Classification Of Accounts

Classification of Accounts:

An account is a record in the general ledger that is used to collect and store debit and credit amounts. For example, a company will have a Cash account in which every transaction involving cash is recorded. If the company sells merchandise for cash, the Cash account will be debited and the Sales account will be credited.

We can classify accounts in two different ways. These are:

  1. Traditional classification of accounts

  2. Modern classification of accounts

Traditional Classification of Accounts:

This is very old method of classifying accounts and is not used in most of the advanced countries. Under this method, accounts are classified into four types. These are:

  1. Personal accounts
  2. Real accounts
  3. Nominal accounts
  4. Valuation accounts

Personal Accounts:

These accounts show the transactions with the customers, suppliers, money lenders, the bank and the owner. A business may have many credit transactions with the above persons or organizations. A separate account is to be prepared for each of them. Persons or organizations with whom the business has credit transactions are either debtors or creditors. If they have to give some money to the firm, they are called debtors. Conversely, if the firm is to pay them some money they are known as creditors. The main purpose of preparing personal accounts is to ascertain the balances due to or due from persons or organizations.

Real Accounts:

These accounts are accounts of assets and properties such as land, building, plant, machinery, patent, cash, investment, inventory, etc. When a machinery is purchased for cash, the two accounts involved are machinery and cash – both are real accounts. But if the same machine is purchased from Z & Co. on credit, for example,  two accounts involved will be those of machinery and Z & Co., the former being a real account and the later being a personal account.

Nominal Accounts:

These are the accounts of incomes, expenses, gains and losses. Examples of nominal accounts are wages paid, discount allowed or received, purchases, sales, etc. These accounts generally accumulate the data required for the preparation of income statement or trading and profit and loss account.

Valuation Accounts:

These are the accounts of provision for depreciation and provision for doubtful debts. Where fixed assets are maintained in the books of accounts at original cost, to reflect the actual book value of the assets, a provision for depreciation account on the credit is maintained. In the balance sheet, it is shown as deduction from the original cost of the asset. Similarly, if the debtors’ personal accounts are retained at total amount due, a valuation account on the credit – provision for doubtful debts is required. In the balance sheet, it is shown as a reduction from sundry debtors account to reflect estimated realizable value.

Modern Classification of Accounts:

The types of modern accounts are;

1. Capital Accounts.

2. Assets  Accounts.

3. Liability Accounts.

4. Expenses Accounts.

5. Income Accounts.

Advertisements

The Accounting Equation

The Accounting Equation? 

The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company’s shareholders. It is the basis upon which the double entry accounting system is constructed.

The Accounting Equation shows that a company’s total amount of assets equals the total amount of liabilities plus owner’s (or stockholders’) equity.

Thus, the accounting equation is;

Assets = Liabilities + Shareholder Equity

The assets in the accounting equation are the resources that a company has available for its use, such as cash, accounts receivable, fixed assets, and inventory.

The Liabilities part of the equation is usually comprised of accounts payable that are owed to suppliers, a variety of accrued liabilities, such as sales taxes and income taxes, and debt payable to lenders.

The Shareholders’ Equity part of the equation is more complex than simply being the amount paid to the company by investors. It is actually their initial investment, plus any subsequent gains, minus any subsequent losses, minus any dividends or other withdrawals paid to the investors.

Every business transaction affects a company’s financial standing which is measured primarily based on assets, liabilities and owner’s equity or stockholders’ equity. The basic accounting equation is a simple way to show the relation between these three items.

KEY POINT:  * The accounting equation demonstrates how business assets are financed*

THE ACCOUNTING EQUATION IN ANALYZING BUSINESS TRANSACTIONS

The accounting equation is at the root of transaction analysis in business. When a business executes any transaction: a sale to a customer, a purchase, a debt payment, a stock sale, the accounting equation must remain in balance. If the equation isn’t balanced, this indicates that the analysis is incomplete or incorrect.

If a transaction changes the total value on one side of the equation, the other side must change by an equal amount. The rules for financial accounting ensure that the equation will remain in balance.

For more information and analysis of simple transactions, visit Ask A Question page.

CAPITAL AND REVENUE ITEMS

CAPITAL EXPENDITURE:

Capital Expenditure is money spent to buy fixed assets. It is an expense where the benefit continues over a long period, rather than being exhausted in a short period. Such expenditure is of a non-recurring nature and results in acquisition of permanent assets. It is thus distinct from a recurring expense.

Capital expenditures are made for the purpose of capital investment. The purchase of large, long-term assets that depreciate over time is a capital expenditure. You make these purchases to provide the assets or infrastructure your company needs to grow its business and generate more profits. As such, you must use a sizable portion of your company’s capital to acquire or install these assets. Many companies use debt financing or retained earnings to finance capital expenditures, but some use equity financing. Hence the use of the term “capital” to describe the expenditure.

 

REVENUE EXPENDITURE:

Revenue expenditures is money spent on the daily running expenses of the business. A revenue expenditure is an amount that is expensed immediately; thereby being matched with revenues of the current accounting period. Routine repairs are revenue expenditures because they are charged directly to an account such as Repairs and Maintenance Expense.

KEY  POINT : Revenue expenses can be fully tax-deducted in the same year the expenses occur.

Revenue expenditures are usually just called “expenses.” Expenses are the costs your company incurs doing its normal business, and they are recognized immediately. In accrual accounting, you recognize revenues when they’re earned and expenses when they’re incurred. When you immediately record your expenses, you are matching them with the revenue those expenses helped produce. For example, labor and materials are expenses incurred to provide the services reflected in the revenue they are matched against.

There are two types of revenue expenditure:

  • Maintaining a revenue generating asset. This includes repair and maintenance expenses, because they are incurred to support current operations, and do not extend the life of an asset or improve it.
  • Generating revenue. This is all day-to-day expenses needed to operate a business, such as sales salaries, rent, office supplies, and utilities.

When Revenue Expenditures are not regarded as Revenue Expenditures?

There are some items of expenditure which are revenue by nature, yet they are not regarded as revenue expenditure. Such expenditures may be divided into two groups:

  1. Deferred revenue expenditure
  2. Capitalized revenue expenditure

1. Deferred Revenue Expenditure:

This is a revenue expenditure, the benefit of which is not confined to one accounting year – it extends to future accounting year or years also. However, this expenditure does not result in the acquisition of any fixed asset. For example, heavy advertisement expenditure is incurred on introduction of a new product in the market. This is a revenue expenditure in nature and the benefit is enjoyed by the business over a number of years, but no asset of permanent nature is acquired. A portion of this expenditure is treated as revenue expenditure chargeable in the current accounting year and the remaining portion is temporarily treated as capital expenditure and shown on the Asset side of the Balance Sheet. Below are a few examples of such expenditure:

(a) Expenditure incurred to the formation of a joint stock company i.e. Preliminary Expenses.

(b) Expenditure on research and experiment connected with the introduction of a new product.

(c) Heavy expenditure on advertisement for marketing a new product.

(d) Heavy expenditure on repairs to property.

(e) Expenditure on removal of business from one place to another place.

2. Capitalized Expenditure:

Some expenditures although of revenue nature basically, are directly connected with fixed assets and spent directly on the acquisition of fixed assets. Such expenditures are added to the cost of assets and are called “Capitalized Expenditures”. For example, we buy a second-hand plant for $50,000. This is undoubtedly a capital expenditure. A further sum of $5,000 is spent on its repair and overhauling in order to bring the plant into proper working order. Expenditure on account of repair and overhauling, although revenue by nature, will be treated as Capital Expenditure in this case and will be debited to plant account not to Repairs A/c. Thus, a revenue expenditure which increases the utility or productive capacity of an asset, is treated as capitalized expenditure. Below are a few examples of such expenditure:

(a) Expenditure on installing an asset. i.e. installation charges.

(b) Expenditure on repair to property, if the production capacity or utility of the property is increased. It may, however, be noted that sometimes a new asset may require some repair after its purchase but before it is installed and put into operation. Cost of such repair, although it may not increase the production capacity of the asset, will be treated as a capitalized expenditure.

(c) Expenditure incidental to purchase of fixed assets, e.g. freight, clearing charges, customs duty, carriage, octroi duty, import duty on assets purchased.

(d) Expenditure on removal of old property.

 

 

For more information on Capital and Revenue Items, visit ‘ask a question’ page.