Organizing the Accounts

In most accounting systems, the accounting structure is organized in such a way as to make reporting accurate for the type of business. A small, cash-operated restaurant might structure their accounts differently than a car dealership would—which would be different from how a refinery complex would. However, there are some common groupings that you’ll find in most accounting systems.

Assets

Assets are items owned by the business such as cash in the bank, company cars, computer systems, and invoices from customers, etc. In general, you will see the assets organized into at least three categories.

Current Assets

Current Assets include cash and items you reasonably expect to turn into cash within the year. At a minimum, this will include any bank accounts, any short-term investments, and receivables (i.e., money owed you from customers). The current assets generally make up the working capital that a business has. Most businesses will try to keep a balance between having enough cash to pay bills and expense but not tying up a lot of money in a non-interest-bearing account.

Some businesses break their cash accounts down even further, dividing them between checking, savings, and possibly money market accounts. Other businesses such as banks and credit unions might break the receivables down, possibly between currently due portions of loans and longer term money owed.

Prepaid Expenses are monies paid out for supplies or services that are expected to be used with the year. For example, a service contract paid in advance for a copier would be considered a Prepaid Expense. Stocking up on shipping supplies after the Christmas rush to save money (but using them up within the year) is another Prepaid Expense.

Inventory

In general, inventory is considered a current asset; you should expect to see the products within the year. However, inventory requires sales effort in order to become cash. By keeping inventory separate, you can get a better handle on actual working funds for bills and expenses. If a short-term event occurs that prevents you from selling products, you still want to have enough current assets to pay your short-term bills.

In addition, inventory is tracked differently since you need to know the cost of inventory items when they are actually sold. We will cover inventory costing methods in a later chapter.

Fixed Assets

Fixed Assets are items purchased to run the business, rather than those planned on being converted to cash. This category includes items such as office furniture, computers, cars, trucks, and machinery. Generally, the items have a large up-front cost but the expectation is that you will get several years of life out of the asset. Selling a Fixed Asset to pay current bills is generally an indication that a company is in financial trouble.

Fixed Assets are expensed differently, through a process known as depreciation. We will cover Fixed Assets and depreciation in a later chapter.

Long-term Assets

Long-term Assets are assets such as investments, treasury bonds, and receivables due in future years. These accounts are different from Fixed Assets because they don’t lose value (i.e., depreciate) over time. Long-term investments are expected to rise in value, or at least stay the same. If a business is planning a large purchase such as a building or plot of land, they could create a special fund which would be classified as a Long-term Asset.

Liabilities

Liabilities generally consist of three categories. Trade liabilities are debts we incur as part of running the business such as purchasing shipping supplies on credit. Tax liabilities are monies we owe to a government taxing agency such as payroll taxes, and sales taxes, etc. And notes are legally binding, generally long-term liabilities for purchases such as Fixed Assets and other items needed to support the business.

Current Liabilities

Most trade liabilities and tax liabilities are current (i.e., they will need to be paid within the current period—most often within a year). Current assets generally need to be sufficient to pay off the current liabilities, otherwise potential cash flow issues can arise. The taxing agencies generally fine companies heavily if they are late with their tax payments. Vendors will sometimes accept late payments but doing so runs the risk of that vendor (who supplies the business with what it needs) no longer extending credit to the business.

Long-term Liabilities

Long-term debts are liabilities that need to be paid but not fully so within the current period. For example, if you buy a fixed asset via a loan, typically the loan repayment term is over multiple years. So the loan itself will be classified as a long-term liability.

However, even though the loan term might be multiple years, a portion of the loan should be included in current liabilities (e.g., the portion of the loan due this year). Each year, a business will prepare a journal entry to re-categorize a portion of the long-term debt into the current liabilities section of the balance sheet.

For example, if we borrow $10,000 for a computer system and finance it over five years, the journal entry might look like the following:

Moving some of the long-term debt into current liabilities gives a company a better understanding of cash needs and whether or not current assets can keep the company on top of its bills.

Equity

The Equity section generally consists of two categories; one is the owner’s contributions into the business and the second is the retained earnings (i.e., the accumulated earnings over the life of the company).

For a sole proprietorship, there is typically a single-owner equity account and, often, a drawing account associated with it (for when the owner withdraws money from the business). A partnership will be similar, with multiple-owner equity accounts for each partner within the business.

Corporations have more entries, using Stockholder Equity instead of an individual’s equity account. The Stockholder Equity account includes Paid-in Capital, Treasury Stock, and Retained Earnings.

Paid-in Capital

Paid-in capital is the amount paid for all stockholders to acquire shares of the company’s stock. This account is often broken down further by class of stock (e.g., preferred versus common stock). Paid-in capital has two components; the first is the actual par or face value of the stock. Most companies have low face values of stock. However, to actually acquire the stock, the purchasers have paid over the par value and this is recorded separately in the equity section.

Treasury Stock

When a company has stock, it can issue any number of shares—not all of which can be purchased. Purchased shares are considered outstanding shares and these shares have rights in the company (e.g., voting, receiving dividends, etc.). Shares that have not been sold, or have been sold and later bought back, are considered treasury stock. When a company computes earnings per share (i.e., how much money each share of stock made), treasury stock is not included in the calculation.

Retained Earnings

Retained earnings for a corporation is the cumulative earnings since the company started minus any dividends paid to stockholders. Technically, this money is owned by the stockholders but, in actuality, the company’s senior management or board of directors decide how much to issue to stockholders as dividends. For example, if the company is planning a future expansion, they might “appropriate” retained earnings rather than declare dividends with the money.

Example Equity Account for a Corporation

The example below shows how a corporation might structure its equity accounts:

• 3000    Stockholder Equity
• 3100    Common Stock
• 3110    Paid-in Capital
• 3120    Excess Paid-in Capital
• 3200    Preferred Stock
• 3210    Paid-in Capital
• 3220    Excess Paid-in Capital
• 3500    Retained earnings
• 3510    General Retained Earnings
• 3520    Reserved for future expansion
• 3900    Treasury Stock

Revenue

The revenue account can be divided into subaccounts in a variety of different ways. For example, a car dealership might break revenue into three areas:

• New car sales
• Used car sales
• Service department

Such a breakdown of the sales account would allow management to see from where the most revenue is coming. Does it make sense to hire more salespeople or service people? Should they continue to sell used cars or just focus on new cars?

A different company might break their sales account down by geographic region, allowing them to decide which regions need increased sales presence.

Expenses

Expenses are generally broken down into two major categories: operating expenses and non-operating expenses. Operating expenses are the day-to-day expenses needed to keep the business running. These can be further broken down as shown below:

Cost of Goods Sold

When a company sells a product or any physical items, there are costs associated with either acquiring the item or producing it. These direct costs include material and labor costs. They are costs that are likely to vary with the quantity of goods sold.

Selling Expenses

Selling Expenses are expenses that are directly related to making the sale (e.g., salaries of salespeople, commissions, travel expenses, advertising, etc.), getting the product to the customer (e.g., freight and shipping charges, etc.) and the cost of storage and equipment. Some of these expenses will increase (e.g., commissions, rental on storage space, etc.) as sales volume increases.

General/Administrative Expenses

General or Administrative Expenses are the expenses needed to manage the business such as manager salaries, legal and professional fees, payroll expenses, utilities, insurance, office space, office supplies, etc. These expenses typically remain the same despite sales fluctuations. Often, you will see these expenses referred to as overhead and allocated to various sales or manufacturing areas.

Depreciation Expense

Depreciation Expense is a gradual deduction of a large purchase over multiple periods. The cash has already been spent to acquire the asset, but with each period, a portion of that expenditure is deducted from income. Since no actual cash was paid out during the period, depreciation expense is generally kept separate to make reporting easier and to see actual cash expenditures needed.

Research and Development

Many companies have ongoing research or development to plan for future products or services. Although such expenses are necessary for long-term growth of the business, they are generally kept in a separate category since they are, typically, not expenses directly needed to produce revenue in the current period.

Non-Operating Section

Non-Operating Section expenses are expenses that must be paid but are not actually necessary to run the business. The two biggest examples are finance costs (e.g., interest expense, bank charges, etc.) and tax expenses (e.g., the amount of tax due in the current reporting period).

Sometimes a business may have revenues and expenses outside the primary business such as the sales of investments, royalties from a patent, etc. These infrequent revenues and expenses are generally included under Non-Operating Section expenses to show they are outside the normal course of the business.

Summary

An accounting system is an organized categorization system consisting of a chart of accounts and transactions against those accounts. The greater the level of detailed categories, the more precise reporting can be performed (however, a greater level of detailed categories also requires more effort to record the transactions). In this chapter, we showed some general, commonly used account classifications. Systems can be much more complex and simple depending on the size of the business and the management structure.