Accounting for small business 

Click here for the guidelines for setting up an accounting system that complies with IRD's requirements

A businessman must keep sufficient records in English or Chinese to enable its taxable profits to be readily ascertained for the last 7 years.  

Generally speaking, business record includes:

• the accounts recording receipts and payments

• the source documents to verify (a) such as vouchers, bank statements, invoices, receipts ... etc.

• the accounts recording assets and liabilities

• the source documents to verify (c) such as vouchers, bank statements, invoices, receipts ... etc.

• the accounts for every debtor and every creditor

• the year-end stocktaking record

Revenue versus Capital  

Every payment is classified into revenue or capital. A revenue payment, e.g. rent, wages, electricity ... etc., is an expense that is to be charged to the Profits and Loss Account at the year end. A capital payment, e.g. purchase of a motor vehicle, trade mark ... etc. is to bring in an asset that is shown in the Balance Sheet. 

Every receipt is also classified into revenue or capital. A revenue receipt, e.g. sale of goods, is an income that is to be recognized in the Profits and Loss Account. A capital receipt, e.g. sale of the business trademark, is to be transferred to capital reserve as shown in the Balance Sheet. 

Unless there are specific provisions in the Inland Revenue Ordinance, the following principles apply:

1. Revenue receipts are assessable.

2. Capital receipts are not assessable.

3. Revenue expenditures are deductible.

4. Capital expenditures are not deductible.  

The double-entry system

Modern accounting makes double entry for every transaction. An account is opened for every kind of revenue receipt, every kind of revenue expenditure, every kind of capital receipt and every kind of capital expenditure. The format of an account is divided into two sides: the left side is called DEBIT (Dr) and the right side is called CREDIT (Cr). 

The double entries for common transactions are summarized as follows. 

As shown above, a debit entry means an increase of asset, an increase of expense, a decrease of liability, a decrease of capital or a decrease of revenue. A credit entry means an increase of liability, an increase of capital, a decrease of asset, an increase of revenue, or a decrease of expense.  

Balancing off an account is to compute the balance between the total of all the debit entries and the total of all the credit entries in an account. This can be done on a monthly basis, a daily basis or after every accounting entry in the account. 

The year-end closing

The main purpose of the year-end closing is to determine how much is the net profit or loss. This purpose is achieved by construction of a Trading and Profit and Loss account (or commonly called Profit and Loss account). The balance of every revenue account and every expense account is transferred to the Profit and Loss Account. If the total revenue exceeds the total expenses, the business makes a profit. If the total revenue is less than the total expenses, it makes a loss. 

A common format of Profit and Loss account is as follows: 

The annual depreciation is usually computed on a straight line basis: say 20% on the purchase cost $40,000. The accounting entry for the annual depreciation charge is: Dr. Profit and Loss Account Cr. Provision for Depreciation Account. Then, the balance on the Provision for Depreciation account recording the accumulated depreciation is shown in the Balance Sheet.    

The net profit is usually the beginning figure for computation of assessable profits: to this figure, non-deductible expenses and depreciation charged to the Profits and Loss account are added and then from the sum, non-taxable receipts and depreciation allowance deducted.  

Apart from profit determination, the year-end closing also involves the preparation of a Balance Sheet which shows all the assets and liabilities as at the year-end date. A common format of Balance Sheet is as follows.

Cash and Bank accounts

For a small business, keeping sufficient business record basically means maintaining accurate and complete cash and bank accounts. This is because almost all the business incomes and expenditures route through this account. Below are my tips on how to keep good record in this respect.

The first step to open a separate bank account for your business. You should use your personal bank accounts for your personal financial transactions only. You should not use your personal bank accounts for your business dealings. Likewise, the business bank account should be restricted for business purpose. If you put your own money into your business to buy business asset, you should transfer the money from your personal bank account to the business account first, then use the business bank account to pay the vendor later. A clear separation of business dealings from private dealings is the foundation for good business record.        

The second step is to open a two-column cash book which is a combination of the cash account and bank account. You should record all cash and bank transactions in the cash book from time to time and keep the cash book up to date. The debit columns record all the receipts and the credit columns record all the payments. A common format of cash book is as follows. 

Note:

1. The “Date” column is to record the date of the transaction.

2. The “Particulars” column is to record what the transaction is about.

3. The “Cheque #” column is to record the cheque number of a payment by cheque.

4. The “Folio” column is to record the folio number of the posting entry of the transaction in the corresponding account under the Double Entry System.

5. The “Debit - cash” column is the debit side of the cash account.

6. The “Debit - bank” column is the debit side of the bank account.

7. The “Credit - cash” column is the credit side of the cash account.

8. The “Credit - bank” column is the credit side of the bank account. 

You should keep all the source documents (e.g. invoices, bills, vouchers, receipts, cheque butts ... etc. ) to substantiate the transactions recorded. The cheque butts should record the date, amount and name of the payee.  

The balance of the bank account in the cash book is usually different from the balance shown on the bank statement. There are a lot of reasons. Perhaps some cheques you sent to the creditor have not been presented to the bank for payment. Perhaps the bank charged you a fee that you have not recorded in the cash book.   

Whenever you receive the bank statement, you should compare it with the cash book to ascertain the reasons for the difference and then make adjustments in the cash book. The adjustments are called “bank reconciliation”. 

The bank statements are very important evidence to prove the accuracy and completeness of your cash book. This is because they are prepared by the bank which is a reliable and independent party and they record almost all your business dealings. So, you must keep all the bank statements at a safe place for at least seven years. If you are subject to a tax investigation and you have lost the bank statements, you will have to obtain them from the bank --- and that will cost you a lot. 

Purchases of goods 

The basic principle is to keep record sufficient to verify all the purchases. In practice, it is advisable to use a Purchases Journal to record all purchases on credit terms. A common format of Purchases Journal is as follows. 

Note:

1. The “Date” column is to record the date of the transaction.

2. The “Name of creditor” column is to record the name of the supplier from whom goods are purchased on credit.

3. The “P.O. No.” column is to record the purchase order number.

4. The “Folio” column is to record the folio of the posting entry of the transaction into the credit side of the relevant creditor account in Purchases Ledger.

5. The “Amount” column is to record the total net cost of the purchase order.

6. At the month ends, the total amount of purchases is posted to the debit side of the Purchases Account in the General Ledger. Then, at the year-end closing, the total purchases as recorded in the Purchases Accounts for the accounting year is transferred to Trading and Profit and Loss Account. 

Cash purchases are recorded in Cash Book, not in Purchases Journal. 

You should keep all the source documents (e.g. purchase orders, delivery notes, invoices, bills, vouchers, receipts... etc. ) to substantiate the transactions recorded.  

Purchases Ledger  

Purchases Ledger is a file containing all the trade creditors' accounts. A creditor account is a personal account that records all the transactions with him. When a credit purchase takes place, the accounting entry is: Dr. Purchases account Cr. Creditor (with his name) account. An example of a trade creditor, say A Ltd., is as follows. 

Stocktaking

The value of stock at the year-end closing is called closing stock. The closing stock is deducted from the total purchases for the accounting year in computing the cost of goods sold. The closing stock is to be carried forward to the following year as opening stock. If the business existed before the year start, the last-year closing stock will become the opening stock for the current year and it will be added to the cost of goods sold. For illustration, please refer to format of Profit and Loss Account. 

The accounting entry for stock account is as follows: (1) Transfer the last-year closing stock to Profit and Loss Account: Dr. Profit and Loss Account Cr. Stock Account. (2) Transfer the current-year closing stock out of the current year purchases to stock account: Dr. Stock Account Cr. Profit and Loss Account (as a deduction from total purchases). The current-year closing stock will be shown under Current Assets in the Balance Sheet.       

A common format of Stock Account is as follows: 

The value of opening stock and closing stock should be substantiated by a stock-taking list. The list should show the date of the stock taking, the persons taking the stock, the quantity and location of each type of stock and how the value of each type of stock is determined. Such record should be retained for 7 years. 

Sales of goods

The basic principle is to keep record sufficient to verify all the sales. In practice, it is advisable to use a Sales Journal to record all sale on credit terms. A common format of Sales Journal is as follows. 

Note:

1. The “Date” column is to record the date of the transaction.

2. The “Name of debtor” column is to record the name of the customer to whom goods are sold on credit.

3. The “S.I. No.” column is to record the sales invoice number.

4. The “Folio” column is to record the folio of the posting entry of the transaction into the debit side of the relevant debtor account in the Sales Ledger.

5. The “Amount” column is to record the total net amount of the sales invoice.

6. At the month ends, the total amount of sales is posted to the credit side of the Sales Account in the General Ledger. Then, at the year-end closing, the total sales as recorded in the Sales Accounts for the accounting year is transferred to Trading and Profit and Loss Account. 

Cash sales are recorded in Cash Book, not in Sales Journal. 

You should keep all the source documents (e.g. delivery notes, invoices, bills, vouchers ... etc.) to substantiate the transactions recorded. 

Sales Ledger 

Sales Ledger is a file containing all the trade debtors' accounts. A debtor account is a personal account that records all the transactions with him. When a credit sale takes place, the accounting entry is: Dr. Debtor (with his name) account Cr. Sales account.  

An example of a trade debtor, say X Ltd., is as follows. 

Books of accounts

As mentioned before, a small business should keep a Cash Book (comprising cash and bank accounts), a Purchases Journal (a daily record of all credit purchases), a Purchases Ledger (a file containing all trade creditors' accounts), a Sales Journal (a daily record of all credit sales) and a Sales Ledger (a file containing all trade debtors' accounts). In fact, there are transactions outside the scope of the aforesaid books of accounts. So, to record these other transactions, a General Journal (a daily record of such other transactions) and a General Ledger (a file containing all accounts except cash, bank, trade creditors and debtors) are opened. That is to say, a full set of accounts for a small business includes: 

1. Cash Book (CB)

2. Purchases Journal (PJ)

3. Sales Journal (SJ)

4. General Journal (GJ)

5. Purchases Ledger (PL)

6. Sales Ledger (SL)

7. General Ledger (GL)

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