This Accounting Basics tutorial discusses the five account types in the Chart of Accounts. We define each account type, discuss its unique characteristics, and provide examples.
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Account Type Overview
Having a good understanding of the account types is necessary for anyone creating accounts, posting transactions and journal entries, or reading financial reports. We briefly define each account type below.
Assets: tangible and intangible items that the company owns that have value (e.g. cash, computer systems, patents)Liabilities: money that the company owes to others (e.g. mortgages, vehicle loans)Equity: that portion of the total assets that the owners or stockholders of the company fully own; have paid for outrightRevenue or Income: money the company earns from its sales of products or services, and interest and dividends earned from marketable securitiesExpenses: money the company spends to produce the goods or services that it sells (e.g. office supplies, utilities, advertising)
Assets can be defined as objects or entities, whether tangible or intangible, that the company owns that have economic value. Tangible assets are physical entities that the business owns such as land, buildings, vehicles, equipment, and inventory. While Intangible assets are things that represent money or value, e.g. Accounts Receivables, patents, contracts, and certificates of deposit (CDs).
Assets are also grouped according to either their life span or liquidity – the speed at which they can be converted into cash. Current assets are items that are completely consumed, sold, or converted into cash in 12 months or less. Examples of current assets include accounts receivable and prepaid expenses.
Fixed assets are tangible assets with a life span of at least one year and usually longer. Fixed assets might include machinery, buildings, and vehicles. Fixed assets are typically not very liquid.
Because of their higher costs and longevity, assets are not expensed, but depreciated, or “written off” over a number of years according to one of several depreciation schedules.
Liabilities are the debts, or financial obligations of a business – the money the business owes to others. Liabilities are classified as current or long-term. Current liabilities are debts that are paid in 12 months or less, and consist mainly of monthly operating debts. Examples of current liabilities may include accounts payable and customer deposits.
Current liabilities are usually paid with current assets; i.e. the money in the company”s checking account. A company”s working capital is the difference between its current assets and current liabilities. Managing short-term debt and having adequate working capital is vital to a company”s long-term success.
Long-term liabilities are typically mortgages or loans used to purchase or maintain fixed assets, and are paid off in years instead of months.
Equity is of utmost importance to the business owner because it is the owner”s financial share of the company – or that portion of the total assets of the company that the owner fully owns. Equity may be in assets such as buildings and equipment, or cash. Equity is also referred to as Net Worth.
For example, if you purchase a $30,000 vehicle with a $25,000 loan and $5,000 in cash, you have acquired an asset of $30,000, but have only $5,000 of equity. The Balance Sheet equation is:
Assets = Liabilities + Owner”s Equity
We can see how this equation works with our example: $30,000 Asset = $25,000 Liability + $5,000 Owner Equity.
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Types of Equity Accounts
There are three types of Equity accounts that will meet the needs of most small businesses. These accounts have different names depending on the company structure, so we list the different account names in the chart below.
Contribution (Money Invested): There are times when company owners must invest their own money into the company. It may be start-up capital or a later infusion of cash. When this occurs, a Capital or Investment account is credited. See the first row in the table below.
Distribution or Draw (Money Withdrawn): If a business is profitable, the owners often want some of the profit returned to them. To track this activity, a Draw or Distribution account is debited. This is the only Equity account (non-contra) that receives debits. See the second row in the table below.
Accumulation from Prior Years: To tracks a company”s Net Income as it accumulates over the years, Retained Earnings or Owner”s Equity is credited. On the first day of the fiscal year, most accounting programs automatically credit this account with the previous year”s Net Income. See the third row of the table below.
NOTE: Most single-owner companies enter journal entries to “close out” the Contribution and Draw accounts to Retained Earnings on the last day of the fiscal year. Partnerships, however, may choose not to close out these accounts so that a permanent record of partner activity is maintained.
|Money invested||Owner”s Investment – or -Capital Contribution||Partner A Capital Contribution,Partner B Capital Contribution, etc.||Paid in Capital – or -Capital Contribution|
|Money withdrawn||Owner”s Draw||Partner A Draw,Partner B Draw, etc.||Distribution|
|Cumulative Earnings (less $$ withdrawn)||Owner”s Equity – or -Owner”s Capital||Partner A Equity,Partner B Equity, etc.||Retained Earnings|
Income or Revenue
Income is money the business earns from selling a product or service, or from interest and dividends on marketable securities. Other names for income are revenue, gross income, turnover, and the “top line.”
Net income is revenue less expenses. Other names for net income are profit, net profit, and the “bottom line.”
Income is “realized” differently depending on the accounting method used. When a business uses the Accrual basis accounting method, the revenue is counted as soon as an invoice is entered into the accounting system.
If the Cash basis accounting method is used, the revenue is not realized until the invoice is paid.
Income accounts are temporary or nominal accounts because their balance is reset to zero at the beginner of each new accounting period, usually a fiscal year. Most accounting programs perform this task automatically.
Expenses are expenditures, often monthly, that allow a company to operate. Examples of expenses are office supplies, utilities, rent, entertainment, and travel.
Like revenue accounts, expense accounts are temporary accounts that collect data for one accounting period and are reset to zero at the beginning of the next accounting period. Most accounting programs perform this task automatically.
A unique type of Expense account, Depreciation Expense, is used when purchasing Fixed Assets. Costly items, such as vehicles, equipment, and computer systems, are not expensed, but are depreciated or written off over the life expectancy of the item.
Another unique account is Accumulated Depreciation—a contra-account. Accumulated Depreciation is used to offset the Asset account for the item. Depreciation can be very complicated, so we recommend seeing your Accountant for help with the depreciation of Assets.
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