Account types are vital for categorising your financial transactions during the bookkeeping process. In this guide, we’ll help you understand why categorizing business transactions is so important and how to do it.
One of the fundamental processes of bookkeeping is to record and track every single financial transaction made by your business. Under the double-entry method, these transactions are denoted in the bookkeeping journal as credit and debit transactions.
A credit refers to a bookkeeping entry that increases the recorded transaction balance – it refers to money that has entered the account from elsewhere.
On the other hand, debit refers to money that decreases the recorded transaction balance – money that leaves the account and goes somewhere.
For example, let’s say you receive money from a sale. This is known as ‘credit sales revenue’ and would be recorded as such in a bookkeeper’s transactional records. Now, on the other hand you have to pay rent to the landlord who leases your business offices. This would be recorded as a ‘debit rent expense’. Although this seems like a simple distinction, it’s enough to confuse many people who attempt to do their own bookkeeping!
This leads to account categorization. In order to distinguish the difference between the types of financial transactions that your business is doing on a day-to-day basis, you need to make categorizations based on where the money you receive, or send, is coming from or going to. These are called accounts. Classifying between the various different kinds of accounts can help to make tracking and analysing your financial transactions much easier.
So, what are the different types of account?
There are five main different types of account listed below.
Revenue refers to the total amount of income your business generates through the sale of goods or services. This is also known as gross sales or is often referred as the ‘top line’ as it is found at the top of an income statement. Income, on the other hand, is calculated by subtracting expenses from the total revenue. What, then, is an expense account?
An expense is ultimately the cost of attempting to generate revenue. Expenses represent the costs required in order for a business to generate an income and, hopefully, turn a profit. Expenses do not just refer to cash, but also office equipment or prepaid expenses such as rent.
An asset might seem like an expense but there is a distinction. An expense usually refers to something with a one-time benefit that helps to keep a business in a position to generate income. An asset, on the other hand, is something that your company owns – closer to something like an investment, real estate or company owned vehicles. It can also refer to cash and office equipment or something non-physical like intellectual property or branding.
A liability refers to a potential outgoing or something that must be paid to someone in the future. One common example of this is a business loan.
Equity, unlike a liability, is internal investment from the owners of the company. There is usually no expectation that this money will be paid back. Common examples of this account type include dividends, which is when money is paid to the shareowners from profits made by the business, or share capital, the amount of money given to the business to aid growth.
Why Account Types Are Important
Knowing what category each account falls into can be a complicated affair. Getting this right, however, can make the difference when it comes to tracking transactional data.
Having well-balanced, clear and organised books can help you keep track of important information and understand how your business has been performing.
Knowing the difference between each account type and what it means for your business can have a huge impact on your growth. The more accurate your books, the more prepared you will be to create financial statements that understand and analyse what your business is doing right, and how it can be improved.
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