We're starting a new video series called Accounting Basics for small business owners who want to learn accounting. Our first video was published today, you can check it out at:
As a compliment to the video we are providing a brief summary of the contents below.
There are five main types of accounts in accounting. When you go to set up your chart of accounts in your accounting program you will need to know what type of account you are creating in order for the program to treat the account properly. There are three main types of permanent accounts and two temporary accounts. The permanent accounts show up on your balance sheet and the temporary accounts show up on your income statement (also known as the profit and loss statement). Let's go over the permanent accounts first:
Assets- these are something of current or future value. Examples of an asset include cash, vehicles, inventory, computers, equipment, etc. One specific type of asset is accounts receivable. Accounts receivables are funds that your clients owe you. Say you sell a service or goods to a client and they are going to pay you at a later date. You record a receivable because that is something of future value to your company. Accounts receivables are one of the harder accounts for many small businesses to manage. Keeping track of who owes what and who is current versus behind on their bills is time consuming. Later in this series we will go over tricks to managing receivables. In general anything with the word receivable at the end of it is considered an asset.
Liabilities-These are amounts that your company owes another entity. These can be loans, interest, or vendors. Accounts payables are amounts that you owe vendors, for example you purchased some inventory and will be paying your vendor at a later date. Accounts payable also tend to be one of the harder accounts to manage for small businesses. You want to make sure your accounts are current to keep good relationships with your vendors. In general anything with payable at the end is a liability. Another important thing to remember, when you set up your accounting program many of them link to your bank accounts and credit cards. A checking account or savings account is an asset, you owe that money. However, just because a credit card has a similar linking procedure through your accounting software does not mean it is also an asset. A credit card is a liability, you owe the financial institution those funds!
Equity-Equity accounts look different for corporations versus sole proprietorships and partnerships. Because most small businesses fall into the later category we are not going to cover corporations. In general each owner of the company has an equity account that their investments into the company are recorded in, they also have a drawings account that reduces their net equity when they take funds from the business. Net income and net loss is attributed to the owners of the company into their equity accounts. A net income increases the equity and a net loss decreases it. Equity can be looked at as the owner's portion of the business. I like to explain it as what is left over for the owner if the company were to be liquidated and all liabilities were to be paid. Realistically this is am estimate, many of the assets may not be able to be liquidated for their book value.
The temporary accounts are closed at the end of the fiscal period into the equity accounts. They are "reset" to zero to begin accumulating again at the beginning of the following fiscal year. Let's take a look at the two types of temporary accounts:
Revenue-This is money that is earned by the business. Most of the revenue that small businesses deal with is either sales revenue or service revenue. There may be some revenue that is earned from investment activity.
Expenses-Costs associated with earning revenue. These can be the cost of goods sold, rent expense, supplies expense, etc.
Revenue and expenses are recorded at different times depending on if the company uses cash basis accounting or accrual basis accounting. We will go over this in depth in another part of the series, but it is something that a company needs to be aware of. The IRS only allows certain companies to operate on a cash basis.
There are other types of accounts besides the five listed above, however for someone learning accounting these are the five that should be focused on for now. Other types of accounts build off of these five and understanding how these accounts relate to each other are the building blocks for adding different account types.