What is Bookkeeping & why it is important? | Methods of Bookkeeping - Zoho Books (2024)

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What is bookkeeping and why is it important?

Bookkeeping is the process of recording your company’s financial transactions into organized accounts on a daily basis. It can also refer to the different recording techniques businesses can use.Bookkeeping is an essential part of your accounting process for a few reasons.When you keeptransactionrecords updated, youcangenerateaccurate financial reports that help measurebusiness performance.Detailed records willalsobe handy inthe event of a tax audit.

This guide will walkyou through thedifferentmethods of bookkeeping, how entries are recorded,andthe major financial statements involved.

Methods of bookkeeping

Before you beginbookkeeping, your business must decide what method you are going to follow.When choosing, consider the volume of daily transactions your business has and the amount of revenue you earn.If you are a small business,acomplex bookkeeping methoddesigned for enterprises may cause unnecessary complications.Conversely, less robust methods of bookkeepingwill not sufficeforlargecorporations.

With this in mind, let’sbreak thesemethods downso you can find the right one for your business.

Single-entry bookkeeping

Single-entry bookkeeping is astraightforward methodwhereone entry is made for each transactionin your books.These transactions are usuallymaintained in a cash book to track incoming revenue and outgoing expenses.You do not need formal accounting training for the single-entry system.The single-entry method will suit small private companies and sole proprietorships that do not buy or sell on credit, own little to no physical assets, and hold small amounts of inventory.

Double-entry bookkeeping

Double-entry bookkeeping is more robust.It follows the principle that every transaction affects at least twoaccounts, and they are recorded asdebits and credits.For example, if you make a sale for $10, your cash account will be debited for $10and your sales account will be credited by the same amount.In the double-entry system, the total credits must always equal the total debits.When this happens,your books are “balanced.”

Using the double-entry method forbookkeeping makes more senseif your business islarge, public, or buys and sells on credit.Enterprises often choose the double-entry system because it leaves less room for error.In a way, it ‘double-checks’ your books because each transaction is recorded as two matching butoffsetting accounts.

Cash-based or accrual-based

The next step is choosing between acashor accrual basis foryourbookkeeping.This decision will dependon when your business recognizesitsrevenue and expenses.

Incash-based, you recognize revenue when you receive cash into your business. Expenses are recognized when they are paid for. In other words,any time cash enters or exits your accounts, they are recognized in the books.This means that purchases or salesmade on credit will not go into your books until the cash exchanges.

In the accrual method, revenueis recognized whenitis earned.Similarly, expenses are recorded when they are incurred, usually along with corresponding revenues.The actual cash does not have to enter or exit for the transaction to be recorded. You canmark your sales and purchasesmade on credit right away.

Both a cash and accrual basis can work with single- or double-entry bookkeeping.In general however, the single-entry method is the foundation for cash-based bookkeeping. Transactions are recorded as single entries which are either cash coming in or going out. The accrualbasis works better with the double-entry system.

How to record entries in bookkeeping

Generating financial statements like balance sheets, income statements, and cash flow statements helps you understand where your business stands andgauge itsperformance. For these reports to portray your business accurately, you must have properly documentedrecords of your transactions.Keeping these records as current as possible is also helpful when reconciling your accounts.

Recording transactions begins with source documents like purchase and sales orders, bills, invoices, and cash register tapes. Once you gather these documents, you can record the transactions using journals, ledgers, and the trial balance. If you are a very small company, you may only need a cash register. The information can then be consolidated and turned into financial statements.

Cash registers

A cash register is an electronic machine that is used to calculate and register transactions. Usually, cash registers are used to record cash flow in stores.The cashier collects the cash for a sale and returns a balance amount to the customer. Both the collected cash and balance returned are recordedin the registerassingle-entry cash accounts.Cash registersalso storetransactionreceipts, so you can easily record them in your sales journal.

Cash registers are commonly found in businesses of all sizes. However, they aren’t usually the primary method of recording transactions because they use thesingle-entry, cash-based system of bookkeeping. This makes them convenient for very small businesses but too simplistic for enterprises.

The journal

The journal is called the book of original entry. It is the place where a businesschronologicallyrecords its transactions for the first time.A journal can be either physical (in the form of a book or diary), or digital (stored as spreadsheets, or data in accounting software). It specifies the date of each transaction, the accounts credited or debited, and the amount involved.While the journal is not usually checked for balance at the end of the fiscal year, each journal entry affects the ledger. As we’ll learn, it is imperative that the ledger is balanced, so keeping an accurate journal is a good habit to keep.This form is useful for double-entry bookkeeping.

The ledger

A ledger is a book or a compilation of accounts. It is also called the book of second entry. After you enter transactions in a journal, they are classified into separate accounts and then transferred into the ledger.These records are transcribed by accounts in theorder: assets, liabilities, equity, income, and expenses.Like the journal, the ledger can also be physical or electronic spreadsheets.

A ledger contains achart of accounts, whichis a list of all the names and number of accounts in the ledger. Thechart usually occurs in the same order of accounts as the transcribed records.

Unlikethejournal,ledgers are investigated by auditors, so they must always be balanced at the end of the fiscal year. If the total debits are more than the total credits, it’s called a debit balance. If the total credits outweigh the total debits, there is a credit balance. The ledgeris important in double-entry bookkeeping where each transaction changes at least two sub-ledger accounts.

Trial balance

The trial balance isproduced from the compiled and summarized ledger entries. The trial balance islike a test to see if your books are balanced. Itlists the accounts exactly in thefollowingorder: assets, liabilities, equity, income, and expenses with the ending account balance.

An accountantusuallygenerates the trial balanceto see where your business stands and how well your books are balanced.This can then be cross-checkedagainst ledgers and journals.Imbalances between debits and creditsare easy to spot on the trial balance.Itis not always error-free, though. Any miscalculatedor wrongly-transcribedjournal entry in the ledger cancause an incorrect trial balance. It isbest to look out for errors early, and correct themon the ledger instead of waiting for thetrial balance at the end of the fiscal year.

Financial statements

The next, and probably the most important, step in bookkeeping is to generate financial statements.These statements are prepared by consolidating information from the entries you have recorded on a day-to-day basis.They provide insight into your company’s performance over time, revealing the areas you need to improve on.The three major financial reports that every business must know and understand are the cash flow statement, balance sheet, and income statement.

The cash flow statement

The cash flow statement is exactly what its name suggests. It is a financial report thattracks incoming and outgoing cash in your business. It allowsyou (andinvestors) to understandhow well your company handles debt and expenses.By summarizing this data, you can see if you are making enough cash to run a sustainable, profitable business.

The balance sheet

The balance sheetreports a business’ assets, liabilities, and shareholder’s equity at a given point in time. In simple words, it tells you what your business owns, owes, and the amount invested by shareholders.However, the balance sheet is onlya snapshot of a business’ financial position for a particular date.It must be compared with balance sheets of other periods as well. The balance sheet allows you to understand the liquidity and financial structure of your business throughanalytics likecurrent ratio, asset turnover ratio, inventory turnover ratio, and debt-to-equity ratio.

The income statement

The income statement,also called the profit and loss statement, focuses on the revenue gained and expenses incurred by a business overtime.There are two parts in a typical income statement. The upper half lists operating income while the lowerhalf lists expenditures.The statement tracks these over a period, such as the last quarter of the fiscal year. It shows how the net revenue of your business is converted into net earnings whichresult in either profit or loss. The income statement does not focus on receipts or cash details.

Bank reconciliation

Bank reconciliation is the process of finding congruence between the transactions in your bank account and the transactions in your bookkeeping records. Reconciling your bank accounts is an imperative step in bookkeeping because, after everything else is logged, it is the last step to finding discrepancies in your books. Bank reconciliation helps you ensure that there is nothing amiss when it comes to your money.

Why is it mandatory?

Bank reconciliation is a must because it:

• Providesthe exact financial situation of your company
• Tracks cash flow accurately
• Helps detect fraud or bank errors

Stay on top of your bookkeeping