The word ‘account’ has several connotations – but it mostly and instantly reminds us of our most possessed and guarded personal entity, i.e., our bank accounts. However, in the accounting world, an account refers to an entity that records the financial activities or transactions of a specific asset, equity, liability or expense, revenue. All the changes to the account are recorded in the general ledger throughout the business year, and financial statements are created based on these. This is how finance firms track records via these individual accounts.
These financial records are of paramount importance to a company as it gives a complete and insightful overview of the credit and debit entries. A company can thus make informed decisions using this accounting data and thereby create a healthy and profitable output.
In this article, we will look at the main types of accounts in accounting and go over illustrated examples to understand each of these types better.
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Account: Basic equation
Financial accounting is based on the ‘Principle of Duality’, which means that every business transaction must be recorded in two different accounts. This accounting framework enables more security and correctness in extracting transactional reports and creates a foolproof accounting system in the firm. Thus, in other words, the ‘Double Entry System’ is usually a default in creating accounting books in finance. With this ‘Dual Accounting Concept’, each business transaction will have a corresponding and opposite record in at least two accounts.
The basic accounting equation can be illustrated as follows:
Assets = Liabilities + Owner’s Equity + Revenues – Expenses
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The main types of accounts
There are three basic types of accounts in accounting:
- Personal account
- Real account
- Nominal account
Let us go over these types individually and understand them better and in-depth.
- Personal account
As the name suggests, personal accounts refer to people. This broadly refers to an individual or a firm, group, association of people, partnership firms, etc. Personal accounts are further classified as:
- Natural account
A natural account is related to natural persons such as ‘Mr. Sharma’s account’ or ‘Deepak’s account’. This usually indicates that the account is of an individual with a valid identity.
- Artificial account
An artificial account refers to a company, group, or institution. These are legally valid entities and represent a company or institution.
- Representative account
A representative account is usually created for representing a specific task or work like prepaid expense, salary account, outstanding interest, etc. Personal accounts have a baseline rule: debit the receiver and credit the giver.
Let’s take an illustrated example to understand personal accounts better.
Let’s assume that Mr. Deepak is buying industrial machinery from Mr. Lever (of Lever Industries, for example) for a credit of 20 lakh rupees. This involves two transactions, i.e., the personal account of Mr. Lever and the Machinery Account.
Lever Industries is the giver of the transaction. Therefore, there will be a credit in the personal account of 20 lakh rupees, and Machinery Account will be debited with the same amount.
This is how the account book records will show in the Lever Industries ledgers.
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|To Mr. Lever
To Mr. Lever
- Real accounts
These accounts are usually related to assets, properties, or possessions. Properties can be physical or non-physical. Therefore, real accounts can be of two types, i.e., tangible and non-tangible.
- Tangible accounts
Accounts with physical existence are classified as tangible accounts. Examples are Machinery A/C, Vehicle A/C, Building A/C, etc.
- Non-tangible accounts
These accounts are physically non-existent but are attached with some money to themselves. These assets have a value attached to them, but you cannot see or feel them.
Examples of such accounts are patents, goodwill, copyrights, etc. The rule of such accounts is: debit what comes in and credit what goes out.
If Tom purchases a vehicle for his business for Rs. 7,00,000 in cash, this transaction will involve two accounts: Vehicle Account and Cash Account. This can be illustrated as follows:
- Nominal accounts
These are usually associated with income, salary, and profit-loss statements and not with physical entities. Example: Rent A/C, Wages A/C, Salary A/C, etc.
The golden rule of these accounts is: debit all expenses and losses, credit all incomes and gains.
If Mr. Sharma paid wages worth Rs. 2,00,000 in cash, this transaction will involve two accounts: Nominal Account and Real Account.
Applying the respective golden rule, here is how the accounting statements for these accounts will look like:
Additional kinds of accounts
There are other types of accounts as well as explained below:
- Cash account: This keeps track of all the cash payments, withdrawals, and deposits.
- Income account: This account is specifically created to track the income sources of the business.
- Expense account: Subsequently, this account is to keep track of the business’s expenditures.
- Liabilities: Debts or loans are classified under the liabilities account.
- Equities: Any investment made by the account owner or common stocks, and retained earnings, are classified as equities.
These are the basic types of accounts in accounting, which serve as the foundation of the finance framework. All the golden rules mentioned above are the basis of how transactions are recorded for each type of account. Transactions are recorded based on these rules, and further, financial reports are based on this data.
Knowing these rules can make accounting easier and make all ledger entries accurate.
To sum up, these are the three golden rules of accounting:
- Debit what comes in, credit what goes out
- Debit the receiver, credit the giver
- Debit all expenses, credit all income