Because the top priority for every business owner is making sales and having satisfied customers, accounting for the results often becomes an afterthought. But muddling through with inadequate financial records should not last forever. Entrepreneurs with long histories of success pierce the shadows about different types of accounts to shed light on what’s really transpiring in their operations.
Setting up new accounts in the correct place on financial statements is a crucial process. Even if you accurately group similar transactions in the same account, misclassifying that account invalidates the precision of your consistency. An account will 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. Only create an asset account to record 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 is cash and anything quickly convertible to cash. Accounts receivable is a current asset just like your bank accounts. Equipment and real estate are fixed assets.
Liabilities are any amounts borrowed plus sums you’re obligated to pay. Payroll taxes owed to the government, but not yet remitted, is 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.
Equity Accounts
The difference between assets and liabilities is equity. One component of equity is the account for current year profit or loss. Profit either increased an asset – like your bank account – or reduced liability. A year-to-date loss must have been covered by either increased liability or reduced assets – such as a lower bank account than when you started.
Fortunately, this balancing dynamic is automatic with 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.
P&L Accounts
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, telephone, and internet service. Remember that new equipment, office furniture, or 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). This is the cost for inventory items that the business sold. Accounting software should automatically reduce inventory and trigger an expense for COGS when you create an invoice to a customer. Generally, you don’t manually add to COGS unless you have a special COGS account for direct sales costs – such as commissions.
Your accountant can deliver advice about selecting what type of account is appropriate for a new category of transactions. The result is well-organized balance sheet and P&L reports that convey useful information.
The Finance Writer 