What is an account?
The term account is used broadly in business in at least two related but different ways:
First, an account refers to a formal business agreement between two parties, usually a seller and a customer, with certain rights, privileges, and obligations for each party. Such an account can be described as a record of the relationship between two parties.
Second, an account is one of the elementary building blocks of an accounting system. An individual account in this sense is a record of the current balance and transaction history of a specific asset, liability, owner’s equity, revenue or expense item.
The discussion below is concerned primarily with defining, explaining, and illustrating account as an accounting concept (the second meaning above), along with related terms such as double entry bookkeeping, contra account, valuation allowance account, and chart of accounts.
How is the term account used in the seller–customer relationship?
In many kinds of situations, customers establish a special kind of relationship with sellers by creating an account with the seller. The relationship between seller and customer is then different from the customer/seller relationship involved in a one-time purchase transaction.
The account implies the relationship will continue for a period of time, during which seller and customer have rights, privileges, and obligations towards each other, which do not apply to those who are without the account relationship.
A customer with a bank account, for instance, may have the right to deposit and withdraw funds, write checks against the account, and receive interest payments for the bank's use of depositor funds. The bank (the seller) on the other hand, may have the right to use the depositor's funds for its own investments and charge the account holder maintenance fees.
Many sellers recognize the special relationship they have with their customers by calling each customer an "account," for which they plan and dedicate sales and service resources.
How does the account serve as the fundamental building block of an accounting an accounting system?
In business, each profit making company establishes an accounting system in order to manage and keep track of incoming and outgoing funds. The accounting system also provides the basis the basis for financial reports the company must file periodically.
The basic building block in such a system is the account, which can be defined as a place for recording changes in value (additions and subtractions) for one specific purpose. In fact, "specific purposes" are divided into five categories, and these categories represent the five—the only five—kinds of accounts possible in an accounting system based on double-entry principles:
First, there are the so-called "balance sheet" kinds of accounts:
1. Asset accounts: Things of value that are owned and used by the business.
Example: Cash on hand
Example: Accounts receivable
2. Liability accounts: Debts that are owed by the business.
Example: Accounts payable
Example: Salaries payable
3. Equity accounts: The owner's claim to business assets.
Example: Owner capital
Example: Retained earnings
Secondly, there are the so-called "income statement" kinds of accounts"
4. Revenue accounts: The amounts earned from the sale of goods and services.
Example: Product sales revenues
Example: Interest earned revenues
5. Expense accounts: Costs incurred in the course of business.
Example: Direct labor costs
Example: Advertising expenses
In reality, even a very small business may identify a hundred or more such accounts for its accounting system, and a very large company may identify many thousands. Nevertheless, for bookkeeping and accounting purposes, all named accounts fall into one of the five categories above (see Chart of accounts, below).
Every financial transaction for the company is recorded as a change in an account. If the company uses double-entry book keeping (as nearly all companies do), every financial transaction causes two equal and offsetting account changes, the change in one account called a debit and the change in another account called a credit.
In the double entry system, just how the bookkeeper and account handle each transaction for an account depends on which of the five account categories the account belongs to. Whether a debit or a credit increases or decreases the account balance depends on the kind of account involved:
|Debit (DR) Entry ...||Credit (CR) Entry ...|
|Asset account||Increases (adds to) account balance||Decreases (subtracts from) account balance|
|Liability account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|Equity account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|Revenue account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|Expense account||Increases (adds to) account balance||Decreases (subtracts from) account balance|
Suppose, for example, that a company acquires assets valued at $100,000. An asset account will increase (be debited) $100,000 (perhaps asset Account 163 from the chart of accounts below, Factory manufacturing equipment). The increase in account balance is called a debit because this is an asset account. However, the balance sheet is now temporarily out of balance until there is an offsetting credit of $100,000 to another account, somewhere in the accounting system. This could be, for instance:
- A credit of $100,000 to another asset account, reducing that account value by $100,000 (from the chart of accounts below, that could be a credit to asset Account 101, Cash on hand).
- If the asset purchase is financed with a bank loan instead of the company's cash, however, the offsetting transaction could be a credit to a liability account, increasing that account value by $100,000 (which could be Account 171, Bank loans payable).
In this way, the basic accounting equation always holds and the balance sheet stays balanced:
Assets = Liabilities + Equities
And, for every pair of account entries that follow from a single transaction:
Debits = Credits
See the encyclopedia Double entry system for more on the accounting mathematics involved in double entry bookkeeping.
What is a contra account (Valuation allowance account)?
Not all accounts work additively with each other on the primary financial accounting reports—especially on the income statement and balance sheet. There are many instances where one account works to offset the impact of another account. The so-called contra accounts "work against" other accounts in this way. In some situations, the contra accounts reverse the debit and credit rules from the table above.
Contra-asset and contra-liability accounts are also called valuation allowance accounts, because they work to adjust the book value, or carrying value for assets or liabilities, as shown in the examples below.
The balance sheet example running throughout this encyclopedia has several contra account examples, including these under Assets:
You may notice from the chart of accounts example below, that Accounts receivable (Account 110 from the chart) and Allowance for doubtful accounts (Account 120) are both asset accounts. Allowance for doubtful accounts, however, is a contra asset account that reduces the impact (carrying value) contributed by Accounts receivable. The balance sheet result is a "Net accounts receivable" less than the Accounts receivable value.
In the same way, Account 163, Factory Manufacturing equipment carries the value of these assets at historical cost—what was actually paid for these assets. This will not decrease as long as the company owns the assets. However, the asset's book value does change downward from year to year, as shown on the balance sheet. Contra Account 175, Accumulated depreciation, factory manufacturing equipment, is subtracted from the Account 163 value, to produce the balance sheet result Net factory manufacturing equipment.
In each case above, incidentally there is also an expense category account involved, and those appear on the income statement, not the balance sheet. In the first example, the expense account is Bad debt expense and in the second case, the expense account is Depreciation expense, factory machinery. The offsetting debit and credit transactions might look like this way in the bookkeeper's journal (the chronological record of transactions):
Journal for Fiscal Year 20YY
630 Bad debt expense
770 Depreciation expense, factory manufacturing equip
All four transactions add to the value of the accounts listed. Debiting each of the two expense accounts adds to account value, as you would expect from the table in the previous section. However notice here that crediting the two asset accounts adds to their value as well—just the opposite of what the same table prescribes for asset accounts. For contra accounts in this situation the rules are reversed, so that the fundamental equation Debits = Credits still holds for every pair of transactions. The examples also show why a contra asset account is said to hold a credit balance.
The above examples show contra-asset accounts, but there are also examples of contra-liability accounts that operate in the same way. For example, on the liabilities side of the balance sheet, a long term liability account Bonds payable may be accompanied by another liability account, a contra liability account called Discounts on bonds payable. The value in the contra account reduces the company's actual liability from the stated figure in the Bonds payable account.
Contra liability accounts—like their contra asset account counterparts—also reverse the debit/credit "rules" from the table in the previous section. An addition to a liability account is normally a credit, but to a contra liability account, an addition is a debit. For this reason, contra liability accounts are said to carry a debit balance.
The meaning of Chart of accounts and Chart of accounts example
One of the first steps in setting up a new accounting system is the creation of a chart of accounts, which is simply a list—the complete list—of named accounts that the company expects to use for recording and reporting financial transactions.
The same list of accounts will be in view throughout the company's entire accounting/bookkeeping cycle. When transactions occur:
- Transactions, as debits or credits to accounts, are entered first in a journal. Journals record transactions chronologically, that is, in the order they occur. This and the next step are normally the responsibility of bookkeepers.
- The next step occurs when the journal transactions are transferred (posted) to a ledger. ( A ledger is a collection of accounts, organized by account type and purpose).
- Finally, the ledger transactions contribute to the financial accounting statements, starting with the income statement and balance sheet, but also including Statement of changes in financial position and statement of retained earnings. The preparation of these reports from ledger entries is normally the responsibility of an accountant.
When setting up an accounting system using an accounting software application, the software will at the outset suggest account names for the chart of accounts, based on the size of the company and the nature of its business. Some small companies will simply use the program's default suggestions, but others will tailor the list to better fit their own situation. In any case the accountant, consultant, or business owner setting up the chart of accounts should be guided by these objectives for the chart:
- Accounts must be included to represent all of the five basic account categories (assets, liabilities, equities, revenues, and expenses).
- The chart should include enough named accounts to provide the resolution management will need to control and manage operations effectively (i.e., there should be enough accounts to show separately each area or entity of interest).
- On the other hand, the materiality concept suggests that accounts for trivial, small, or rarely used items can be omitted. When these transactions do occur, they will be entered under the headings of a few more general and inclusive accounts.
- Each account should have a unique number as well as a name. Account numbers should be chosen to show which category an account belongs to, and which accounts within category are similar to each other (see the example chart of accounts extract below).
- The initial set of account numbers should allow for later expansion of the list. E.g. the chart might initially list Account 140, Prepaid Expenses, followed by Account 150, Employee Advances. If the need arises later to add another account between these two, there are nine account numbers available.
Example chart of accounts.
The example chart of accounts below is really better described as an extract from a chart of accounts, rather than a complete chart. It shows the structure and general approach to account numbering and naming, but a complete example—even for a very small company—would no doubt list many more accounts.
|Acct No||CHART OF ACCOUNTS|
|Asset Accounts - Current Assets|
|101||Cash on hand|
|103||Regular checking account|
|105||Payroll checking account|
|120||Allowance for doubtful accounts|
|130||Work in progress inventory|
|139||Finished goods inventory|
|Asset Accounts - Fixed Assets|
|160||Furniture and fixtures|
|163||Factory manufacturing equipment|
|170||Accumulated depreciation, furniture, fixtures|
|172||Accumulated depreciation, vehicles|
|175||Accumulated depreciation, factory mfr equip.|
|179||Accumulated depreciation, buildings|
|Asset Accounts - Other Assets|
|194||Notes receivable, non current|
|Liability Accounts - Current Liabilities|
|Liability Accounts - Long Term Liabilities|
|260||Bonds payable |
|270||Discount on bonds payable|
|280||Bank loans payable|
|410||Product sales revenues|
|430||Rental property revenues|
|450||Interest earned revenues|
|Expense Accounts - Cost of Goods Sold|
|520||Raw materials costs|
|530||Direct labor costs|
|540||Indirect labor costs|
|550||Manufacturing plant costs|
|Expense Accounts - Other|
|630||Bad debt expense|
|720||Salary and wage expense|
|750||Equipment lease expense|
|760||Depreciation expense, vehicles|
|770||Depreciation expense, factory mfr equipment|