Navigating the Accounting Maze: Deciding Which Account to Set Up

Lucy

As an accounting student, one of the first and most important concepts you’ll need to grasp is how to decide which account to set up in accounting. This is crucial because accounts are the building blocks of financial records. Accounts allow businesses to organize, classify, and record transactions, which are later used to create financial statements.

In this tutorial, we’ll break down the process of setting up accounts step by step. We’ll explore various types of accounts, go through the process of creating journal entries, and look at how these entries flow into financial statements. By the end, you’ll be comfortable making decisions on which account to use for different types of transactions.

Understanding the Different Types of Accounts

Before you can decide which account to set up, you need to understand the different types of accounts available. In accounting, accounts are classified into five major categories:

Assets: These are resources that the company owns or controls and expects to provide future economic benefits. Examples include cash, accounts receivable, inventory, and equipment.
Liabilities: These represent the company’s obligations to others, such as loans, accounts payable, and accrued expenses.
Equity: Equity is the owner’s claim to the assets after all liabilities are settled. This includes common stock, retained earnings, and other owner investments.
Revenues: These accounts track the income a company earns through its operations, such as sales revenue, service revenue, or interest income.
Expenses: These accounts represent costs incurred by a business to generate revenue, such as rent, salaries, utilities, and depreciation.

Each of these account categories serves a different purpose, and knowing where a transaction fits into these categories will help you decide which account to set up.

The Accounting Equation and How It Guides Account Setup

The accounting equation is the foundation of double-entry bookkeeping:

Assets = Liabilities + Equity

This equation must always balance, meaning the total amount of assets always equals the sum of liabilities and equity. Every transaction affects at least two accounts, and the accounting equation ensures that the records stay balanced.

When deciding which account to set up, think about where the transaction fits in relation to assets, liabilities, and equity. Let’s explore this in more detail with examples and journal entries.

Deciding Which Account to Set Up: A Step-by-Step Approach

Step 1: Understand the Transaction

Before you choose which account to use, first analyze the transaction. What happened in the business? Was there an increase in assets? A decrease in liabilities? Or did the business earn revenue?

Let’s go through some examples:

Example 1: The company purchases equipment worth $5,000 on credit.
- This transaction involves both an increase in assets (equipment) and an increase in liabilities (accounts payable). Therefore, we need to set up two accounts: Equipment (Asset) and Accounts Payable (Liability).
Example 2: The company receives $1,000 in cash from a customer for services rendered.
- This transaction affects two accounts: an increase in cash (Asset) and an increase in revenue (Revenue). The accounts to be set up here are Cash (Asset) and Service Revenue (Revenue).

Step 2: Determine the Nature of the Account

Once you understand the transaction, determine the nature of the account you’ll need to create. Is it an asset, liability, equity, revenue, or expense?

If the transaction involves something the company owns, it’s likely an Asset.
If the transaction represents money the company owes, it’s a Liability.
If the transaction affects the owner’s stake in the company, it’s Equity.
If the transaction brings in income, it’s Revenue.
If the transaction represents a cost to the company, it’s an Expense.

Step 3: Record the Transaction with a Journal Entry

Now that you know which accounts to set up, it’s time to record the transaction in the journal. In double-entry accounting, every transaction involves a debit and a credit.

A debit increases assets and expenses but decreases liabilities, equity, and revenue. A credit, on the other hand, increases liabilities, equity, and revenue, but decreases assets and expenses.

Let’s look at the examples and create journal entries.

Example 1: Purchase Equipment on Credit

Transaction: The company purchases equipment worth $5,000 on credit.

Accounts Involved:

Debit Equipment (Asset) $5,000 (increases asset)
Credit Accounts Payable (Liability) $5,000 (increases liability)

Journal Entry:

| Date         | Account               | Debit     | Credit    |
|--------------|-----------------------|-----------|-----------|
| Nov 1, 2024  | Equipment             | $5,000    |           |
|              | Accounts Payable      |           | $5,000    |

Example 2: Receive Cash for Services Rendered

Transaction: The company receives $1,000 in cash from a customer for services rendered.

Accounts Involved:

Debit Cash (Asset) $1,000 (increases asset)
Credit Service Revenue (Revenue) $1,000 (increases revenue)

Journal Entry:

| Date         | Account               | Debit     | Credit    |
|--------------|-----------------------|-----------|-----------|
| Nov 2, 2024  | Cash                  | $1,000    |           |
|              | Service Revenue       |           | $1,000    |

Step 4: Post the Journal Entry to the Ledger

After recording the journal entry, the next step is to post it to the ledger. The ledger is a collection of accounts that shows the transactions affecting each account. For example, the Cash account will show all the debits and credits related to cash.

Let’s take a look at how the accounts would look after posting these journal entries.

Ledger Entries for Equipment and Accounts Payable

Equipment Account:

| Date         | Debit     | Credit    | Balance   |
|--------------|-----------|-----------|-----------|
| Nov 1, 2024  | $5,000    |           | $5,000    |

Accounts Payable Account:

| Date         | Debit     | Credit    | Balance   |
|--------------|-----------|-----------|-----------|
| Nov 1, 2024  |           | $5,000    | $5,000    |

Ledger Entries for Cash and Service Revenue

Cash Account:

| Date         | Debit     | Credit    | Balance   |
|--------------|-----------|-----------|-----------|
| Nov 2, 2024  | $1,000    |           | $1,000    |

Service Revenue Account:

| Date         | Debit     | Credit    | Balance   |
|--------------|-----------|-----------|-----------|
| Nov 2, 2024  |           | $1,000    | $1,000    |

Step 5: Prepare Financial Statements

Now that we have recorded and posted the transactions, it’s time to prepare the financial statements. The two main financial statements used by businesses are the Income Statement and the Balance Sheet.

Income Statement

The Income Statement summarizes the company’s revenues and expenses, showing the net profit or loss for a specific period.

For the example transactions, the income statement will show:

Income Statement for the period ended November 2, 2024:

| Revenues             | $1,000     |
|----------------------|------------|
| Expenses             |            |
| Net Income           | $1,000     |

Balance Sheet

The Balance Sheet provides a snapshot of the company’s financial position at a particular point in time, listing assets, liabilities, and equity.

Balance Sheet as of November 2, 2024:

| Assets                       |           |
|------------------------------|-----------|
| Cash                         | $1,000    |
| Equipment                    | $5,000    |
| Total Assets                 | $6,000    |

| Liabilities                  |           |
|------------------------------|-----------|
| Accounts Payable             | $5,000    |
| Total Liabilities            | $5,000    |

| Equity                       |           |
|------------------------------|-----------|
| Retained Earnings            | $1,000    |
| Total Equity                 | $1,000    |

| Total Liabilities and Equity | $6,000    |

Practice Questions

Question 1: A company borrows $3,000 from the bank. Which accounts will you use, and what will the journal entry look like?
Question 2: The company pays $500 for rent. What accounts should be involved, and what is the journal entry?
Question 3: The company sells goods for $2,000 on credit. Which accounts should be affected, and what is the journal entry?

Answers Section

Answer 1:

Accounts Involved:
- Debit Cash (Asset) $3,000
- Credit Bank Loan (Liability) $3,000

Journal Entry:

| Date         | Account               | Debit     | Credit    |
|--------------|-----------------------|-----------|-----------|
| Nov 3, 2024  | Cash                  | $3,000    |           |
|              | Bank Loan             |           | $3,000    |

Answer 2:

Accounts Involved:
- Debit Rent Expense (Expense) $500
- Credit Cash (Asset) $500

| Date         | Account               | Debit     | Credit    |
|--------------|-----------------------|-----------|-----------|
| Nov 4, 2024  | Rent Expense          | $500      |           |
|              | Bank Loan             |           | $500      |

Answer 3:

Accounts Involved:
- Debit Accounts Receivable (Asset) $2,000
- Credit Sales Revenue (Revenue) $2,000

| Date         | Account               | Debit     | Credit    |
|--------------|-----------------------|-----------|-----------|
| Nov 5, 2024  | Accounts Receivable   | $2,000    |           |
|              | Sales                 |           | $2,000    |

Conclusion

In this tutorial, we’ve explored how to decide which account to set up when recording business transactions. The process involves understanding the nature of the transaction, determining which category of accounts it falls under, and recording it in the journal. From there, the information flows into the ledger and eventually to the financial statements. By following these steps, you can ensure that your accounting records are accurate and complete, laying the foundation for successful financial reporting.