When you are running a small business, it is important to have an understanding of the different types of accounts that can be used. This blog post will cover bank accounts, cash accounts, income accounts, expense accounts, undeposited funds, and equity as well as assets and liabilities.
The first step in this process is to understand what these terms mean.
How Do We Classify Accounts in Business
There are five broad classifications of accounts in a business. They are:
- Revenue accounts
- Expense accounts
- Asset accounts
- Liability accounts and
- Equity accounts.
Revenue or income accounts record what the business earns, or sells. Examples of this can be interest earned on investments, dividends on shares, fees paid to the business, and sales of services or products.
Expense accounts record what it costs the business to make sales and keep the business afloat. These accounts include things like rent, advertising, phone and communication costs, travel, and employee wages. It includes non-cash expenses like depreciation on assets.
This recognizes the idea that what we use in business eventually wears out so it is not worth as much. You could say it depreciates.
Asset accounts record what the business owns. They list what we use in the business. It can be things like our computer, motor vehicle, land and buildings, desks, shares, crypto-currencies, bank accounts, and money due from customers.
Asset accounts get split into current assets and long-term assets. Current assets are generally used up inside of 12 months, and long-term assets are held for more than one year.
Current assets can include things like accounts receivable, cash in the bank, and stock held for sale. Long-term assets include things like office furniture, motor vehicles, and land and buildings.
Liability accounts record what the business owes. These include things like bank overdrafts, credit cards, long-term loans, car finance, money due to suppliers and contractors.
Similarly, liabilities accounts get split between current or short-term liabilities and long-term liabilities. Short-term liabilities include things like accounts payable, bank overdraft, and credit card debt, These get paid within 12 months. Long-term liabilities include loans that will take longer than one year to pay off.
Equity accounts show what the business is worth. It is essentially the difference between what is owned and what is owed. The accounting formula is Assets - Liabilities = Equity (or worth).
The Different Types of Accounts in Small Business
Some accounts are important to keep your eye on when you are in business. They give you a quick look at how you are doing.
Bank accounts, cost of goods sold, receivables and payables are essential to stay on top of.
There are two types of bank accounts, a chequing account, and a savings account. A business will typically have both a checking and saving account, often with more than one bank for safety's sake. The function of the different accounts is to show how much money your business has available right now.
A checking account is used to pay day-to-day business expenses and also to pay suppliers for goods sold. Typically income coming into the business gets banked into the checking account. Money is manually deposited or comes in as an automatic bank transfer.
A savings account is where the bulk of your money will be held in a long-term deposit, earning interest that helps to grow the balance over time. Savings accounts are useful to accumulate cash reserves that are surplus to current business needs in a low-risk environment.
A cash account is for business funds that are still on hand and not yet deposited into one of the other accounts. These undeposited funds are either money not yet banked or held as petty cash.
A petty cash account is for those little day-to-day business expenses and payments for when the expense or payment doesn’t exceed $200 (or any other predetermined amount). It is usually kept as a predetermined float, for example, $500, and is topped up regularly from the business checking account.
Business Certificate of Deposit (CD) Account
CDs typically have a fixed term, which is specified when the money goes into the CD and will specify what interest rate it earns for that period as well. The typical length of time on a CD is six months to five years with rates that are set at the time of purchase.
The interest rate on a CD typically depends on the term and who is purchasing the bank CD account. For example, CDs that are opened for individual retirement plans earn higher rates than those CDs opened by businesses or other organizations.
Withdrawing money from a CD before it matures will incur an early withdrawal penalty that can be as high as six months' worth of interest.
Credit Card Accounts
Business credit card accounts are an excellent way to get the business running initially. They can be set up to offer a line of credit so that if your cash flow is insufficient, you can always borrow from the credit card company. This is like a revolving credit arrangement where you pay down the card then use it again for future payments.
A revolving account offers an open-ended amount of borrowing without interest charges or other restrictive features such as a need for collateral. A business credit card is used to make purchases and then repay them over time with interest.
Credit cards can be paid off at any point without penalty - unlike some bank loans or overdrafts.
The accounts payable account represents money owed to others for goods or services rendered.
This is a liability to the business because it can represent an expense that has already been incurred but not yet paid. There will be payments due at some point in the future and it is important to pay these debts by the due date to keep the provision of goods and services flowing smoothly into your company.
Accounts receivable are money owed to the business from customers or clients. The amount owed is based on goods and services that have been delivered but not yet paid for.
Accounts receivable are an asset of a business because they represent future potential regain in bank balance when payment is received.
Small business owners should be aware that accounts receivable are also a potential liability. This is because when they become overdue, these customers may not have the ability or willingness to repay the debt and it can be expensive to recover the debt.
Accounts Receivables should always be monitored closely for signs of risk.
Cost of Goods Sold
The cost of goods sold is an account that tracks how much money a company spent on goods that are resold to your customers. Cash accounts are used to track where any of this money came from, and they report out who paid it.
The cost of goods sold is calculated by subtracting the closing stock from your opening stock for the year and then adding purchases of new stock. Revenue minus the cost of goods sold is your gross profit.
Gain or Loss on Foreign Exchange
When you buy or sell goods or services overseas and you have to get paid or to pay your supplier in an overseas currency, you are exposed to exchange rate fluctuations where your invoiced value and the paid value differ when converted back to your base currency. Sometimes you make a profit and other times you lose money.
Many business people cover themselves against losing money on overseas trading by taking out a foreign currency risk hedge.
This is an insurance product that protects you from fluctuations in exchange rates with no additional premium payments, so when your invoiced value differs from what you paid for goods and services abroad, any loss will be offset by the hedging benefit.
What this does is turn possible unknown costs into known expenses that can be recovered in the selling price of your goods and services.
Which Accounts Are Useful in Your Business?
Not every business needs all of the different types of accounts. The stage of your business, the amount of money you have invested in it, and how you do business will affect which accounts are useful for your business.
A bank account is the essential business account because it keeps your personal money separate from business funds. When starting up, many entrepreneurs start off with no equity and so must borrow money to fund their business.
At the end of the day, it comes down to what you need.
The best way to find out which types of accounts are useful in your business is to sit down and think about how you operate and implement your decisions from that.