Chapter 4 — The Five Account Types and Your Chart of Accounts

The Five Account Types and Your Chart of Accounts

Every dollar in your business lives in one of five account types, and every transaction touches at least two of them. Learn the five, and you can classify anything.

The five account types

Assets — what the business owns. Cash, bank accounts, accounts receivable (money customers owe you), inventory, equipment, vehicles, buildings, prepaid insurance. Assets appear on the balance sheet.
Liabilities — what the business owes. Accounts payable (bills you owe vendors), loans, credit card balances, payroll taxes owed, unearned revenue (money collected for work not yet done).
Equity — the owner’s stake. Owner’s capital (what the owner invested), retained earnings (accumulated profits), minus owner’s draws. Sole proprietors use “Owner’s Capital” and “Owner’s Draw”; S corporations use “Shareholder Distributions” and “Retained Earnings” — the idea is identical: what’s left for the owner.
Income (Revenue) — what the business earns. Sales, service income, fees, interest earned. Income appears on the profit & loss statement, and it increases equity.
Expenses — what the business spends to earn that income. Rent, wages, supplies, insurance, advertising, utilities, depreciation. Expenses appear on the profit & loss statement, and they decrease equity.

Notice the pattern: assets, liabilities, and equity are permanent accounts — their balances carry forward year to year and make up the balance sheet. Income and expenses are temporary accounts — they reset to zero at year-end, and their net result flows into equity as profit or loss.

The income/expense trap: what is NOT what it seems

Small businesses misclassify the same few things over and over:

Owner draws are not expenses. Taking money out for yourself is a withdrawal of equity, not a cost of doing business. Recording your grocery run as “office expense” inflates your deductions and misstates your profit — and it won’t survive an audit.
Loan principal payments are not expenses. When you pay $800 on a truck loan, the interest portion is an expense, but the principal portion just reduces a liability — settling a debt, not spending.
Buying equipment is not (immediately) an expense. A $4,000 computer is an asset. It becomes an expense gradually through depreciation — or possibly all at once under Section 179 or bonus depreciation. But on day one, it’s an asset purchase, not an expense.
Customer deposits are not income yet. If a client pays you $5,000 in advance, that’s unearned revenue — a liability. You owe them the work. It becomes income when you do the work.

Your chart of accounts

The chart of accounts is simply the list of every account your business uses — the five types, broken into the categories you need. A restaurant needs “Food Costs” and “Beverage Costs”; a freelance designer needs “Software Subscriptions” and “Subcontractors.”

Design principles

Keep it useful, not exhaustive. If you can’t imagine a decision you’d make differently by splitting an account, don’t split it. Forty well-chosen accounts beat two hundred confusing ones.
Separate what you’ll need at tax time. Your tax return asks for expenses in specific categories — advertising, vehicle, office, contract labor. Design expense accounts that map cleanly to your return’s lines, so year-end is a matter of running a report instead of re-sorting a year of transactions.
Number your accounts. The standard convention: 1000s — Assets (1010 Cash, 1020 Checking, 1200 Accounts Receivable, 1500 Equipment); 2000s — Liabilities (2010 Accounts Payable, 2100 Credit Card, 2300 Loan Payable); 3000s — Equity (3010 Owner’s Capital, 3020 Owner’s Draw); 4000s — Income (4010 Service Income, 4020 Product Sales); 5000s — Expenses (5010 Rent, 5020 Wages, 5030 Supplies). Numbering isn’t required by law — it just keeps reports sorted and makes new accounts easy to add.
Don’t create an account for a one-time event. One parking ticket all year goes in “Miscellaneous.” New accounts are for recurring, meaningful categories.

A starter chart for a service business

A starting point for, say, a home-cleaning business — copy it and adjust:

Assets (1000s): 1010 Business Checking · 1020 Business Savings · 1200 Accounts Receivable · 1300 Prepaid Insurance · 1500 Cleaning Equipment
Liabilities (2000s): 2010 Accounts Payable · 2100 Business Credit Card · 2200 Payroll Tax Payable · 2300 Equipment Loan
Equity (3000s): 3010 Owner’s Capital · 3020 Owner’s Draw
Income (4000s): 4010 Residential Cleaning Income · 4020 Commercial Cleaning Income
Expenses (5000s): 5010 Wages · 5020 Cleaning Supplies · 5030 Vehicle Expense · 5040 Insurance · 5050 Advertising · 5060 Phone & Internet · 5070 Professional Fees · 5080 Miscellaneous

Accounts you should never combine

Never combine business and personal. One business account, one set of books, zero personal transactions. The owner who buys business supplies with a personal card should submit an expense report — not shrug and lose the deduction.
Never net income against expenses. If you earned $5,000 on a project and spent $1,000 on materials, record $5,000 of income and $1,000 of expense — not $4,000 of income. Netting hides both numbers and destroys your margin analysis.
Never combine loan principal with interest. Only interest is an expense. Keep the principal in a liability account so you always know what you still owe.
Never combine different tax years. Shifting income between years to manipulate a tax bill isn’t clever planning — it’s misreporting.

Contra accounts, briefly

Some accounts exist to be subtracted from their partners. Accumulated depreciation sits against equipment on the balance sheet, showing both what the asset cost and how much has been used up. Allowance for doubtful accounts estimates receivables you probably won’t collect, shown as a reduction of accounts receivable. The pattern: an account with the opposite normal balance of its partner, showing net reality more clearly.

When to revise the chart

Review the chart once a year, ideally at year-end close: merge accounts with zero activity; break out a “miscellaneous” balance that’s gotten large — one holding 15% of expenses is telling you a real category is missing; add accounts for new recurring costs; rename anything that confused you. Don’t renumber mid-year if you can avoid it — it complicates year-over-year comparisons. Make chart changes effective January 1.

Key takeaways

There are only five account types: assets, liabilities, equity, income, and expenses.
Assets, liabilities, and equity are permanent (balance sheet); income and expenses are temporary (profit & loss).
Owner draws, loan principal payments, equipment purchases, and customer deposits are commonly misclassified — get these right.
Design your own chart of accounts: useful detail, tax-friendly categories, numbered 1000s–5000s.
Don’t create accounts for one-time events; review and tidy the chart once a year.