Business owners either handle their accounting themselves or they hire someone else to do it. In general, startups and sole proprietors choose the first option to reduce their expenses. Even if you do hire an accountant, it's important that you have a basic understanding of what is involved. Start by learning about the five major accounts, so you know how to read financial reports.
Accounting Categories and Their Role
There are five main types of accounts in accounting, namely assets, liabilities, equity, revenue and expenses. Their role is to define how your company's money is spent or received. Each category can be further broken down into several categories.
Asset accounts, for example, can be divided into cash, supplies, equipment, deferred expenses and more. Equity accounts may include retained earnings and dividends. Revenue accounts can include interest, sales or rental income.
The five major accounts relate to each other. If one changes, the others will change too. For instance, if you purchase a new computer worth $1,000 with a loan, then both the Assets and Liabilities accounts will increase by $1,000 each.
These accounting categories are relatively new. Traditionally, the accounts were classified into four types: valuation accounts, nominal accounts, real accounts and personal accounts. However, most companies nowadays rarely use this approach.
The assets account includes everything that your company owns. Assets are divided into tangible and intangible. Examples of tangible assets include desktop computers, laptops, cars, cash, equipment, buildings and more. Your trademark, logo, copyrights and other non-physical items are considered intangible assets.
When you're starting a business, it's your responsibility to list the types of assets that your company has. Every time you purchase new products, add them to your list. Let your accountant know about it so he or she can deduct any expenses that are considered necessary for your business.
Any product or service that your company purchases to generate income or manufacture goods is considered an expense. This may include advertising costs, utilities, rent, salaries and others. Some expenses are deductible and help reduce your taxable income.
For example, you may deduct direct labor costs and business-related travel costs, but you cannot deduct personal expenses, donations, exchange loss and penalties.
Revenue or Income
Revenue, one of the primary types of accounts in accounting, includes the money your company earns from selling goods and services. This term is also used to denote dividends and interest resulting from marketable securities.
Liabilities include the debts or obligations payable to creditors and other outsiders to which your company owes money. These can be loans, unpaid utility bills, bank overdrafts, car loans, mortgages and more.
The equity account defines how much your business is currently worth. It's the residual interest in your company's assets after deducting liabilities. Common stock, dividends and retained earnings are all examples of equity.
After recording these transactions, your accountant will make a balance sheet. This information will provide a snapshot of what your business owns and owes. It reflects your company's financial position and offers valuable insights into its overall performance.