The top priorities for business owners are making sales and satisfying customers, so accounting for results often becomes an afterthought. But muddling through with inadequate financial records should not last forever. Entrepreneurs with long histories of success find they can shed light on what’s really happening in their operations by learning about different kinds of accounts and how to use them.
It’s crucial to set up new accounts in the correct place on financial statements. Even if you accurately group similar transactions in the same account, if you put that account in the wrong place, it will throw off your results. An account should appear on either of the two basic financial reports – the balance sheet or the profit and loss statement (P&L).
Assets and liabilities
The balance sheet conveys what your business owns and how much it owes. Create an asset account to record only things you own and things you’re entitled to receive. Bank accounts, inventory for resale, office furniture, computers, and the cost of an exclusive franchise territory are all examples of assets.
A current asset includes cash and anything that is quickly convertible to cash. Accounts receivable is a current asset just like your bank accounts. Equipment and real estate are fixed assets.
Liabilities include any amounts borrowed, plus sums you’re obligated to pay. Payroll taxes owed to the government, but not yet remitted, are a liability. Current liabilities are amounts owed within one year, such as payroll taxes, sales tax collected, and unpaid bills. Loans from financial institutions are generally long-term liabilities.
The difference between assets and liabilities is equity. One component of equity involves an account for current-year profit or loss. Profit either increases an asset – like your bank account – or reduces a liability. A year-to-date loss must have been covered by either increased liability or reduced assets (such as a lower bank balance than when you started.)
This balancing act happens automatically in modern accounting software. Current-year profit or loss flows over to an equity account on the balance sheet. Other equity accounts are simply the profit from past years – called Retained Earnings – and capital you contributed to the business.
Profit and loss accounts are the revenue and expenses of the business. A single account for all revenue is sufficient for most small entities. Expenses are more complicated. Typical expense accounts are rent, advertising, business meals, licenses, and telephone and Internet services. Remember that new equipment, office furniture, and computers are assets that appear in balance sheet accounts.
Inventory items acquired for resale are also assets, not expenses. However, the P&L has a special category called cost of goods sold (COGS) – the cost of inventory items the business sold. When you create a customer invoice, accounting software automatically reduces inventory and triggers an expense for COGS. You don’t manually add to COGS unless you have a special COGS account for direct sales costs, – such as commissions.
Your accountant can help you select accounts for a new category of transactions.