What is bookkeeping?

If you’re new to business you’re probably wondering what is bookkeeping? Why do I need to do bookkeeping? And how do I do the bookkeeping? To help you answer these questions, here we explain what bookkeeping is and the theory behind it. How to do the bookkeeping is explained on our other posts: bookkeeping using spreadsheets and on our bookkeeping using software posts.

What is bookkeeping?

Bookkeeping is the process of recording all of the financial transactions of a business. The financial transactions would include sales, purchases, income, payments, vat, payroll etc. Historically, each transaction would be written in one or more books by a person known as the bookkeeper. Nowadays we use spreadsheets and online accounting software to help us keep the books.

Why do I need to do bookkeeping?

You need to do the bookkeeping to have a record of every financial transaction. You need bookkeping records to be able to prove to the tax inspector how much tax is due. It is a legal requirement of directors of companies to keep up to date bookkeeping records. Other businesses are also required by HMRC to keep bookkeeping records as evidence of how much profit has been made.

Accountants use the bookkeeping records to check that transactions have been recorded correctly. Then they prepare reports on how much money the business has made (profit & loss report). And how much money it owns and owes (balance sheet). These reports also help to work out how much tax is payable.

Do I need to know how bookkeeping works?

Online accounting software deals with the technical aspects of bookkeeping for you. So you don’t really need to know the theory behind bookkeeping. However, a general understanding of bookkeeping theory can help you understand how to use online accounting software.

Bookkeeping theory

The main method of bookkeeping is called double entry, where every transaction would be entered into 2 different books. Like a gangster film, where one set of books are accurate and the other set is for the tax inspector? No! There are several books that make up whole bookkeeping system. For example a sales book, purchases book, bank book. Each transaction would have a double effect on the business’s finances and in its books. For example, when a business buys stock with cash, it has increased its costs and reduced its cash. That’s a double effect, so the transaction would be recorded twice. Once in the purchases book and again in the cash book.

Another example

For another example, let’s say the business sells the stock on credit (buy now pay later). The first double entry will be in the sales invoice book, showing the invoices owed to the business. The other entry will be in the nominal ledger to show that a sale has been made. When the customer pays the invoice, this is a new transaction that requires another double entry. One entry is to the sales invoice book to mark the invoice as now being paid. The other is to the bank book to show that the bank balance has increased.

Debits and Credits

Each bookkeeping entry is either a debit or a credit. A double entry must be opposing, so one is a debit and the other is a credit. This way, all of the debits totalled up should equal all of the credits totalled up. So the books are balanced and the accountant is happy! To remember whether something should be a debit or credit can take years of practice until it finally clicks. But here are the rules:

Four types of accounts

Sales and costs are self explanatory, but we should explain what we mean by assets and liabilities. Assets are the things the business owns or is owed. For example: equipment, stock, cash in the bank, money owed from customers. Liabilities are the things that the business owes. For example: money owed to suppliers, bank loans, tax owed to HMRC. Shares and profit reserves are also liability accounts because they are ultimately amounts owed to the shareholders. However, software often refers to these as equity accounts.

So we have four main types of accounts:

• Sales are usually a credit
• Costs are usually a debit
• Assets are usually a debit
• Liabilities are usually a credit.

Bookkeeping reports

The profit and loss report shows the sales and costs. The balance sheet shows the assets and liabilities. The difference between the sales and costs (profit or loss) is added to the balance sheet. This is done in an account called retained earnings or profit or loss which makes everything balance.

We bring together all of the different accounts at the end of a period of time (usually 1 year). We list all of the sales, costs, assets and liabilities accounts along with their total debit or credit balance. This ‘Trial Balance’ report is to check that the total debits equals the total credits, and everything balances. Then we summarise those amounts on the profit and loss report and the balance sheet report.

Do I need to know bookkeeping for online accounting software?

Do you need to know this if you use online accounting software such as Xero and Pandle?. Well, knowing the basics of what bookkeeping is can help you understand how online accounting software works. Also, how to use it correctly. It seems you are only making one entry onto the software. But in fact, the software is itself dealing with the double entry, and keeping everything balanced.

Example 1

Creating a sales invoice on your accounting software will add the total amount to the balances owed from customers (asset). It will also add the net amount of the invoice to sales (sale). If VAT is applicable it will also add the VAT amount to the VAT account (liability). When the bank income appears on your accounting software, you know that you’ve already added that sale to sales. So you know not to categorise the income as sales. Instead, you need to record it as a sales receipt and match it to the sales invoice. Then the software will increase the bank balance, and reduce the amount owed from customers.

Example 2

Likewise with a bank transfer. If you move money from one business bank account to another, you need to record this as a bank transfer. When you deal with one side of the bank transfer, your accounting software will create the other side. In the other bank account, you know you’ve already created the other side of the bank transfer. So you just need to match it with the transaction that’s already there from the first bank account. If you create another transfer, you will end up with duplicate transactions in both accounts.

Journal Adjustments

Knowing what bookkeeping is can also help you adjust your online accounting too. We often call these adjustments journals. A journal changes the balances of your accounts, without the use of bank transactions, or sales or purchase invoices. Every journal needs to balance, i.e. the total debits equal the total credits, to keep the accounts balanced.

Example

If you pay wages, the wages payment doesn’t usually reflect the full cost of the wages. That’s because of the tax deductions reducing the gross wages to net wages. So you could use a journal entry to record the full cost and the taxes due. You would debit the gross wages and any employers NIC to the cost accounts. Then credit the net wages to a liability account, and credit the total PAYE/NIC to another liability account. Then when you pay the wages, you know that you’ve recorded the cost already. So the payment needs to categorised to the net wages liability account (as a debit to offset the earlier credit). Similarly with the PAYE/NIC payment, you need to categorise that to that liability account too.

Wages on software

If your payroll software is part of your online accounting software, it should automatically enter these adjustments for you. However, it helps to know what it has done so you can deal with the payments correctly.

Summary

To sum up, bookkeeping is a very important process of recording all business transactions. It is a legal requirement for all businesses. The theory of bookkeeping (double entry debits and credits) will help you to understand how to use online accounting software.

If you need help with the bookkeeping, we can do that for you as part of our Monthly package. Or we can guide you through it as part of the advice included in our fixed fees. You can see our fees and get an instant quote using the buttons below.