How can I keep track of receipts better?

How do I keep good records in case of an audit?

• I am in the process of starting an online proofreading and editing business. I am planning on advertising on craigslist and customers will contact me with their proofreading requests, and they will pay me through PayPal. I know that my PayPal Business account automatically keeps track of all payments received. So I'm good on that front. I assume that if I get audited, all I need to do is print out my monthly payment received statements as proof of how much revenue I received. My main problem is the expenses. My main expenses will be advertising expense, PayPal fees expense (those are deductible, right?), and contract labor expense. Please let me clarify the expenses: 1. Advertisement Expense - I'm planning on paying someone to post 200 ads a week on craigslist to advertise my proofreading services. 2. PayPal Fees Expense - PayPal takes 5% off of every payment received and an additional 30 cents off. 3. Contract Labor Expense - I'm expecting a high volume of orders so I'm planning to subcontract and hire independent contractors to proofread the documents that I don't have time for. I've been doing research on keeping good records and they say to keep the receipts. All of my transactions will be made electronically through PayPal so I won't have any physical expense receipts. I'm planning on logging in each expense transaction in Microsoft Excel. Will a print out of my Microsot Excel spreadsheet detailing all the expenses be sufficient evidence that the money I spent was for business expenses? Or will I need to print out PayPal sheets of every single transaction of my expenses? I don't know how to use Quickbooks, so is Excel ok? Any information on how to keep good records so that I can prepare for an audit would be appreciated. Thank you.

• Answer:

  There are two main reasons why businesses keep track of their finances, because the government requires them to and because they want good information when making business decisions. Your question seems to be related to the first reason, so my answer will consider only that. A tax auditor is really looking for one thing - proof that the numbers you submitted are correct. And that's how you need to think. For each transaction, how can you prove that the transaction was accurately recorded? The best proof is a piece of paper issued by the other party to the transaction or a third party. For example, if you paid a sub-contractor to proof-read some documents, the cancelled cheque would be the best proof. Also having a receipt from the sub-contractor is a good move. If you want to give an auditor a good degree of confidence in your ability to provide accurate numbers, be able to put your hand on any piece of paper he asks for. If he wants it, lo and behold, you've got it in your hand. That's means having a filing system that works for you. Separating your files by year is a good idea because that's how the tax man thinks. A lot of source documents nowadays are sent by e-mail or downloaded from a website (e.g., PayPal transactions, utility bills, online banking statements). Download ALL electronic documents and save them on your own computer. The audit could be happening five or ten years down the road and there's no guarantee the source documents will still be available on the website, so keep your own copy. [Some people would also suggest printing every document and filing it with your other papers.] You asked, "Will a print out of my Microsot Excel spreadsheet detailing all the expenses be sufficient evidence that the money I spent was for business expenses?" The answer is NO. A spreadsheet proves nothing. You will need a source document for every transaction, but even that is not enough. You will still need to be able to prove that the expense was incurred for the business. If you didn't have the business, would you have incurred the expense anyhow? If not, then it's probably a valid business expense. The next thing to consider is the tax rules that exist. If you don't know the rules, there's no way you can follow the rules, which makes for a very difficult audit. Also, if you don't know the rules, how can you make valid business decisions? After all, the government is going to get a big chunk of your income. There's a huge opportunity here to reduce your tax expense, but only if you know how. One of the biggest mistakes is using the cash basis of bookkeeping instead of the accrual basis. Basically, the tax man doesn't care when the money changed hands. He cares when it was earned. For example, if one of your customers pays you in March 2012 for work you did in 2011, the revenue has to go on your 2011 taxes, not your 2012 taxes. The same thing works for expenses. If you pay for some advertising in 2011, but the advertising isn't published until 2012, the expense would be in 2012, not 2011. Another big mistake is not knowing the difference between an expense and a capital cost. In simple terms, an expense is something that is used up in a few days, weeks, or months. A capital cost is something that is used over a period of years. Expenses and capital costs are treated differently. An expense becomes a deduction from total revenues in the year it is used up. A capital cost becomes a deduction from total revenues over the number of years that you use the asset in the business. In accounting, the process of allocating the "right" amount to the right year (for capital costs) is called depreciation. The tax man may call this by another name (e.g., in Canada, it's called capital cost allowance). The simplest method of bookkeeping is to record everything on a cash basis in a spreadsheet, then adjust the totals at the end of the year to account for all the transactions that really belong to another year. Some people hire bookkeepers to take care of this year-end stuff, but, to be honest with you, this task really should be handed over to an accountant. There is a difference! I've been more than ready for an audit for several decades. Absolutely everything is in impeccable order. But I've never had an audit. So, if you beat me to it, good luck!