How Accounting Blew My Mind
Or, “How I was Doing Bookkeeping Wrong (and You Might Be Too)”
In This Post:
How I was doing bookkeeping wrong (and you might be too)
How it’s supposed to work
Pretty cool, right?
There are certain unforgettable moments when a concept suddenly clicks and your mind lights up like a Christmas tree. That happened to me when I took an accounting principles course online and saw the way that certain data points intersected in the three financial statements, interlocking like puzzle pieces.
It then happened again (and maybe even more powerfully) when I went on to learn bookkeeping and saw how the matching principle works. This blew my mind because it turns out that I’d been doing it wrong, and the right way is a brilliant system that fixes all the issues I’d been struggling with.
How I was Doing Bookkeeping Wrong
Like most solopreneurs, I thought bookkeeping was merely a simple matter of tracking everything in a money-in/money-out way. Money going out = expenses, money coming in = income. Subtract expenses from income to get your net revenue. Duh.
But doing things like this means that your monthly reports will often show big swings in both income and expenses when you do things like pay for a whole year’s worth of cloud storage at once, or get paid for 3 months of work in one invoice. Also, that’s just not your business bookkeeping is supposed to be done.
So how is it supposed to work, then?
Instead of tracking everything in one big bucket that money goes in and out of, you’re supposed to have several buckets. Asset accounts. Liability accounts. Revenue accounts. Expense accounts.
Why all these buckets? Let’s use that year’s worth of cloud storage as an example. In my old system, I would’ve categorized it as an expense. Money spent on stuff I bought for my business is a business expense, right?
Not quite. At least, not yet. This purchase is for an entire year’s worth of cloud storage, so it needs to be dealt with a little differently.
We own one year’s worth of cloud service, and we’ll be using a little bit every day. The portion that has been used is a business expense. But the portion that remains sitting around waiting to be used is a business asset because it’s technically something your business owns.
When you bought this year’s worth of cloud storage, you have essentially converted some cash assets into this cloud storage asset. So this purchase transaction should be categorized in an asset account, not an expense account.
It’s only when you use some of that cloud storage, do you turn that bit into an expense.
How does that happen? Let’s say you do your bookkeeping on a monthly basis. Each month, you or your bookkeeper should expense 1/12 of that cloud storage cost, moving it from the asset account to an expense account with a journal entry (knowing what that is and how to do it correctly is why you need a bookkeeper. Please note that I am simplifying the heck out of things in this example and not even getting into current vs fixed assets.)
Now your monthly Income Statement (better known as the ol’ Profit & Loss) and other expense reports will show how much you spent on cloud storage per accounting period, instead of showing one big spike that looks like you went on a spending spree that month.
And don’t worry, we’re not ignoring how much you spent on that big cloud storage bill by not categorizing it all as an expense upfront.
When you categorize the purchase as an asset, that means you’ll see that value in your Balance Sheet. The portion that is used and expensed each month is reflected under the operating expenses section of your Income Statement.
This is why knowing how to read your financial statements is important. It tells you a ton of valuable information about what you have, what you owe, what you’ve made, how much you spent to make it, and how much money you have on hand (because that doesn’t always match up with what you’ve made at any point in time.)
This same principle applies to other things like inventory and raw materials that you’ve bought (100 tires for your custom bike business, or a box of wholesale t-shirts for your gift shop.) Those aren’t marked as expenses at first. They are assets because until you sell them, you’ve only turned your cash asset into a different type of asset (inventory asset.) It’s only when you’ve sold a thing does the cost of its constituent materials then gets expensed.
The value of any large equipment (laptops, forklifts, delivery cars, etc) also gets expensed bit by bit (depreciation) so you can incorporate that cost into your cost of doing business and how much you should charge. If you had to buy a car to be a rideshare driver, part of each fare should be allocated to paying for that car.
Even payments for work you haven’t done yet get categorized in a similar way. If you got paid upfront for a job that takes you 3 months to complete, you won’t record the initial payment as income. It’s relegated to a liability account because it’s a debt if you don’t actually end up fulfilling the job. As you complete the project milestones, the equivalent portions then get transferred to your income account.
I ask you, is this not a brilliant system?
Maybe I’m especially impressed by this because I had so severely underestimated bookkeeping. Or maybe it’s because I’ve struggled for years, trying to generate an accurate analysis of the data from my old in-vs-out system.
I don’t think I’m alone in this, though. I bet a lot of people don’t realize what an intricate system that proper bookkeeping requires, and the accurate business analysis that it can unlock.
So here I am today, all in love with accounting principles and bookkeeping. No one understands why I find it so awesome, so this is my attempt at trying to explain (as simply as possible) why I find it so clever. I’m not sure if I’m succeeding on that front but if this is speaking to you in any sort of way, please send me a message because we should be friends!