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Account, Contra Account, Chart of Accounts
Explaining Definitions, Meaning, Account Examples

 

The accounting system is the living embodiment of the Chart of Accounts. Each account records the history and current balance of an asset, liability, equity, revenue, or expense item. After a reporting period, firms publish account balances in financial reports such as the Income statement and Balance sheet.

The account is the basic building block of the accounting system.

What is An Account?

In business, the term account has two related but different meanings.

Account: First Definition

Firstly, an account is a fundamental building block of an accounting system.

  • An individual account records the current balance and transaction history of a specific asset, liability, owner’s equity, revenue or expense item.
  • A firm's accounting system may consist of scores, hundreds, or thousands of individual accounts.

The complete list of active accounts resides in the firm's Chart of Accounts. Responsibility for updating and reporting account balances falls to the firm's accountants, who serve literally as "keepers of the accounts." Sections below further define account categories and illustrate typical transactions for each account type.

Account: Second Definition

Secondly, "account" refers to a formal business relationship between two parties, usually a seller and a customer. When one is an account of the other, each party has particular rights, privileges, and obligations.

Firms that sell to other businesses designate their major repeat customers as accounts. In such cases, the seller may appoint one of its own sales staff as "Account Manager," dedicated to that account. Account managers in this sense are responsible for sales performance with this customer. And, they are also responsible for building a continuing customer-seller relationship with the account.

In some cases, the seller may carry customers as accounting systems accounts (as in the first definition above). Banks, for instance, refer to depositor customers as Liability accounts. And, banks carry loan customers as asset accounts.

Account, Contra Account, and Chart of Accounts Explained in Context

Sections below further define and illustrate the term account. This term appears in context with account-related concepts such as the following:

Account
Contra Account
Assets Account
Liability Account
Equity Account
Revenue Account
Expense Account
Accountant
Chart of Accounts
Valuation Allowance Account
Double Entry Accounting
Debit
Credit
Journal
Ledger
Credit Balance
Debit Balance
Account Manager


 

Contents

Related Topics

  • Accrual Accounting presents an introduction to the account role in an accrual system.
  • See articles Journal and Ledger for more on account entry and account posting in the accounting system.
  • The article Trial Balance explains how account balances transfer to financial statements at the end of an accounting period.
 

Accounting System Building Block
Primary Definition for Account

In business, each profit-making firm creates and uses an accounting system to manage and keep track of the company's:

  • Incoming revenues and outgoing expenses.
  • Assets, liabilities, and equities.

These five kinds of items, in fact, represent the five account categories in an accrual accounting system. As a result, the accrual accounting system also provides the basis for the financial reports the firm must file periodically.

The basic system building block is the account.An account is merely a record for registering values and changes in amount for one specific item or item class. Each account has the following properties:

  1. An account category: Revenue, Expense, Asset, Liability, or Equity. All accounts must belong to one of these categories, although sub-categories also exist, as sections below explain, such as contra accounts or non-cash accounts.
  2. A unique account name and number. (See the Exhibit 5 Chart of Accounts below for examples).
  3. A balance. For Asset and Expense accounts, a "positive" balance is a debit balance. For Revenue, Liability, and Equity accounts, a "positive" balance is a credit balance.

The term gives its name to the profession, accounting or accountancy. A practitioner with the necessary training and certification is an accountant. The accountant's role is literally "keeper of the accounts."

Accounts in Five Basic Categories
Asset, Liability, Equity, Revenue, Expense

Each "account," therefore, serves to manage and track an item or item class. For accounting purposes, in fact, "items" appear in the above five above. And, for firms that use accrual accounting, these five are the only kinds of accounts possible in the accounting system.

Firstly, the system includes three kinds of Balance sheet accounts.

  1. Asset accounts.
    These represent items of value the firm owns or controls, and uses for earning revenues.  
        Example-1: Cash on Hand.
        Example-2: Accounts Receivable.
        Example-3: Property, Plant, & Equipment
  2. Liability accounts.
    Liabilities are debts the business owes to creditors. "Long-term liabilities" typically include obligations to lending firms and bondholders. Short-term liabilities, on the other hand, represent near-term debts incurred in operating the business.
        Example-4: AccountsPayable.
        Example-5: Salaries Payable.
        Example-6: Bonds Payable.
  3. Equity accounts.
    Equities are items the firm owns outright. As such, "equities" represent owners claims to business assets.
        Example-7: Owner Capital.
       Example-8: Retained Earnings.

Double entry accounting ensures that account balances, at all times maintain the "balance" in the so-called Balance sheet equation:

Assets = Liabilities + Equities

Secondly, the accounting system includes two kinds of Income statement accounts

  1. Revenue accounts
    In business, firms earn revenues from the sale of goods and services, or from investments.
        Example-9: Product sales revenues
        Example-10: Interest earned revenues
  2. Expense accounts:
    These accounts represent expenses incurred in the course of business.
        Example-11: Direct labor costs
        Example-12: Advertising expenses

At the end of the reporting period, firms report revenue and expense account balances in the structure of the Income statement equation:

Net Income = Revenues – Expenses

In reality, even a small business may identify a hundred or more such accounts for its accounting system, while a large firm may have many thousands. Nevertheless, for accounting purposes, all named accounts fall into one of the five categories above (see Chart of accounts, below).

Debits and Credits for Different Account Categories
How They Change Account Balances

Every financial transaction for the company changes the balance of accounts. If the firm uses double-entry accounting (as nearly all companies do), every financial transaction causes two equal and offsetting changes to at least two different accounts. The impact in one is a "debit" (DR), and the change in another is a "credit" (CR).

Those unfamiliar with double-entry accounting sometimes assume that a "Credit" adds to the balance and that a "Debit" lowers the balance. In fact, this is sometimes true but not always. Many people are familiar with the terms debit and credit from managing their bank statements, on which banks "credit" (add to) and "debit (subtract from) their checking accounts.

In the double-entry system, however, whether a debit or a credit increases or decreases the account balance depends on the kind of account involved. The bank statement usage is in fact technically correct, but only because the checking account owner is—to the bank—a liability account.

Exhibit 1, below summarizes Debit and Credit impacts in the five account categories.

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

Exhibit 1. Debits and Credits have different impacts on different account types.

 

The Balance Sheet Always Balances
Debits and Credits Together Maintain the Balance

Suppose, for example, that a firm acquires assets valued at $100,000. As a result, the firm increases (debits) an asset account for $100,000. This impact could occur in "Account 163, Factory manufacturing equipment" from the Chart of accounts below. Here, the increase is a "debit" because this is an asset account.

After just one debit transaction, however, the Balance sheet now needs an offsetting credit of $100,000 to another account, to restore its balance. The offset could be either of the following:

  • A "credit" of $100,000 to another asset account reduces that account value by $100,000. If the firm purchased with its cash, it could credit asset account "101, Cash on hand" to restore the Balance sheet balance.
  • If instead, the firm finances the purchase with a bank loan, the offsetting transaction could be a credit to a liability account. Increasing (crediting) "Account 171, Bank loans payable" by $100,000 would restore the Balance sheet balance.

In this way, the basic accounting equation always holds, and the Balance sheet stays balanced:

Assets = Liabilities + Equities

Also, 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 accounting.

What is a Contra (Valuation Allowance) Account?
Contra Accounts Reverse the Rules

Not all accounts work additively with each other on the primary financial accounting reports. Sometimes one "account" works to offset the impact of another "account" of the same type. The so-called contra accounts"work against" other accounts in this way. And, in some situations, the contra accounts reverse the debit and credit rules from Exhibit 1 above.

Contra asset and contra liability accounts are also called valuation allowance accounts. They have this name because they work to adjust the book value, or carrying book value for assets or liabilities, as the examples below show.

Example: Balance Sheet Contra Accounts

The Balance sheet example running throughout this encyclopedia has several contra account examples. Under Balance sheet assets, for instance, these accounts include "Allowance for doubtful accounts" and "Accumulated depreciation. Exhibit 2, below, shows how the contra accounts "work against" other asset accounts, "Accounts receivable" and "Factory manufacturing equipment."

 

Exhibit 2. Contra asset accounts impact on Balance sheet asset accounts.

You may notice from the Chart of accounts example in Exhibit 5 below, that "Accounts receivable" (Account 110) 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" values these assets at historical cost—the actual purchase price for these assets. This book value remains constant as long as the firm owns the assets. However, the asset's book value does reduce from year to year, as the Balance sheet shows. 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."

Depreciation Turns Asset Book Value Into Expense

Note, by the way, that depreciation expense works in this way to implement the accounting matching concept. This idea is the universally recognized principle that firms report revenues when they earn them, matched in the same period with the expenses that brought them.

The complication results from the accounting definition of expense: An expense is a decrease in owner's equity caused by the using up of assets. The funds for asset purchase are not an expense—at least not at the time of asset purchase. The assumption in financial accounting is that assets are used up over time,thereby incurring "expenses" over time. As a result, depreciation methods allow owners to turn asset purchase price into depreciation expense, over time.

Two Journal transactions for writing off debt and two for charging depreciation expense.

Each Balance sheet asset item in Exhibit 2, incidentally, also involves an Income statement "Expense category" account. These expense impacts appear on the Income statement, but not on 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 appear as follows in the bookkeeper's journal (the chronological record):

Grande Corporation
Journal for Fiscal Year 20YY
Date AccountDebit
Credit

30-Jun-20YY
30-Jun-20YY

31-Jul-20YY
31-Jul-20YY

 630  Bad debt expense
 120       Allowance for doubtful accounts

 670  Depreciation expense, factory manufacturing equip
 175       Accumulated depreciation expense, factory
              manufacturing equipment

$137,000


$2,782,000

$137,000



$2,782,000

Exhibit 3. Journal entries for writing off bad debt and for entering charging a depreciation expense.

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 reverse, so that the basic equation, Debits = Credits, still holds for every pair of transactions. The examples also show why a contra asset account is said to keep a credit balance.

Contra Liability Accounts

The above examples show contra-asset accounts, but there are also contra-liability accounts that operate in the same way. For instance, under Balance sheet Liabilities,  a long-term liability account "Bonds payable" may have with it a contra liability account such as "Discounts on bonds payable." The value in the contra account reduces the company's actual liability below 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 Exhibit 1 table above. An addition to a liability account is usually a credit, but a similar addition to a contra liability account is a debit. For this reason, contra liability accounts are said to carry a debit balance, even though liability accounts ordinarily carry a credit balance.

The Chart of Accounts and the Accounting Cycle

Firms begin setting up a new accounting system by creating a Chart of accounts. This chart is merely a list—the complete list—of named accounts the company expects to use for recording and reporting financial transactions.

Accounts in the Accounting Cycle

The same list of accounts remains in view throughout the firm's entire accounting cycle. Business firms complete the full accounting cycle every reporting period. For public companies, this means ending a cycle every fiscal quarter as well as the fiscal year. Exhibit 4 below, shows how account information moves through the period.

 

Exhibit 2. The accounting cycle. Transactions (Step 1) enter the journal when they occur, as the 2nd step in the accounting cycle. Accountants transfer (post) journal entries to a ledger as the 3rd step. As a 4th step, they check entries with a trial balance and correct them if necessary. The final stage occurs when the firm publishes financial statements. Note, however, however, that public companies must also complete the cycle by having reports audited and then filing them with securities authorities.


Setting Up the Chart of Accounts

When setting up an accounting system using a commercially-available accounting application, the software will at the outset suggest account names and reference numbers for the Chart of accounts. It will base suggestions on the size and complexity of the company and the nature of its business. Some small firms will merely use the program's default suggestions, but most will tailor the list to fit their situations.

In any case, the accountant, consultant, or business owner setting up the Chart of accounts should pursue several objectives for the chart:

  • The chart must represent all five basic account categories (assets, liabilities, equities, revenues, and expenses).
  • The chart should include enough accounts to provide the resolution managers needs to control and manage operations effectively. They may need, therefore, to add quite a few additional accounts, especially where:
    • The firm has a complex organizational structure.
    • The firm has a complex cost structure.
    • It produces and sells many different products or services.
    • The firm has many customers, most of whom need their own "accounts."
  • On the other hand, the materiality concept suggests that firms can disregard small, trivial, or rarely used items. When these transactions do occur, the accountant can enter them under the headings of a few  more general and inclusive accounts—such as "Miscellaneous expense."

Reference Numbers Organize the Chart of Accounts.

Notice that Exhibit 3 journal entries identify each account with both a number and name. And, the example Chart of accounts in Exhibit 5, below, also shows account names with reference numbers (identifiers). In principle, these numbers could be anything. In practice, however, accountants use a numbering system that helps software and human accountants alike recognize immediately:

  • The account category.
  • The rank order of the account within its category.

Account numbering systems usually use 3 - 6 digits to identify each account. A typical 3-digit system might assign numbers as follows:

Three Digit Identifier System

   100 - 199   Asset accounts
   200 - 199   Liability accounts
   300 - 399   Equity accounts
   400 - 499   Revenue accounts primary business
   500 - 599   Expense accounts - Cost of Goods Sold (Expense accounts) 
   600 - 699   Expense accounts - Other operating expenses
   700 - 799   "Other revenue" (e.g., interest income)
   800 - 899   "Other expenses" (e.g., income taxes)

The example Chart of Accounts in Exhibit 5, below, uses this 3-digit scheme. This approach allows for at most 100 individual accounts in each tier (e.g., Asset accounts). A 4-digit plan would, of course, designate asset accounts with the range 1000 - 1999, allowing for a possible 1,000 different accounts in that tier.

Regardless of how many digits the firm uses, numbering systems usually follow these principles:

  • The first digit signals immediately the account category. Therefore, an account number beginning with 1, for instance, must be an asset account.
  • The initial account number set should allow for later expansion. E.g., the chart might initially list Account 140, Prepaid Expenses, followed by Account 150, Employee Advances. If then, the firm needs to add accounts between these two, there are nine new account numbers available.
  • Numbers after the first digit organize accounts roughly in order of currency.
    • "Current asset" accounts have lower numbers than "Long-term asset" accounts for that reason.
    • Current liabilities accounts have lower numbers than long-term liabilities accounts.
    • Revenue and expense accounts carry numbers roughly in the order they appear on the Income statement.

Example Chart of Accounts

The Exhibit 5 Chart of accounts, below, is just an extract from real a chart of accounts. Its purpose is to show the general approach to account numbering and naming. A complete example—even for a small company—would no doubt list many more accounts.

GRANDE CORPORATION CHART OF ACCOUNTS 1- January 20XX

Acct No Account Name

100 - 149 Asset Accounts - Current Assets

100 Petty cash
101 Cash on hand
103 Regular checking account
105 Payroll checking account
110 Accounts receivable
120 Allowance for doubtful accounts
130   Work in progress inventory
139   Finished goods inventory
140   Prepaid expenses
149   Employee advances

150 - 189 Asset Accounts - Fixed Assets

160   Furniture and fixtures
162   Vehicles
163   Factory manufacturing equipment
165   Buildings
169 Land
170 Accumulated depreciation, furniture, fixtures
172 Accumulated depreciation, vehicles
175 Accumulated depreciation, factory mfr equip.
179 Accumulated depreciation, buildings

190 - 199 Asset Accounts - Other Assets

190 Accumulated amortization
194 Notes receivable, non-current

200 - 249 Liability Accounts - Current Liabilities

200 Accounts payable
234 Payroll payable
235 Accrued fees
240 Accrued interest

250 - 299Liability Accounts - Long-Term Liabilities

260 Bonds payable
270 Discount on bonds payable
280 Bank loans payable
290 Equipment payable

300 - 399 Equity Accounts

320 Owner capital
350 Retained earnings
380 Dividends

400- 499 Revenue Accounts

410 Product sales revenues
420 Services sales
430 Rental property revenues
450 Interest earned revenues

500 - 599 Expense Accounts - Cost of Goods Sold

520 Raw materials costs
530 Direct labor costs
540 Indirect labor costs
550 Manufacturing plant costs

600 - 699 Expense Accounts - Other Operating Expenses

601 Supplies Expense
630 Bad debt Expense
635 Advertising Expense
640 Salary and wage Expense
650 Travel Expenses
660 Equipment lease Expense
670 Depreciation expense, vehicles
680   Depreciation expense, factory mfr. equipment

700 - 799 Other Revenues

750 Interest Income

800 -899 Expense Accounts - Other

800 Income tax expense

Exhibit 5. Example Chart of accounts for a small firm. The chart is a list of account names and reference number. Note especially that for a large and complex business, the list may include hundreds or thousands of items.

Accounts in the Seller-Customer Relationship
Second Definition for Account

In many kinds of situations, customers enter a relationship with sellers by creating accounts with them. The relationship between seller and customer then differs from the customer-seller relationship involved in a one-time purchase transaction.

The account implies the relationship will continue for a timespan, during which seller and customer have rights, privileges, and obligations towards each other. These are not available to those without the account relationship.

  • Firms that sell to other businesses recognize repeat customers as accounts. The seller may designate one of its own sales staff as dedicated Account Manager for that customer. Account managers of this kind are responsible for account planning and building a continuing relationship with the customer. They are also responsible for sales performance with this customer.
  • A bank customer with a bank account, for instance, has a right to deposit and withdraw funds, write checks against that account, and receive interest payments for funds on deposit. The bank (the seller) on the other hand, may use the depositor's funds for its investments and charge the account holder maintenance fees.
  • Retail merchants sometimes recognize specific customers as accounts. Account holders may have the right to charge purchases with merchant-issued credit and make monthly payments on their account balance.

Sellers and service providers sometimes actually create for each customer an accounting system account. Banks, for instance, carry depositor customers as Liability accounts. And, the same banks recognize loan customers as Asset accounts.

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