The sudden surge of accounting software into the market over the last few years has put accounting and bookkeeping into everyone’s hands.
Or has it?
Nothing is more frustrating than thinking you know something only to be left, at the end of it, mired down in confusion and complexities which force you to call in a professional anyway!
Welcome to the world of accounting.
The basics “before the basics”
Tools like Xero, Sage, Quickbooks and FreeAgent try to remove the complexity of setting up your accounts with them by simply walking you through the procedure. And, when the time comes to do your VAT in Xero or to set up your sales tax in Quickbooks or FreeAgent, these tools simply send you a notification alerting you to the fact that this must now be done.
Great. So, by using Xero or Quickbooks or FreeAgent, you’re automatically in compliance with Making Tax Digital and your corporate tax returns.
Did you pay all that money just to be in compliance?
Using these sophisticated tools for nothing more than “reminders” to keep your bookkeeping and tax returns up to date is a glorious waste of time. It’s like buying a Porsche and then using it for no more than Driving Miss Daisy down the road to get her groceries.
Getting started properly with an accounting tool requires understanding some fundamentals about accounting so that you can leverage these fundamentals to your benefit and ensure that your business stays profitable.
If you truly want to get the most out of Xero, Quickbooks and FreeAgent, you should, minimally, know what a double ledger is and why it is used in accounting.
More vital is to understand the “Suspense Account” and why, suddenly, there’s now this massive value in red automatically inserted into your books after you’ve inputted all your data!
And, whereas you can certainly set up your Xero accounts in just a few clicks by following their instructions, you’ll only ever take that Porsche down to the grocery store and nowhere else if you don’t spend at least some time learning more about accounting each day.
You don’t necessarily need to do it immediately after signing up. But you should try and learn a little every time you update your books.
So, the “basics before the basics” of setting up a Xero account is to know what you’re doing.
Well, fear not: We’re here to help.
The utterly essential things to know about accounting
Double Entry vs Single Entry
One of the key historical breakthroughs in accounting was the invention of the Double Entry Bookkeeping system. This system was codified by a Franciscan friar by the name of Luca Pacioli in 1494.
In short, Double Entry Bookkeeping requires a matching entry in the “Credit” column for every entry in the “Debit” column, and vice versa. For example, if you buy some equipment, your cash is debited while your assets are credited.
In a single-entry system, only one entry is required and is more appropriate for small, cash-based systems. But this system has many limitations.
Why is this important to know? Well, Xero, Quickbooks, FreeAgent — all the big names in accounting software — use the double-entry system regardless of whether you’re a small business or a large one.
It is necessary to use this system to produce many of the accounting reports required to see if a company is viable or not.
Because double-entry systems always need to balance, and every transaction must be explained, a “Suspense Account” is used every time there’s an amount that you don’t know where to put.
Eventually, all Suspense Account entries will need to be explained for your books to be considered complete.
But…there’s one Suspense Account entry that doesn’t necessarily need to be explained and that’s when you first start using Xero, Quickbooks or any other accounting software: After you’ve typed in your opening balances for all your bank accounts into these systems, you will need a matching entry to start off your books in zero.
For example, if all your opening balances add up to a total of £10,000 in your bank accounts when you open your Xero account, then you will need a -£10,000 entry somewhere to start your books off at zero. That initial balancing entry goes into the suspense account.
Online accounting tools will automatically add the opposite value of your opening balances into your suspense account so you can start off with “zero” and keep your books balanced.
Even if you are a sole trader, it is crucial to maintain a separate business bank account from your personal account in order to keep your books in order.
This makes it easy for you to “reconcile” your bank accounts to your accounting system, which means having all of the transactions in your bank accounts assigned to the proper “accounts” (i.e. “books” or “ledgers”) in your accounting system, always entered twice (debit and credit) with nothing unexplained.
This is called bank reconciliation.
The Three Core Reports
Which brings us to the final thing you need to know: The three main accounting reports.
Only by using a double-entry system, knowing the purpose of the suspense account’s initial entry, and understanding the concept of bank reconciliation can you start to make sense of the three core reports in your accounting software.
These reports are:
- P&L Statement (or “Income Statement”): a summary of “revenues, costs, and expenses incurred during a specified period”.
- Cash Flow Statement: How much liquid cash you have in your accounts right now
- Balance Sheet: “A statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period.” (source)
These three reports are the foundation of a successful business and good accounting. When asking the question “Where do I start with Xero/Quickbooks/FreeAgent?” the answer is “Start with the minimum required information to produce the three core reports!”
Accounting is fun when you know the basics. Because accounting is all about turning a profit and making money.
Isn’t making money fun?
Don’t get too tangled up with your accounting software initially. Enter your opening balances; don’t get freaked out about that “strange” suspense account entry after you’ve done that (it’s only there to start you off at “zero”) and then reconcile your bank accounts.
Once you’ve done that, then you can really start leveraging the power of each of these systems: Utilising the P&L Statement, Cast Flow Statement and Balance Sheet to see where your business is at and take appropriate action as needed.
And that’s where you start off with your new fancy-shmancy accounting system, be it Xero, Quickbooks, Sage or FreeAgent!
Shoaib Aslam is the co-founder of Pearl Chartered Accountants, a UK-based chartered accountancy firm that has multiple locations across London. They are experts in helping startups and established businesses with all aspects of growth, strategy, scaling up, accounting and tax planning.