Bookkeeping Methods for the Self-Employed
Author: Brad Howland
First Posted: July 20, 2007
My tax clients often ask me: "What's the best way to keep our books and records?" Of course, everybody is different, and the same method won't work for people with different skills. After thinking about it for a while I realized that a little overview of various bookkeeping methods might be useful for many people!
I call these:
- The Shoebox Method;
- The Pen and Paper Method;
- The Spreadsheet Method;
- The Accounting Software Method;
- The Bookkeeper Method; and
- The Combination Method
I recommend that you invest in a printing calculator, regardless of which method you use. A printing calculator is one of the best tools available for audit-proofing a tax return. All receipts in each category should be added up with the calculator, then stapled together with the printed tape on top. This technique makes it easy for an auditor to verify a total, and in an audit situation anything you can do to make the auditor's job easier will pay big dividends.
I also recommend that you maintain a checkbook register (either by hand or in a spreadsheet or accounting program), and that you reconcile the register each month with your bank account statements. Record your checks, deposits, transfers, and automatic payments in your checkbook ledger as they occur, keep a running tally of the account balance, and work through the account reconciliation statement provided by your bank each month.
There is a trend these days to simply download account transactions to the personal computer through online banking, automatically accepting the bank's version of events as being correct. But the whole point of monthly reconciliation is to verify your own records with the bank's records. Banks do make mistakes sometimes!
The Shoebox Method
Required: shoebox, checkbook ledger, printing calculator, file folder or envelopes
Pros: You don't have to sit down and add up receipts very often. Instead, at predetermined intervals (i.e. monthly, annually), you have loads of work to do.
Cons: You don't have an ongoing picture of your financial situation. Maintaining a checkbook ledger and reconciling monthly bank statements takes a lot of manual labor.
Method: Obtain receipts when you pay for items used in your business and toss them into the shoebox. Also put your pay stubs, invoices, or other income records into the shoebox.
Go through the shoebox periodically, sort the income and expense items into categories, and add them up using your printing calculator. Move the receipts from the shoebox to the appropriate file folder or envelope.
How often you need to do this depends on your situation. For example, if you must pay quarterly taxes to the IRS or CRA, you will need to clean out the shoebox four times each year to figure out how much to pay. If you have payroll taxes to take care of you might need to do it once every two weeks. If you have nothing like this to worry about, you might get away with cleaning out the shoebox once each year at tax time.
The Pen and Paper Method
Required: accounting paper, checkbook ledger, file folder or envelopes
Pros: You get a slightly more accurate picture of your financial situation than you do with the shoebox method.
Cons: Tedious number crunching doesn't yield big benefits.
Method: Purchase some accounting paper from an office supply store such as Office Depot or Staples. Office Depot has some nice Blueline paper, varying in width from two to 36 columns, which should meet the requirements of most people.
The usual technique is to set up the accounting paper with income and expense category headings across the top of the columns, with the first column reserved to record the dates and payees/payers down the left hand side of the page.
As you pay expenses or earn income, record the date of each transaction along with the payee/payer in the left column and the amount in the appropriate category column. Store the income and expense documents in the file folder as they come in.
Every once in a while draw a line across the paper and total up the amounts in all the columns. If you do this monthly, you will have a useful set of numbers for budgeting and financial reporting purposes.
The Spreadsheet Method
Required: computer, spreadsheet program, file folder or envelopes
Pros: Less work than the Pen and Paper Method. Once the data is entered into the spreadsheet it can be manipulated to produce budgets, charts, or financial reports (if you have the skills).
Cons: Requires a computer and enough computer savvy to be able to use a spreadsheet program at a satisfactory level. Producing budgets, charts, or financial reports is harder in a spreadsheet program than it is in a dedicated accounting program.
Method: Acquire a spreadsheet program. The all-time world's greatest spreadsheet program is Microsoft Excel, a component of Microsoft Office, but if you don't want to pay for this program there are other options. Your computer might have Microsoft Works installed, which includes a serviceable spreadsheet program, or you might try out the free spreadsheet that comes with Open Office. Another free option is Google Docs and Spreadsheets.
A spreadsheet is like a big sheet of accounting paper that can automatically calculate the sum of the numbers in a column. Take the time to read the spreadsheet's help file and learn the keyboard shortcuts, which are a joy to use once they are mastered. You will want to learn how to quickly add and delete rows and columns, format cells, and "autosum" a column of numbers. A simple way to set up your spreadsheet is in a similar manner to The Pen and Paper Method, with category headings across the top and left columns reserved for date and payee/payer information. Enter your income and expense amounts in the spreadsheet as they occur and store the documents in the file folder.
The Accounting Software Method
Required: computer, accounting program, file folder or envelopes
Pros: Accounting programs are easier to use than a spreadsheet. Once the data is entered into the program it is simple to produce budgets, charts, and financial reports. Reconciling bank accounts with the monthly bank statements can actually be fun, believe it or not. If you have employees, the integrated payroll features can be a time-saver. If you need to use the accrual method of accounting (required in Canada but not necessarily in the United States), a software program makes it easy to track accounts receivable and payable.
Cons: Requires a computer and enough computer savvy to be able to use an accounting program at a satisfactory level. Accounting programs can be expensive and require a lot of initial set up work. Integrated payroll features usually require a monthly subscription.
Method: If a spreadsheet is like a big sheet of accounting paper that automatically calculates, then an accounting program is like a whole bunch of sheets of accounting paper that can transfer data from one sheet to another. Your choice of software depends on your needs. Quicken is often a good choice for personal financial use, while QuickBooks and Simply Accounting are intended more for businesses with significant accounting requirements, such as payroll or inventory tracking.
Follow the instructions during set up to create all the different accounts you need, which can include bank accounts, investment accounts, credit card accounts, and assets/liabilities. In Quicken each account looks something like a checkbook register, making it easy to enter income and expense items. I recommend setting up a "Cash on Hand" account, to use when you pay for an item with cash or receive cash for work performed. If you withdraw cash out of a bank account, record it as a transfer from the bank account to Cash on Hand.
Enter income and expense amounts as they occur, and store the income and expense documents in the file folder. Have fun producing budgets, charts, and financial reports at the click of a button.
The Bookkeeper Method
Required: a bookkeeper
Pros: No work or bookkeeping skills needed.
Cons: Can be expensive, depending on how many monthly transactions the bookkeeper has to deal with.
Method: Find a good bookkeeper. Most cities have business service providers dedicated to helping out the self-employed (e.g. Padget Business Services) and many tax preparation offices offer bookkeeping services. A good bookkeeper can often be found by word of mouth or on the Internet.
Store your income and expense documents in a shoebox, periodically giving them to the bookkeeper to sort and add up for you. Your bookkeeper will do all the tedious data entry for you, probably using accounting software, and will produce any reports that you need.
The Combination Method
Required: any or all of the above
Pros: You can set up a system that works for you, not against you, using whatever techniques you prefer.
Cons: Can't think of any!
Method: One example of a combination method would be to enter all transactions in accounting software as they occur, then toss the receipts in a shoebox until tax time. In January go through the shoebox and add up all the receipts using your printing calculator, using the documents to back up your income tax items. This approach allows you to easily produce reports and reconcile bank statements during the year, then audit-proof your income tax return with a "paper trail."
Another example: If you have only one or two employees and don't want the expense of a monthly subscription, you could calculate your payroll taxes in Canada using the free online payroll calculator provided by CRA, then use your accounting skills to enter them manually into your accounting software or spreadsheets.
Yet another example: Use an accounting program to keep track of your transactions on an ongoing basis, but create your budget in a separate spreadsheet program. The budgeting features in most accounting software packages are complicated and hard to use, whereas spreadsheet programs often have templates available (either built in or online) that are great for simple budgeting purposes.