The Importance of Record Keeping
Everyone in business should keep records. There are many benefits to doing this, two of which are relevant from an asset protection viewpoint:
- Proper management and documentation of business activity prevents your company’s protective liability veil from being “pierced” (compromised) due to an “alter-ego” ruling, if your business is ever sued.
- Proper documentation can also save your skin in an IRS audit!
What Kinds of Records Should I Keep?
Generally, the law does not require any special kind of records. You may choose any record keeping system suited to your business that clearly shows your revenues and expenditures.
You should set up your record keeping system using an accounting method that clearly shows your business’s revenues and expenditures for each fiscal year. An accounting method is a set of rules used to determine when and how to report revenue and expenses in your books and on your income tax returns. There are two basic accounting methods: the cash method and the accrual method. Under the cash method, you generally report revenue in the fiscal year you receive it and deduct expenses in the fiscal year you pay them. Under the accrual method, you generally report income in the fiscal year you earn it, regardless of when payment is received, and deduct expenses in the fiscal year you incur them, regardless of when payment is made. The cash method is easier to use, while the accrual method tends to give a more accurate assessment of business finances.
Your record keeping system should include a summary of your business transactions. This summary is ordinarily made in your books (for example, accounting journals and ledgers). Your books must show your gross revenue, as well as your deductions and credits. For most small businesses, the business checkbook (discussed later) is the main source for entries in the business books. In addition, you must keep supporting documents, explained next.
Supporting Documents
Purchases, sales, payroll, and other transactions you have in your business will generate supporting documents. Supporting documents include sales slips, paid bills, invoices, and receipts. These documents contain the information you need to record in your books.
It is important to keep these documents because they support the entries in your books. It is very important to keep them in an orderly fashion and in a safe place. For example, organize them by month and year and type of or expense.
Gross receipts are the revenue your business receives. You should keep supporting documents that show the amounts and sources of your gross receipts. Documents that show gross receipts include the following.
- -Cash register tapes.
- -Bank deposit slips.
- -Receipt books.
- -Invoices.
- -Credit card charge slips.
Purchases are the items you buy and resell to customers. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. Your supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following.
- -Cash register tape receipts.
- -Credit card sales slips.
- -Invoices.
Expenses are the costs you incur (other than purchases) to carry on your business. Your supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following.
- -Cash register tapes.
- -Account statements.
- -Credit card sales slips.
- -Invoices.
Use of a petty cash fund is not recommended for easy record keeping.
Recording Business Transactions
A good record keeping system includes a summary of your business transactions. (Your business transactions are shown on supporting documents just discussed.) Business transactions are ordinarily summarized in books called journals and ledgers. You can buy them at your local stationery or office supply store. However there are also computer software packages that you can use for record keeping. They can be purchased in many retail stores or online. These packages are very useful and relatively easy to use; they require very little knowledge of bookkeeping and accounting. Computerized record keeping is briefly discussed followed by a more in-depth description of the traditional record keeping system.
(Whichever system you use to record business transactions will be most effective if you follow good record keeping practices. For example, record expenses when they occur, and identify the source of recorded receipts. Generally, it is best to record transactions on a daily basis.)
Computerized System
It is highly recommended that you use QuickBooks or a similar software program. It will help you accurately account for business transactions with little knowledge of accounting. Remember, if you use a computerized system, you must also be able to produce sufficient legible supporting records, which need to reconcile with your computerized records.
Traditional Record Keeping
Of course instead of using computer software, you may decide to document your business transactions using a traditional “on paper” system. In this case, you will record your gross receipts and expenditures in a book of original entries called a journal. You derive the information for each journal entry from original source documents, such as, sales slips, cash register tapes, check stubs, purchase invoices and other items that record your business transactions. You may need to create subsidiary journals for specific, frequently occurring types of transactions, such as sales and expenses.
Next the totals from the journal are summarized and reported in a book of accounts, known as a general ledger. The summary and totals from all journals are entered into the general ledger. A general ledger is a summary book that records transactions and balances of individual accounts.
Whether you keep journals and ledgers and how you keep them depends on the type of business you are in. Regardless it is highly recommended that you have a business checkbook.
Business Checkbook
One of the first things you should do when you start a business is open a business checking account. You should keep your business account separate from your personal checking account.
The business checkbook is your basic source of information for recording your business expenses. You should deposit all daily receipts in your business checking account. You should check your account for errors by reconciling it.
Consider using a checkbook that allows enough space to identify the source of deposits as business income, personal funds, or loans. You should also note on the deposit slip the source of the deposit and keep copies of all slips.
You should make all payments by check to document business expenses. Avoid writing checks payable to cash. If you must write a check for cash to pay a business expense, include the receipt for the cash payment in your records. If you cannot get a receipt for cash payment, you should make an adequate explanation in your records at the time of payment.
Use the business account for business purposes only. Indicate the source of deposits and the type of expense in the checkbook.
Distribution of LLC Property to Its Members
Write checks payable to yourself only when making withdrawals from your business for personal use. In an LLC, this withdrawal should be noted as a “distribution to member(s).” In a single member LLC, where the member is also the LLC manager, nothing further needs to be done besides noting the withdrawal accordingly. However, in order to eliminate the potential of a future “alter-ego” ruling, a multi-member or manager-managed LLC needs to follow these guidelines for maximum protection:
If an LLC is manager-managed, then only the manager should distribute LLC funds, unless there is a statement to the contrary in the LLC’s operating agreement.
Distributions to members need to conform to the provisions of the LLC’s operating agreement. In other words, if you have 2 LLC members, and each member is entitled to 50% of LLC distributions, then if $1,000 is distributed to the first member, generally speaking $1,000 should be distributed to the 2nd member also.
Bookkeeping System
You must decide whether to use a single- or a double-entry bookkeeping system. The single-entry system of bookkeeping is the simplest to maintain, but it may not be suitable for everyone. You may find the double-entry system better because it has built-in checks and balances to assure accuracy and control.
Single-Entry Overview
A single-entry system is based on the profit or loss statement. It can be a simple and practical system if you are starting a small business. The system records the flow of income and expenses.
Double-Entry Overview
A double-entry bookkeeping system uses journals and ledgers. Transactions are first entered in a journal and then posted to ledger accounts. These accounts show income, expenses, assets (property a business owns), liabilities (debts of a business), and net worth (excess of assets over liabilities). You close income and expense accounts at the end of each tax year. You keep asset, liability, and net worth accounts open on a permanent basis.
In the double-entry system, each account has a left side for debits and a right side for credits. It is self-balancing because you record every transaction as a debit entry in one account and as a credit entry in another.
Under this system, the total debits must equal the total credits after you post the journal entries to the ledger accounts. If the amounts do not balance, you have made an error and you must find and correct it.
How Long To Keep Records
You must keep your records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, this means you must keep records that support an item of income or deduction on a return until the period of limitations for that return runs out. To support items of income or deduction on your tax return, you must keep records until the statute of limitations for that return expires. Ordinarily, the statute of limitations for an income tax return expires 3 years after the return is due or filed, or 2 years from the date the tax is paid, whichever is later.
Keep copies of your filed tax returns. They help in preparing future tax returns and making computations if you later file an amended return.
Employment taxes
If you have employees, you must keep all employment tax records for at least 4 years after the date the tax becomes due or is paid, whichever is later.
Records for Non-Tax Purposes
When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes. For example, your insurance company or creditors may require you to keep them longer than the IRS does.
Sample Record System
Two examples of record keeping follow.
These sample records should not necessarily be viewed as a recommendation of how to keep your records. They are intended to show how a business may keep its records.
The following example illustrates a computerized record keeping system used by Larry, who sells wedding dresses on a popular online auction website called wee-Bay.
- Larry sees an opportunity to buy wedding dresses at his local Las Vegas thrift store and sell them on wee-Bay.
- After consulting his asset manager, Mr. Fowler, Larry decides the best legal structure for his new business would be an LLC.
- Wed4Less LLC is born and Larry sets out to start business.
- Larry visits weeBay.com and registers online.
- Next to make transactions easier he signs up for a free PayPal business account at paypal.com.
- Now armed with a PayPal business credit card he sets out to scour the local thrift stores for the finest wedding dresses available.
- Larry purchases three dresses and a veil for $170 and lists them on wee-Bay.
- Wed4Less LLC is a hit and the three dresses and veil are all purchased by the end of the week for an astonishing $1200.
- Larry prints a copy of each electronic transaction receipt and puts them in a folder with the receipts from the thrift store to keep track of his supporting documents.
- Finally Larry downloads his financial transactions from PayPal directly into his QuickBooks software for error free record keeping.
Setting Up Your Own Record Keeping System
The following example illustrates record keeping with a simple journal and ledger.
- After consulting his asset manager, Larry registers Wed4Less LLC and plans to start business.
- In order to keep his business separate from his personal affairs, Larry opens a separate business account at his local bank. Larry orders numbered checks with stubs to record check details and obtains a deposit book. With this type of account, Larry makes sure that his bank will be mailing him a statement every month so that he can perform bank reconciliation.
- At a stationery store, Larry buys a journal and ledger. Larry buys a simple journal with twelve columns.
Using a Single-Entry System (See Figure C.1)
On each page Larry records the transactions for the month and the monthly totals from each column will be calculated. He will use at least one page for every month of the year. Depending on the number of transactions, he may need several pages for each month. In these cases, he calculates the sub-total at the end of the page and carries forward the sub-total to the top of the next page.
He uses the first three columns to record the Date, Details of the Transaction, and the Check Number. He pays all bills with a numbered check and makes sure he fills in the details on the check stub (i.e. what was purchased, date, and invoice number). Making this a habit helps him if he ever needs to trace a transaction.
Larry’s next two columns are Revenue and Expenses. Each transaction will be entered in one of these columns. Revenue refers to money coming into the business from sales. Expenses represent payments the company is making and as such, are an outflow of money.
Example:
Larry’s example Revenue/Expense Journal shows entries for Wed4Less LLC.
Larry’s transactions are as follows:
- Check # 37 for $12.00 dated April 18 to Las Vegas Thrift to pay for a wedding veil.
- Check # 38 for $15.00 dated April 19 to Cheap Clothes Thrift Store for two wedding dresses.
- Check # 39 for $23.00 dated April 27 to Buy-It-Cheap for a wedding gown.
- Bank deposit April 29 for $1200.00 for Sales of wedding dresses and veil sold on April 28.
When the columns are totaled at the end of the month, the total under Expense should equal the sum of all the expense breakdown columns. The Revenue total should equal the sum of all of the monthly revenue breakdown columns. This is used to test and balance your books, insuring amounts and entries were made correctly. The receipts, paid invoices, and other statements should be stored in a manner that allows easy retrieval as needed. One method is to staple all monthly receipts together, put them in an envelope and file them in chronological order.
For an example of how Larry might use a double-entry system to document his business activity, see Figure C.2, below.
Final Advice
In order to maintain control, business record keeping entries should be completed daily. To ensure their completion, regular time should be set aside for them. Ensure that the same person, for consistency’s sake, always does this task. Some type of introductory training in accounting may be helpful if you are unfamiliar with accounting processes.
FIGURE C.1
| Very Simple Single-Entry Journal | ||
| Date | Revenue and Description | Expense and Description |
| … | ||
| April 5, 2003 | Purchased Dress for $30 | |
| April 6, 2003 | Purchased Dress for $20 | |
| April 12, 2003 | Sold Dress for $210 | |
| April 14, 2003 | Sold Dress for $325 | |
| … | ||
| Totals | $535.00 | $50.00 |
| Gross Profit | $535 – $50 = $485 | |
FIGURE C.2
Double-Entry Business Ledger |
|||||||||
| Left Side | Right Side | ||||||||
| Date | Description | To or From | Cash Received $ | Cash Disbursed $ | Cash Balance $ | Revenue | C.O.G.S. | Operation Costs | |
| … | $200 | ||||||||
| May 5, 2003 | Purchased Green Wedding Dress | From Las Vegas Thrift | $30 | $170 | $30 | ||||
| May 6, 2003 | Purchased Baby Blue Wedding Dress | From CheapClothes | $20 | $150 | $20 | ||||
| May 12, 2003 | Sold Green Wedding Dress on eBay | To luckybride257 | $210 | $360 | $210 | ||||
| May 14, 2003 | Sold Baby Blue Wedding Dress on eBay | To madinlove58 | $325 | $685 | $325 | ||||
| … | |||||||||
| Totals | Totals | $535 | $50 | ||||||
Entering Records – Left Side
Starting from the left page, fill in the date, description, who it was to or from, and write the money amount in the right place – money coming to you is written in “Cash Received” and money going out is “Cash Disbursed”. Then you update your cash balance, or what you currently have.
Entering Records – Right Side
Every time money is written on the left page, you would write it also on the right page in the right place. Revenue is where you enter money coming in from sales. C.O.G.S. (Cost Of Goods Sold) is where you write the costs based on what you sold, for example if you bought dresses and resold them, then every time you bought dresses you put that in C.O.G.S. Operating costs, simply record the costs that don’t relate to how much you sell, for example renting space for your business.
For example if you received $80 from selling a wedding dress, you write in the date, the description, the place in the “To or From”, and $80 in the “Cash Received” column, and update the “Cash Balance” column.
Then, on the right page, you re-write the $80 in the revenue column.