FM-10

RECORDKEEPING IN SMALL BUSINESS

TABLE OF CONTENTS

INTRODUCTION 1

THE NEED FOR GOOD RECORDS 1

Monitor Inventory 1
Control Expenses 1
Fulfill Payroll Requirements 1
Determine Profit Margin 1
Improve Cash Flow 2
Use Supplier Discounts 2
Measure Performance 2

RREQUIREMENTS OF A GOOD SYSTEM 2

Commercial Record-Keeping Systems 2
Computerized Record Keeping 2

METHOD OF ACCOUNTING
Cash Basis Method 3
Accrual Basis Method
THE ACCOUNTING CYCLE
Journals 3
General Ledgers 3
Trial Balance 4
Financial Statements 4
Percentages 4

HOW TO ANALYZE YOUR RECORDS

Analyzing Payroll Expenses 7
Ratios 7

OTHER IMPORTANT RECORDS

Accounts Receivable 8
Payroll and Taxes 8
Petty Cash 8
Insurance 9
Business Equipment 9

ACCOUNTING SERVICES
Selecting the Accounting Service 9
Advice and Assistance 10
Cash Flow Requirements 10
Business Borrowing 10
Legal Structure 10
Tax Considerations 10

APPENDIXES
A. Financial Status Checklist 11
B. Information Resources 13

INTRODUCTION

An appropriate record-keeping system can determine the survival or failure of a new business.
For those already in business, good record-keeping systems can increase the chances of staying
in business and the opportunity to earn larger profits. Complete records will keep you in touch
with your business's operations and obligations and help you see problems before they occur.

This publication explains the characteristics of and procedure for establishing a good
record-keeping system.

THE NEED FOR GOOD RECORDS

Accounting records furnish substantial information about your volume of business, such as how
present and prior volumes compare, the amount of cash versus credit sales and the level and
status of accounts receivable. In addition, good accounting records help to accomplish the
following tasks.

Monitor Inventory

While a large inventory allows goods to be delivered when they are ordered, too large an
inventory represents an excess investment. If your inventory does not turn over quickly, your
business may lose profits due to obsolescence, deterioration or excess investment.

Any items removed from inventory for personal use should be set aside in a special account for
two reasons: first, they need to be recognized separately for tax purposes and, second, including
these items in business gross profit calculations can be misleading.

Control Expenses

Accounting records detail the amounts owed to suppliers and other creditors so that you can plan
the availability of cash to meet your obligations. Such records also provide information
regarding expenditures and allow you to establish controls over them. At all times, you must be
aware of your individual expense requirements and how they relate to the overall picture.

Fulfill Payroll Requirements

Payroll is one of the largest expenses in a small business.

Adequate payroll records should meet the requirements of the

 Internal Revenue Service.

 State department of revenue.

 Local department of revenue.

 Workers' compensation laws.

 Wage and hour laws.

 Social security requirements.

 Unemployment insurance requirements.

For each of these categories you are required to provide annual reports and summaries. In
addition, you must provide employees with the W-2 forms needed to file federal and other
income tax returns. In order to provide this detailed information, it is essential for you to
maintain good accounting records.
Determine Profit Margin

Good accounting records will indicate a business's level of profit, and provide specific
information on the profitability of certain departments or lines of goods within your business.
Such analysis is important to avoid continuing product lines far beyond their profitability. In
most cases, you can avoid losses if you maintain current records and analyze the information
from your records on an ongoing basis.

Improve Cash Flow

Good accounting records provide detailed reports of cash availability, both on hand and in the
bank, and of cash shortages or the diversion of cash. Since cash is your most liquid asset,
you must carefully account for it.

Use Supplier Discounts

A cash budget will provide the business owner with a projection of the availability of cash that
may be used to pay invoices as they become due. Discounts from suppliers for prompt payment
can amount to substantial savings. A 2 percent discount is common if you pay the bill in full
within 10 days; if not, full payment is due within 30 days. In business, this is commonly referred
to as "2/10, n/30" where n = the net sum due. It means you pay 2 percent less if you pay within
10 days or you pay full price within 30 days. Take into account that this discount is cumulative.
If you make timely payments for each month of the year you will gain a 24 percent benefit (2
percent 12 months).

Measure Performance

Finally, good business records help you measure your business's performance by comparing your
actual results with the figures in your budget and those of other similar businesses.

REQUIREMENTS OF A GOOD SYSTEM

The following criteria are essential to a good record-keeping system:

 Simplicity

 Accuracy

 Timeliness

 Consistency

 Understandability
  Reliability and completeness

There are several copyrighted accounting systems that can be purchased and adapted to the
individual business, or you may find it is better to use a system specifically designed for your
business and one that meets the above-mentioned criteria.

Commercial Record-Keeping Systems

Record-keeping systems are currently available from various sources in the marketplace:
stationery stores, publishers and business advisory services. These systems either are specifically
designed for a certain type of business or are general enough to be used by many different types
of businesses. Systems are available for cash basis recording, accrual basis recording and for
both single and double entry.

Computerized Record Keeping

Consider using a computer for your business operations. Compare different software systems and
make sure that the system you choose provides accurate and timely information and offers more
than adequate presentation of accounting information for small businesses.

Low-cost computer programs are available that can handle many of the book entries that are
necessary in a system that is maintained by hand. Appropriate hardware and a good general
ledger software program can offer you substantial assistance in recording business transactions
and summarizing the information into appropriate accounting presentations.

Currently available software allows you to enter transactions individually; these transactions are
posted directly to the general ledger. A printout at the end of a given period shows the individual
account activity, and also includes a balance and total of the accounts and provides a trial
balance presentation. If the software is designed properly, it will provide appropriately prepared
financial statements (balance sheet, income statements).

METHODS OF ACCOUNTING

There are two basic methods of accounting: cash basis and accrual basis. The method you choose
will depend on your type of business. Cash basis is the simpler method. It is mainly used by
service businesses that do not maintain inventory or startup businesses that do not offer credit.
The accrual method is used by businesses that provide for credit sales or maintain an inventory.

Cash Basis Method

In cash basis accounting, you record sales when cash is received and expenses when they are
actually paid. Using the cash basis method is like maintaining a checkbook. Under this method,
accounts receivable are not recorded as sales until they are collected. Accounts payable are not
recorded as expenses until the account is paid. Bad debt, accruals and deferrals are not
appropriately recorded under cash basis because they are examples of outstanding credit
(business notes). The cash basis method is not appropriate for businesses that extend credit.

Accrual Basis Method

In accrual basis accounting, you report income or expenses as they are earned or incurred rather
than when they are collected or paid. Record credit sales as accounts receivable that have not yet
been collected.

The accrual basis also provides a method for recording expenditures paid in a single installment
but covering more than one period. For example, interest may be paid semiannually or annually,
but it is recorded on a monthly basis.

The accrual method satisfies the matching concept, i.e., matching income with related
expenditures. Consequently, it can provide a clear and accurate view of business operations for a
given period.

THE ACCOUNTING CYCLE

The accounting cycle can be described as follows:

1. A business transaction occurs, giving rise to an original document that is recorded

in a book of original entries called a journal.

2. The totals from the journal are summarized and reported in a book of accounts,
known as a general ledger.

3. The general ledger contains the individual accounts maintained by the business.

4. The individual accounts are listed in the form of debits and credits, known as the
trial balance of the general ledger.

5. From this trial balance, after making certain adjustments, you prepare the
business's financial statements.

Journals

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.

General Ledgers

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, and is organized
into five classes of individual accounts, as follows:

1. Assets -- A record of all items that the business owns.

2. Liabilities -- A record of all debts the business owes.

3. Capital -- A record of all ownership or equity.

4. Sales -- A record of all income earned for a specific period.

5. Expenses -- A record of all expenditures incurred during a given period.

When the trial balance is prepared, these classifications are easily recognized.

Trial Balance

At the end of the fiscal year or accounting period, the individual accounts in the general ledger
are totaled and closed. The balances of the individual accounts are summarized in the financial
statements.

Financial Statements

The main types of financial statements are the balance sheet and the income statement, also
known as the profit and loss statement. The balance sheet is a report of a business's financial
condition (assets, liabilities and capital) at a specific moment in time (see Example 1) and the
income statement is a summary of profit and loss for a specific period of time, generally a
month, quarter or year (see Example 2). Other statements may be prepared. For example, a cash
flow statement identifies the sources and applications of cash. Statements may also be prepared
to indicate manufacturing expenses or other special areas that are of interest to you.

Percentages

Percentages are used in financial statements to show the part of each sales dollar used by the
various expenses. Percentages are especially helpful for comparing current year financial
statements with those of prior years to determine business trends. Percentages are also helpful
for comparing your figures with those of other firms in the same line of business (see
Example 3).

Example 1
ABC SALES CO.
BALANCE SHEET
December 31, 199_
Assets
Current assets
 Cash $23,590
Notes receivable 10,000
Accounts receivable 20,880
Merchandise receivable 62,150
Store supplies 960
Office supplies 480
Prepaid insurance 1,650

Total Current Assets $119,710

Plant assets
Land $20,000
Building $140,000
Less accumulated depreciation 33,900 106,100
Office equipment 15,570
Less accumulated depreciation 8,720 6,850
Store equipment 27,100
Less accumulated depreciation 15,700 11,400
Total plant assets 144,350
Total assets $264,060

Liabilities

Current liabilities

Accounts Payable $22,420

Mortgage note payable
(current portion) 5,000
Salaries payable 1,152
Total current liabilities $28,572

Long-term liabilities

Mortgage note payable 20,000

Total liabilities $48,572

Stockholders' Equity

Capital Stock $100,000

Retained earnings 115,488
Total stockholders' equity $215,488

Total liabilities and

stockholders' equity $264,060

Example 2
ABC SALES CO.
INCOME STATEMENT
 December 31, 199_

Revenue from Sales

Sales $732,163
Less: Sales returns
and allowances $6,140
Less: Sales discount 5,822 11,962
Net sales 720,201
Cost of merchandise
Merchandise inventory
January 1 purchases 530,280
Less purchases discount 2,525
Net purchases 527,755
Merchandise available
for sale 587,455
Less merchandise inventory
December 31 62,150
Cost of merchandise sold 525,305
Gross Profit 194,896

Operating Expenses

Selling expenses
Sales salaries $60,044
Advertising 10,460
Depreciation-store equipment 3,100
Insurance-selling 2,080
Store supplies 2,010
Miscellaneous (selling) 630
Total selling expenses 78,324
General expenses
Office salaries 21,032
Heating and lighting 8,100
Taxes 6,810
Depreciation-building 4,500
Depreciation-office equipment 1,490
Insurance-general 830
Office supplies 610
Miscellaneous 760
Total general expenses 44,132
Total operating expenses 122,456

Net income from operations 72,440

Other Income-interest income 3,600
Other expense-interest expense 2,440 1,160
Net Income 73,600
 Example 3--Appliance Repair Company
Income Statement Showing Expenses as
Percentage of Sales
Total Parts Service
Amount Percent Amount Percent Amount Percent
Gross Sales $70,000 100.00 $25,000 100.00 $45,000 100.00

Cost of sales
Opening
inventory 13,000 13,000
Purchases 25,000 25,000
Total 38,000 38,000
Ending
inventory 14,000 14,000
Total cost
of sales 24,000 34.29 24,000 96.00
Gross Profit 46,000 65.71 1,000 4.00
Operating
expenses
Payroll 26,000 37.14 26,000 57.78
Rent 3,000 4.29 1,500 6.00 1,500 3.33
Payroll taxes 1,500 2.14 1,500 3.33
Interest 600 .86 300 1.20 300 .67
Depreciation 1,400 2.00 1,400 3.11
Truck expense 5,500 7.86 5,500 12.22
Telephone 2,400 3.43 1,200 4.80 1,200 2.67
Insurance 1,000 1.43 400 1.60 600 1.33
Miscellaneous 1,000 1.43 500 2.00 500 1.11
Total Expenses 42,400 60.58 3,900 15.60 38,500 85.55

Net Profit (Loss)

(Exclusive of
owner's salary)3,600 5.14 (2,900)(11.60) 6,500 14.44

HOW TO ANALYZE YOUR RECORDS

To chart the progress of your business, you should become familiar with various forms of
financial statements analysis and measurement.

Financial statements indicate which items need more attention. For example, profits may be too
low or rent unnecessarily high. Perhaps there is a way to use the business vehicles more
efficiently, to increase inventory turnover or to reduce long distance telephone bills.

In analyzing financial statements, carefully examine all items that do not seem realistic. Answer
the following questions:

 Why are certain expenses at a particular level?

  Are there any ways to reduce or avoid certain expenses?

 Should you incur all of your expenses?

 Does the level of profit justify your investment, time and effort?

Financially significant items should be analyzed regularly. For example, examine payroll as a
percentage of total administrative expenses. Keep in mind that, if your business is a
proprietorship, your salary is not a payroll expense; however, if your business is a corporation,
your salary should be a payroll expense.

Analyzing Payroll Expenses

In justifying payroll and other expenses, answer the following questions:

 Are accurate records maintained for time spent on various jobs and functions?

 Is the eight-hour day of each employee accounted for appropriately?

 When employees are paid overtime, is the additional expense reflected in charges
to the customer?

 Is the level of payroll expense appropriate for your type of business?

 Are you billing on a guaranteed price basis or on an hourly basis?

 When using guaranteed price basis for billing, does actual time spent exceed time
estimated for the job?

 Do employees work with a minimum of wasted effort and time?

 Are you operating at maximum efficiency? What strategies can be implemented

to maximize efficiency?

Ratios

Accountants use various ratios to evaluate financial statements, such as ratios that assess
liquidity, solvency and profitability.

Liquidity

These ratios indicate the availability of cash and the firm's

ability to pay liabilities.

Current ratio: Current assets divided by

Current liabilities
Acid test Cash, cash equivalents and
(liquidity ratio): Receivables divided by
Current liabilities

Day's sales Accounts receivable divided by

in receivables: Credit sales divided by 360

Inventory turnover: Cost of sales divided by

Average inventory

Capital and Long-term Solvency

These ratios indicate the firm's ability to meet debts when due.

Equity/debt ratio: Total equity divided by

Total debt

Total equity to Total equity divided by

fixed assets: Net fixed assets

Profitability

These ratios indicate your firm's performance.

Gross profit margin: Gross profit divided by

Sales

Net income to sales: Net income divided by

Sales

Operating income to sales: Income before income taxes

divided by Total assets

Return on total assets: Net income and interest expenses

divided by Total assets

Return on total assets: Net income divided by

Total equity

OTHER IMPORTANT RECORDS

In addition to accounting records, you will need to keep separate records for accounts receivable,
payroll and taxes, petty cash, insurance, business equipment and perhaps other items.
Accounts Receivable

A good record-keeping system should provide you with a detailed report of accounts receivable,
including current information on customers and a running balance of their accounts. To maintain
a good accounts receivable system, record credit charges on a
regular basis. It is essential that you follow up on all late paying and delinquent customers.

Accounts receivable should be aged at the end of each month. This means organizing the
accounts into those that are current; 30-, 60-, and 90-days old and older. This arrangement helps
you to take appropriate, timely actions.

One example of a timely action is to transfer delinquent accounts to a notes receivable account.
Notes receivable are loans the business makes to others, either inside or outside the business.
Each note receivable should contain specific terms of credit and interest and should be signed by
the customer. An additional timely action to decrease the number of bad accounts and avoid the
effort of collecting payments from slow-paying customers is to issue a formal complaint with
your local credit bureau.

Payroll and Taxes

Current Internal Revenue Service (IRS) regulations require that you withhold federal income tax
and social security (FICA) from each employee. You must remit the amount for taxes to the IRS
on a quarterly, monthly or more frequent basis. A detailed reporting system for payroll will help
you make timely tax payments.

Gather specific information about each employee on individual employee record cards. All
employees should fill out federal Form W-4, which indicates their filing status and the number of
exemptions they claim. Use this information to compute the federal withholding and social
security (FICA) deductions for each payroll check.

Prepare Employees Quarterly Federal Tax Return (Form 941) by totaling each employee's
withholding for federal taxes and social security. File Form 941 with the IRS.

Each payroll period, total the accumulated withholdings of both federal taxes and social security
for all employees. If this total exceeds $500 for any month, you must deposit this amount by the
15th day of the following month in a depository bank (an authorized financial institution or a
federal reserve bank). Generally, when the total exceeds $3,000, you must deposit this amount
within three business days. Any overpayment in taxes is paid back to you quarterly.

At the year's end, you are required to prepare not only the information normally required for that
quarter, but also summaries of each employee's total earnings and withholdings for the year
(Form W-2). Provide this form to each employee and the IRS.

A Word of Caution
It is very easy to fall behind in making tax payments. If you find yourself short of cash, do not be
tempted to delay payment of taxes. The IRS will not bill your business for taxes due nor will it
notify you of late payments. Delayed payments can easily add up to a large sum; the debt may
impede the growth of your business and may even force you to close your business, to say
nothing of the federal penalties incurred for late payments.

With a good record-keeping system, you can simplify the process of filing taxes to the point
where the information needed to complete the forms is automatically generated. Setting up such
a system is a rather technical task and you may need to seek guidance.

Petty Cash

Sometimes a petty cash fund is needed to purchase small items required on a day-to-day basis. If
this is necessary, draw a check to petty cash for a nominal amount.

Problems often arise when cash is easily available; therefore, if possible, avoid a petty cash fund.
However, very often the convenience of having a small amount of cash available will facilitate
the smooth operation of your business. Be sure to balance this fund monthly, based on the cash
balance plus receipts for all expenditures.

Insurance

Most businesses have several types of insurance. For each policy, you should have the following
information:

 Clear statement of the type of coverage.

 Names of individuals covered.

 Effective dates and expiration date.

 Annual premium.

Review your insurance policies on a regular basis. In addition, annually consult an insurance
specialist, who will review the total insurance package to determine what coverage is appropriate
and ensure that premiums remain in line with prior quotations.

Business Equipment

Keep an accurate list of permanent business equipment used on both a regular and stand-by
basis. The list should describe the equipment and provide serial numbers, date of purchase and
original cost. Keep the list available for insurance or other purposes. You will also need this
information to prepare accurate depreciation schedules.

ACCOUNTING SERVICES
You have several choices in who should maintain your accounting system. You can

 Maintain the books yourself.

 Hire a bookkeeper on a full-time or part-time basis.

 Hire the accountant who set up your books.

 Set up a hybrid system in which you maintain the day-to-day reports, while an
accountant does the period-end record preparation, summaries and renconiliations
and the returns for sales tax, excise tax and payroll taxes.

In making the choice, you must decide whether you have the ability and time to set up and
maintain good records or if you should engage an outside accounting service. It is usually
suggested that you hire an accountant to do the final year-end preparations and to advise you. No
matter what you choose, you should remain familiar with your books and participate in the
record-keeping process. This will maximize the services provided by the accountant and allow
you to keep track of your business.

Selecting the Accounting Service

If you decide to hire an outside service, find an accounting firm that will work closely with your
business and provide you with the information necessary to develop a successful operation.
Interview several accounting professionals and compare their level of accounting knowledge,
computer literacy, knowledge of and experience with small business accounting and any
specialized knowledge required in your business.

There are many types of professionals you may consider, such as a certified public accountant,
an enrolled agent or an accredited accountant.

 Certified Public Accountant (CPA) -- A person who has passed the American
Institute of CPAs' national examination, which tests an individual's ability in
accounting, auditing, law and related areas.

 Enrolled Agent (EA) -- An individual who has passed a two-day exam prepared
by the IRS, covering many areas of federal taxation. This person is generally
considered a tax specialist.

 Accredited Accountant -- An individual who has passed a rigorous examination

prepared by the Accreditation Council of Accountancy and Taxation, a national
accounting accreditation board affiliated with the National Society of Public
Accountants and the College for Financial Planning in Denver, Colorado.
Accredited accountants specialize in small business accounting.

Other accountants in public practice perform various levels of accounting and write-up services.
When selecting an accountant, the cost of the accountant's fees must be weighed against the
benefits received. Frequently, the accountant's professional advice can increase profits to more
than cover the expense. Monthly services by an accounting firm will provide you with complete
and timely information and also will allow the accountant to develop knowledge of your
business and be in a more comfortable position to render professional advice as the business
grows.

Advice and Assistance

In addition to bookkeeping, an accountant can advise you on financial management. He or she

can assist with cash flow requirements and budget forecasts, business borrowing, choosing a
legal structure for your business and preparation and advice on tax matters.

Cash Flow Requirements

An accountant can help you work out the amount of cash needed to operate the business during a
certain period for example, a three-month, six-month or one-year projection. The accountant
considers how much cash you will need to carry your accounts receivable, to increase inventory,
to cover current invoices, to acquire needed equipment and to retire outstanding debts.
Additionally, the accountant can determine how much cash will come from collection of
accounts receivable and how much will have to be borrowed or provided from other sources.

In determining cash requirements, the accountant may notice and call attention to danger spots,
such as accounts that are in arrears or delinquent areas or areas of excess expenditure.

Business Borrowing

An accountant can assist you in compiling the information necessary to secure a loan: the assets
the business will offer for collateral, the present debt obligations, a summary of how the money
will be used and repayment schedules. Such data show the lender the financial condition of the
business and your ability to repay the loan. Remember, lenders have two very definite
requirements: (1) that the business have adequate collateral to secure the loan and (2) that the
business will be able to repay the loan. An accountant can advise on whether you need a short-
or long-term loan. In addition, your accountant may introduce you to a banker who knows and
respects his or her financial judgment.

Legal Structure

It is wise to discuss the type of business organization that best fits your needs with an accountant
and an attorney. They can point out the advantages and disadvantages of the various forms of
business organization, such as a

 Proprietorship -- An extension of individual ownership.

  Partnership -- Multiple proprietors.

 Corporation -- A completely separate legal entity.

In addition, they can advise you on immediate plans regarding management, financing,
long-range plans to bring others into the business and estate planning, all of which affect the type
of business you choose.

Tax Considerations

This is an area in which an accountant can provide much advice and assistance. Your accountant
can suggest methods to record and document the various types of information necessary for
taxes.

APPENDIX A: FINANCIAL STATUS CHECKLIST

What You Should Know

Daily

1. The balance of cash on hand.

2. The bank balance.

3. Daily summaries of sales and cash receipts.

4. Any errors or problems that have occurred in collections.

5. A record of monies paid out, both by cash and by check.

Weekly

1. Accounts receivable (particularly those accounts that appear to be slow paying).

2. Accounts payable (be aware of the discount period mentioned above).

3. Payroll (be aware of the accumulation of hours and the development of the
payroll liability).

4. Taxes (be aware of any tax items that are due and reports that might be required
by government agencies).

Monthly
1. If you engage an outside accounting service, provide records of receipts,
disbursements, bank accounts and journals to the accounting firm. This will allow
 the firm to maintain good records and present them to you for review,
consideration and support in decision making.

2. Make sure that income statements are available on a monthly basis, and certainly
within 15 days of the close of the month.

3. Review a balance sheet that indicates the balance of business assets and the total
current liability.

4. Reconcile your bank account each month so that any variations are recognized
and necessary adjustments made.

5. Balance the petty cash account on a monthly basis. If you allow this account to
extend for a longer period, it may create substantial problems.

6. Review federal tax requirements and make deposits.

7. Review and age accounts receivable so that slow and bad accounts are recognized
and handled.