Recordkeeping

This part explains why you must keep records, what kinds of records you must keep, and how to keep them. It also explains how long you must keep your records for federal tax purposes. A sample recordkeeping system is illustrated at the end of this part.

Why Keep Records?

Everyone in business must keep records. Good records will help you do the following.

Monitor the progress of your business. You need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make. Good records can increase the likelihood of business success.

Prepare your financial statements. You need good records to prepare accurate financial statements. These include income (profit and loss) statements and balance sheets. These statements can help you in dealing with your bank or creditors.

• An income statement shows the income and expenses of the business for a given period of time.
• A balance sheet shows the assets, liabilities, and your equity in the business on a given date.

Identify source of receipts. You will receive money or property from many sources. Your records can identify the source of your receipts. You need this information to separate business from nonbusiness receipts and taxable from nontaxable income.

Keep track of deductible expenses. You may forget expenses when you prepare your tax return unless you record them when they occur.

Prepare your tax returns. You need good records to prepare your tax return. These records must support the income, expenses, and credits you report. Generally, these are the same records you use to monitor your business and prepare your financial statements.

Support items reported on tax returns. You must keep your business records available at all times for inspection by the IRS. If the IRS examines any of your tax returns, you may be asked to explain the items reported. A complete set of records will speed up the examination.

Kinds of Records To Keep

Except in a few cases, the law does not require any special kind of records. You can choose any recordkeeping system suited to your business that clearly shows your income.

The business you are in affects the type of records you need to keep for federal tax purposes. You should set up your recordkeeping system using an accounting method that clearly shows your income for your tax year. See Accounting Method, earlier. If you are in more than one business, you should keep a complete and separate set of records for each business.

Your recordkeeping system should include a summary of your business transactions. This summary is ordinarily made in your books (for example, accounting journals and ledgers). Your books must show your gross income, as well as your deductions and credits. For most small businesses, the business checkbook (discussed later) is the main source for entries in the business books. In addition, you must keep supporting documents, explained next.

Supporting Documents

Purchases, sales, payroll, and other transactions you have in your business will generate supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents contain the information you need to record in your books.

It is important to keep these documents because they support the entries in your books and on your tax return. Keep them in an orderly fashion and in a safe place. For instance, organize them by year and type of income or expense.

Gross receipts. Gross receipts are the income you receive from your business. You should keep supporting documents that show the amounts and sources of your gross receipts. Documents that show gross receipts include the following.

• Cash register tapes.
• Bank deposit slips.
• Receipt books.
• Invoices.
• Credit card charge slips.
• Forms 1099-MISC.

Purchases. Purchases are the items you buy and resell to customers. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. Your supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following.

• Canceled checks.
• Cash register tape receipts.
• Credit card sales slips.
• Invoices.

These records will help you determine the value of your inventory at the end of the year. See Publication 538 for information on methods for valuing inventory.

Expenses. Expenses are the costs you incur (other than purchases) to carry on your business. Your supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following.

• Canceled checks.
• Cash register tapes.
• Account statements.
• Credit card sales slips.
• Invoices.
• Petty cash slips for small cash payments.

A petty cash fund allows you to make small payments without having to write checks for small amounts. Each time you make a payment from this fund, you should make out a petty cash slip and attach it to your receipt as proof of payment.

Travel, transportation, entertainment, and gift expenses. Special recordkeeping rules apply to these expenses. For more information, see Publication 463.

Employment taxes. There are specific employment tax records you must keep. See Publication 15.

Assets. Assets are the property, such as machinery and furniture, that you own and use in your business. You must keep records to verify certain information about your business assets. You need records to figure the annual depreciation and the gain or loss when you sell the assets. Your records should show the following information.

• When and how you acquired the asset.
• Purchase price.
• Cost of any improvements.
• Section 179 deduction taken.
• Deductions taken for depreciation.
• Deductions taken for casualty losses, such as losses resulting from fires or storms.
• How you used the asset.
• When and how you disposed of the asset.
• Selling price.
• Expenses of sale.

Documents that may show this information include the following.

• Purchase and sales invoices.
• Real estate closing statements.
• Canceled checks.

What if I don't have a canceled check? If you do not have a canceled check, you may be able to prove payment with certain financial account statements prepared by financial institutions. These include account statements prepared for the financial institution by a third party. These account statements must be highly legible. The following is a list of acceptable account statements.

Proof of payment of an amount, by itself, does not establish that you are entitled to a tax deduction. You should also keep other documents, such as credit card sales slips and invoices, discussed previously.

Recording Business Transactions

A good recordkeeping system includes a summary of your business transactions. (Your business transactions are shown on the supporting documents just discussed.) Business transactions are ordinarily summarized in books called journals and ledgers. You can buy them at your local stationery or office supply store.

A journal is a book where you record each business transaction shown on your supporting documents. You may have to keep separate journals for transactions that occur frequently.

A ledger is a book that contains the totals from all of your journals. It is organized into different accounts.

Whether you keep journals and ledgers and how you keep them depends on the type of business you are in. For example, a recordkeeping system for a small business might include the following items.

• Business checkbook.
• Daily summary of cash receipts.
• Monthly summary of cash receipts.
• Check disbursements journal.
• Depreciation worksheet.
• Employee compensation record.

The business checkbook is explained next. The other items are illustrated later under Sample Record System.

Whichever system you use to record business transactions will be most effective if you follow good recordkeeping practices. For example, record expenses when they occur, and identify the source of recorded receipts. Generally, it is best to record transactions on a daily basis.

Business checkbook. One of the first things you should do when you start a business is open a business checking account. You should keep your business account separate from your personal checking account.

The business checkbook is your basic source of information for recording your business expenses. You should deposit all daily receipts in your business checking account. You should check your account for errors by reconciling it. See Reconciling the checking account, later.

Consider using a checkbook that allows enough space to identify the source of deposits as business income, personal funds, or loans. You should also note on the deposit slip the source of the deposit and keep copies of all slips.

You should make all payments by check to document business expenses. Write checks payable to yourself only when making withdrawals from your business for personal use. Avoid writing checks payable to cash. If you must write a check for cash to pay a business expense, include the receipt for the cash payment in your records. If you cannot get a receipt for a cash payment, you should make an adequate explanation in your records at the time of payment.

Use the business account for business purposes only. Indicate the source of deposits and the type of expense in the checkbook.

Reconciling the checking account. When you receive your bank statement, make sure the statement, your checkbook, and your books agree. The statement balance may not agree with the balance in your checkbook and books if the statement:

• Includes bank charges that you did not enter in your books and subtract from your checkbook balance, or
• Does not include deposits made after the statement date or checks that did not clear your account before the statement date.

By reconciling your checking account, you will:

• Verify how much money you have in the account,
• Make sure that your checkbook and books reflect all bank charges and the correct balance in the checking account, and
• Correct any errors in your bank statement, checkbook, and books.

You should reconcile your checking account each month.

Before you start to reconcile your monthly bank statement, check your own figures. Begin with the balance shown in your checkbook at the end of the previous month. To this balance, add the total cash deposited during the month and subtract the total cash disbursements.

After checking your figures, the result should agree with your checkbook balance at the end of the month. If the result does not agree, you may have made an error in recording a check or deposit. You can find the error by doing the following.

1. Adding the amounts on your check stubs and comparing that total with the total in the "amount of check" column in your check disbursements journal. If the totals do not agree, check the individual amounts to see if an error was made in your check stub record or in the related entry in your check disbursements journal.
2. Adding the deposit amounts in your checkbook. Compare that total with the monthly total in your cash receipt book, if you have one. If the totals do not agree, check the individual amounts to find any errors.

If your checkbook and journal entries still disagree, then refigure the running balance in your checkbook to make sure additions and subtractions are correct.

When your checkbook balance agrees with the balance figured from the journal entries, you may begin reconciling your checkbook with the bank statement. Many banks print a reconciliation worksheet on the back of the statement.

To reconcile your account, follow these steps.

1. Compare the deposits listed on the bank statement with the deposits shown in your checkbook. Note all differences in the dollar amounts.
2. Compare each canceled check, including both check number and dollar amount, with the entry in your checkbook. Note all differences in the dollar amounts. Mark the check number in the checkbook as having cleared the bank. After accounting for all checks returned by the bank, those not marked in your checkbook are your outstanding checks.
3. Prepare a bank reconciliation. One is illustrated later under Sample Record System.
4. Update your checkbook and journals for items shown on the reconciliation as not recorded (such as service charges) or recorded incorrectly.

At this point, the adjusted bank statement balance should equal your adjusted checkbook balance. If you still have differences, check the previous steps to find errors.

Table 3. Period of Limitations

Bookkeeping System

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.

An example of a journal entry showing a payment of rent in October is shown next.

General Journal

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.

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 in Cumulative Bulletin 1998-1 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. Revenue Procedure 81-46 is 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. Revenue Procedure 97-22 is 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, below, contains the periods of limitations that apply 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 (Page 18)

This summary is a record of cash sales for the day. It accounts for cash at the end of the day 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 carries the total receipts shown in this summary for January 3 ($267.80), including cash sales ($263.60) and sales tax ($4.20), to 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 (Page 19)

This shows the income activity for the month. Henry carries the total monthly net sales shown in this summary for January ($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 (Page 20)

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

4. Employee Compensation Record (Page 22)

This record shows the following information.

• The number of hours Henry's 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.

Henry carries the January gross payroll ($520) to the Annual Summary.

5. Annual Summary (Page 22)

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

Henry carries the cash receipts total shown in the annual summary ($47,440.95) to Part I of Schedule C (not illustrated). He carries the total for materials ($10,001.00) to Part II of Schedule C.

A business that keeps materials and supplies on hand generally must complete the inventory lines in Part III of Schedule C. However, 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.

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 (Page 22)

This worksheet shows the information used in figuring the depreciation allowed on assets used in Henry's business. Henry figures the depreciation using the modified accelerated cost recovery system (MACRS). He also 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." Depreciation and the section 179 deduction are discussed in Publication 946. Henry uses the information in the worksheet to complete Form 4562, Depreciation and Amortization (not illustrated).

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.

7. Bank Reconciliation (Page 23)

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. Henry 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.

• Daily summary cash receipts
• Monthly summary cash receipts
• Check disbursements
• Check disbursements contd
• Employee compensation record, annual summary, and depreciation worksheet
• Bank reconciliation

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