Maintaining and tracking your finances can be a hassle, especially if you have many transactions. Even if you outsource bookkeeping to someone else, having a solid understanding of how the process works will help you make sense of your financial statements and use them to grow your business.
This guide will take you through the basics of transaction categorization and the many ways it can help you.
Why is it important to categorize your transactions?
With categorization, you can understand and track your income and expenses, retrieve information easily, and spot errors. Planning your budget gets easier, too. With the various categories you set, you can visualize your expense trends and make a comparison between the different categories. All of this helps you stay on top of your cash flow and make effective business decisions, especially when it comes to identifying your spending patterns
Credits and Debits
At its core, bookkeeping is the practice of tracking where money has come from and gone to. Although every business may be different on the surface, when it comes to bookkeeping, every business’s transactions are considered as credits and debits.
Simply put, credit is money that has come from somewhere, whereas debit is money that has gone somewhere. When transactions are described in “bookkeeper speak” they’re often being “credited” to or “debited” from an account of some kind.
One of the most important rules of bookkeeping is that for every debit there must be an offsetting credit, and vice versa. Keep in mind that debits and credits confuse many people who try to do their bookkeeping, but once you learn to differentiate between the two, you’ll find the rest of the bookkeeping process a lot easier to understand.
Bookkeeping Journals and Journal Entries
While debits and credits help to keep track of money coming into and out of accounts, the record of these transactions is called a journal. Similar to a diary, a journal keeps track of the debit and credit transactions via journal entries and can ultimately tell the story of how the business operates. These records are vital for the proper preparation of financial statements, such as balance sheets and income statements, as well as for tax preparation.
As we said earlier, an important feature of journal entries is that for every credit there must be a corresponding or offsetting debit (and vice versa). This process is known as double-entry bookkeeping because at least two entries in the journal are made for every transaction that takes place.
Accounts
Think of an account as a type of placeholder. It can describe an internal location, like a bank account, credit card, or inventory or it can describe money moving in and out of the company, like an office expense, payroll expense, or sales revenue.
Account types
1. Assets
An asset is something that the company owns. An asset can be physical, like cash, bank accounts, inventory, or equipment. Alternatively, an asset can be part of an agreement with someone who agrees to pay the business something in the future, like accounts receivables or loans. Finally, an asset can be something intangible, like intellectual property.
2. Liabilities
It’s common for businesses to take out loans to purchase goods or pay for services. These loans are called liabilities, which simply refers to the fact that money that has to be paid to someone in the future. One particularly common type of liability is accounts payable. This account refers to money that is owed to a vendor when they provide a business with a product or service upfront and ask for payment later
3. Equity
Equity is money that comes from the owners of the company. The key distinction between equity and liability is that there’s usually no expectation that this money will be paid back.
A few common accounts of this type are:
Share Capital: The amount of money that the owners have given to the company as startup or growth funding.
Retained Earnings: The profit that the company has earned
Dividends: The amount of money that the company has paid to the owners (shareholders) from its profits. This is counted as a negative number, since as profit is paid back to owners, the amount of profit remaining within the company decreases. Equity decreases as dividends are paid.
4. Revenue
Revenue is money that the company has collected from customers for sales, or as payment for services.
5. Expense
An expense is money that is paid out by the company to keep the business running. Expenses must be differentiated from investments. With an expense, the company gets a one-time benefit from the money spent. With an investment, the company will get a lasting benefit from the money spent. Investments get categorized as assets, not expenses.
Reach Out for Help
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Cloud Bookkeeping, Inc.
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Ontario California 9176
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Suite 3000 Newport Beach, CA 92660
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Website: www.cloudbookkeepinginc.com
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