposed to be the person who would never fall asleep on the job, right? Now I knew I’d been kidding myself.
One of their most disturbing discoveries was that Luna Gym had almost $8,000 in outstanding accounts payable. Each day, Maria was accumulating late fees. Margaret had created an accounts payable ledger, but most of these bills were not recorded in it. Celia dug a little deeper and found a pouch full of undeposited membership checks. No wonder she was low on money!
You can imagine how angry I was about Margaret at that point. Celia made it clear she was sympathetic, but in the end she said, “Yes, Margaret has done a really bad job. But you know, this is your business, not hers. With better oversight, things would never have gotten to this point.”
And of course she was right. It was a lot easier to yell about Margaret than to look at my role in this disaster. But if I’d been doing my job right, I wouldn’t even have hired Margaret, let alone given her so much control.
I decided right then that if my business could be saved, I’d get involved and stay involved.
…
HIRING ACCOUNTING PROFESSIONALS
Very few businesses can get by without professional accounting help. There are many services to choose from.
Bookkeeping. You can hire a bookkeeping service to do any or all of the tasks required in your system, including accounts receivable, accounts payable and payroll.
System design. You may need help designing an accounting system and internal controls. Some firms will help you design your accounting system based on their software.
Income taxes. You will almost certainly need help planning for and preparing your income tax returns.
Writeup. You may be able to keep your books, but you’ll probably need help with financial statements and other reports.
Auditing. As your business grows, you may need an independent audit. An audit may also be required for a loan or when a business is offered for sale.
Temporary services. Perhaps all you need is some help getting through the year-end closing of your books, or preparing your annual budget. Or maybe you have a busy season and need extra help with accounts receivable or inventory. If so, consider using one of the temporary services in your area.
Certified public accountants (CPAs) are the only accounting professionals who can perform an independent audit. They also offer auditing, income tax planning and preparation, estate planning, financial planning, and writeup services. Although their rates may seem high, they can often save you money by refining your accounting system or reducing your income taxes.
Some states have licensed accountants who are not CPAs, such as public accountants and licensed tax consultants. Public accountants can help design your accounting system, perform routine bookkeeping chores or handle payroll. They may not perform an independent audit. As their name implies, licensed tax consultants specialize in income tax return preparation.
When looking for a bookkeeper, follow these basic rules:
Write a job description. State which modules in your accounting system, and which specific functions in those modules, are the responsibility of the new bookkeeper. Some bookkeeping positions are “full charge,” which means the person works with every accounting module. How many days per week will you need help?
Make sure applicants have the right type of experience. You don’t need to hire the most experienced applicant, but you should judge whether the applicant will be able to handle his level of responsibility. Do you have other bookkeepers on staff who will supervise and train the new employee, or will this bookkeeper be in charge? Do you need someone to come in and start from scratch, or are your systems in good working order?
Check the applicant’s accounting knowledge. Tests or interview questions work best. Your CPA can help you come up with appropriate questions.
Consider the requirements of your current program. Is it important that the new bookkeeper be familiar with that program? Or do you want someone who can help select an accounting program and design internal controls?
Check references. It can be difficult to discover a dishonest bookkeeper in advance, but you won’t know anything if you don’t ask questions.
Working With Accountants
Most accountants charge by the hour, so give them organized, complete financial information. Bringing an accountant a shoebox of loose receipts will cost you extra!
An accountant with experience in your industry will understand the issues businesses like yours face, but will still need to know particulars about your goals and financial situation. You must be candid with your accountant, so find someone you can trust. Professional accountants keep strict confidence regarding client information.
If you hire an accountant to help design your accounting system, be very clear about the information you need. Some accountants focus on income tax requirements and will design a system that responds primarily to those laws. Your accounting system should balance your need to meet tax requirements with your need for everyday management information.
…
The next day, Celia found $5,000 in uncashed checks for membership dues, which made her worry that Maria might have a sizable tax bill in the next quarter.
But after doing some calculations, she realized that if Maria collected all her accounts receivable, deposited the “lost” membership dues, and negotiated for more time with her largest creditors, she could pay her taxes and—hopefully—begin to operate in the black by year’s end.
Celia also felt that Luna Gym was undercharging for its memberships. Not only could her market bear a higher price, but she was not currently generating enough revenues to reach her target profit level.
On reflection, Maria decided she shouldn’t expand until she was generating maximum revenues from her existing space. For instance, using the childcare room for massage therapy during off-peak hours would even out her revenue stream while also offering clients more services.
Soon, Maria had hired a new, qualified manager, who was responsible for maintaining membership records, paying bills, depositing dues and keeping books.
Things are great now. I know they are, because I check my accounts every day to make sure of it.
When I think how close I came to losing everything, it’s scary. It’s not just the financial side of things. It’s the fact that it all would’ve been so unnecessary.
Because the reality is, you don’t have to learn things the hard way. There are all these incredible, proven tools that exist to keep you from getting into the kind of trouble I was in. Now that I understand them, I can’t believe I waited so long to use them.
…
Conclusion
Accounting is complicated and time-consuming, but it’s also fundamental to your success. It provides the information you need to run your business, and it’s the basis for the tax information you must file with the government.
No one expects you to turn into an accountant overnight, but you must be involved in and knowledgeable about your accounting process.

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Cash Disbursements Journal |  |  |  |  |  | Page 7
Date | Check | Cash | Accts Payable | Customer | Other | Description
1/7 | 101 | 437 | 437 | Baker Co.
1/8 | 102 | 500 |  |  | 500 | Rent

| NxLeveL® TECH TIP BUSINESS RESOURCES AND THE WEB
The Paperless Office Moving toward a paperless office can save considerable space and time, in addition to protecting critical data from local disasters such as fires and floods by backing it up offsite. Here are some basic steps you can take to reduce the amount of paper in your life: Ask for electronic statements, bills and records from banks, insurers and suppliers. Download these documents to the appropriate storage file. Scan, shred and recycle receipts and other documents you don’t need to keep in paper form. Inexpensive receipt scanners are widely available. Scan paper documents and save them as PDFs. Use a standard naming format that will make them easier to find. Where possible, use optical character recognition (OCR) to ensure that the full text of each document is searchable. Print electronic documents to PDF where necessary. (Any document you can print out can also be printed as PDF.) Use a service like Google Docs for employee manuals and related documents. Use an online login system in place of employee time cards. Back your records up to a remote hard drive, cloud host or file management service.

Form | Name | Description
941 | Employer’s Quarterly Federal Tax Return | Reports federal income and Social Security taxes withheld from employees, and FICA taxes imposed on the employer. Due after the end of the quarter.
940 | Employer’s Annual Federal Unemployment Tax Return | Reports federal unemployment tax for the year.
8109 | Federal Tax Deposit Coupons | Used to make deposits of withheld income and employee and employer shares of Social Security taxes. May also include deposits for federal unemployment insurance.
W-2 | Wage and Tax Statement | Given to each employee to detail earnings and amounts withheld. These must be sent to employees no later than January 31. A copy also goes to the Social Security Administration along with Form W-3 (see below).
W-3 | Transmittal of Wage and Tax Statements | Summarizes total earnings, Medicare wages, Social Security wages, and withholding for all employees. Must be sent to the Social Security Administration by February 29, along with W-2s for all employees.
W-4 | Employee’s Withholding Allowance Certificate | The employer gives this form to all new employees, who complete it and return it to the employer. The employer uses the completed W-4 to calculate withholdings for each employee.
1099-MISC | Wage Statement | Given to contract employees to detail earnings. Must be sent to employees by January 31. Must be sent to the IRS by the end of February (paper) or March 31 (electronic), along with Form 1096 (see below). State regulations may differ.
1096 | Annual Summary and Transmittal of U.S. Information Returns | Summarizes earnings for contract employees. Must be sent to the IRS by the end of February (paper) or March 31 (electronic), along with all 1099s sent to contract employees.

An Accounting Checklist Regular accounting tasks should be added to your calendar. Here is a basic list; you may need to do additional tasks depending on your type of business. Also, businesses with a high sales volume may need to do some of these tasks more often (e.g., they may need to reconcile their accounts weekly—or even daily—instead of monthly).
DAILY Check cash on hand and bank balance. Record cash and credit card receipts. Record invoices and bills. Make bank deposits and post payments to the appropriate journal. Complete payroll tasks (this may include making payroll tax deposits). Check data entry for quality. Record incoming inventory. File all sales, purchase and expense invoices, correspondence and other paperwork in the appropriate folders. MONTHLY Reconcile your bank and credit card statements. Post any fees, interest or chargebacks to the appropriate journals. Classify journal entries by account number and post them to the General Ledger. Prepare and review your balance sheet and profit and loss statements. Review accounts receivable and send reminders to slow and delinquent accounts. Review accounts payable and note any early-payment discounts. Make federal and state tax deposits. Balance and replenish petty cash, and make sure all expenditures are documented. | Make payroll tax deposit, if necessary. Assess inventory and adjust stock levels and order quantity as needed. QUARTERLY Make estimated federal and state tax payments if necessary. File FICA and withholding returns and deposit withholdings if necessary. Make FUTA deposits if necessary. Compare budgeted projections to actual results. Send aged receivables to collections. Test your data backup and recovery system. YEARLY Prepare and file all year-end payroll and contractor reports and returns (1099s, W-2s, FUTA Form 940, etc.). Pay any outstanding bills or invoices you intend to deduct for the past tax year. Prepare and review annual financial reports (e.g., annual profit or loss statement and end-of-year balance sheet). Prepare and file taxes. Verify and update employee withholding and address information. Assess and improve internal controls. Prepare journals and records for the coming tax year.