An accounting system is built from its 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.
In business, the term account has two related but different meanings.
Account: First Definition
Firstly, account is defined as the basic 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 category.
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 certain rights, privileges, and obligations.
Firms that sell to other businesses typically 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 actually carry customers as accounting systems accounts (as in the first definition above). Banks, for instance, carry 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, explain, and illustrate the term account. This term appears in context with account-related terms such as the following:
- What is an account?
- Account, First definition: Accounts are the basic building blocks of an accounting system
- The five account categories: Revenue, Expense, Asset, Liability, Equity.
- Debits and Credits for account categories.
- Debits and Credits maintain Balance sheet balance.
- What are contra accounts (valuation allowance accounts)?
- What is a chart of accounts?
- Account, Second definition: Account as a seller-customer relationship.
- 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.
In business, each profit-making firm creates and uses an accounting system in order to manage and keep track of the firm'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 simply a record for registering values and changes in value for one specific item or class of items. Each account has the following properties:
- 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.
- A unique account name and number. (See the Exhibit 5 Chart of Accounts below for examples).
- 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."
Each account, therefore, serves to manage and track an item or item class. For accounting purposes, in fact, "items" appear in the five categories appearing 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.
- 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
- Liability accounts.
Liabilities are debts the business owes to creditors. Long term liabilities typically include obligations to lending firms and bond holders. Short term liabilities, on the other hand, represent near term obligations incurred in operating the business.
Example-4: Accounts payable.
Example-5: Salaries payable.
Example-6: Bonds payable.
- 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.
- 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
- 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 very 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).
Every financial transaction for the firm changes account balances. If the company 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 change in one account is a debit and the change in another account is a credit.
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 own 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 in different kinds of accounts.
Suppose, for example, a firm acquires assets valued at $100,000. As a result, the firm increases (debits) an asset account $100,000. This could be "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. This 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 own 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.
Not all accounts work additively with each other on the primary financial accounting reports. Sometime one account works to offset the impact of another account. 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. This is because they work to adjust the book value, or carrying 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 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."
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 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 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 transactions 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, 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 appear as follows in the bookkeeper's journal (the chronological record of transactions):
Journal for Fiscal Year 20YY
630 Bad debt expense
670 Depreciation expense, factory manufacturing equip
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 are reversed, 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 hold 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 example, 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 normally a credit, but an 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.
Firms begin setting up a new accounting system by creating a Chart of accounts. This is simply 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 completing the cycle every fiscal quarter as well as the fiscal year. Exhibit 4 below, shows how account information moves through the cycle.
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 simply use the program's default suggestions, but most will tailor the list to better fit their own 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 include accounts from 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 a many customers, most of whom need their own "accounts."
- On the other hand, the materiality concept suggests that small, trivial, or rarely used items can be omitted. When these transactions do occur, they can be entered 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.
- Where the account lists 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 scheme 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 , later, 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, while long term assets have higher numbers.
- 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.
The Exhibit 5 Chart of accounts, below, is essentially just an extract from real a chart of accounts. Its purpose is to show the general approach to account numbering and naming. A more complete example—even for a very 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
|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|
150 - 189 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|
190 - 199 Asset Accounts - Other Assets
|194||Notes receivable, non current|
200 - 249 Liability Accounts - Current Liabilities
250 - 299 Liability Accounts - Long Term Liabilities
|260||Bonds payable |
|270||Discount on bonds payable|
|280||Bank loans payable|
300 - 399 Equity Accounts
400- 499 Revenue Accounts
|410||Product sales revenues|
|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
|630||Bad debt expense|
|640||Salary and wage expense|
|660||Equipment lease expense|
|670||Depreciation expense, vehicles|
|680||Depreciation expense, factory mfr. equipment|
700 - 799 Other Revenues
800 -899 Expense Accounts - Other
|800||Income tax expense|
Exhibit 5. Example Chart of accounts for a small firm. The chart simply lists of accounts by name and reference number. Note especially that for a large and complex business, the chart may include hundreds or thousands of accounts.
In many kinds of situations, customers enter a kind of 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 period of time, 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 typically 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 the account, and receive interest payments for deposited funds. The bank (the seller) on the other hand, may use the depositor's funds for its own 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 carry loan customers as Asset accounts.