Basic Bookkeeping Categories

Bags filled with different colored beans symbolic of the categories bookkeepers use.

Bookkeeping Categories

Bookkeepers do more than simply keep track of profits and losses. They record every financial transaction related to an entity.  It is only with these records that business owners and accountants can analyze the overall well being of a company. Because there is so much varied activity related to a business on any given day, staying organized is paramount to a company’s success, and subsequently, one of a bookkeeper’s most important roles. How do they do it? With bookkeeping categories, that’s how.

All bookkeepers use the same five bookkeeping categories to keep transactions organized. Because all bookkeepers use these same designations, it creates a universal language wherein anyone who understands bookkeeping can judge the financial health of a company. Each category is important for understanding the financial picture of a company.

Profit & Loss Account

The five categories bookkeepers use are assets, liabilities, equity, income, and expenses. These five categories are then divided in two accounts. One of these accounts is called a profit/loss account (also known as a income statement). This account tracks the total amount of revenue coming in versus going out, or in other words, how much money you are making. (Things get a little more confusing with accrual accounting, but most small businesses use cash accounting.) It is made up of income and expenses. Income refers to any revenue coming into the business. This can include product sales, services, consulting income, etc. Expenses refer to the things you pay for in order to keep the business running. This includes payroll, rent, utilities, or any other overhead expense. The purpose of a profit/loss account is to determine your net income (profits). In order to achieve this, you simply subtract your overall expenses from your overall income.

 

Income               –Expenses                            =Net Income
Examples:

product sales, services, consulting income etc.

Examples:

payroll, rent, utilities

Total profits

Balance Sheet Account

Just because your income statement says you’re making lots of money doesn’t necessarily mean that your company is stable.  This is why you also need the three remaining categories. They can tell you a lot about the financial health of your company. These remaining categories are assets, liabilities, and equity. They are grouped into what’s known as your balance sheet account. Your assets are everything you OWN or have the rights to. Some examples you would file into the assets category include bank accounts, cash, accounts receivable (what customers owe you), inventory, and equipment, just to name a few. Your liabilities are the things that you OWE. This would include accounts payable (unpaid bills), credit cards, loans, sales tax payable, etc. Finally, your equity is what the business is worth in a given moment in time. This would include your capital investment (your original investment), retained earnings (remaining profits), and shareholder contributions. When you add your total liabilities to your total equity, it should equal your total assets. This is why it’s called a “balance” sheet account.

 

Liabilities      +Equity           =Assets
Examples: accounts payable, credit cards, loans, sales tax payableExamples: capital investment, retained earnings, shareholder contributionsExamples: banks accounts, cash, accounts relievable, inventory, equipment

 

Asset Liability Ratios

The best and easiest way to determine the financial health of your business is through your balance sheet account. A healthy business has a 2:1 ratio of current assets to current liabilities. Your current assets are assets that will be converted into cash within the next 12 months. Similarly, current liabilities are bills that are due within twelve months. For example, if your current assets total $20,000, and your current liabilities are $10,000, you have a healthy business. If you have a higher ratio, say 3:1 or even 10:1, it may be time to consider investing, or time to pay off loans with your excess capital. If you ratio is less than 2:1, you need to make changes in order to protect your company.

In summary, individuals and business need documentation of every single transaction in order to have a complete understanding of where they stand financially. However, this quickly amounts to an enormous amount of information. In order to save time, bookkeepers organize each transaction into specific categories. With this information in tow, business and individuals are able to make confident and informed decisions about the future of their enterprise.

There you have it. My OC Bookkeeper’s introduction to the most basic bookkeeping categories. Check out our introduction to balance sheets to learn a bit more about balance sheets, and check out our introduction to income statements to learn a bit more about income statements. Or, Investopedia is a great place to learn about all things business, finance, and accounting. And of course, remember to reach out to My OC Bookkeeper – Orange County’s best small business bookkeeping company for all of your bookkeeping and tax needs.

Like videos? Here is a great educational video on bookkeeping categories – for other great accounting videos check out our YouTube channel.

Introduction to the Income Statement

Computer screen showing revenue, which is part of income statements

Income Statement Basics

Understanding income statements is crucial if you want to know how businesses operate. Whether you are running a small company in Orange County or are just interested in accounting, learning income statement basics is time well spent. So, without further ado,  My OC Bookkeeper presents you with our introduction to income statements 2018. (Also, remember an income statement is the same thing as a profit and loss statement. One name is never enough in accounting…)

The income statement, balance sheet and statement of cash flows combine to create a business’s financial statements. (Check out our introduction to the balance sheet here.) Each component of the financial statements provides a unique kind of information about a business: the balance sheet offers a snapshot of the financial condition at a given moment in time, the income statement tracks the revenues and expenses through time, and the statement of cash flows tells you how close you are to running out of cash. These statements can be used to do everything from checking last month’s profits to building complex financial models and are included in annual reports or 10-Ks. (Check out the U.S. Securities and Exchange Commission website to see some sample public company 10-Ks.)

What Does an Income Statement Show Me?

The income statement uses flow variables. This means that it provides you with information regarding what happened over a period of time, for example throughout the first quarter. (Do you remember our introduction to the balance sheet? We learned there that unlike the income statement the balance sheet provides a snapshot of a company in time, for example on a given day.)

What does an income statement track through time? All of your revenues and all of your expenses. At the very top the statement is the amount of revenue that was earned throughout the period in question. It may just provide a single ‘revenue’ line item, or it could break up the revenues into types, for example sales revenue, marketing revenue, etc.

Now that you know how much you earned you need to know how much you spent. After the revenues the expenses are deducted. Expenses can be all kinds of things. Rent, marketing expense, gas expense, salaries, debt payments, you name it.

After we deduct the expenses we get to the most important thing of all: profits. This comes at the bottom of the income statement – hence the expression ‘the bottom line’.

So the income statement will not only tell you your profits, but also breakdown where they come from and what expenses had to be deducted to get there. This is key information for any small business owner. (Whether you are in Orange County or not.) If you want to succeed you must know where your money is coming from and where it it going.

Income Statement Vocabulary

A more advanced understanding of an income statement starts with vocabulary. We’ve put together some useful definitions below. Don’t worry if you haven’t encountered any of them. Some are reserved for more advanced financial statements. (Check back for some upcoming advanced financial statement training posts.)

Cost of Goods Sold (COGs)

This is a line item which can be deducted from total revenue create a new category: gross profit. COGs represents a grouping of all of the expenses directly related to the actual creation of a product. (As opposed to its sale, for example.) All of the costs of manufacturing your widgets and the materials you used in making them can be included in COGs.

Gross Profit

When you deduct cost of goods sold (COGs) from your total revenue to calculate your gross profit you are using ‘gross profit’ accounting . This can be useful when you want to know how much money your product has created after deducting the production expenses ONLY. To do this you just just add two new line items to the statement, i.e. COGS and gross profit. Then you just deduct all of the regular expenses to reach your bottom line.

Depreciation and Amortization

This is a line item on your income statement which deducts value from your assets based on an assumed depreciation / amortization schedule. That just means that the value of assets that you own, i.e. assets on your balance sheet, decrease over time. Factories, tractors, and wind mills all fall apart eventually. A business owner has to account for this loss in value and it is down by deducting it from the income statement. (This might sound a bit strange. Come back around for some advanced financial statement training if you find this provocative.)

What is the difference between depreciation and amortization? Depreciation is for tangible assets like buildings, and amortization is for intangible assets like contracts.

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Interest, taxes, depreciation, and amortization are usually some of the last things you deduct on the income statement. Before you do so, you may want to get a subtotal letting you know how the business is doing outside of these issues. That’s all EBITDA is. Simple.

EBIT

EBIT stands for earnings before interest and taxes. It’s basically the same thing as EBITDA but it represents your total profit after deducting depreciation and amortization but before deducting interest and taxes.

Gains & Losses

With gains and losses you are getting into some stranger territory but the concept remains quite easy. You get a gain when you sell an asset that is not your product for a gain relative to the price you paid for it. So if you sold an extra widget maker for $100 more than you paid for it you have a gain. If you sold it at a loss you have a loss.

More Learning

So there you have it. Income statements basics 2018. Be sure to also check out our introduction to the balance sheet and our upcoming introduction to the statement of cash flows. Also, check back soon for some advanced financial statement tutorials and feel free to to watch the intro to the income statement video below.

Are you a small business in the Orange County, CA area? If so, reach out to us at My OC Bookkeeper for some help with all things accounting and tax.