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November 23, 2023 - BY Pat Kearns
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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Having a good understanding of the account types is necessary for anyone creating accounts, posting transactions and journal entries, or reading financial reports.
Account Type Overview
- 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 outright
- Revenue or Income: money the company earns from its sales of products or services, and interest and dividends earned from marketable securities
- Expenses: money the company spends to produce the goods or services that it sells (e.g. office supplies, utilities, advertising)
Now let's look a closer look at each of these basic elements of accounting.
► Assets
Assets can be defined as objects or entities, whether tangible or intangible, that the company owns that have economic value to the business.
Tangible assets are physical entities that the business owns such as land, buildings, vehicles, equipment, and inventory.
Intangible assets are things that represent money or value, such as accounts receivables, patents, contracts, and certificates of deposit (CDs).
A company's assets are also grouped according to their life span and liquidity - the speed at which they can be converted into cash. Assets are classified as current assets or fixed assets.
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, or non-current 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.
Examples of asset accounts that display on the Balance Sheet include Cash, Accounts Receivable, Prepaid Expenses, Inventory, Employee Advances, Accumulated Depreciation, Furniture, and Equipment.
► Liabilities
Liabilities are the debts, or financial obligations of a business - the money the business owes to others. Liabilities are classified as current liabilities or long-term liabilities.
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, or non-current liabilities, are typically mortgages or loans used to purchase or maintain fixed assets, and are paid off in years instead of months.
Examples of liability accounts that display on the Balance Sheet include Accounts Payable, Sales Tax Payable, Payroll Liabilities, and Notes Payable.
► Equity
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 or shareholder(s) fully owns. Equity may be in assets such as buildings and equipment, or cash. Equity is also referred to as Net Worth.
Examples of equity accounts that display on the Balance Sheet include Paid in Capital, Capital Stock, Retained Earnings, Owner's Draw, Distributions, and Dividends.
The three account types we've thus far discussed, assets, liabilities, and equity, are the three elements of the accounting equation. Their relationship is shown on the Balance Sheet using the accounting equation:
Assets = Liabilities + Equity
Writing the accounting equation a bit differently often makes it easier to understand the concept of owners' equity:
Equity = Assets - Liabilities
As you can see, owner or shareholder equity is what is left over when the value of a company's total liabilities are subtracted from the value of its assets.
A decrease in liabilities increases equity, but an increase in liabilities decreases equity. Likewise, increasing assets increases equity, but a decrease in assets lowers equity.
If we purchase a $30,000 vehicle (asset) with a $25,000 loan (liability) and $5,000 in cash (equity), we've acquired an asset of $30,000, but have only $5,000 of equity in the asset.
We see this using either version of the accounting equation: $30,000 = $25,000 + $5,000 ... OR ... $5,000 = $30,000 - $25,000.
Now let's draw our attention to the three types of Equity accounts, discussed below, that will meet the needs of many small businesses.
○ Types of Equity Accounts ○
There are three types of Equity accounts that we need to know about. 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.
| Sole Proprietor | Partnership | Subchapter S Corporation | |
|---|---|---|---|
| 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
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.
Unlike liability accounts which are negative accounts and are reported on the Balance Sheet, expenses maintain a positive balance and are reported on the Income Statement or Profit and Loss Report (P&L).
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.
Summary
The major financial statements that a company produces on a regular basis report on these five account types. The Balance Sheet shows the relationship between Assets, Liabilities, and Equity, where assets normally maintain a positive balance and equity and liabilities maintain a negative balance.
Expenses and Income (revenue) are reported on the Income Statement. Also known as the Profit and Loss report, this report subtracts expenses from revenue to determine the net profit of a business.
We highly recommend Bookkeeping All-in-One for Dummies for those folks new to bookkeeping and accounting. It provides a good overview of "keeping the books" while still addressing topics such as sales and purchase transactions and financial reports.(affiliate link)
Disclaimer:: Keynote Support is providing general information in a highly readable format as a service to the visitor. We have made every effort to provide information accurate as to the date of this article. Every customer environment and each transaction is unique, so please use the information and examples in this article only as a guide. In addition, the reader cannot infer from this article that Keynote Support is providing financial or accounting advice. Consult with a financial or accounting professional for assistance with your unique requirements.
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