You must decide whether to use a single- or a double-entry bookkeeping system. The single-entry system of bookkeeping is the simplest to maintain, but it may not be suitable for everyone. You may find the double-entry system better because it has built-in checks and balances to assure accuracy and control.

Single-entry. A single-entry system is based on the income statement (profit or loss statement). It can be a simple and practical system if you are starting a small business. The system records the flow of income and expenses through the use of:

1. A daily summary of cash receipts, and

2. Monthly summaries of cash receipts and disbursements.

Double-entry. A double-entry bookkeeping system uses journals and ledgers. Transactions are first entered in a journal and then posted to ledger accounts. These accounts show income, expenses, assets (property a business owns), liabilities (debts of a business), and net worth (excess of assets over liabilities). You close income and expense accounts at the end of each tax year. You keep asset, liability, and net worth accounts open on a permanent basis.

In the double-entry system, each account has a left side for debits and a right side for credits. It is self-balancing because you record every transaction as a debit entry in one account and as a credit entry in another.

Under this system, the total debits must equal the total credits after you post the journal entries to the ledger accounts. If the amounts do not balance, you have made an error and you must find and correct it.

Computerized System

There are computer software packages that you can use for recordkeeping. They can be purchased in many retail stores. These packages are very useful and relatively easy to use; they require very little knowledge of bookkeeping and accounting.

Table 3

If you use a computerized system, you must be able to produce sufficient legible records to support and verify entries made on your return and determine your correct tax liability. To meet this qualification, the machine-sensible records must reconcile with your books and return. These records must provide enough detail to identify the underlying source documents.

You must also keep all machine-sensible records and a complete description of the computerized portion of your recordkeeping system. This documentation must be sufficiently detailed to show all of the following items.

• Functions being performed as the data flows through the system.

• Controls used to ensure accurate and reliable processing.

• Controls used to prevent the unauthorized addition, alteration, or deletion of retained records.

• Charts of accounts and detailed account descriptions.

See Revenue Procedure 98-25, printed on page 7 of Internal Revenue Bulletin 1998-11, for more information.

Microfilm

Microfilm and microfiche reproductions of general books of accounts, such as cash books, journals, voucher registers, and ledgers, are accepted for recordkeeping purposes if they comply with Revenue Procedure 81-46, printed on page 621 in Cumulative Bulletin 1981-2.

Electronic Storage System

Records maintained in an electronic storage system are accepted for recordkeeping purposes if the system complies with Revenue Procedure 97-22, printed on page 652 in Cumulative Bulletin 1997-1. An electronic storage system is one that either images hardcopy (paper) books and records, or transfers computerized books and records to an electronic storage media, such as an optical disk.

How Long To Keep Records

You must keep your records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, this means you must keep records that support an item of income or deduction on a return until the period of limitations for that return runs out.

The period of limitations is the period of time in which you can amend your return to claim a credit or refund, or the IRS can assess additional tax. Table 3 contains the period of limitations that applies to income tax returns. Unless otherwise stated, the years refer to the period after the return was filed. Returns filed before the due date are treated as filed on the due date.

Keep copies of your filed tax returns. They help in preparing future tax returns and making computations if you later file an amended return.

Employment taxes. If you have employees, you must keep all employment tax records for at least 4 years after the date the tax becomes due or is paid, whichever is later.

Assets. Keep records relating to property until the period of limitations expires for the year in which you dispose of the property in a taxable disposition. You must keep these records to figure any depreciation, amortization, or depletion deduction, and to figure your basis for computing gain or loss when you sell or otherwise dispose of the property.

Generally, if you received property in a nontaxable exchange, your basis in that property is the same as the basis of the property you gave up, increased by money you paid. You must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property in a taxable disposition.

Records for nontax purposes. When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes. For example, your insurance company or creditors may require you to keep them longer than the IRS does.

Sample Record System

This example illustrates a single-entry system used by Henry M. Brown, who is the sole proprietor of a small automobile body shop. Henry uses part-time help, has no inventory of items held for sale, and uses the cash method of accounting.

These sample records should not be viewed as a recommendation of how to keep your records. They are intended to show how one business keeps its records.

1) Daily Summary of Cash Receipts

This summary is a record of cash sales for the day. It accounts for cash over the amount in the Change and Petty Cash Fund at the beginning of the day.

Henry takes the Cash Sales entry from his cash register tape. If he had no cash register, he would simply total his cash sale slips and any other cash received that day.

He enters the total receipts for January 3 ($267.80), including cash sales ($263.60) and sales tax ($4.20), from the Daily Summary of Cash Receipts in the Monthly Summary of Cash Receipts.

Petty cash fund. Henry uses a petty cash fund to make small payments without having to write checks for small amounts. Each time he makes a payment from this fund, he makes out a petty cash slip and attaches it to his receipt as proof of payment. He sets up a fixed amount ($50) in his petty cash fund. The total of the unspent petty cash and the amounts on the petty cash slips should equal the fixed amount of the fund. When the totals on the petty cash slips approach the fixed amount, he brings the cash in the fund back to the fixed amount by writing a check to "Petty Cash" for the total of the outstanding slips. (See the Check Disbursements Journal entry for check number 92.) This restores the fund to its fixed amount of $50. He then summarizes the slips and enters them in the proper columns in the monthly check disbursements journal.

2) Monthly Summary of Cash Receipts

This shows the income activity for the month. Henry carries the total monthly net sales ($4,865.05) to his Annual Summary.

To figure total monthly net sales, Henry reduces the total monthly receipts by the sales tax imposed on his customers and turned over to the state. He cannot take a deduction for sales tax turned over to the state because he only collected the tax. He does not include the tax in his income.

3) Check Disbursements Journal

Henry enters checks drawn on the business checking account in the Check Disbursements Journal each day. All checks are prenumbered and each check number is listed and accounted for in the column provided in the journal.

Frequent expenses have their own headings across the sheet. He enters in a separate column expenses that require comparatively numerous or large payments each month, such as materials, gross payroll, and rent. Under the General Accounts column, he enters small expenses that normally have only one or two monthly payments, such as licenses and postage.

Henry does not pay personal or nonbusiness expenses by checks drawn on the business account. If he did, he would record them in the journal, even though he could not deduct them as business expenses.

Henry carries the monthly total of materials ($1,083.50) to the Annual Summary. Similarly, he enters monthly expenses for telephone, truck, auto, etc., in the appropriate columns of this summary.

4) Employee Compensation Record

This record shows the following information.

• The number of hours his employee worked in a pay period.

• The employee's total pay for the period.

• The deductions Henry withheld in figuring the employee's net pay.

• The monthly gross payroll, which is carried to the Annual Summary.

5) Annual Summary

This annual summary of monthly cash receipts and expense totals provides the final amounts to enter on Henry's tax return. He figures the annual summary from the total of monthly cash receipts items, as shown on the Monthly Summary of Cash Receipts. He figures the monthly expenses from the Check Disbursements Journal. As in the journal, he keeps each major expense in a separate column.

Henry enters the cash receipts total ($47,440.95) from the annual summary in Part I of Schedule C (not illustrated).

He carries the total for materials ($10,001.00) from the annual summary to Part II.

There are no inventories of materials and supplies in this example. Henry buys parts and supplies on a per-job basis; he does not keep them on hand. A business that keeps materials and supplies on hand generally must complete the inventory lines in Part III of Schedule C.

Henry enters annual totals for interest, rent, taxes, and wages on the appropriate lines in Part II of Schedule C. The total for taxes and licenses includes the employer's share of social security and Medicare taxes, and the business license fee. He enters the total of other annual business expenses on the "Other expenses" line of Schedule C.

6) Depreciation Worksheet

Another major item is the depreciation allowed on assets used in Henry's business. The sample depreciation worksheet shows examples of items depreciated using the modified accelerated cost recovery system (MACRS). Depreciation is discussed in Publication 946.

Henry must take depreciation in the year it is allowable. He cannot deduct in the current year the allowable depreciation he did not take in a prior year. If he does not deduct the correct depreciation, he may be able to make a correction by filing Form 1040X, Amended U.S. Individual Income Tax Return, or by changing his accounting method. For more information on how to correct an incorrect depreciation deduction, see chapter 1 in Publication 946.

He chooses to deduct $18,000 of the cost of certain depreciable property purchased and placed in service in his trade or business during the year. This is the "section 179 deduction." The section 179 deduction is discussed in Publication 946.

The amount of depreciation Henry can claim for the tax year is shown on his depreciation worksheet. He uses the worksheet to complete Form 4562, Depreciation and Amortization (not illustrated).

7) Bank Reconciliation

Henry reconciles his checkbook with his bank statement and prepares a bank reconciliation for January as follows.

1. Henry begins by entering his bank statement balance.

2. Henry compares the deposits listed on the bank statement with deposits shown in his checkbook. Two deposits shown in his checkbook--$701.33 and $516.08--were not on his bank statement. He enters these two amounts on the bank reconciliation. He adds them to the bank statement balance of $1,458.12 to arrive at a subtotal of $2,675.53.

3. After comparing each canceled check with his checkbook, Henry found four outstanding checks totaling $526.50. He subtracts this amount from the subtotal in (2) above. The result of $2,149.03 is the adjusted bank statement balance.

4. Henry enters his checkbook balance on the bank reconciliation.

5. He discovered that he mistakenly entered a deposit of $600.40 in his checkbook as $594.40. He adds the difference ($6.00) to the checkbook balance of $2,153.03. There was a $10.00 bank service charge on his bank statement that he subtracts from the checkbook balance. The result is the adjusted checkbook balance of $2,149.03. This equals his adjusted bank statement balance computed in (3) earlier.

The only book adjustment Henry needs to make is to the Check Disbursements Journal for the $10 bank service charge. He does not need to adjust the Monthly Summary of Cash Receipts because he correctly entered the January 8 deposit of $600.40 in that record.

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