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.
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.
The group of accounts used by a business is called a Chart of Accounts. Each account is numbered and follows this general standard:
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.
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.
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.