The Five Major Types of Accounts
If you’ve heard about debits and credits, you’ll know that the actions of debiting and crediting have an impact on certain accounts by increasing and decreasing them. But, how much do you know about the accounts they affect?
Each time you buy or sell a product or a service, you are required to record the transaction in the corresponding account. In other words, you need to keep your business accounting books updated at all times. That way, you can track all the money going out of and coming into your business. Moreover, you’ll know exactly how much money you have in each account. Unless you sort and track your transactions by accounts, you won’t make accurate financial statements and sensible business decisions.
Most businesses list their accounts by keeping a chart of accounts (COA) – a document that lets you organize your account types, number each account, and quickly find information about any past transaction.
There are five different types of accounts in accounting that provide a structure to the chart of accounts, namely assets, expenses, liabilities, equity, and revenue. Given that their role is to define your business’s channels for spending or receiving money, each account category can be further broken down into several subcategories. It’s also important to note that the five major accounts are interrelated. Therefore, a change in one account triggers a chain reaction, making the other accounts change as well.
In this article, we’ve made sure to provide a detailed definition of each account type, analyze its unique features, and offer multiple examples.
Assets are the physical (tangible) or non-physical (intangible) types of property that add value to your business. In other words, assets are resources owned by your company that have monetary value as they can be converted into cash. Depending on the nature of your business, several different things can be classified as assets. Vehicles, computers, equipment, buildings, and cash are considered tangible assets, while your copyrights, trademarks, logos, and similar non-physical items are intangible assets.
Note that this account type can be broken down into multiple subaccounts. Here are a few common examples of assets’ sub-accounts:
- Checking account – This is your company’s bank account.
- Petty cash – A petty cash fund is a small amount of money used for expenses too minor to merit writing a check.
- Inventory – A company’s inventory usually consists of goods in three stages of production: raw goods, in-progress goods, and finished goods that are ready to be sold.
- Accounts receivable – Even though your accounts receivable account isn’t the money you already have, it’s considered an asset as it’s the money that’s owed to you.
Keep in mind that debits increase assets and credits decrease them. Make sure to debit an asset account each time you add money to it and credit it when taking money from it.
These accounts reflect the outflow of money. Any cost your company incurs, such as purchasing a service or a product to manufacture goods or generate income, is considered an expense. Examples of expenses include advertising costs, utilities, salaries, rent, and others.
Note that some expenses are deductible, which means that they can help you reduce your taxable income. You can deduct business-related travel and direct labor costs. However, you cannot deduct personal expenses, penalties, and donations.
Much like various types of assets, expense accounts can also be fractioned in multiple subaccounts such as:
- Cost of goods sold (COGS) – This refers to the money you have paid for producing the goods you’ve sold.
- Payroll – Payroll or wages expense is the money paid to the employees for their work.
- Rent – This is the cost of renting equipment or office space.
- Insurance – This subaccount refers to the cost of the business insurance you’ve used.
- Equipment – This is the cost of equipment you’ve purchased.
Note that credits decrease business expenses while debits increase them. Therefore, remember to increase your expense accounts each time your company spends money.
Liabilities represent expenses your company has incurred but has yet to pay. These include any debts or obligations to creditors and other third parties to which your business owes money.
A company’s financial obligations can be described as current or long-term. Debts that need to be paid within 12 months or less are classified as current liabilities. These mainly consist of monthly operating debts such as the customer deposit and accounts payable. Note that business owners typically use current assets such as the money in the company’s checking account to cover current liabilities. The difference between a company’s current assets and liabilities is called working capital.
Noncurrent or long-term liabilities are debts that are paid off in years instead of months. These usually include mortgages, car loans, and business loans used to maintain or purchase fixed assets.
Common examples of subaccounts that fall under the liability account category include:
- Payroll liabilities – This type of liability subaccount includes payroll-related costs such as wages employees have earned but haven’t yet received and taxes withheld from employees.
- Sales tax liabilities – This subaccount represents your sales tax obligations.
- Unearned revenue – This account type represents payments received on work that have not been completed yet.
- Accounts payable – These are the bills your company must pay. They are considered liabilities (not expenses), as these are the costs you have incurred but not paid for yet.
- Notes payable – These are your company’s financial obligations from signing a promissory note.
- Mortgage payable – This account type may refer to the mortgage you have on business property or any other business-related mortgage.
Note that the general rule for liability accounts is that credits increase them while debits decrease them.
Also referred to as net worth, equity indicates how much your company is currently worth. This account is of utmost importance to a company’s owner as it represents the value of the owner’s investment in the company. Equity is the difference between your business’s assets and liabilities or, more precisely, the residual interest in your company’s assets after the liabilities have been deducted. Dividends, common stock, and retained earnings are all examples of this account type.
The role of equity in a chart of accounts may differ slightly based on whether a business is structured as an LLC, a sole proprietorship, or a corporation.
Let’s take a look at some equity subaccount examples:
- Owner’s equity – Equity is the amount of money that is returned to a business owner if all of the company’s assets are liquidated and all of its debt paid off.
- Common stock – This account type is used to record the investment of the company’s owners.
- Retained earnings – You’ll need this type of equity account to keep track of the earnings of your company (especially if you are running a corporation) and to record when these earnings are given back to the owners in the form of dividends.
Keep in mind that an equity account increases through credits and decreases through debits. In other words, each time your assets grow, your equity increases. Also, as liabilities increase, your equity decreases.
Revenue or income, the last of the five primary types of accounts in accounting, represents the value of the goods or services provided and thus the money your business earns from selling them to clients. This term is also used to denote the money earned from interest and dividends on marketable securities. In short, revenue accounts track the money your business brings in, both from its operations and nonoperating activities.
Given that their balance is reset to zero at the beginning of a new accounting period (typically defined as a new fiscal year), revenue accounts are temporary or nominal accounts. Note that most accounting software solutions perform the resetting automatically.
Examples of income subaccounts are as follows:
- Product sales – This account may include the revenue from a service you provide and the value of the products you sell.
- Earned interest – This account indicates the value of interest earned on investments or bank accounts.
- Miscellaneous income – Any other type of revenue falls under the miscellaneous income category.
According to the rules of accounting, you increase your revenue account by crediting it. In the same vein, by debiting revenue accounts, you’ll decrease them.
The Importance of a Chart of Accounts
Now that you’ve learned about all the account types that form part of a chart of accounts, it’s time to talk about all the benefits of this financial listing. A chart of accounts lets you organize your company’s complex financial data and break it down into easy-to-understand, logical categories. This listing also plays an important role in laying the foundation for all your business’s critical financial reports.
However, many business owners consider their charts of accounts much more than just organizational tools. Keeping all your financial data in one place and analyzing the relationship between various accounts can provide invaluable insights into your company’s performance. Here’s an overview of the main benefits a chart of accounts can introduce into your business:
1. Understanding your earnings
One of the most apparent advantages of a chart of accounts is that it can give you an excellent insight into your company’s revenue. Not only can this listing show you how much money your company earns, it can also help you pinpoint peaks and valleys in your income account, understand how much cash flow is available for you to use, and calculate how long that amount should last you considering your average monthly business expenses.
2. Spending smarter
We can all agree that a straightforward list of items you spend your hard-earned money on isn’t a sight for sore eyes. However, your chart of accounts can help you shift your perspective, offering a clearer view of your spending habits. That way, you’ll be able not only to deal with your essential recurring expenses such as rent, internet, and utilities but also to inspect other examples of your expenses and maybe even cut down on some costs if needed.
3. Figuring out how much you owe
Another tremendous benefit of a chart of accounts is that it offers a clear picture of how much money you owe, both in current and noncurrent liabilities. A thorough analysis of your company’s chart of accounts can help you figure out how much of your monthly income you can comfortably afford to put toward your debts. It can also help you create a sustainable longer-term debt repayment plan, no matter which types of liabilities you need to deal with.
4. Upgrading your reports
A chart of accounts is essentially a numbered list that organizes your finances into a system of accounts. Having a detailed and accurate chart of accounts makes it easier for your accounting professional, bookkeeping service provider, or yourself to develop in-depth financial reports, such as a cash flow statement, income statement, and balance sheet, which can help you grasp the financial position of your company.
5. Simplifying the way you file taxes
An added bonus of keeping a neat and accurate chart of accounts is that it’ll make your life much simpler come tax season. This listing tracks your company’s income and expenses, which are precisely the items you’re required to report on your income tax return each year.