I thought I’d share with you how I, as a sole proprietor, manage my accounting. The system I use is based on advice from my accountant that has worked well for me over the eight years I’ve been in this business. My goal here is to give you an idea of how it is done, and not to replace the advice you get from your accountant. I should also mention that if your business is structured as a partnership or corporation, my system might not be appropriate.

You will need a good accountant. Your accountant will calculate your quarterly tax obligation, prepare your annual tax return, and advise you on how to structure and maintain your books.

Keeping the books means ultimately ending up with two reports (ledgers) at the end of the tax year – how much money you made (Cash Receipts) and how much money you spent (Expenses). Now this is overly simplified, but your accountant basically subtracts your expenses from your earnings to determine your taxable income, the amount you must pay taxes on.

You and your accountant should determine what constitutes a legitimate expense (deduction). How far you push the envelope is driven by how aggressive/conservative you and your accountant are. In other words, you and your accountant need to find a comfort level as it relates to defending your deductions if audited. You should also keep in mind that a more aggressive approach could actually trigger an audit. The IRS does not publish what triggers an audit, but a good accountant knows what some of the red flags are.

There are a lot of software packages available for maintaining the books. Quick Books is probably the most popular. My business does not involve keeping a product inventory, or paying employees, so a simple spreadsheet is more than adequate for maintaining Cash Receipts and Expense ledgers.

Cash Receipts Ledger

This ledger records the company name, check number, check date, deposit date, and check amount. I post this information by each deposit, with a sub total for each deposit. Later it can be sorted by company name, with a subtotal for each company, if that’s how your accountant wants to see it.

Expense ledger

This ledger records the company name, amount paid, method of payment (cash, check, credit card), category of expense, and brief description of expense. Your accountant should determine expense categories, such as office supplies, software, computer hardware, and postage. As I understand it, categories are needed because some items get a partial deduction while others get a total write off. Software, for example, is amortized over several years, while computers get a 100 percent deduction.

As I said, your ultimate goal is to end up with these two reports. But they need to be backed up with supporting documentation. The quality of that documentation plays an important role in how well you perform in an audit. Basically you need to maintain a clear paper trail that supports those two reports. In future posts I’ll talk about the details involved in maintaining that paper trail.