The terms “books” comes from the old days – before computers – when businesses actually maintained ledger books that the company’s listing of accounts and accounting transactions were recorded in. They were called the books of account. Business owners began to refer to their “books” and the term stuck.
Most all businesses these days use accounting software to maintain their accounting records. Accounting software was developed to make setting up and maintaining your company’s books easier and most have pre-established lists of suggested accounts for different industries.
As a small business owner, you should know a little something about the general types of accounts that exist before you determine the exact ones you’ll need. I would like to explain the basic categories of accounts that you will be using then provide some examples of specific accounts in those categories that will probably be used by most small businesses.
Basic Accounting Categories
There are five basic categories, or types, of accounts that are used in accounting:
1. Assets
2. Liabilities
3. Income
4. Expenses
5. Equity
Assets are those things that a company owns that will have value into the future or that will be used generally for more than 12 months. For example, computers, office furniture, vehicles or large equipment, and buildings or land. Items that might be purchased in bulk but will be used up within a short period of time are not considered assets. Also, money that you have in the bank or that people owe you is categorized as an asset.
Liability is another word for the money that the business owes. For example bank loans, lines of credit, mortgages, leases and unpaid bills. And it could also be money owed to the owner or owners.
Income is the money that comes into the business. It is generated when you sell your products or services. Payments that people or companies make to your business on accounts or notes receivable, however, are not classified as income.
Expenses are created pretty much any time a company spends its money. They are the costs that a business incurs in the process of generating income. But sometimes, money is spent to purchase assets. These transactions are not categorized as expenses. Also, loan payments are not classified as expenses.
Equity is basically the money that an owner puts into the business or doesn’t take out in the form of a cash payment to himself. I’m not going to go into much detail about equity in this post because of the complexity of the issue. Check back for a separate post on equity in the near future.
Individual Accounts
Within the asset category, you will have your bank accounts and accounts receivable. As your business develops, you might find that you loan someone money, and that creates a note receivable. In addition, paying expenses in advance (like a full year of general liability insurance) creates a prepaid expense that is categorized as an asset because your business hasn’t “used up” or “consumed” the full value of the insurance yet.
Within the liabilities category, you might have a mortgage or lease payable; vehicle loans; of course accounts payable; and maybe, a line of credit payable.
The Expense category is typically the largest and might include accounts such as rent; utilities like gas, electric, telephone and internet; vehicle expenses; shop supplies; equipment rental; trash disposal; and so on and so on. The list is limited only by your need for detail. You might start out with one expense account for utilities and put everything into that account (i.e. gas, electric and telephone). And that’s ok. But, if you want to know how much you spent for your cell phone because you’re shopping for a new carrier, you would have to sort through that account and identify just the cell phone expenses then total them up in order to know that. Using more itemized, or subaccounts, would solve that problem.
NOTE: Please don’t use a miscellaneous account. Too often I see small businesses posting transactions into a miscellaneous account (usually because they don’t want to create a new one) then not paying attention to what’s accumulating there. Soon, they have a balance in this account of several thousand dollars and they wonder, “What in the world did I buy?” Trust me, expenditures totaling $3000 are not miscellaneous. They really can be categorized elsewhere.
Cost of goods sold is a type of expense but is a separate category in most accounting software. I don’t recommend that small businesses use the cost of goods sold accounts unless they really understand the concept or have an accountant helping them with their books [See my prior post titled “Why Every Small Business Needs An Accountant (Not Just A Bookkeeper)”]. And usually, even then, only if the business is buying merchandise that is being marked up and resold or maybe parts that are then assembled into a finished product and therefore, need to be inventoried. It’s really not necessary.
The income category is where you will record your sales revenue. Most companies have one to three income accounts. They should be named as you use them in your business. For example consulting income, hardware sales, food sales, laundry receipts or maybe accounting services. Just use whatever makes common sense and helps you keep track of what you are doing.
Chart of Accounts Example
Below is an example of a standard chart of accounts for a service business:
Wells Fargo Checking Account Asset
Accounts Receivable Asset
Deposits Paid Asset
Prepaid Expenses Asset
Computer Equipment Fixed Asset
Office Furniture Fixed Asset
Accumulated Depreciation Fixed Asset
Accounts Payable Liability
Loan Payable to Wells Fargo Bank Liability
Truck Loan Liability
Owner’s Contributions Equity
Consulting Services Income
On Site Training Sessions Income
Insurance Expense
Office Supplies Expense
Postage Expense
Rent Expense
Utilities Expense
Electric Expense
Internet Expense
Telephone Expense
Keeping it Simple
Keep your chart of accounts simple in the beginning. Having too many accounts can cause confusion and inconsistency in reporting. It also makes your reports longer and can just clutter them up. Don’t accept every account that the accounting software suggests you use from the start. Remember, you can always add new accounts as you need them.