Introduction To Small Business Accounting

Regardless of the type of software you use to record your financial transactions, there are five major types of accounts small businesses use, and these accounts feed into the financial statements. 

Let’s take a look at the major account types, typical accounts in each, how they impact the financial statements, and how account reconciliation software can help confirm account balances.  

Assets 

An asset is anything a company owns that promises a future economic benefit. Liquid assets like cash are an easy example of asset accounts. Inventory is an asset account recording the value of inventory held, while the value of property, plant, and equipment can also be recorded in asset accounts, depending on the nature of the business.  

Prepaid expenses are another form of asset, because you own the right to use them up in the future. An example of this would be a Prepaid Insurance account, to record insurance already paid for future periods. Receivables are also asset accounts because they represent money to be paid to you in the future. 

Liabilities 

Liabilities are anything you owe and will need to pay in the future. Many liability accounts end in “payable” such as Accounts Payable, Income Tax Payable, Salary Payable, etc. These are typically amounts that have accrued and will be paid at the end of the month, quarter, year, or pay period. Since they’ve been accrued but not paid, they’re a liability for the company. 

Mortgages and loans are also common liability accounts. 

Equity 

Equity accounts show the value of the business, which is essentially the difference between assets and liabilities. If assets are what you own and liabilities are what you owe, equity is the balance of these numbers and functions like your business’s net worth. 

If your company has issued stock, the value of that stock will be recorded in an equity account. Owners’ Equity and Retained Earnings are the other major equity accounts reflecting what the business is worth and who owns how much. 

Together, assets, liabilities, and equity make up the Balance Sheet, which gives you a snapshot of the business’s worth at a given point in time. 

Revenue 

Revenue is the income of the business. Common revenue accounts include Sales, Interest Revenue, Rent Revenue, etc. Another type of account often seen alongside revenue accounts is contra revenue accounts. Contra revenue accounts offset revenue accounts and include things that reduce revenue such as discounts and returns. Rather than simply reducing the Sales account, a contra account allows you to keep track of the full sales revenue and account for returns and discounts separately.   

Expenses

Expense accounts include any number of expenditures from a business. The expenses may be incurred from day-to-day operations, like utility expense, rent expense, advertising expense, cost of sales, etc. or may even represent finance charges like interest expense. When costs are prepaid, as in the above example of prepaid insurance, they are converted to expenses as they are used up through regular journal entries.    

Revenue and expense accounts make up the Profit and Loss Statement, also known as the Income Statement. It records the profit or loss for a period by contrasting incoming revenue and outgoing expenses. Unlike the Balance Sheet, which shows a snapshot on a certain date, the Income Statement shows the revenue and expenses over a period of time, typically a month or year. 

Reconciling Accounts

Many of the accounts listed above will feed into one another over time. To ensure that accounts are accurate, journal entries are often made as part of the monthly closing process. An example of this was already mentioned above; a portion of prepaid expenses will be moved to the appropriate expense account as it’s used up. For example, if 6 months of insurance is prepaid for a total of $3000, there needs to be a $500 credit to Prepaid Insurance and a $500 debit to Insurance Expense at the end of each month as that prepaid insurance is used up. 

Along with journal entries, account reconciliation is a major part of the closing process. Reconciliation involves verifying opening and closing account balances and transactions against an external source, like a bank account statement or loan statement. While this isn’t possible with every account, it’s a best practice to reconcile as many accounts as possible every month, with a particular focus on high-risk accounts with large numbers of transactions. Monthly closing and reconciliation software can help streamline and automate the process to save time and ensure accounts are accurate. 

Making Sense of Accounting Flow

All the types of accounts mentioned above are designed to track the different ways money moves in and out of a business. The standard “double-entry” accounting system requires an entry in at least two accounts for any transactions, to mirror what’s really happening. As an example, if cash is used to purchase inventory, Cash will decrease and Inventory will increase. If the inventory is bought on credit, Inventory will increase and so will Accounts Payable. Financial statements like the Balance Sheet, Income Statement, and Statement of Cash Flows give a clear picture of one aspect of the business, informed by the balances in those accounts. This allows both business owners and investors to make wise decisions.