The Basic Accounts – How the Accounts Connect
At some point, every type of account will interconnect with each of the others. Assets will be used to pay for expenses. Inventory products bought on account involve both assets and liabilities. Product sales hit both cost and revenue accounts. Owner withdrawals deplete both assets and equity. Every single transaction your business conducts involves at least two accounts, sometimes more, and they most often are of different types.
In addition to that, though, the accounts have to be in specific balance. The company’s total assets must be exactly equal to its combined liabilities and equity. To get to that balance, the net result of combining the revenue, cost, and expense accounts must be folded into the equity account.
The Formal Connection
Periodically, you (or your accountant) will produce financial statements for your company. These statements are formal reports that lay out exactly what has been going on for the preceding period, and where things stand right now.
There are three main financial statements that you will create: the balance sheet, the statement of profit and loss, and the statement of cash flows (you will learn about these in more detail in Chapter 14). The balance sheet provides a snapshot of your assets, liabilities, and equity on a particular date. The statement of profit and loss informs you of your revenues, costs, expenses, and business results (the profit or loss) for a specific time. Finally, the statement of cash flows shows you how the money came into and went out of your company during that same specific period; this statement typically includes every account type, because they all have some relationship with cash.
The Everyday Connection
For many small businesses, daily transactions include three types of accounts: revenues, expenses, and cash. These are the accounts that will be involved in the vast majority of transactions, and your checkbook will often be the first place that transactions are recorded. Bring products into the picture, and liabilities become an everyday account as well. Even though you won’t necessarily see a daily entry in your equity accounts, they are impacted by every revenue and expense transaction.
At the most basic level, though, the connections among the accounts are what keep your business flowing. You use a combination of liabilities and equity to purchase assets. Assets are your company’s resources, and you use them to create revenue, some directly and some indirectly. For example, there’s a clear link between inventory and revenue production, but your computer also can bring in revenue. You can use your computer to create invoices, design promotional flyers, keep your books in order, even learn more about your industry and find new ways to bring in customers. Expenses also go directly toward revenue production; you can’t run a company without phones and electricity and pens. Those revenues and expenses come together, hopefully with revenues greater than expenses, to create additional equity.