Bookkeeping and accounting

Don't forget to keep these records so that you (and the tax agency) know how your business is doing.

If you’re getting paid, congratulations! You’ve created something that people wanted enough to trade money for. To make sure your business stays healthy, and help you focus more on the business than on keeping the lights on, you will want to keep records of money moving in and out of your business. Welcome to the fascinating world of bookkeeping and accounting.

What is bookkeeping? What is accounting?

Historically, there was a distinction between the functions of bookkeeping and accounting, but the distinction is weakening as more of both functions are done by computers rather than people.

Bookkeeping is recording details about transactions to the books (ledgers) of the company. It has historically been seen to be work done by detail-oriented specialists, but not something which required a higher degree.

Accounting turns the data from books into conclusions about the health of the business. Some of this function has largely been subsumed by computer programs—given that the books of the business are computerized, calculating e.g. a balance sheet (a report listing the present assets and liabilities of the business) is trivial.

In most businesses, accountants advise about the structure of the business (for example, how funds flow between a parent corporation and a subsidiary), design procedures and controls for novel transactions which are more complicated than the routine work handled by bookkeepers/computers, and advise the business’ owners/managers on financial topics. They also often help with tax planning and preparing tax returns.

What are “books?”

Your business keeps many types of records. One category of these, which describes the movement of value into and out of the business, is called “books.” The books track value, not necessarily always money, but for convenience’s sake we’ll talk about money rather than the long list of valuable things a business can keep records about.

The physical manifestation of the “books” is different at every business—at some businesses it is a literal book with a physical ledger of transactions, at others it is an Excel file, at others it is distributed among multiple different accounting systems.

Each entry in a ledger has an amount, a description, a date, and some notion of where the money is coming from and where it is going to. You can think of your checkbook or bank statement as a ledger, though a very simple one relative to one your business is likely to have.

Most businesses use double-entry bookkeeping, where the business keeps multiple logical ledgers, each representing an account of the business. “Accounts” here could correspond to actual bank accounts or to something which is useful to think about but which doesn’t have a physical place of its own, like “revenue.” Double-entry bookkeeping has every transaction recorded twice: as a credit to one account and a debit to another.

Double-entry bookkeeping was a revolutionary technology back in the 1400s, because it makes errors and malfeasance less likely than using a single ledger for the business. These days computers do most of the actual work, so the business owner can probably avoid thinking about the logistics of bookkeeping that frequently and instead focus on making good decisions about the outputs from the bookkeeping/accounting processes.

Separating one’s financial lives

One of the first steps to take for establishing proper accounting controls on your business is to separate your personal life from your business life. This is often difficult early, as many entrepreneurs start by operating the business as an extension of their personal identity. That is natural and expected, but as early as feasible, you should make a clear division between money inside the business and money outside the business.

This has a few benefits:

One of the easiest ways for creditors of a company, or others with claims against it, to “pierce the corporate veil” is to demonstrate that the company was not a bonafide business but rather treated like just a separate pocket for the entrepreneur. “Piercing the corporate veil” is legal jargon for voiding the presumption of that the liabilities of the corporation rest solely with the corporation and not its owners. As the owner of a company, you urgently want to avoid this happening.

Paying personal expenses out of the corporate accounts or corporate expenses out of your personal accounts tends to demonstrate that the company is just a fiction. Since entrepreneurs who incorporate want (and should benefit from) the limitation on liability offered by incorporation, they should be careful to maintain the distinction.

Additionally, it is just operationally easier if your business transactions and personal transactions stay in separate accounts. You have no particular obligation to keep accurate books for yourself, but you do for your business. If every transaction on a credit card is known to be business-related, that makes your bookkeeping easier; if you know with certainty that none are business-related, then you can throw away that statement without consequence for the business.

Enforcing discipline on movement of money between the corporation and yourself can help surface issues before they’re unsolvable. Businesses are complicated; even small businesses can easily have hundreds of transactions in a month. It is very easy to have the inaccurate perception that one’s business is doing well while it is actually bleeding money. This can happen if you have money coming in and out of your personal accounts all the time, and you might not realize it unless you pay very close attention to how often you are personally incurring business expenses. This happens to even very talented entrepreneurs, and it can be a painful realization to wake up to.

Internet businesses are, happily, very well-positioned to separate from your personal finances, because of how much of the business takes place electronically. If you remember a few simple rules, your business will default to doing the right thing. Let’s walk through how you should handle some of the most common transactions.

Ways to simplify bookkeeping

Revenue: Open a business checking account as the primary holding place for money for the business. Make sure that all revenue for the business is deposited into that checking account. For example, have Stripe (or your other credit card processor) send funds to that account. If you receive checks, deposit them into the account (rather than cashing them).

Doing this will allow you (or your bookkeepers) to quickly scan deposits into the business, which will almost all be revenue items, and match them against your sales.

Non-revenue deposits: Money occasionally moves into businesses for reasons other than “a customer paid it to you.” Prominent examples include investment, entrepreneurs loaning money to the business, etc. You should keep these transactions as infrequent as possible and document them appropriately.

Early in the life of the business, when it is not yet cash-flow positive, an entrepreneur will often need to inject money into it. This is fine, assuming you can afford it, but: arrange for this to be as infrequent as possible. Monthly is a good cadence for this; multiple times a week is not.

Expenses: Open one or a small number of credit cards. These can be in your personal name or in the name of the business—business credit cards are often difficult to qualify for early in the life of your business. Put all business expenses on a credit card where possible; never put a personal expense on the business credit cards.

Don’t make transactions which are mixed in character; they’re painful for bookkeeping later. If you need to make a purchase from Amazon with business-related items and unrelated items, make two purchases instead. It may cost you a bit of extra shipping (or extra SaaS accounts, or extra time asking a clerk to ring up two purchases at a store), but you’ll save on bookkeeping fees and aggravation. There are many places in your business where your personal attention unlocks added value; answering the question “Was this pack of batteries you ordered business or personal?” is not one of them, so don’t organize the business such that you’re routinely asked that question.

Pay those credit cards from the business checking account, and only from the business checking account.

You should minimize the number of business expenses which occur via any method other than your business credit card, most especially cash transactions. If you need to reimburse yourself or an employee, make sure you keep records of both the expense and the reimbursement.

Some government agencies, landlords, etc may only be able to be paid by check; use your online banking to write them checks directly from the business checking account, or use direct debits or ACH payments to pay them.

Loans from the business to the entrepreneur: Prefer to avoid making these. Investors hate them because historically they can indicate misuse of company funds. They complicate bookkeeping unnecessarily. They make the story that you and your business are separate a harder one to sell. Ideally, you want flow of cash between the business and yourself to be unidirectional and relatively infrequent: a monthly salary check, a quarterly distribution, etc. These are easy to account for and have clear treatment in terms of tax consequences.

Loans get… messy. For example, it is very easy for lax bookkeeping to result in loan repayments to the business being either recorded as entirely revenue (which is incorrect, and increases the business’ tax burden unnecessarily) or deemed as revenue by the tax agency (which is incorrect, but might be difficult to defend against given lax bookkeeping).

If you need credit, get it from a bank. Paying an 18% APR on a balance averaging $5,000 over the course of a year is a lot less expensive than paying for your accountant to answer the IRS’ questions about an informal loan that is lacking in documentation or extensive transactions between the owner and the business.

The IRS also has toothy rules about “related-party loans”, which require more documentation than loans received from banks. If you fail to maintain this documentation, you can be penalized, not because you intended to abuse the loan but simply because you failed to follow the rules about documentation.

Speak to your accountant to appropriately document these loans if you choose to make them. Or save yourself the trouble, and just don’t borrow money from or lend to your business without careful consideration.

Cash accounting vs. accrual accounting

There are two methods of accounting widely used by internet companies: cash accounting and accrual accounting. They result in materially different processes involving bookkeeping/accounting and can result in substantial differences in taxes. You’ll likely pick one of the two methods and stick with it for years at a time. (The two methods imply different ways of keeping the books for your company; you’ll also have to tell the IRS which method you were using when you file your first tax returns for the company. Changing methods requires both filing forms with tax agencies and often a lot of internal work to make sure the transition is accounted for correctly, so you’ll want to avoid it where you can.)

In the cash method, your business records revenue as soon as it is “available to you without restriction.” This is a term-of-art from the IRS; a simplified view of it is “If your customer thinks they’ve paid you, you’ve probably booked revenue in the amount they think they paid you.” Revenue which has hit one of your accounts is certainly revenue as of that instant; checks which have been sent to you are revenue as of when they are sent rather than when they are received.

Expenses are similarly simple: you book them when they’re actually paid.

Many entrepreneurs start their businesses using the cash method, as it is very easy to understand, even for entrepreneurs without a business background.

The accrual method is more complicated than the cash method. The tradeoff it makes is to allow the business (and other interested parties) to have a more accurate understanding of the true health of the business at any point in time.

In the accrual method, both revenue and expenses are recognized once the amount is fixed, known to be (in principle) collectible, and after economic performance has happened.

This means that, for example, if you accept funds for an order but have not shipped yet, you do not recognize revenue until you ship. (You book an asset for the funds and a liability of unearned revenue representing the obligation of the corporation to ship the equivalent value of goods; you then decrement the liability when you ship and increment revenue.) Bookkeeping: easy, once you get the hang of it… but your time is better spent doing almost anything else, so pay someone to do this for you.

Many investors will expect to see books done in the accrual method, as there are a variety of ways to report via the cash method which make a business seem to be more successful than it actually is. Switching one’s accounting method can be done at the end of a tax period, but is more than a bit of a headache, so if you know you’re on the investment track you might want to start with the accrual method to save yourself having to revisit all your books a few months down the road.

Substantiation requirements

Your business is required to be able to substantiate (provide documentation about the facts regarding) any transaction on your books. You will want to maintain organized records, in addition to your books, which will let you quickly answer questions asked about any transaction.

This is most important for larger transactions or for transactions in a few high-risk parts of one’s tax return, but in principle, you need to be able to substantiate everything.

The IRS does not mandate that you have any particular style of recordkeeping, only that you do it in a consistent manner which lets you comply with your obligations. Internet companies customarily keep most of their records in one or more computer systems. It is important that you know what information is where, that you’re able to pull it at will, and that your records are available for the appropriate length of time. (In general, this is 3 years after the filing of the tax return for that year, but there are some exceptions. As a practical matter, internet businesses should store substantiating data indefinitely. Hard disk space is practically free; it’s certainly cheaper than setting up a process to routinely make the keep-or-delete decision about particular documents.)

Substantiating revenue items is fairly easy: keep copies of receipts and invoices. (These are described, in detail, in another chapter.) If you have particularly large transactions, you probably will want to be able to point to contracts or other documentation attesting to the details of what work was actually performed.

Your receipts/invoices will generally be centralized by nature in your system. If you happen to migrate systems, remember to save old receipts/invoices somewhere that won’t get wiped after the migration is over. Organizing them by year minimally; it is often useful to be able to order them within the year, as a common form of inquiry is “Your books show a revenue item for $12,000 on December 3rd, 2012. Substantiate it in an appropriate level of detail.”

Substantiating expense items is modestly trickier, as expenses are typically far more varied than revenue. Additionally, certain flavors of expenses have anomalously detailed recordkeeping requirements.

You will want to have a policy that any purchase of goods or services at your company requires a written receipt and/or invoice, and that all receipts/invoices are kept in a central place. Many companies use receipt-tracking or expense-tracking software. A lower-tech, but still compliant, way to do this is to establish a receipts@ email address for your company and require all employees, as a matter of policy, to have receipts either delivered there or to forward receipts there if they are issued one personally.

If a transaction doesn’t result in a receipt, you should treat that as an anomaly. Part of the discipline of having receipts is to force money moving out of the company to come with documentation justifying it; transactions which do not have receipts are suspicious by nature, and may represent activity that your business wants to clamp down on, like embezzlement. Most of the time the reason is innocuous, but you should still immediately create a written record of the transaction and store it wherever you store receipts/invoices. (Note that backfilling written records from e.g. credit card statements is not acceptable; the IRS wants records to be maintained contemporaneously with the transaction or shortly thereafter, when the details are still fresh and when there is minimal possibility for fudging them for one’s tax advantage.)

Written records don’t have to be particularly elaborate for most transactions, particularly small-dollar ones; receipts aren’t generally that elaborate, either. You’ll want to cover who you paid (in an appropriate level of detail—”A man” is not appropriate, “the flower shop on 3rd street” probably is, at least for a small transaction), exactly how much was paid, the manner of payment (from an account, in cash, etc), what was purchased, and one’s rationale for not having a formal receipt/invoice.

Electronic records count as written records, particularly when you maintain them in an orderly fashion in the ordinary course of business. If it is your business’ ordinary practice to keep receipts in the receipts@ email inbox, for example, then a two-line email to receipts@ is a written record created in the ordinary course of business at your company, and it will generally be treated with routine deference.

You should keep statements (and similar documents) for all bank accounts, credit cards, etc indefinitely. Note that banks will sometimes retain statements on their own systems for less time than you’d like them to be retained—make a practice of saving the electronic copies in a place you control. Banks do go out of business occasionally; you don’t want to have to reconstruct an account statement from 5 years ago simply because you closed the account or the bank was bought in the interim.

Travel, transportation, entertainment, and gift expenses are sometimes abused by some taxpayers and, as a result, have specific recordkeeping requirements. You should be especially careful to keep written contemporaneous records for these transactions; the IRS describes what you need in Publication 463. A preview of coming attractions: you should keep a spreadsheet for each employee which shows any dates of travel, where they stayed (get receipts!), and what the business purpose for the travel was. You should, any time you do business entertaining (including meals), record the participants and the specific business purpose contemporaneously with information about the transaction; many small businesses simply write this on the back of the receipt.

As with most tax topics, the authorities try to be reasonable about the degree of ceremony required for small transactions, and it goes up as transactions get larger, more frequent, or more material in the total context of your business. It is unlikely that you need to write much more than “Dan Smith; candidate; discussed employment opportunity” if you buy someone $20 worth of lunch; if your end-of-year party costs your company $150,000, run that by your accountant and ask them what the appropriate level of substantiation is.

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