In previous chapters of this section “Basics of accounting”, we have learnt that there are five (5) types/categories of accounts in which all business transactions are classified:
- Income (or revenue)
But what is an account? In accounting, the term account is used for a unique space where all the transactions of a specific item are recorded. Previously, when accounting was done on registers or pages, separate pages or sections were maintained for all accounts. Now, separate accounts (unique spaces) are created in the accounting software for each unique item by giving a unique account number and account name for identification. For example, under the broad category of Assets accounts, separate accounts of (i) office equipment, (ii) vehicles, (iii) trade receivables, (iv) prepayments (v) cash in hand (vi) bank balance etc. are maintained. Transactions related to each account are then recorded in relevant account, for example, if an entity has paid USD 100 as prepaid insurance, it will be recorded as an addition in the prepayments account and a reduction in the bank balance account.
Based on the nature of item for which an account is created, it is then linked to either of the following two categories of accounts:
- Balance sheet accounts
- Income statement accounts
In addition, each account is further linked to one of the five broad categories of accounts for reporting purposes. By doing so, it becomes easier to sort the transactions. Accounts linked with assets, liabilities, equity, income, and expenses categories will be clubbed under the relevant categories, respectively, while preparing the financial statements.
Balance sheet accounts
As the name suggests, information related to balance sheet accounts is reported in the balance sheet. These accounts are often referred as permanent accounts as these accounts are not closed at the end of an accounting period. Balances of these accounts are carried forward to the next accounting period as opening balances.
Following are the accounts which are classified as balance sheet accounts:
Income statement accounts
As the name suggests, information related to income statement accounts is reported in the income statement. These accounts are often referred as temporary accounts as these accounts are closed at the end of each accounting period. Closing balances of all the income statement accounts are clubbed and the net amount (net profit or loss for the period) is taken to retained earnings/accumulated losses account which is a balance sheet account within equity. Purpose of this exercise is to render all the balances of income statement accounts zero so that in the next accounting period, the income statement accounts will represent only the financial performance of that accounting period.
Following are the accounts which are classified as income statement accounts:
- Income (or revenues)
To sum up this topic, let’s take a look at the following flow chart to remember the categories of accounts.