Key Takeaways
- Ledger accounts are individual records in the company’s general ledger that keep records of every financial transactions of the company.
- The T-account is a visual representation of the ledger accounts that helps accountants analyze the effects of a transaction before recording them in the accounting system.
- A Permanent Account is an account with a permanent balance that is carried forward to the next accounting period. On the other hand, a Temporary Account is an account whose balance is closed at the end of the accounting period.
- The Chart of Accounts is a list of all general ledger accounts that are being used by the company.
The Ledger Account
The accounting information system records and tracks the financial transactions of a business. It systematically classifies every transaction into accounts that are stored in a large database of financial transactions called the General Ledger.
The accounting information system basically processes financial data into useful information that you can find in your company’s financial statements. These financial statements, which include the statement of financial position, income statement and statement of cash flows can be used by various stakeholders such as investors and creditors to make important financial decisions.
The statement of financial position reports three main sections or elements called assets, liabilities and equity, while the income statement reports two main elements, namely income and expenses. For every financial transaction that is recorded in the accounting system of the company, the amounts of these financial statement elements either increase or decrease depending on the nature of the transaction.
To record these increases and decreases, accountants use a device called Ledger Account.
Ledger Accounts are individual account records that makeup the general ledger of a company. Each ledger account is classified as an asset, a liability or an equity.
As mentioned earlier, the general ledger is a database containing the financial transactions of a company. Within the general ledger are ledger accounts which we can simply refer to as accounts.
When recording financial transactions, we can segregate them into different ledger accounts based on their type and nature. When you look closer at the details of an account in the general ledger, you’ll notice that it contains all the accumulated records of financial transactions that are similar in nature.
For example, let’s assume that your company buys and sells hardware storage devices such as memory cards and hard drives. When you buy inventory from your supplier, you record the purchase transaction in an account called Merchandise Inventory. Likewise, when you sell them to a customer, you record the sales transaction in the same account.
The purchase transaction increases the balance of the Merchandise Inventory account while the sales transaction decreases it because of the outflow of a product from the account. Remember that both transactions are of the same type or nature which involves the product inventories of the business.
Let’s assume, as a second example, that your business maintains a checking account with a bank that is used for depositing sales and issuing checks for payments. All transactions related to this checking account will be recorded in a ledger account called Cash in Bank. This account will show all checking account deposits as increases to the Cash in Bank account and all cash withdrawals or check payments as decreases.
Each account in the general ledger has their own Account Title to distinguish one account from another. Below are examples of common account titles that companies use to distinguish one account from another:
Asset accounts – Cash on Hand, Cash in Bank, Accounts Receivable, Notes Receivable, Accrued Interest Receivables, Merchandise Inventories, Finished Good Inventories, Prepaid Office Supplies, Prepaid Rent, Equipment, Machinery, Furniture, Building, Land, Goodwill, and Patent.
Liability accounts – Accounts Payable, Notes Payable, Loans Payable, Bonds Payable, Mortgage Payable, Salaries Payable, Income Tax Payable, Interest Payable, and Utilities Payable.
Equity accounts – Owner’s Capital, Owner’s Drawing, Partner’s Capital, Partner’s Drawing, Ordinary Share Capital or Common Stock, Preference Share Capital or Preferred Stock, Accumulated Profits or Retained Earnings, Treasury Share or Treasury Stock.
Income accounts – Service Revenue, Sales, Interest Income, Royalty Income, Dividend Income, and Gain on Sale of Equipment.
Expense accounts – Cost of Sales, Utilities Expense, Wages or Salaries Expense, Rent Expense, Interest Expense, Advertising Expense, Depreciation Expense, and Loss on Sale of Equipment.
Similar items can be grouped together in one account. For example, currencies, coins, checks, and bank drafts can be grouped and recorded in the Cash or Cash on Hand account. Customer invoices are grouped in the Accounts Receivable account.
We use the ledger account as a device to accumulate financial information that will be used to prepare financial statements. However, in most accounting systems, transactions inside the accounts are not allowed to be deleted to avoid instances of fraud. So to prevent making any erroneous transaction entries, accountants use a tool called the T-account.
Analyzing Transactions Using The T-Account
The T-account is a tool used to aid accountants in making preliminary analysis of transactions before entering them in the accounting system. It is used to analyze the effects of a transaction on the ledger accounts that are involved.
The T-account is like a scratch paper that you use to analyze the effects of transactions in each account. In a classroom setting, students are also trained to use T-accounts when analyzing practice problems in accounting.
The T-account, which is an informal version of the ledger account, serves as a visual aid to provide a view of all transactions that have been recorded in a single ledger account over a given time period. Like the ledger account, it contains the beginning and ending balances in addition to the increases and decreases in its amount during the period.
Below is an illustration of a T-account.
Looking at this illustration, you can tell that the T-account has three parts: the account title, the debit side and the credit side.
- Account Title – the account title is placed at the top of the T-account to distinguish it from other T-accounts.
- Debit – this refers to the left side of the T-account and can be abbreviated as Dr.
- Credit – this refers to the right side of the T-account and can be abbreviated as Cr.
A Debit Entry is a term used for transaction entries that are recorded on the debit or left side of the T-account. When the term Debited is mentioned, it means to record a debit entry on an account. For example, we can say that the Accounts Receivable account was debited by $1,000 for the sale of merchandise for $1,000.
On the opposite side, a Credit Entry is used for transaction entries that are recorded on the right side of the T-account. Credited means to record a credit entry on an account. In the previous example, we can say that the Sales account was credited by $1,000 for the sale of merchandise.
Debiting and crediting an account would result in either an increase or a decrease in the amount or balance of an account. Some accounts would have their balance increased when transactions are recorded on their debit side. Other accounts, on the other hand, will have an increased balance when transactions are recorded on their credit side.
The accounting equation, Assets = Liabilities + Equity, guides accountants when recording and analyzing financial transactions. This equation presents assets on the left side of the equation while liabilities and equity are presented on the right side.
The position of an account in the accounting equation determines what side of the T-account will the account be increased or decreased. A debit entry does not necessarily mean an increase and a credit entry does not necessarily mean a decrease.
Based on the accounting equation, debit entries increase accounts that are located on the left side of the equation while credit entries increase accounts that are located on the right side of the equation. On the other hand, credit entries decrease accounts on the left side of the equation while debit entries decrease accounts on the right side of the equation.
To easily understand this, you may refer to this table:
The following rules on debit and credit entries should be observed when recording transactions:
- Assets – increases are recorded on the debit side while decreases are recorded on the credit side.
- Liabilities – increases are recorded on the credit side while decreases are recorded on the debit side.
- Equity – increases are recorded on the credit side while decreases are recorded on the debit side.
- Income – since revenue accounts increase equity, then increases are recorded on the credit side while decreases are recorded on the debit side.
- Expenses – since expense accounts decrease equity, then increases are recorded on the debit side while decreases are recorded on the credit side.
The table below summarizes these rules:
Account Balance
The Account Balance is the difference in amounts between the total debits and the total credits in the account.
One important characteristic of the accounting equation, Assets = Liabilities + Equity, is that it should always be in balance. This means that the total amount of assets a company has should equal the combined total amounts of liability and equity accounts.
This also applies to the total debits and total credits of all combined accounts in the general ledger. If you add the total debits of all combined ledger accounts, the resulting amount should equal the total amount of credits.
However, when you look at individual ledger accounts, you may notice that some of them have a total debit amount that is not equal to the total credit amount. This difference in amount is what we call the Account Balance.
Whenever transactions are recorded in the accounting books, the balance of accounts involved fluctuate due to the increases and decreases in the amounts related to those transactions. At the end of the accounting period, the balance of the accounts can either result to a debit balance or a credit balance.
An account has a Debit Balance when the total of its debits are higher than the total of its credits. Conversely, an account has a Credit Balance when the total credits are higher than the total debits.
Debit Balance = Total Debits > Total Credits
Credit Balance = Total Debits < Total Credits
Let’s look at some examples to understand the concept of a debit balance or credit balance.
Example 1
A review of the checking account of a company showed a beginning balance of $500, total deposits of $1,500 and total withdrawals of $700 as shown in the T-account above.
To determine the account balance, add the beginning balance and deposits to get the total debits and from that sum, deduct the withdrawals which are the total credit. The difference will be an account balance amounting to $1,300. The company’s Cash In Bank account reflected a debit balance of $1,300 because the total debit is higher than the total credit.
The Cash in bank account normally has a debit balance at the beginning as illustrated in the T-account above. However, one situation where this account will have a credit balance is in the case of a bank account overdraft where the bank account balance falls below zero.
Example 2
The Accounts Payable account of a company showed a beginning balance of $400, total purchases on account of $1,000 and total payments of $850 as shown in the T-account above.
To determine the account balance, add the beginning balance and purchases to get the total credits and from that sum, deduct the payments which are the total debit. The difference will be an account balance amounting to $550. The Accounts Payable account of the company has a credit balance of $550 because the total credit is higher than the total debit.
Note that the beginning balance of a liability such as an Accounts Payable is normally on the credit or right side of the account. One situation in which this account will have a beginning debit balance is when an overpayment has been made by the company to its supplier.
Example 3
The Prepaid Office Supplies account of a company showed total purchase of office supplies during a period of $200 and total usage of office supplies of $200 by the end of the period as shown in the T-account above.
In this case, total debits is equal to total credits. This is an example of a Zero Account Balance where there is no difference in the total amounts of both debits and credits in the account.
Aside from debit balance, credit balance and zero account balance, another relevant term you should know is Normal Balance.
The Normal Balance of an account depends on the account’s location in the basic accounting equation, Assets = Liabilities + Equity.
For asset accounts, the normal balance is always a debit balance because they are located in the left side of the accounting equation and their amounts are increased by a debit entry. For liability and equity accounts, the normal balance is always a credit balance because they are located in the right side of the accounting equation and their amounts are increased by a credit entry.
How about the normal balances of income and expense accounts? Although income and expense accounts don’t show in the accounting equation, they actually affect the equity side of the equation. income accounts increase equity while expense accounts decrease equity.
The table below summarizes the normal balances of each account group.
Accounts are also classified into permanent accounts, temporary accounts and contra accounts.
Permanent Accounts
A Permanent Account is an account where the balance is carried forward to the next accounting period. Its balance is not closed at the end of the accounting period. Permanent accounts are also called Real Accounts.
All accounts in the statement of financial position are permanent accounts. The only account in the statement of financial position that is not considered a permanent account is the Owner’s Drawing account because at the end of the reporting period, its balance is closed and deducted from the Owner’s Capital account and not carried forward to the next period. The Owner’s Capital and Owner’s Drawing account are equity accounts that are used by a sole proprietorship form of business only.
Permanent accounts are real values that shows their balances at a particular point in time. Their balances are not closed or brought back to zero at the end of the accounting period.
An example of a permanent account is the Fixed Assets account. The balance of this account is never brought to zero at the end of the accounting period and its amount is carried forward to the next period for as long as the company owns fixed assets.
A business does not start a new accounting period with a zero amount in its permanent accounts. Unless there are no transactions that have ever been recorded in an account or unless the items inside the account are fully liquidated, all permanent accounts will always have a balance. If all items inside the Fixed Assets account are sold in the previous period, then it is only in this case that the account will have a zero balance in the next accounting period.
Temporary Accounts
A Temporary Account is an account where the balance is closed at the end of the accounting period and transferred to a permanent account. Temporary accounts are also known as Nominal Accounts.
All income and expense accounts in the income statement are considered temporary accounts because their amounts or balances are closed at the end of the reporting period and transferred to a permanent equity account such as the Owner’s Capital account (for sole proprietorship), Partner’s Capital account (for partnership) or Retained Earnings account (for corporations). The income statement shows temporary accounts that track income and expense transactions during a period, which is why this report covers only a certain period of time, and not a particular point in time like the statement of financial position.
The owner’s drawing account in a sole proprietorship or partner’s drawing account in a partnership are also considered temporary accounts even though they are found in the statement of financial position and not in the income statement. The reason for this is that their balances are closed to the Capital account as a deduction at the end of the accounting period. In the next accounting period, the drawing account starts fresh with a zero balance.
Closing the account means bringing the account’s balance to zero or nil at the end of the accounting period. In the next accounting period, a new set of temporary accounts will be opened so they can be used to record and track new transactions during that period.
When closing temporary accounts, you can use a clearing account called the Income and Expense Summary account temporarily hold the account balances of temporary accounts that are being closed. The balance of this clearing account will then be closed to the proper equity accounts.
Companies, especially the large ones, have numerous revenue and expense accounts that if closed directly to equity, may unreasonably clutter up those accounts. In this case, it is recommended to use of a clearing account such as the income and expense summary account. The Income Summary account also ensures that all revenue and expense transactions are recorded correctly and completely to avoid any mistakes in transferring the amounts to equity.
Contra Accounts
A Contra Account is an account whose amount are deducted from another accompanying account or from accounts in the same category.
Contra accounts have two characteristics:
- They have a companion account from which their amounts will be offset or deducted.
- Their normal balance is the opposite of their companion account. So if the normal balance of their companion account is a debit balance, then the contra account’s normal balance is a credit balance. However if the contra account does not have a companion account, such as in the case of treasury shares, their normal balance is the opposite of the normal balance of other accounts in the same category.
When the contra account’s amount is deducted from the amount of its companion account, the difference is a net amount or carrying value of the companion account. When reporting these accounts in the financial statements, the original amount of the companion account is still presented first followed by the contra account’s amount and the net amount.
For example, let’s assume that a company’s Accounts Receivable shows a balance of $1,000 and it estimates that 10% or $100 of the said balance will not be collected. The estimated $100 will be recorded in a contra account called Allowance for Bad Debts. The Accounts Receivable is the companion account of the Allowance for Bad Debts and from which the latter will be deducted. As a result, the net amount of the Accounts Receivable will be $900 after the deduction.
The presentation of these accounts in the statement of financial position would be:
The use of contra accounts allows the reporting of the original amount as well as the net amount or carrying value separately. It is more informative to present the accounts this way rather than presenting only their net amounts.
Contra accounts can be classified into Contra-asset, Contra-liability, Contra-equity, Contra-revenue, and Contra-expense.
Contra-asset Accounts
Contra-asset Accounts are asset accounts with a credit balance as their normal balance. Instead of the normal debit balance that most assets have, the normal balance of a contra-asset account is located at the credit side of the T-account.
The two common examples of contra-asset accounts are Allowance for Bad Debts and Accumulated Depreciation.
The Allowance for Bad Debts, also called Allowance for Doubtful Accounts, is a contra-asset account that represents estimated amounts of Accounts Receivable that the company considers as uncollectible from customers. In the statement of financial position, it is presented as a deduction from Accounts Receivable to arrive at the net realizable value. The Net Realizable Value of an Accounts Receivable is the amount of receivable that the company expects to collect from its customers.
The Accounts Receivable account is presented in the statement of financial position as follows:
Accumulated Depreciation is a contra-asset account that represents the expired cost of a property, plant and equipment or fixed asset as a result of usage or wear and tear over the useful life of the asset. In the statement of financial position, it is presented as a deduction from the original cost of the related fixed asset to arrive at the asset’s carrying value. The asset’s Carrying Value or Book Value is the remaining amount of the asset that is recorded in the company’s accounting books.
Contra-liability Accounts
Contra-liability Accounts are liability accounts with a debit balance as their normal balance as opposed to the normal credit balance that liabilities have. The normal balance of a contra-liability account is located at the debit side of the T-account.
An example of a contra-liability account is the Discount on Bonds Payable. This account represents interest expense that are yet to be amortized over the life of the related bond.
The Discount on Bonds Payable account is deducted from the related Bonds Payable account to arrive at the latter’s book values. It is presented in the statement of financial position as follows:
Contra-equity Accounts
Contra-equity Accounts are equity accounts with a normal debit balance, instead of the credit balances that equity accounts normally have. Two examples of contra-equity accounts are the Owner’s Drawing account and Treasury Share account.
The Owner’s Drawing account which was earlier discussed as a temporary equity account is deducted from the related Owner’s Capital account to arrive at the latter’s net amount. The owner’s capital account is usually presented in the statement of financial position at its net amount.
However, a company can opt to present the drawing account separately from the capital account in order to show more information regarding the amounts of personal withdrawal of assets made by the owners. It can be presented in the statement of financial position as follows:
Treasury Shares or Treasury Stocks are shares that were previously-issued to shareholders but are eventually repurchased or reacquired by the company but not yet retired. The Treasury Share account is presented as a deduction from the Shareholders’ Equity in the statement of financial position.
The Treasury Shares account does not have any companion equity account from which it can be deducted to arrive at the net amount. Instead, it is presented in the statement of financial position as follows:
Contra-revenue accounts
Contra-revenue Accounts are revenue accounts with a normal debit balance, instead of the normal credit balance of typical revenue accounts. The common contra-revenue accounts are the Sales Discount account and the Sales Returns and Allowances account used by merchandising and manufacturing businesses. These accounts are deducted from the Gross Sales account to arrive at Net Sales.
Net sales can be presented in the income statement as follows:
Contra-expense accounts
Contra-expense Accounts are expense accounts with a normal credit balance as opposed to the normal debit balance that expense accounts typically have. The common contra-expense accounts are Purchase Discounts and Purchase Returns and Allowances. These accounts are deducted from the Purchase account to arrive at Net Purchases.
Net purchases can presented in the income statement as follows:
Organizing Accounts Using The Chart of Accounts
The Chart of Accounts is a list of all general ledger accounts that are being used by the business for recording financial transactions.
Depending on the nature and size of the business, a company may use as many general ledger accounts as they need in recording financial transactions. However, having many ledger accounts can easily lead to confusion and a disorganized accounting information system.
The chart of accounts helps a company organize its financial transactions. It gives accountants an overview and guide on which accounts to use when recording transactions. The Chart of Accounts consists of four columns as follows:
- Account Title – this column lists the names of each ledger account
- Account Type – this column lists which financial statement element or account type (asset, liability, equity, revenue, or expense) a specific ledger account belongs. Each account is categorized into asset, liability, equity, revenue, or expense account types.
- Account Number – this column lists numbers that are systematically assigned to each account either manually or automatically by an accounting software.
- Description – this column shows a description of transactions that will be recorded for each account.
Below is an example of a chart of accounts.
Notice that the chart of accounts above is arranged in an order where assets are listed first, followed by liabilities, equity, revenue, and expense. This is also usually the order they are presented in the financial statements.
Account numbers are used for easy reference when entering transactions in the accounting books and charging amounts to each account. They serve as identification numbers to easily identify an account.
Account numbers arrange the accounts in a manner where each account type have a set number sequence that are assigned to them. Asset accounts have a set number sequence that are different from the number sequence assigned to liabilities, equity, revenue, and expenses.
Assigning unique series of numbers for each account type creates a flexible numbering system where newly-added accounts will not affect other account numbers. When a new account is added, it will be assigned an account number that is not yet used by other accounts of the same type. That’s why it is important to leave a lot of room between account numbers to accommodate new accounts.
In the sample chart of accounts above, take note of the number sequence assigned to each account type.
- Assets – from 100 to 199. A different range of account numbers can be used to segregate current assets from non-current assets.
- Liabilities – from 200 to 299. A different range of account numbers can be used to segregate current liabilities from non-current liabilities.
- Equity – from 300 to 399.
- Income – from 400 to 499. A different range of account numbers can be used to segregate revenues from gains.
- Expenses – from 500 to 599. A different range of account numbers can be used to segregate cost of goods sold from operating expenses and losses.
In a computerized accounting system, the software may automatically assign an account number to each account. However in a manual accounting system, the accountant develops a custom numbering system for the company.
Managing the Chart of Accounts
One of the factors you should consider when establishing the company’s chart of accounts is the type of accounts to be used depending on the nature of your business operations. Every company’s chart of accounts are different from one another because it is not likely that two businesses who have the same exact operations.
Using a computerized accounting system when establishing your chart of accounts could be advantageous if the software already has a selection of preformatted chart of accounts that is available for various types of business operations. Your company can use these preformatted chart of accounts and custom-tailor them to their specific needs. They can add new accounts that would fit the business plan or delete accounts that may not be useful.
Regularly reviewing your chart of accounts is an important task to ensure more efficiency in recording transactions. A new account can be added if it is necessary to have a more detailed tracking on certain transactions. When new accounts are added or existing accounts deleted, a revised chart of accounts should be distributed to the employees working on the accounting information system.
However, you should also make necessary precautions before deleting an account to avoid any irreversible mistakes. It is recommended to keep any unused accounts for at least until the end of a 12-month accounting period before deleting them.
Another advantage of computerized accounting systems is that they give companies an option to archive an account or make it inactive. This is useful you have an account that has not been used for a long time and if you decide not to use the account anymore.
Archiving accounts or making them inactive is a better and safer option than deleting them because these functions will still retain the accounts in the system while prohibiting new transactions to be entered in the account. This is especially useful during an audit because transactions entered in the archived or inactive accounts are still retained and reports can still be run for those accounts.
Review Questions
- What are ledger accounts?
- Why is there a need to use T-accounts before entering transactions in the accounting system?
- What are the normal balances of revenue and expense accounts?
- What happens to a temporary account at the end of the accounting period?
- What are the normal balances of each type of contra account?
