Understanding bookkeeping begins with understanding the purpose of a bookkeeping system and how the information gives a picture of the health of a business.
The Purpose of Bookkeeping
Even owners of very small businesses can benefit from a knowledge of the bookkeeping process. Bookkeeping helps business owners stay organized and informed about the health of their business. To state it very simply, bookkeeping is the process of classifying and recording the day to day transactions that a business is involved in.
Every transaction must be classified, recorded, and organized in such a way that the information can give a picture of the business.
- Classify so the transactions can be grouped.
- The record so the information can be summarized.
- Organize the information to produce reports that can be analyzed.
Classify the Transaction
Before a transaction is recorded, it must be classified regarding any of three basic account types:
- Asset
- Liability
- Equity
Doing so allows the transactions to be recorded and grouped according to account type. The information can then be summarized into reports.
Learning to tell whether a transaction involves an asset, liability, or equity account is one of the keys to understanding bookkeeping. The three basic account types make up a basic mathematical formula called “The Accounting Equation” and can be further broken down into sub-types if needed.
Record the Transaction
The transaction is then recorded either by hand into books called Journals and Ledgers or electronically on computerized software so the information can be summarized.
There are a number of bookkeeping programs on the market such as Quicken, Quickbooks or Peachtree and even some free open source programs such as GnuCash, that can save a great deal of time and generate reports at the drop of a hat.
Organize the Information
Once the information is recorded correctly and summarized, it can be organized in various ways by owners, investors, operators, banks or government institutions to:
- Determine whether the business is making or losing money.
- Determine whether to approve a loan or financing.
- Produce accurate government filings
- Track and analyze such things as income, expenses, debts, receivables, and other information.
The information is usually summarized into 3 basic reports. It’s these reports that investors, owners, and operators use when they analyze business finances.
- The Income Statement (sometimes called The Profit and Loss)
- The Balance Sheet
- The Statement of Cashflows
Different reports reveal different things about the business such as:
- Liquidity – how much cash is available and whether the business will be able to pay its bills.
- Solvency – how well the business can pay its bills when due.
- Profitability – the performance of the business.
It’s easy to see how important this information is. It can make the difference between securing a loan or investment capital, or hiring and layoff decisions. Good bookkeeping is essential and even some knowledge of how it all works will better prepare a business owner for success, even if the bookkeeping is outsourced from companies like NumbersByVictoria.com.
