Four basic principles of small business bookkeeping

Last month I wrote about simple but effective bookkeeping* systems for sole proprietors and small organizations. Since then, I’ve met or looked at four small business bookkeeping systems that had serious deficiencies that were not apparent to the operator. This post takes a step back to take a quick look at the most basic legal and operational principles of modern bookkeeping.

1) Your legal requirement to keep records and the legal standard for record keeping: A person who receives income has a legal obligation under both federal and state law to keep records that meet minimum standards. In some cases, like in Pennsylvania and other state resort areas, there is a local government requirement. The standards and the effect of not meeting them is often developed in case law over time. It’s not as if you can read IRS or state revenue regulations and learn how to do bookkeeping. However, we can read references on legal requirements scattered throughout the law. Recent laws focus on maintaining the privacy and security of recordkeeping information that involves other people’s private information. While we see that many small business owners do not keep records that would meet minimum legal requirements, there does not seem to be any immediate compelling reason that would change this behavior.

2) Standards evolve with advancing technology: Practices that were acceptable in the past do not meet minimum standards today simply based on the widespread adaptation of technology. For example, a box of paper receipts was valuable documentation in the past but a tax examiner may legally refuse to look at it in an exam today. In another case that I personally litigated on behalf of a former business client where I had an ownership interest, a New Jersey appeals court found that a third party was liable for maintaining business records of unrelated parties base on posting of their business advertising on their own business page on Facebook.** We should expect recordkeeping standards to continue to evolve.

3) The single most important goal of a bookkeeping is to establish credibility: Anybody can put numbers on a page and call it bookkeeping. The real significance is determined by noting whether those numbers can be traced to and supported by external data sources.  The most common example is that a financial statement should be easily traceable back to a bank or transaction processor. Without this link and reconcilliation reports available to the user, the bookkeeping lacks credibility. I tell clients that the single most important part of their bookkeeping system is the integrated bank reconcilliation reporting. Too many skip this step and this makes their bookkeeping system almost worthless for external reporting purposes.

4) The cost/benefit relationship must be reasonable. It burden of maintaining records must be justified by the benefits of that effort. This is a basic accounting principle. I address it, for example, as a first consideration in my pricing policy. We see references to maintaining this cost/benefit relationship scattered throughout case law and federal tax procedures.

*I use “bookkeeping” and “recordkeeping” as synonyms in this post. Bookkeeping is the term used more commonly in accounting discussions and recordkeeping is a term used more commonly in legal discussions.

** See the nicknamed “Crab king” case commentary