eRank does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors.
Let’s face it – accounting is a part of every business including a handmade business. Everyone understands that accounting is tracking your money, what you are paid and what you spend.
Beyond that, though, you may hear other terms and not know exactly what they mean and how they apply to your business. It is important to understand the accounting terms, whether you are doing your own accounting or are outsourcing your accounting to someone else.
Let’s Speak Accounting!
This list contains some of the most common accounting terms, but it is not a complete list of all terms. If we covered all the accounting terms, this would become more of a book length, and many of you would start nodding off. However, if you are interested in learning more accounting terms, the New York State Society of Certified Public Accountants (NYSSCPA) has created a very thorough glossary
You may hear someone talk about double-entry versus single-entry accounting. Both types of accounting have two sides to every entry. In single-entry accounting, the second side of the transaction entry is always assumed to be cash and not physically recorded. In double-entry accounting, which is the type that most accounting software uses, you see both sides of the transaction entered.
For example, you purchase some fabric to create your handmade item. The two sides of the transaction are cash and inventory, which can be recorded using either method. Double-entry accounting allows for a different recording of the transaction. If you purchased the fabric on your credit card, the two sides of the transaction are now credit and inventory.
Chart of Accounts
The chart of accounts is the center of all your accounting. It is a list of all the different types of income and expenses related to your business as well as your bank accounts, any money owed to you, or any money you owe.
The accounts can be a name or a combination of a name and a number and are typically grouped together into categories based on the different types of accounts. The chart of accounts can be as simple or detailed as you need for your business. Here is an example of a basic chart of accounts.
Debits and Credits
Most of us have heard the terms debits and credits used in some form of our daily lives. Debits and credits are the way that the accounts in your chart of accounts increase or decrease in value and whether it increases or decreases depends upon the type of account. The banking institution uses the terms quite regularly, but this is where confusion may occur.
In banking terms, a credit increases your bank balance, and a debit decreases the value. However, in accounting terms, a debit to your bank account increases the value, and a credit to your bank account decreases the value. Luckily, with today’s accounting software programs, you do not have to remember what action a debit or credit has on each type of account. However, if you would like a cheat sheet of each account type, here is one to download.
Four main financial statements exist. With most small businesses, however, there are two that are used regularly: Income Statement and Balance Sheet. The Income Statement is also known as a Profit and Loss Statement or a P&L Statement. All three terms mean the same report and are used interchangeably.
The P&L shows all the income received and all the expenses purchased for a specified period of time. It will show you whether you made money or lost money for that period of time. It is a valuable report and should be reviewed regularly.
While the P&L shows you what your business is doing in a specified period, the Balance Sheet gives you a view of the value of your business over all. It shows all the assets of the business including the current balance of your checking account and any money owed to you by customers as well as the current balance of any loans or credit that you owe along with any outstanding bills that you owe. If you are applying for any type of loan or credit, the financial institution will want to see both these statements.
Income and Expenses
Income and expense accounts show the activity of your handmade business. Income may also be called revenue or sales, and it is the amount that you received from a customer that purchased your handmade item.
Expenses are the amount that you paid to operate your business such as utilities, supplies, and rent. As you can probably guess, the income and expense accounts are listed on your Income Statement or P&L and will net together to show what type of profit your handmade business makes.
Receivables and Payables
Receivables may also be referred to as accounts receivable or AR, and payables may be referred to as accounts payable or AP. All the terms are interchangeable and come down to personal preference. AR is the money that customers owe to you, that you are to “receive” in the future. AP is the money that you owe to someone such as the electric company, a supplier, or other vendor and are to “pay” in the future.
The current balance of the AR and AP accounts are shown on your Balance Sheet. Receivables and payables are used in accrual-basis accounting. See the next section for more information on accrual-basis accounting.
Cash versus Accrual
If you are setting up a new accounting software or outsourcing your accounting work, you will be asked if you are a cash-basis or accrual-basis business. What does this mean? Cash-basis means that money received and money paid is recognized on your financial statement when money changes hands. If someone buys one of your handmade items, when you receive the cash, you record the transaction as income to your business. However, if the customer purchases the handmade item on account, meaning that they will pay you later for it, you do not recognize the income until he pays you.
In accrual-basis accounting, you record the income or expense when the transaction occurs, even if no money is exchanged. To record the transaction, accounts receivable or accounts payable will be used as the second side of the transaction instead of cash.
Most small businesses including handmade businesses elect to be a cash-basis business because it simplifies the accounting and gives a current picture of your business with regards to cash. No accounting for future income or expenses is included on the P&L with cash-basis accounting.
The above seven sections of accounting terms provide a good start to be able to “speak accounting” when necessary. All business owners need to at least understand the basis of their accounting, even if they are not performing the accounting for their business.
Hopefully, this article helps you understand your handmade business’s accounting and what is included in the process of tracking your income and expenses.
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Michelle Badger, Accountant (25 + years) and Etsy seller