Before you set up your bookkeeping system, you'll need to make some decisions including your accounting method and accounting period of your fiscal year. If you plan to hire a bookkeeper or accountant, it's a good idea to sit down with him at this point to discuss what's best for your situation.

American businesses will find IRS Publication 538, Accounting Periods and Methods, useful. In Canada, the CRA's Business and Professional Income (T4002) can help.

Determining Your Accounting Method

Accounting methods refer to the set of rules that you use to determine when to report income and expenses. There are two generally accepted accounting methods: cash and accrual.

Cash Method

This is the simplest method in which you record income when money is received and expenses when money is paid out. In the United States, it's often used by sole proprietors who have service-based businesses that don't maintain inventory. If your business has inventory, you generally have to use the accrual method. In Canada, however, the cash method is only available to farmers, fishermen, or self-employed commissioned sales agents.

Accrual Method

This method requires you to report income when it is earned (when you invoice your client, for example), regardless of when the money actually arrives. Similarly, you report expenses when they're incurred, even if you don't pay the bill until later. As a result, you'll have receivables (money owed to you but not yet received) and payables (money owed by you but not yet paid) on your balance statements. In the United States, inventory-based business generally must use this method, and it can also be used by any other business that chooses it. In Canada, most businesses have to use the accrual method.

In the United States, you can sometimes combine the two methods, using the accrual method to calculate business expenses, for example, and the cash method to calculate personal items — and there are a number of special rules. IRS Publication 334, Tax Guide for Small Business can help.

Establishing Your Fiscal Year

The government requires that you file an income tax return for your business each year. In the United States, you have the choice of using the calendar year (January 1 to December 31) or a twelve-month period of your choice. Once you've made that choice, however, you need to stick with it or apply to the IRS to change it. If you're a sole proprietor or partner, using the calendar year keeps your business on the same schedule as your personal taxes, which makes reporting your earnings straightforward.

In Canada, if you're self-employed as a sole proprietor or partner, you generally need to use the calendar year as your fiscal year. If your business is a corporation, however, you can choose your fiscal year.

Business Versus Personal Expenses

Do everything that you can to separate your business finances from your personal finances. Set up a separate checking account and use separate credit cards for personal and business expenses. If you don't believe that it makes sense for you to do this, at least keep scrupulously detailed records about which expenses are personal and which are business.