SQL Server service account
The SQL Server service account is used to run SQL Server. It is the service account for the following SQL Server services:
Use either a Local System account or a domain user account.
If you plan to back up to or restore from an external resource, permissions to the external resource must be granted to the appropriate account. If you use a domain user account for the SQL Server service account, grant permissions to that domain user account. However, if you use the Network Service or the Local System account, grant permissions to the external resource to the machine account (domain_name\SQL_hostname$).
The instance name is arbitrary and was created when Microsoft SQL Server was installed.
Setup user account
The Setup user account is used to run the following:
Server farm account or database access account
The server farm account is used to perform the following tasks:
The server farm account is automatically added as a SQL Server login on the computer that runs SQL Server. The account is added to the following SQL Server security roles:
Ok, makes sense. So you login to the app server with the setup account, and install SharePoint. Then you do the same on one or more Web Servers. Now go back to the app server and run the Configuration Wizard and set up the farm and Central Admin. After some configuration (setting up services, the first site collection), you come back to the Web Servers and attempt to add them to the farm. The whole process goes smoothly and the Web Server connects to the farm. Great, now you go to the Servers in Farm page in Central Admin, and to your dismay the Web Server line item shows an error and that it needs upgrading.
What?? So you run the 'stsadm -o localupgradestatus' on the Web Server and it shows you as everything being ok. Hmm..
The way I found to get around this is to remove the Web Server from the farm, then log off the Web Server. Log back on using the Server farm account, not the setup account. Now run the Configuration Wizard and add the Web Server back to the farm. This works well and now when you go to the 'Servers in Farm' page, everything looks good!