Understanding Accounting

The Accounting Equation
Businesses use a variety of systems to record transactions and prepare financial statements. Regardless of the system used, all accounting is based on the
accounting equation (Assets = Liabilities + Capital).7 Each transaction affects an asset, a liability, or capital and is recorded such that the books of account remain in balance with the equation.
The Accounts

Accounts simply serve to group similar transactions under one heading. As mentioned previously, "Electricity" can be the name of an account. While some accounts are standard and needed by all businesses, others are added based on a particular need. One business may group electricity and heat under an account called "Utilities," while another business may prefer to see the individual amounts and create two acounts called "Electricity expense" and "Heat expense." The account names and their totals make it easy to gather financial data into an useful and organized financial statement.
     Regardless of the account name assigned to a group of similar transactions, each account will fall under one of the account types indicated by the Accounting Equation (Assets = Liabilities + Capital). Every transaction affects either assets, liabilities, or capital.
Assets are tangible (a fax machine) or intangible (a trademark) property, generally with a value of more than $50 to $100 and with a useful life of more than one year. Because an asset is expected to assist in generating income over the span of its useful life, the portion of use must be expensed against the income it generates.8 For this reason, if you purchase a piece of equipment costing $5,000 and you expect to use it in your business for 5 years, $1,000 of the cost is expensed each year. Expensing the cost of an asset over the period of its useful life is called depreciation.
     Some typical asset accounts are: Cash, Equipment, Buildings, Accounts Receivable, and Notes Receivable.
Liabilities are amounts owed to others. If a business borrows $10,000 from the bank, it incurs a liability of $10,000. Some typical liability accounts are Accounts Payable and Notes Payable.
Capital, in simplest terms, is what you have left after you sell all of your assets and pay off your liabilities. In this case, the value of an asset is not what you can get on the open market, but the actual value shown on your books. For this reason, capital doesn't necessarily reflect the actual value of your business.
     If an owner invests money in or removes money from the business, the transaction affects a capital account. The regular income and expenses of the business, because the net difference between them represents money available to (profit) or money invested by (loss) the owner, fall under capital.
Chart of Accounts

The group of accounts used by a business is called a Chart of Accounts. Each account is numbered and follows this general standard:
Asset accounts begin at 100 or 1000
Liability accounts begin at 200 or 2000
Capital accounts begin at 300 or 3000
Revenue accounts begin at 400 or 4000
Cost of sales accounts begin at 500 or 5000
Expense accounts begin at 600 or 6000

     Companies often begin with a standard Chart of Accounts and add more accounts as the business grows. Four digit account numbering is recommended as it allows for more versatility.
     Accounts are ordered logically to appear in the Chart of Accounts, Ledger, and Financial Statements in the same order. This makes it easier to find the account in the Ledger and prepare the Financial Statements.
     In the following examples, the titles in bold indicate the heading which would be used on a Financial Statement. They are given to indicate the type of account which follows, but do not contain any transaction amounts.

Chart of Accounts For a Professional
100 Assets
110 Cash
115 Accounts receivable
120 Office equipment
123 Furniture & fixtures

200 Liabilities
210 Accounts payable
220 Note payable

300 Owner's Equity
310 Ben Law, capital
312 Ben Law, drawing
315 Net income (loss)
400 Income
410 Fees

600 Expenses
610 Salaries
611 Payroll taxes
612 Employees Health Insurance
615 Other insurance
617 Accounting & legal fees
620 Office supplies
625 Telephone
650 Utilities
655 Rent
660 Depreciation expense

Chart of Accounts For a Retail Sales Corporation
1000 Assets
1010 Current Assets
1011 Cash
1012 Petty cash
1014 Accounts receivable
1015 Allowance for doubtful accounts
1102 Prepaid insurance
1103 Merchandise inventory
1104 Store supplies
1105 Office supplies
1106 Short-term investments
1200 Long-Term Assets
1201 Notes receivable
1202 Long-term investments
1300 Plant & Equipment
1301 Land
1302 Building
1303 Accum. depr., building
1304 Furniture & fixtures
1305 Accum. depr., furn. & fixt.
1306 Office equipment
1307 Accum. depr., office equipment
1308 Store equipment
1309 Accum. depr., store equipment

2000 Liabilities
2100 Current Liabilities
2101 Accounts payable
2103 Taxes payable
2200 Long-Term Liabilities
2201 Notes payable
3000 Capital
3100 Common stock
3200 Retained earnings

4000 Income
4100 Sales
4101 Sales returns & allowances
4102 Sales discounts

5000 Cost of Goods Sold
5100 Purchases
5101 Purchases returns & allowances
5102 Purchases discounts

6000 Expenses
6100 Salaries
6101 Payroll taxes
6102 Employee benefits
6103 Office supplies
6104 Telephone expense
6105 Utilities expense
6106 Accounting fees
6107 Attorney fees
6108 Maintenance
6109 Repairs
6110 Store supplies
6111 Insurance
6112 Licenses and fees
6113 Advertising
6500 Depreciation expense
6900 Income taxes expense


7. Accounting Equation: Assets = Liabilities + Capital
All transactions of a business are categorized according to the account type specified by the accounting equation. Each transaction affects both sides of the equation, thereby keeping the books of account in balance. return
8. Matching Principle
A business incurs expenses in order to earn income. The expenses represented on financial documents should match the income earned. For example, a business earning income from the sale of paper products to other businesses would not be expected to show a purchase of 100 pounds of hot dogs on its books. return

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Copyright © 1997-2007 Kathleen A. O'Connell, ALL RIGHTS RESERVED. Last updated Dec. 27, 2007