Accounting can be a confusing subject for many people, including students and small business owners. Part of this confusion is due to the accounts used in accounting and how they relate.
Accounting accounts can be broken down into one of three categories. These categories are assets, liabilities, and equity.
Asset accounts can be broken into current and fixed assets.
Current assets include accounts such as cash, checking accounts, investment accounts, and certificates of deposit that mature in the short-term (less than one year). Other current asset accounts may include accounts receivable, inventory accounts.
Fixed asset accounts may include land, buildings, furniture, fixtures, equipment, vehicles, and other items that can be depreciated. There are also fixed asset accounts that are called contraasset accounts which include items such as depreciation. These accounts counter (or subtract from) asset accounts.
Liability accounts are broken into current and long-term liabilities. Current liabilities include items such as accounts payable, wages payable, taxes (various types) payable, and deposits from customers (for work not completed yet). Once a bill is paid it is moved from accounts payable and counted as an expense. This removes the money from the asset account it is paid from (e.g. a business’ checking account) and removes the amount from the accounts payable account.
Long-term liability accounts include loans (that have a term exceeding one year). This can include liabilities for anything from equipment and vehicles to bank and land loans.
Equity accounts as well as liabilities can be considered as the source of the company’s assets.
These accounts include any capital invested by owners.
Accounts used in accounting affect one another in the basic manner of Assets = Liabilities + Equity. Double entry accounting teaches us that whenever one account is affected, it must affect at least one other account.
For example, if a company purchases $1,000 of inventory on account from their vendor, both the inventory and accounts payable accounts will increase. This supports the accounting equation of Assets (+$1,000 to inventory) = Liabilities (+$1,000 to accounts payable) + Equity. The equation is still in balance.
By understanding this basic equation and what types of accounts go into each of the accounting categories, a small business owner (or interested person) can gain a solid foundation to learn more of the basics of accounting.