Accounts, terminology and classifications

In depth

What the standard setters say

The plain-language definitions above follow the conceptual frameworks of the FASB and the IASB, which define the elements precisely so that every standard uses them in the same way. Their wording differs in places that matter.

Three differences are worth noticing. First, the IASB defines an asset through control; the FASB’s 2021 wording leaves the word out, though its explanation still requires that the entity can obtain the benefit and restrict others’ access to it. Either way, a loyal customer base or a talented barista is not an asset in the accounting sense. Second, the IASB’s element is income, which covers both revenue from ordinary activities and other gains; the FASB defines revenues and gains separately and says that which one an inflow is depends largely on the nature of the business and the activity involved. Selling coffee catering is revenue for Lantern; selling its old grinder for more than its recorded amount would be a gain. Third, the IASB writes the residual nature of equity into the other definitions: income and expenses are changes in equity other than those from the owners’ contributions or distributions.

That last point is why dividends are not an expense under either framework. The IASB excludes distributions to holders of equity claims from expenses by definition, and the FASB defines distributions to owners as a separate kind of change in equity. A dividend reduces equity because the owners take resources out, not because the business used anything up in earning revenue.

Current and noncurrent: the rules

Under US GAAP, current assets are cash and other assets reasonably expected to be turned into cash, sold or consumed during the business’s normal operating cycle. The operating cycle is the average time between acquiring the materials or services a business works with and finally collecting cash from its customers. Where several cycles fit into a year, as at Lantern (buy beans, cater an event, collect the invoice, all within about a month), one year is used instead. Where the cycle is longer than twelve months, as the US standards note for the tobacco, distillery and lumber businesses, the longer cycle is used. Hence the usual summary: one year or the operating cycle, whichever is longer. Current liabilities are obligations expected to be settled out of current assets or by creating other current liabilities, which in practice means those due within the same period.

IFRS reaches almost the same place by a slightly different route. An asset is current if the entity expects to realise, sell or consume it in its normal operating cycle, holds it mainly for trading, expects to realise it within twelve months after the reporting date, or it is cash not restricted for at least twelve months; every other asset is noncurrent. A liability is current if it will be settled in the normal operating cycle, is held mainly for trading, is due within twelve months after the reporting date, or the entity has no right at that date to defer settlement for at least twelve months. IFRS also allows a business to present all its assets and liabilities in order of liquidity instead, when that is more useful, as it often is for banks.

Contra accounts

A contra account is an account paired with another account whose balance it reduces. The two are reported together, with the contra balance subtracted from its partner. The most common example is accumulated depreciation. When Lantern bought its espresso machine and grinder, it recorded them at their $12,000 cost in Equipment. Each month a slice of that cost is treated as used up; lesson 9 calculates the slice, which for Lantern is $200 a month. Instead of reducing the Equipment account, Lantern adds each slice to a separate account, Accumulated Depreciation—Equipment. At 31 March the balance sheet shows both: Equipment $12,000, less accumulated depreciation $200, giving a net amount of $11,800.

Why not cut Equipment to $11,800 directly? Because the two figures tell a reader different things. The cost shows how much was invested; the accumulated depreciation shows how much of that investment has been used up, which hints at how old the equipment is and when it may need replacing. Keeping them apart also keeps the original cost on record for when the asset is eventually sold or scrapped. A contra account keeps its own balance, moves in the opposite direction from its partner (lesson 4 shows that this means it carries its balance on the opposite side), and belongs to its partner’s group: Accumulated Depreciation—Equipment is a noncurrent contra-asset because Equipment is noncurrent. Later courses meet other contra accounts, such as an allowance for doubtful accounts, which reduces accounts receivable by the amount not expected to be collected, and sales returns and allowances, which reduce revenue.

Permanent and temporary accounts

A permanent account is one whose balance carries forward from one period to the next. Every asset, liability and equity account is permanent, and so is every contra-asset account: accumulated depreciation keeps growing, month after month, until the asset is disposed of. Permanent accounts are also called real accounts. A temporary account collects one period’s activity and is then emptied, so that it starts the next period at zero. Every revenue and expense account is temporary, and so is Dividends. Temporary accounts are also called nominal accounts.

At the end of each period the temporary accounts are closed: their balances are transferred into Retained Earnings, the permanent equity account where accumulated profit lives. Lantern’s chart also contains Income Summary, a temporary account used only during that closing process. Lesson 11 teaches the closing entries; for now the point is classification. The reason for the split is simple. Revenue for April must not include March’s revenue, but cash at 1 April is the same cash as at 31 March: performance is measured period by period, while position accumulates.

The chart of accounts

A chart of accounts is the list of every account a business uses, each with a name and usually a number, arranged by type. It is the business’s vocabulary: it makes sure the same kind of event is always recorded in the same account, whoever records it, so that balances can be added up and statements prepared automatically. Here is Lantern’s chart, walked through by group.

The first digit tells you the type: 1 for assets, 2 liabilities, 3 equity, 4 revenue, 5 expenses. Within each type, the numbers leave gaps (101, 110, 112, 115, 120…) so that new accounts can be slotted into the right place later. The chart also lists accounts Lantern does not use in March, such as Van, Land and Building: a chart holds the accounts a business expects to need, and grows when it needs more.

This numbering is a common convention, not a rule. Neither US GAAP nor IFRS prescribes account names or numbers. Many businesses use four or more digits, give cost of sales and operating expenses separate ranges, or add segments to each code for a department, location or product line, so that a hotel chain can see the rooms revenue of one hotel as easily as of the whole group. What the standards do govern is how accounts are classified and presented in the statements.

Same item, different names

This course uses US account names, as Lantern does. Under IFRS, and in UK company law and practice, several of the same items go by other names. The names change nothing about classification: trade receivables are current assets whatever they are called.

Judgement calls

Most accounts classify themselves. A few need thought, and they are the ones that students, and sometimes businesses, get wrong. In each case the test is the same: what right or obligation exists at the reporting date, and when will it turn into cash, be used up or be settled?

• Prepaid insurance is an asset, not an expense. On 4 March Lantern paid $1,800 for cover running from 1 March 2026 to 28 February 2027. On that day it holds a right to twelve months of protection, an economic benefit it controls, so the payment creates an asset, Prepaid Insurance. As each month passes, a twelfth of the cover expires and becomes Insurance Expense: $150 a month. Because the policy runs for twelve months, all of it is current. If a business paid for three years of cover in advance, then by the same definitions the part covering the months beyond the next twelve would be noncurrent.
• Unearned revenue is a liability, not revenue. Harbor Tech’s $2,400 deposit arrives before Lantern has catered any of the three $800 events. Lantern now owes Harbor Tech either the events or the money back: a present obligation, so a liability. Each event catered turns $800 of the liability into revenue, the first on 26 March. The events all fall within the next two months, so the liability is current.
• Equipment or supplies? Both are things Lantern buys to use, but they are classified by how long they last. Beans, milk, cups and lids are used up within weeks: they are Supplies, a current asset that becomes Supplies Expense as it is used. The espresso machine and grinder will serve for about five years: they are Equipment, a noncurrent asset whose cost is spread over those years. Between the two lies a grey zone of cheap but durable items, such as a milk jug or a tamper. Tracking each for years would cost more than the information is worth, so most businesses set a policy, often a minimum cost below which durable items are expensed when bought: materiality and the cost constraint from lesson 1 at work.
• The current portion of a long-term loan. Classification follows the dates on which each part of an obligation falls due, not the loan’s original length. Lantern’s $10,000 note runs for two years from 1 March 2026, with interest paid every three months and the principal repayable when the note matures on 1 March 2028, so at 31 March 2026 the whole $10,000 is noncurrent. A year later, at 31 March 2027, it will be due within twelve months and will have become current. Suppose instead the bank had required $5,000 back on 1 March 2027 and $5,000 on 1 March 2028. Then at 31 March 2026 the balance sheet would show a current liability of $5,000 and a noncurrent liability of $5,000. Showing the whole loan as noncurrent would hide a large payment due within the year.
• Future interest is not a liability yet. Over its two years the note will cost $1,200 of interest ($10{,}000 \times 6\% \times 2$). At 31 March Lantern owes only March’s interest, $50, because only March has passed; the obligation for April’s interest arises in April, as Lantern goes on using the bank’s money. Liabilities are present obligations, not every payment a business expects to make.