Bookkeeping basics

The record comes before the report

The first thing a set of books does is remember. Human memory is unreliable about money in a particular way: it remembers the large and the recent and forgets the small and the routine, which is exactly backwards, because most businesses are undone by an accumulation of small routine amounts rather than by one dramatic one. A written record made at the time of the transaction is not bureaucracy, it is the only evidence that will exist later.

The practical minimum for any small operation is a dated line for every movement of money, with the amount, the other party, and a short description of what it was for, kept alongside the document that proves it. Everything else in bookkeeping is an elaboration of that line.

Journals and ledgers

Traditionally the record is kept in two shapes. The journal is chronological: it lists transactions in the order they happened, which is how they are observed. The ledger is categorical: it gathers the same transactions under headings such as sales, rent, wages, or a particular customer, which is how they need to be read.

Software has hidden this division without abolishing it. When a modern package shows a bank feed, that is the journal. When it shows a profit and loss report by category, that is the ledger. Understanding that both views exist, and that they are the same data sorted two ways, explains most of what is otherwise confusing about accounting software.

Two entries for every transaction

The organising idea of bookkeeping is that every transaction has two sides, and recording both of them is what makes the record self-checking. If a business buys a machine for cash, something arrived and something left. Recording only the arrival produces books that show assets appearing from nowhere. Recording both produces books in which the totals must agree, and disagreement is a signal that something is missing.

This is double-entry bookkeeping, and its usefulness has nothing to do with formality. It is an error-detection system. A single-entry record can be wrong in ways that leave no trace. A double-entry record has to be wrong twice, in exactly compensating amounts, before it looks correct, and that is rare enough to be worth the extra effort.

Cash recording and accrual recording

There are two moments at which a transaction can be recorded: when the money moves, or when the obligation arises. Recording on movement is cash-basis bookkeeping. Recording on obligation is accrual-basis bookkeeping. A business that invoices in one month and is paid in the next will show those two events in different periods depending on which basis it uses.

Neither is a trick. Cash recording answers the question of what the bank did. Accrual recording answers the question of what the business did. Small operations often start on a cash basis because it is simpler and matches how they experience their own finances, and move to an accrual basis as the gap between doing the work and being paid for it grows large enough to distort the picture.

Checking the record against the world

A book of account is a claim about reality and needs testing against it. The internal test is the trial balance: totalling every debit and every credit and confirming the two agree. It catches arithmetic and one-sided entries, though it cannot catch a transaction posted correctly to the wrong heading.

The external test is reconciliation: comparing the record with a statement produced by someone else, usually a bank. Items appear on one and not the other for legitimate reasons, mostly timing, and the reconciliation is the short written explanation of every such difference. Done monthly it takes a few minutes and surfaces errors while they are still traceable. Left for a year it becomes the single most disliked task in small-business administration.