In the fundamental accounting equation, assets, liabilities, and owner's equity are known as "elements" of the equation. Within each element is a type of account.
An account is a record or file used to collect financial changes. These changes are a result of "transactions," which are financial events that cause the accounts in the accounting equation to change. In their simplest form there are six types of accounts. They are the asset, liability, owners equity, revenue, cost, and expense accounts.
These six accounts can be further subdivided into Permanent and Temporary accounts. The asset, liability, and owners equity accounts are classified as "permanent accounts" In that they normally maintain a balance and their balances are carried forward from one accounting period to the next. They are an expression of the financial position of the enterprise at a given point in time and are reported on in the balance sheet.
Assets are anything of monetary value owned by a business. The six basic categories of assets are cash, receivables, inventories, plant, and equipment. Assets are listed on the balance sheet as either "current" or "fixed". Current assets are cash, other assets are those that may reasonably be expected to be realized in cash, by being sold, or used up, usually within one year or less through normal operations of the business.
Building and equipment assets are called permanent tangible or fixed assets. Except for land, these assets gradually wear out or otherwise lose their usefulness with the passage of time. This is known as depreciation. The expense associated with depreciation is refereed to as depreciation expense.
Included in each of the asset accounts are:
Liabilities are claims against the assets of a business by creditors as a result of buying or borrowing on credit. Liabilities are identified by the word "Payable" attached to the account title and like assets are classified as current or as long-term.
Current liabilities are debts that must be paid within one year of the balance sheet date and include accounts payable, notes payable, loans payable, and federal income taxes payable. Debts that are not due within one year of the balance sheet date are considered long-term or fixed liabilities. Mortgage payable represents a long-term liability. Owner's equity represents the owner's claim against the assets of a business. This financial interest by the owner is derived from the fundamental equation by subtracting the liabilities from the assets as:
ASSETS - LIABILITIES = OWNERS EQUITY
Examples of owner's equity accounts include capital, capital stock, paid-in capital, retained earnings, and treasury stock.
Balance sheet accounts represent the worth of the organization. The Balance Sheet is the current status of the asset, liability, and owner's equity capital accounts. Depending on the type of account debited or credited the dollar amount either increases or decreases. There are rules for increasing and decreasing balance sheet accounts. These are the permanent accounts.
The balances of the permanent accounts are carried forward from one accounting period to the next. An account balance is the difference between the total debits and credits to an account. If the debit side is larger, then the account has a "debit balance"; if the credit side is larger, the account has a "credit balance". The account balances represent the financial condition of the business as of a specific date, and are reported on in the balance sheet.
The rules for debiting and crediting are developed from the accounting equation. All accounts making up the equation have a "normal balance side". The normal balance side is that side (debit or credit) of an account in which the balance would appear if an account has monies placed in it.
Again we can use the T" accounts to illustrate this principle. It is difficult for non-accountants to remember when a transaction should be a debit or credit to the account. The following are some rules to assist in remembering when to increase or decrease the Balance Sheet Accounts.
|Assets =||Liabilities +||Owner's Equity|
Revenue, cost, and expense accounts are classified as "temporary accounts" because they collect information for only one accounting period. Their balances are then transferred to the Owner's Equity (capital) account during closing procedures at the end of the accounting period. These temporary accounts are an extension of owner's equity and represent the net result of current operations. Revenues increase the owner's equity account as a result of the selling of goods and/or services. Sales, fees, and commissions are names which identify revenue accounts. The closing process zeroes the books for the next accounting period.
Costs decrease the owner's equity account as they are subtracted from revenues in determining "gross profit". They represent the cost of goods purchased for resale to customers. A cost account commonly used is the purchases account. Other cost accounts include transportation, purchase returns and allowances, and purchases discounts. Expenses decrease the owner's equity account as they are subtracted from revenues and represent the purchases of goods and services used to operate or manage the business. Expenses are also known as expired costs. Expense accounts are generically named and include such titles as delivery, insurance, payroll taxes, rent, salaries, supplies, telephone, and utilities.
Revenue, cost, and expense accounts are known as "temporary accounts" because their balances are closed (zeroed) out at the end of the accounting period to permit the separation of one accounting period to the next.
Revenue, cost, and expense accounts are reported on in the financial statement called the income statement. This report reflects the financial activity of the company for a particular length of time known as an accounting period. (Refer to discussion of accounting periods.)
The recording of all revenues (sale, fees commissions, etc.), costs (cost of goods, etc.), and expenses into the owner's equity capital account is not practical. For proper control all entries in the account would need to be sorted in order to separate each different revenue, cost, and expense transaction, which would be time consuming and confusing.
A better solution is to provide a separate account for each revenue, cost, and expense transaction permits the collection of expenditures by specific types - advertising expense, rent expense, salaries expense, utilities expense, and so on. The individual amounts of each revenue, cost, and expense account are then distinguishable and readily available.
Since revenue increases an owner's equity, revenue accounts have their normal balance side on the right (credit) and the same rules apply for the increasing and decreasing as the owner's equity account. Revenue accounts are increased onthe right (credit) side and decreased on the left (debit) side.
As costs and expenses decrease the owner's equity, their normal balance side is on the opposite side of the revenue account as their balances are subtracted from revenue. The balances in these accounts are increased on the debit (left) side because owner's equity is decreased on the debit (left) side and the balance decreased on the credit (right) side.
Liabilities and owner's equity are on the right side of the equation. Their normal balance side would be on the right (credit) side. Their increase and decrease sides are opposite that of assets. They are increased on the right side (credit side) of the account, and decreased on the left side (debit side).
Below are the rules for increasing and decreasing Income Statement (temporary) Accounts.