What is a Contra Account in Accounting?
You’ve probably heard of a general ledger account, but have you heard of a contra account? Well, a contra account is essentially a type of general ledger account. However, it has a few unique characteristics worth noting. To learn more about contra accounts and how they are used, keep reading.
Contra Accounts: The Basics
As explained by Investopedia, a contra account is a type of general ledger account that’s used specifically for the purpose of reducing an associated account’s balance. In a typical asset account, the balance is negative. In a contra account, however, the balance is positive — and this is the characteristic feature of contra accounts. They have a credit balance instead of a debit balance, allowing them to reduce the paired account’s total balance.
How Contra Accounts are Used
Contra accounts are used in a variety of applications, one of which is for uncollectible accounts. In the same Investopedia article cited above, it explains that contra accounts can be added to an accounts receivable. The balance is used to represent the total amount that’s expected to go uncollected; thus, reducing the amount of revenue reported in accounts receivables. In a perfect world, business owners would always receive payment for the products and services they sell. However, there are times when a customer may not pay, which is where contra accounts come into play. Using a contra account, you can record nonpayments so they don’t adversely affect your accounts receivables.
Another example of a contra account is an accumulated depreciation account. This type of account is used to offset the fixed assets account. While the fixed asset account has the cost of acquisition, the contra account reflects the total cost of all depreciation expenses that have incurred against the respective assets over time. Business owners and accounts typically look at both the contra account and accumulated depreciation account to determine the net dollar value of the assets.
There’s also a contra liability account, which is somewhat confusing given that it’s not an actual liability account. Rather, a contra liability account is used to offset a payable account. A bond discount account, for instance, is a type of contra liability account. When a bond discount account is added to a contra liability account, it reveals the carrying value of the respective bond. Hopefully, this gives you a better understanding of contra liability accounts.
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Accounting Best Practices for Small Business Owners
Running a successful small business is no easy task. According to the Small Business Administration (SBA), there are nearly 28 million small businesses with fewer than 499 employees operating in the United States. Unfortunately, more than half of these small businesses will close within their first five years. Whether you currently own a small business or are thinking of launching one, you should follow the accounting tips listed below to increase your chances of success.
Separate Personal and Business Expenses
One of the most common accounting mistakes made by small business owners is mixing together personal and business expenses. While paying for a business-related expense using your personal credit card may seem harmless enough, it can make it difficult to prepare and file your taxes. To simply your taxes, it’s recommended that you separate your personal and businesses expenses, using only business accounts to pay for business-related expenses.
Leave a Paper Trail
In addition to separating your personal and business expenses, you should also leave a paper trail. In other words, avoid using cash to pay for business expenses, and instead use a credit card, debit card or check. Granted, it’s not illegal to pay for business expenses using cash. The problem with cash is that it doesn’t offer an easily accessible record. You may obtain a receipt, but you won’t be able to download or access records of your cash transactions. On the other hand, using a credit card, debit card or check to make purchases creates a digital record, which you can later access if needed.
Accounting Software
Some business owners assume that accounting software isn’t necessary. If they only perform a few transactions per week, for instance, a small business owner may use Microsoft Excel to keep track of their income and expenses. In doing so, however, they set up themselves up for failure. Regardless of how many transactions your business performs, using the right accounting software will certainly help. Quickbooks is a versatile, easy-to-use accounting solution that allows you to keep track of inventory, expenses, income and more. Most small business owners and professional accountants will agree that it’s well worth the investment.
Pursue Accounts Receivables
Assuming your small business sells a service — and you allow customers to pay after the service has been completed — you should follow up on accounts receivables to collect money due. Overlooking accounts receivables could result in a substantial loss of income.
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Assets vs Liabilities: What’s the Difference?
In financial accounting, you’ll come across the terms “assets” and “liabilities” quite frequently. While you may have a general understanding of these terms, you probably don’t know the complete details. So, if you’re interested in learning more about assets and liabilities — and how they differ from one another — keep reading.
The Basics of Assets vs Liabilities
In the most basic sense, a liability is any financial sacrifice that a business is contractually obligated to make, whereas an asset is a financial resource of monetary value.
Exploring Assets
An asset is essentially any tangible or intangible “thing” that can be converted into real money. The International Accounting Standards Board further explains that assets are “resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.” Common examples of assets include cash, deposit accounts, accounts receivables, inventory, machines/equipment and prepaid expenses. However, long-term investments may also fall under the category of assets, including bonds, stock, property, sinking funds and pension funds. The defining characteristic of an asset is that it holds monetary value.
Exploring Liabilities
On the other hand, a liability is money owned by a business. When a business borrows money, it takes on debt liability. The business acquires short-term capital, though it’s contractually obligated to pay back that debt, usually with interest to the respective lender.
Calculating liabilities is essential in determining a business’s total assets. On a typical balance sheet, for instance, the formula liabilities + owner’s equity is used to calculate the business’s total assets.
However, there are two different types of liabilities that are reported on a balance sheet: current liabilities and long-term liabilities. Current liabilities are those which are expected to be liquidated within a year. Common examples of current liabilities include wages, taxes and accounts payables. Long-term liabilities, however, are those which are expected to be liquidated after a year. Examples of long-term liabilities include notes payables, long-term bonds, product warranties, leases and penion obligations.
It’s important to note that a debit can either increase or decrease the total amount of a liability. When a business deposits cash into a bank account, the bank debits an asset and credits a liability. When a business withdraws money from a bank account, the opposite happens.
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What is Working Capital in Accounting?
Some business owners assume that working capital is the amount of money they have or revenue they generate, but this isn’t necessarily true. Working capital can best be described as the amount of money and assets a business has minus its debt and liabilities. To learn more about working capital and how it pertains to accounting, keep reading.
As explained above, working capital is the amount of assets a business has minus its liabilities. If a business has $100,00 of assets — cash, outstanding invoices, property, etc. — and $30,000 of debt, for instance, it’s working capital is $70,000. The $30,000 worth of debt is subtracted from the business’s $100,000 worth of assets; thus, leaving $70,000 of working capital.
Why Working Capital is Important
So, for what reasons do business owners need to keep track of their working capital? For starters, it allows business owners to see whether or not they can cover short-term liabilities, such as overhead and payroll. If a business has a low working capital, it may struggle to cover short-term expenses like these. On the other hand, a high working capital indicates the business is financial stable and can easily cover these expenses.
Furthermore, lenders often scrutinize a business’s cashflow and working capital when the business applies for a loan. While lenders use a variety of criteria to determine whether to approve or deny a business’s loan applicant, there’s a great deal of emphasis placed on working capital — and for good reason. If a business has a low or even negative working capital (see below), it may struggle to pay back the loan. This doesn’t necessarily mean the lender will reject the business’s loan application; however, they may charge higher interest rates and/or require the use of collateral.
Negative Working Capital
Let’s hope his doesn’t occur with your business, but there are times when a business’s liabilities may exceed its assets. Known as negative working capital, this indicates the business is struggling financially and may not be able to pay its short-term debt and liabilities. If a business’s debt and liabilities exceed its total assets, the business has negative working capital.
To recap, working capital is a measure of a company’s short-term financial health. It uses the formula of assets minus liabilities, revealing its working capital. Hopefully, this gives you a better understanding of working capital in accounting.
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What is Cash Flow in Business Accounting?
Maintaining a positive cash flow is important when running a business. Whether your business offers a product or service, you probably need cash on hand to conduct your normal day-to-day operations. But what exactly is cash flow?
Cash Flow: The Basics
Cash flow can best be described as the difference in cash from when the beginning of a period to the end of that period. The beginning period is called the “opening balance,” whereas the end period is called the “closing balance.” If the closing balance is lower than the opening balance, the respective business has a negative cash flow for that period. If the closing balance is higher than opening balance, the business has a positive cash flow.
Cash Flow Statements
In accounting, a cash flow statement is a financial statement that reveals a business’s cash flow. Also known as a statement of cash flows, it’s used to show the short-term financial health of a business. Several third-party entities scrutinize the cash flow statements of businesses, some of which include lenders, creditors, investors and shareholders.
More specifically, a traditional cash flow statement should consist of three primary segments: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Cash flow statements refer to the money coming into a business as “inflow,” whereas the money going out is referred to as “outflow.”
There are several methods used to create cash flow statements, the two most common being direct and indirect. The direct method involves reporting major classes of cash receipts and expenditures. The indirect method, on the other hand, involves the use of net-income as a beginning market, after which it adjusts for all non-cash transactions followed by an adjustment for cash-based transactions.
Goals of Cash Flow Analysis
In addition to cash flow statements, some businesses conduct a cash flow analysis to achieve similar accounting goals. The goals of a cash flow analysis is to determine the rate of return for a project; to determine liquidity problems; evaluate the quality of income generates by accrual accounting; and to evaluate the risks of a financial product.
Of course, Intuit’s Quickbooks accounting software makes cash flow statements a breeze. You can easily run a statement of cash flow reports by logging in to your Quickbooks account and selecting Reports > All Reports > Business Overview > Statement of Cash Flows.
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What Is Accountants Receivable in Accounting?
In business accounting, accounts receivable refers to money owned for products or services. Also known as A/R, it’s essentially an invoice for payment that hasn’t been received yet. If your business performs a service and allows customers to pay after it has been completed, for instance, you’ll have an accounts receivable for completed jobs that customers haven’t paid for.
The purpose of accounts receivable to keep track of money due. If a customer owes you money, you need a record so you can collect it. Accounts receivables allows business owners to do just that.
Of course, not all businesses need accounts receivables. If your business requires payment at the time the customer purchases the goods or service, you won’t have any money due, in which case you also won’t have any accounts receivables.
Accounts Receivable in Quickbooks
When using Quickbooks, you’ll probably come across accounts receivable. Quickbooks automatically creates and adds them to your chart of accounts the first time you create an invoice. Quickbooks will then use this accounts receivable to track who owes money to your business and how much they owe. This information is listed as accounts receivables in your Quickbooks account. If you have two or more accounts receivable, Quickbooks will allow you to choose the account you want to use when creating a new invoice or entering a customer payment.
Accounts Receivable Financing
There’s also a special type of business financing that involves the use of accounts receivables. Known as “accounts receivable financing,” this is an asset-based financing option in which a business owners sells his or her business’s accounts receivables for capital. The financing company, typically called a “factoring company” pays the business owner for his or her accounts receivables. Rather than paying the business owner, however, the customer pays the factoring company. It’s a mutually beneficial financing option that allows business owners to receive cash in less time while the factoring company earns additional money on the receivables.
Normally, accounts receivables financing companies pay roughly 80% for accounts receivables. If an invoice is worth $1,000, for instance, the factoring company will pay $800 for the invoice. However, the company may also pay the remaining 20% / $200 after it has collected payment from the customer. In this scenario, the factoring company makes a second payment to the business for the remaining amount of the invoice minus a factoring fee.
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What is Chart of Accounts in Business Accounting?
In business accounting, a chart of accounts (COA) is a detailed list of accounts used by the respective business. It’s purpose is to define the class of items that the business pays for while also organizing the business’s finances. A typical COA contains lists the type of account and number associated with the account. Normally, account numbers in COAs are at least five digits in length. Each of these digits represents a different division within the company or department.
By defining the class of items for which a business pays, COAs help to segregate various transactions. A COA, for instance, separates expenses from revenue, allowing businesses to see a general overview of their organization’s financial health. While other lists can also reveal a business’s financial health, COAs are simple and easy to create, assuming you know how they work.
So, how are accounts listed on COAs exactly? Normally, they are listed in the order of their appearance on bank and financial statements. This means balance sheet accounts are listed first, followed by asset accounts, liability accounts, equity accounts, etc. However, being that most countries do not have a standard COA — including the United States — some companies may format their COA in a different manner. The key thing to remember when creating a COA is that it should be consistent with your business’s past practices. If use a different format, stick with that format instead of changing to a new format.
There are many different types of accounts, each of which has its own specific use. An asset account, for instance, may include bank accounts with a positive balance, cash, goodwill and accounts receivable. A liability account, on the other hand, represents debt and other financial obligations of the business, including bank loans, credit cards, bonds payable, etc. Other types of accounts used in COAs include equity accounts, revenue/income accounts, expense accounts and contra accounts.
Of course, COAs are also an important part of Quickbooks. Whether it’s Quickbooks Online or Quickbooks Desktop, a COA follows a similar principle by listing all accounts — asset, liability, equity, expense, etc. — used in a business’s transactions. This is perhaps one of the most important elements of Quickbooks accounting, as it helps to keep a business’s financial information and transactions properly organized.
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Debt Capital vs Equity Capital Financing: What You Should Know
If you’re thinking about starting your own business, you’ll need to acquire an appropriate amount of capital. Whether it’s retail, manufacturing, business-to-business services (B2B), automotive, etc., all businesses require some initial capital to turn their vision into a reality. Without capital, you won’t be able to buy inventory, hire employees, or get your business up and running. While there are dozens of different financing options for small businesses, most fall under the category of debt capital or equity capital.
Debt Capital
The most common type of financing for small businesses is debt capital. As the name suggests, this if a financing option in which an entrepreneur or business owner receives capital while taking on debt. A bank-issued business loan, for instance, is a form of debt capital. The business owner receives capital, but only under the conditions that he or she repay it, usually with interest.
The problem many small business owners face with debt capital, however, is the strict requirements for obtaining it. Banks and other financial institutions selectively choose to whom they give debt capital. They’ll look at your business’s history, credit report, income and expenses, and other factors to determine whether you’re a suitable candidate. If you don’t have a good credit score, you may have trouble getting approved for debt capital.
Equity Capital
Equity capital differs from debt in several ways, the most notable being that it doesn’t involve debt. Unlike debt capital, you don’t have to pay back capital gained through equity financing, making it an attractive choice for smaller startups without a proven track record.
So, what’s the catch with equity capital? The catch is that you must “give up” partial ownership in your business. The financing company gives you capital, while give you the financing company equity in your company. It’s a mutually beneficial form of financing: the business owner gets the cash he or she needs to run their business, while the financing company gets partial ownership in said business.
You can typically acquire equity capital more easily than debt capital, as financing companies look at your projected revenue and profit rather than historic data. With that said, some business owners aren’t willing to give up partial ownership in exchange for capital. If you’re struggling to choose between debt capital and equity capital, weigh the pros and cons of each to determine which financing options is right for you.
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What is ‘Goodwill’ in Business Accounting?
The term “goodwill” — when speaking in the context of business accounting — refers to a business’s asset that’s created and recorded when a company acquires another company. There are a few requirements for goodwill, however. The purchase price of said company, for instance, must be greater than the combination of the fair value of the tangible and intangible assets acquired, and all liabilities must be assumed when calculating this information. To learn more about goodwill and when it’s appropriate to record it in your business’s accounting books, keep reading.
It’s important to note that goodwill represents the total assets, not separate assets. It doesn’t include any identifiable assets that can be separated or divided from the company entity and sold or otherwise exchanged for money or assets. Some common identifiable assets that can not be included in goodwill are a company’s name, customer/client relationships, artistic assets, patents and proprietary practices or technologies.
The total goodwill is the excess of money paid to buy the purchased business (known as purchase consideration) over the value of the assets and liabilities. On the balance sheet, goodwill is considered an intangible asset, as it cannot be seen or touched. In comparison, tangible assets can most certainly be seen or touched.
As noted in the US GAAP and IFRS, goodwill shouldn’t be amortized. Rather, the company should value goodwill on an annual basis to determine whether or not impairment is needed. Generally speaking, if the fair market value drops below what the company was purchased for, you should record an impairment to bring the value down to the fair market. On the other hand, if the company’s fair market value increases, you do not need to account for it on your statements. Some private companies may choose to amortize goodwill over the course of 10 or fewer years as an accounting alternative.
With that said, companies in the United States do not have to amortize any goodwill recorded in their books. In 2001, this requirement was dropped, making the process of acquiring companies just a little easier.
Hopefully, this gives you a better understanding of goodwill in business accounting and why it’s used. To recap, goodwill is an intangible asset that’s created and recorded when a company buys another company. It’s reported on the buying company’s balance sheet as a noncurrent asset.
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What is a Trial Balance in Accounting?
While most business owners and professional accountants are familiar with terms like gross revenue and net profit, a lesser-known term is “trial balance.” So, what exactly is trial balance and how to you calculate it? To learn more about trial balance in accounting, keep reading.
Trial Balance: The Basics
A trial balance is essentially a list of all general ledger accounts, including revenue and capital accounts. It contains the names of all nominal ledger accounts and their respective balances.
As you may already know, every account in the nominal ledger features either a debit or credit balance. A trial balance contains two separate columns, one for the credit balances and another for the debit balances. All credit balance values are listed in the debit column, while the credit values are listed in the credit column.
Purpose of Trial Balance
Businesses use trial balances to show that the value of their debit balances is equal to the total of their credit balances. When creating a trial balance, the business owner or accountant must check to make sure the debit column is equal to the value of the credit column. If the debit column does equal this amount, there’s an error somewhere in the nominal ledger accounts, which the business owner or accountant must identify before he or she can make a profit and loss statement.
Trial balances also allow for the creation of other financial reports. Because they contain every debit recorded by the respective business, trial balances can be used for a wide variety of reports. Furthermore, they help business owners and accountants identify errors, which of course is essential in small business accounting.
How to Create a Trial Balance Report
While it may sound confusing, creating a trial balance report is actually a relatively easy and straightforward process.
A typical trial balance report contains a column for all debits and another column for all credits. There’s also a third column in which the name of these accounts are listed. A row for “sales” may reveal a $10,000 credit listed in the credit column, while a row for office renovations may have a $4,000 expense listed in the debit column. Business should create trial balance reports by including all relevant credit and debit accounts. Each debit should feature a corresponding credit entry. After completing the trial balance report, you can add the two columns up to check and see if they are equal.
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