Bookkeeping foundations: the two bases compared, and what each hides

Bookkeeping exists so that a question about the past can be answered without anyone having to remember. That is the whole purpose, and every rule in it earns its place by making some future question answerable.

Which customers owe us money, and since when, and whether that cost belongs to March.

What we agreed to pay this supplier, whether we paid it twice, what the bank balance was on the last day of the quarter, and why it differs from profit. None can be reconstructed from memory a year later, and all get asked.

This page is about the method underneath. It uses one hypothetical example, and the figures in it are invented for illustration.

What to take away

Every entry has to carry four thingswhat happened, when it happened, which accounts it affects, and the document that proves it. An entry missing any of the four will fail later.
The books are not proved by adding up. They are proved by reconciliation to an outside record.
Recording is a question of evidence and it should be settled without asking anyone. Deciding is a question of rules that vary, and that goes to an accountant.

The four questions every transaction answers

Before an entry is made, it should be able to answer all four. Most defects in a set of books are one of these left blank.

Four questions before every entry

What happened, not just what hit the bank
When the event occurred, not payment date
Which accounts it touches, at least two
What document proves it, attached at entry

Attach the document to the entry at the moment of entry. Three months later the transaction is a line of text and nobody can tell what it was.

Why every entry has two sides

Double entry sounds like a formality and is actually a self checking mechanism. Each transaction is recorded twice, once as where the value went and once as where it came from, and the two must agree. It is where a university course in financial accounting starts, and everything else in the subject is built on it.

One invoice, two entries

March
Invoice 1,000 income up, receivables up
March
Bank untouched, 1,000 still owed
April
Aged receivables still shows 1,000 owed
May
Cash lands receivables down, bank up
May
No new income recorded, debt settled

Here is a hypothetical to make it concrete. You invoice a customer 1,000 for work delivered in March, and they pay in May.

In March, two things are true at once: you have earned 1,000, and you are owed 1,000. So the entry records income of 1,000 and an increase in receivables of 1,000. Nothing has touched the bank.

In May, when the money lands, no income arises. The customer's debt is settled. The entry reduces receivables by 1,000 and increases the bank by 1,000.

At the end of March, the books already show the work was done, and at the end of April they still show 1,000 owed. That is why an aged receivables report can exist.

When the cash arrives in May, it does not appear a second time as income, the error that inflates a year's revenue.

The reason the two sides must always agree is that a single sided entry can be wrong without anything looking wrong. With two sides, most errors of entry announce themselves.

The two bases, and what each one hides

There are two ways of deciding when something belongs in the books, and they answer different questions.

Cash basis versus accrual basis

Cash basis

Income recorded: When money received
Costs recorded: When money paid
Good at showing: Bank balance movement
Hides: Money owed, unbilled work
Typical failure: Great month that was last month's invoices

Accrual basis

Income recorded: When work delivered
Costs recorded: When cost incurred
Good at showing: Whether period was profitable
Hides: Whether you can pay this week
Typical failure: Profitable year with no cash

The two bases compared

Cash basis

Income recorded: When money is received
Costs recorded: When money is paid
Good at showing: What actually happened to your bank balance
Hides: Money owed to you and by you, and unbilled work
Typical failure: A great month that was really last month's invoices being paid

Accrual basis

Income recorded: When the work is delivered or the goods handed over
Costs recorded: When the cost is incurred or consumed
Good at showing: Whether the trading period was profitable
Hides: Whether you can pay anyone this week
Typical failure: A profitable year with no cash in it

Using the same hypothetical: on a cash basis that 1,000 is May income, and March looks like a month with nothing in it. On an accrual basis it is March income, and May shows nothing.

Neither picture is wrong.

Each answers a different question. A growing business usually needs both: the accrual view to learn whether the model works, and a cash view or forecast to learn whether it survives until the model does.

Which basis your entity may or must use, and whether you can change it, depends on rules. Those rules vary by jurisdiction, entity type, and size, and they change. The federal guide to accounting periods and methods states the position for United States federal tax. It shows how conditional the answer is.

It remains an accountant's question. Ask before you build a year of records on an assumption.

The chain from document to report

Every figure on a report should be traceable back through the same links. Where a set of books is untrustworthy, one of these links is broken.

Document to report, six links

Source document, stored and findable
The entry, dated and linked
The ledger, in order with balance
Control account agrees with subsidiary
Trial balance, arithmetic only
Statements built from ledger balances

Source document.The invoice, receipt, contract or statement, of the kind the federal guidance on what records a business keeps describes. Stored, and findable by the reference on the entry.
The entry.Date, description, amount, accounts, and a link to the document.
The ledger.All entries for one account, in order, with a running balance.
The control account.The total of a subsidiary ledger, such as all customer balances, held as one figure in the main ledger. The two must agree, and where they do not, an entry has gone somewhere it should not.
The trial balance.All accounts listed, debits equal to credits. This proves arithmetic, and nothing else. A trial balance can balance perfectly on a set of books that is completely wrong.
The statements.Built from the ledger balances, using a defined mapping.

The most common break is between one and two: an entry that no document supports. The second most common is between three and four, where a customer receipt was posted directly to the bank without touching the customer's account.

Reconciliation is the only proof

Internal consistency proves nothing, because a set of books can be internally consistent and describe events that did not happen. What proves it is agreement with a record produced by somebody else.

Reconcile against outside records

Bank statement, item by item not balance to balance
Customer balances against what customers say
Supplier balances against supplier statements
Card and processor accounts, net of fees
Loan schedules, splitting principal and interest

A reconciliation is a list of differences with a reason beside each one. If the only output is that a balance agreed, the work has not been done.

Closing a period

A period close is the moment you stop changing history. It exists so that a report printed today still produces the same numbers next year.

Closing a period

Date every entry inside the period
Reconcile every account to outside record
Empty the holding account of unclear items
Check control accounts agree
Read statements against prior two periods
Lock the period so entries cannot drift

Empty the holding account where unclear items were parked, check the control accounts agree, read the statements against the previous two periods, then lock the period so entries cannot drift back.

Where something was wrong, correct it with a new dated entry that reverses and replaces the original. Never delete. Deletion removes the evidence of what was originally recorded, which destroys the only property that makes books worth keeping.

Where recording stops and advice begins

This line is worth learning because crossing it accidentally is expensive and staying behind it unnecessarily is slow.

Recording or deciding

Is it settled by evidence in the paperwork?

Yes

Resolve it yourself, every time

Send to a qualified accountant

Recording is settled by evidence: which document, which date, which account, which side. Whether a payment matches an invoice. Whether a deposit is a sale or a transfer. Whether a receipt has been allocated. You should resolve these yourself, every time, from the paperwork.

Deciding is settled by rules that vary and change: whether a cost is deductible, how an asset is written down over time, whether a person engaged for work is an employee or a contractor for reporting purposes, when a debt should be treated as bad, which basis or standard applies to your entity. These are not bookkeeping questions wearing a disguise. Send them to a qualified accountant, and send them with a clean set of books and a short written list of what you were unsure about.

Common questions

How often should I do this?

Weekly for entry, monthly for reconciliation and close. The work is roughly linear if done monthly and roughly quadratic if left to the year end, because by then nobody remembers what anything was.

Do I need to understand debits and credits?

Not the vocabulary. You do need the idea that every transaction has two sides and that both are recorded, because that is what makes the reports mean anything.

Can I rely on the bank feed?

As a convenience, yes. As the source of truth, no. The feed tells you money moved. It does not know why, and the automatic suggestions it makes are pattern matches, not decisions.

What should I do with a transaction I do not understand?

Park it in a clearly named holding account and empty that account within the month, while somebody still remembers. Anything sitting there longer should become a written question to a named person with a date on it.

How long do I keep the documents?

Retention periods are set by rules that differ by place and by document type, and the federal guidance on how long to keep records shows how much the answer depends on circumstance. Confirm yours rather than adopting a number you read somewhere. Whatever the period, store them so they can be found by the reference on the entry.

What is the single highest value habit?

Attaching the document to the entry when you make the entry. It costs a few seconds and it is the difference between a set of books that can answer questions and one that can only produce totals.