Equity is not a temporary account. It is a permanent or real account that represents the ownership interest in a business and is not closed at the end of an accounting period. In contrast, revenue, expenses, and drawings are temporary accounts that are closed at the end of each accounting period to prepare the books for the next period.
Temporary accounts, also known as nominal accounts, are those that deal with revenues, expenses, and withdrawals (or drawings). They are called “temporary” because they are only relevant for a specific accounting period, typically a fiscal year, and are closed at the end of that period. Let’s take a closer look at each type of temporary account:
- Revenue Accounts: Revenue accounts include all the income a business generates from its primary operations. This may encompass sales revenue, service fees, interest income, and more. These accounts are crucial for determining a company’s profitability and are closed at the end of the accounting period to prepare for the next.
- Expense Accounts: Expense accounts record all the costs incurred to run a business, such as rent, utilities, wages, and office supplies. Like revenue accounts, expenses are temporary and are closed at the end of the accounting period. The difference between total revenues and total expenses results in the net income or net loss for the period.
- Drawings (or Withdrawals): The drawings account is specific to sole proprietorships and partnerships and tracks the owner’s withdrawals from the business for personal use. Like revenue and expense accounts, the drawings account is closed at the end of the accounting period.
Permanent accounts, also known as real accounts, are those that involve assets, liabilities, and equity. These accounts are considered “permanent” because they carry forward their balances from one accounting period to the next. Here’s a breakdown of each type of permanent account:
- Asset Accounts: Asset accounts encompass everything a business owns or has a claim to. This includes cash, accounts receivable, inventory, buildings, and equipment. The balances of asset accounts are carried over from year to year and play a vital role in determining the overall financial health of a company.
- Liability Accounts: Liability accounts record a company’s obligations to creditors and other entities. This may include loans, accounts payable, and accrued liabilities. Similar to asset accounts, the balances in liability accounts are carried forward and contribute to the overall financial picture of the business.
- Equity Accounts: Equity accounts represent the owner’s interest in the business. These accounts include common stock, retained earnings, and additional paid-in capital. Equity accounts are also permanent and continue from one period to the next.
The Importance of Distinguishing Temporary from Permanent Accounts:
- Financial Reporting: It allows for accurate financial reporting, as income, expenses, and withdrawals are isolated within a specific period, making it easier to assess a company’s performance.
- Taxation: Temporary accounts directly influence a company’s tax liability. Knowing which accounts are temporary helps in preparing tax returns and estimating tax payments.
- Decision-Making: Business owners and stakeholders rely on financial statements to make informed decisions. Properly categorized accounts contribute to transparent and meaningful financial reports.