Bookkeeping Systems
Bookkeeping
Types of Bookkeeping Systems
A business needs to determine the type of bookkeeping system that will be used for recording their business transactions.
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Single Entry System
Many small businesses start out using the single entry system.
The single entry system is an “informal” accounting/bookkeeping system where a user of this system makes only one entry to enter a business financial transaction. It generally includes a daily summary of cash receipts and a monthly record of receipts and disbursements (worksheets). A checkbook, for example, is a single entry bookkeeping system where one entry is made for each deposit or check written. Receipts are entered as a deposit and a source of revenue. Checks and withdrawals are entered as expenses. If a manual system is used, in order to determine your revenues and expenses you have to prepare worksheets to summarize your income and categorize and summarize your different types of expenses. Bookkeeping software and spreadsheets are also available to do this for you. The emphasis of this system is placed on determining the profit or loss of a business.
It got its name because you record each transaction only once as either revenue (deposit) or as an expense (check). Since each entry is recorded only once, debits and credits (recording method required for the double entry system) are not used to record a financial event. For those interested, the Internal Revenue Service’s Publication 583 – “Starting a Business and Keeping Records” has a detailed example of a single entry type of system. While the single entry system may be acceptable for tax purposes, it does not provide a business with all the financial information needed to adequately report the financial affairs of a business. In the near future, we’ll probably see the single entry system follow the same path as the dinosaur – extinction.
Double Entry System
The double entry system is the standard system used by businesses and other organizations to record financial transactions. Since all business transactions consist of an exchange of one thing for another, double entry bookkeeping using debits and credits , is used to show this two-fold effect. Debits and credits are the device that provide the ability to record the entries twice and are explained in more detail later in this tutorial. The double entry system also has built-in checks and balances. Due to the use of debits and credits, the double-entry system is self-balancing. The total of the debit values recorded must equal the total of the credit values recorded. This system, when used along with the accrual method of accounting, is a complete accounting system and focuses on the income statement and balance sheet. This system has worldwide support as the system to use by businesses for recording their financial transactions.
The double entry system is the standard system used by businesses and other organizations to record financial transactions. Since all business transactions consist of an exchange of one thing for another, double entry bookkeeping using debits and credits , is used to show this two-fold effect. Debits and credits are the device that provide the ability to record the entries twice and are explained in more detail later in this tutorial. The double entry system also has built-in checks and balances. Due to the use of debits and credits, the double-entry system is self-balancing. The total of the debit values recorded must equal the total of the credit values recorded. This system, when used along with the accrual method of accounting, is a complete accounting system and focuses on the income statement and balance sheet. This system has worldwide support as the system to use by businesses for recording their financial transactions.
It got its name because each transaction is recorded in at least two places (accounts) using debits and credits.
Accounting Methods
Another decision faced by a new business is what accounting/bookkeeping method is going to be used to track revenues and expenses. An accounting method is just a set of rules used to determine when and how income and expenses are reported.
If inventories are a major part of a business, the decision is made for the business owner by the Internal Revenue Service (IRS). Some business will be required to use the accrual method of accounting while others may be granted an exception and allowed to use the cash basis along with some special rules.
You’re more than likely to encounter both the term method and basis used when this topic is discussed. In some cases you’ll see the term cash method used and other cases see the term cash basis used. Likewise you’ll see the term accrual method used and the term accrual basis used. They both refer to the same concept and are used interchangeably.
Cash Method
The cash method or basis of accounting recognizes revenues (earnings) in the period the cash is received and expenses in the period when the cash payments are made. Actually, two types of cash methods (basis) of accounting exist:
strict cash method (basis)
modified cash method (basis)
A strict cash method follows the cash flow exactly. A modified cash method includes some elements from the accrual method of accounting and provides special methods for handling items such as inventory and cost of goods sold, payroll tax expenses and liabilities, and recording and depreciating property and equipment.
Many small businesses, whether they know it or not, are actually using a modified cash method.
By concentrating on recording revenues and expenses, the purpose of the cash or modified cash method of accounting is on determining the net income or loss for a period based on the cash received and the cash spent.
Information, such as the amounts billed to customers for products and/or services and not paid, and the amounts billed by suppliers for their products and/or services and not paid is not normally recorded and maintained in the “books” using the cash method.
Many small businesses start out using the cash basis rather than the accrual basis of accounting.
Use of the cash basis generally is not considered to be in conformity with generally accepted accounting principles (GAAP). Is this necessarily bad ? No, if no need is foreseen for what are called audited financial statements there’s no need for concern. In most cases, audited statements are only required for the “big boys” (companies whose ownership interests are publicly traded). The “little guys” like the ma and pa shops don’t need to worry. Still, when possible, a business should strongly consider using the accrual method of accounting.
Accrual Method
The accrual method or basis of accounting records income in the period earned and records expenses and capital expenditures such as buildings, land, equipment, and vehicles in the period incurred.
The purpose of the accrual method of accounting is to properly match income and expenses in the correct period.
In order to accomplish this, the accrual method of accounting records revenue as earned when the product and/or service is shipped or rendered and invoiced (billed) to customers. Likewise, expenses and capital expenditures are recorded as incurred when the product and or service is shipped or rendered and invoiced (billed) by the supplier.
Information, such as the amounts billed to customers for products and/or services and not paid, and the amounts billed by suppliers for their products and/or services and not paid is recorded and maintained in the “books” using the accrual method. This is the accounting method that is required to be used in order to conform to generally accepted accounting principles (GAAP) in preparing financial statements for external users.
Difference Between The Two Methods
The difference between the two methods used for recording revenues and expenses results from when the business transaction is recorded in the “books” ( timing ). A business using the accrual method will record revenues and expenses in their “books” before a business using the cash method. In other words, unlike the cash method , they don’t wait until they get paid by the customer or wait until they pay a supplier to record the transaction.
Comment: I’ve heard that “forewarned is forearmed” so here goes. Cash Flow and Profits are two different “animals”. Due to the timing difference as to when revenue and expenses are recorded and when the cash resulting from the revenue and expenses is actually received or paid out , a business using the accrual method of accounting and reporting a “hefty” profit does not necessarily mean that they have the cash to pay their bills.
Even though the accrual method provides a better measure of profit and loss, many small businesses still use the cash basis of accounting. I think with the advent of easier to use computer accounting and bookkeeping software, we’ll see more businesses adopting the accrual basis of accounting.
Relationship Between the Type of Bookkeeping System Used and the Accounting Method Used
What if any is the relationship between the type of bookkeeping system used and the method
of accounting ?
The Single Entry bookkeeping system is used along with the Cash Method of accounting.
Debits and Credits are not used to record financial events.
The Double Entry bookkeeping system can be used with both the Cash and Accrual methods of accounting.
Debits and Credits are used to record financial events.
So You Know
You can use a different accounting method, the cash method or the accrual method, for each business that you set up.
Also, you can keep two sets of books, one on the cash basis and the other on the accrual basis, for the same business. You do; however, have to select one of the methods for tax purposes and continue to use it in the future. This is perfectly legal. It’s when you keep two sets of books to hide your true earnings when the trouble begins.
Accounting and Bookkeeping Software
Let’s muddy the water about the single and double entry accounting method at least as to how it relates to using bookkeeping and accounting software.
Single or Double Entry ?
Accounting and bookkeeping software programs actually allow the user to make a single (one) entry and the software handles creating the debit and credit entries “behind the scenes”. The double-entry system is still there, but it’s hidden from the user. The one exception is the general journal where the user does enter debits and credits.
Let’s look at a sample transaction of invoicing (billing) a customer to illustrate what I’m talking about.. An invoice to a customer is created and printed and the resulting transaction is automatically recorded in the “books” as an increase to the amounts owed by customers and an increase to revenues (sales) using debits and credits.
Wow, since it’s automatic, does that mean we don’t need to learn about debits and credits later ?
Only in your dreams. Although an airplane can be flown on auto-pilot, would you want to be on that plane without a trained pilot ? The same applies to using accounting and bookkeeping software. You need a properly trained bookkeeper or accountant that is also familiar with the software product in order to properly use the software. That ole saying “GIGO” (Garbage In – Garbage Out) definitely applies here.
Let’s also muddy the water regarding the cash method and accrual method of accounting. Some accounting software allows you to convert data back and forth between a cash basis and accrual basis of accounting. As I stated earlier, you do have to select one of the methods for tax purposes and continue to use it in the future.
What’s the Recommended Type of Bookkeeping System and Accounting Method ?
Most accountants when asked will recommend that a business use the double entry bookkeeping system and the accrual basis or method of accounting which is based on the revenue realization principle and a principle called the matching concept. The revenue realization principle states that revenue should be recorded when actually earned.
Don’t tell me accountants actually play matchmakers or promote a dating service! No the matching principle is recording the revenues earned during a period using the revenue realization principle and matching (offsetting) the revenues with the expenses incurred in generating this revenue. Why is this so important ? All businesses small and large need information to determine how well or badly they are performing; however, if this information is misleading it could lead to false conclusions and unnecessary actions.
Show me what you mean.
The following sample business transactions for a mowing and landscaping company will be used to illustrate the accrual basis of accounting/matching concept and the cash basis of accounting.
(1) January xxxx Billed $30,000 To Customers For Services Performed & Completed In January XXXX
(2) January xxxx Received Payments From Customers of $15,000
(3) January xxxx Billed $12,000 by Outside Contractors For Services Performed & Completed In January XXXX
(4) January xxxx Paid Outside Contractors $8,000
(5) February xxxx Received Payments From Customers of $15,000
(6) February xxxx Paid Outside Contractors $4,000
| Cash Basis | Accrual Basis | |||||
Period | Jan xxxx | Feb xxxx | Total | Jan xxxx | Feb xxxx | Total |
| Revenue | $15,000 | $15,000 | $30,000 | $30,000 | 0 | $30,000 |
| Expenses | $8,000 | $4,000 | $12,000 | $12,000 | 0 | $12,000 |
| Profit | $7,000 | $11,000 | $18,000 | $18,000 | 0 | $18,000 |
Possible Conclusions From The Cash Method
Made money in January and February.
Our company is making more profit on the same amount of revenues. We had revenues of $15,000 in both January & February but made a bigger profit in February.
In February, we must have implemented some expense saving measures or got cheaper prices on our contracted services.
Are any of these conclusions valid ? No not a one ! The “real” world as illustrated by the accrual method shows we had a great January and made $18,000 but February was terrible. We celebrated our great January and sat on our “you know what” and didn’t go out and get additional business and mow some more yards and do some more landscaping.
Next, we'll learn about the Rules of the "Bookkeeping Game".