We all already know what debits and credits are. They increase or decrease in its accounts based on money that you earn and money that you spend. Simple right? But there’s a whole lot more to understanding the different account types in accounting.
First off, the moment you purchase or sell any goods and/or services, you should be updating your chart of accounts.
Setting up all of your accounts is the first step to a smooth and efficient experience in TrulySmall Accounting. But before we get going, we recommend a quick read on:
All set? Good—let’s go!
Arguably, the most important part of bookkeeping is keeping track of your earnings and spendings: the two main types of accounts in an accounting system are income and expenses.
Different types of income can be taxed differently. By categorizing your income and expenses, you can optimize these for your business and increase your profit margins. In order to take full advantage of tax regulations, business owners in most countries need to track their business expenses in categories such as office supplies or meals and entertainment.
There is also a third type of account that is important to mention and that is a liability account. A liability account is used to track things that are basically the opposite of an asset—a thing that actually costs you money to get rid of. The most common types of liabilities are credit issued from a vendor or a bank (lines of credit, credit card debt, accounts payable, etc.).
Meet the 5 Account Types
Businesses have many accounts in their books, and nearly every account (described later on) falls under these five categories.
1. Assets / Bank Account Types
The asset account represents the value of the assets owned by the business. Only items that have a resale value should be recorded in this account. Every year the assets are adjusted to accommodate depreciation or appreciation of their value (examples of assets would be furniture, computers, real estate, etc.).
A cash account is the easiest way to record cash payments, deposits and withdrawals. We would use this option in TrulySmall Accounting when entering income or expenses received in cash under Terms or Payments Accounts. This will show that you were paid in cash or that you paid for something in cash.
A common scenario where the payment terms would be cash is when a business owner accidentally paid an expense from their personal credit card. In this case, many business owners might choose to say they have paid for this expense with cash since their personal credit card is not tracked for business purposes.
We use this account type to refer to bank accounts that are used for the purpose of running your business. A common example would be a small business that has a checking account where money can be deposited and used for bill payments and incidental expenses.
Another use case would be a savings account where a business puts aside some money to cover the taxes they might owe the government at the end of the year during tax season.
Find out more about how bank accounts are seamlessly pulled into TrulySmall Accounting and automated here.
Accounts receivable represents the money that is owed to the business. Accounts receivable is usually in the form of outstanding invoices issued by the business that have not yet been paid.
You can create, send, and track your invoices seamlessly in TrulySmall Accounting if your intention is to use a double-entry accounting software that allows for the full lifecycle of accounting, including detailed reporting and customization. On the other hand, TrulySmall Invoices—our product that focuses mainly on invoices can help you stay on top of your accounts receivable as well.
A common practice is for a business to collect cash and checks into an envelope and deposit them all in one lump sum. When this happens it appears on the bank statement as one transaction. To manage this in TrulySmall Accounting, we record that transaction in Undeposited Funds and then transfer the specific amounts of each item from the original deposit into the appropriate account. Following this protocol ensures that when performing a bank reconciliation, the transaction date and amount will match a line on the bank or credit card statement.
2. Liabilities / Credit Cards Account Types
A liability account represents a type of debt or upcoming cost for the business. The type of liability determines the duration of the debt.
Accounts payable represents the money that the business owes. Accounts payable usually comes in the form of bills or invoices from others vendors or service providers.
A credit card is an indispensable tool for a small business owner. In fact, it is quite normal for a small business owner to have multiple credit cards.
Credit cards are great for keeping tracking of expenses because many credit card companies will send you a statement at the end of the month with details of your business expenses. This provides an excellent opportunity for you to check to see if the expenses you entered into your online accounting software can match up with the credit card statement.
An equity account represents the net worth and ownership of the business. Examples of these accounts include:
- owner investments (contributed capital)
- retained earnings (owner’s equity in the company)
- common stock (security that represents ownership in a corporation)
4. Income Accounts
Income accounts are used to track the source of income so that a business owner can track where their money is coming from.
As an example, Habitsoft Inc. began as a custom software development company that also provided a consulting service. When setting up their accounts they created three different income accounts:
- Software Development Income
- Consulting Income
- Interest Income (for interest paid by the bank on any positive balances)
In most cases it’s also a good idea to create an Other Income category for things that you are not sure about and you can consult with your accountant later on.
Gain or Loss on Foreign Exchange
This account is used to track the gains or losses caused by a change in value of foreign currencies between the time an invoice is issued and when it is paid. In TrulySmall Accounting, this account is part of your default chart of accounts. You can opt to use it (or not), depending on whether your business tends to invoice or pay in foreign currency or not.
5. Expense Accounts
An expense account is meant to represent a category of expenses for the business. Basically, any type of product or service that does not have a resale value is an expense. If you are paying for an item that can be resold, it should be recorded as an asset.
Before setting up your expense accounts it is a good idea to consult your local tax laws as they may have certain categories you will have to adhere to. Examples of these would be things like office supplies, meals & entertainment, telecommunications, etc.
When you sign up for TrulySmall Accounting, a list of expense accounts are automatically included. Review this list to see if it is aligned with your local tax laws. From there, you can add any expense categories you feel are necessary.
Cost of Goods Sold
The cost of goods sold is the cost that goes into creating the product that the business sells. The only costs included here are those that are directly tied to the production of the products.
For example, raw material and labour used to produce a physical product would be included in the cost of goods sold; however, the cost of shipping the finished product to the retailer where it was sold would not.
A peek inside TrulySmall Accounting
When you first set-up your business in TrulySmall Accounting, you are presented with a default chart of accounts. This default list represents some of the most common account types used across most businesses. That said, you may want to add or remove particular accounts to suit the needs of your business’ special needs. After all, it is as unique as a snowflake.
And there you have it! A high-level overview of the different account types used in an accounting system. As always, if you have any questions about accounting, bookkeeping, or best practices with setting up your chart of accounts—our support team is here to help. Contact us at firstname.lastname@example.org or on Twitter at@KashooOnline.
*TrulySmall Accounting also offers a 14-day free trial for those of you who want to experience the flexibility and seamlessness of our software’s chart of accounts. Try it today to see how quickly it is to set-up and get going.
This is the second part in an ongoing series of articles diving into accounts and how they are used in the context of accounting.