Classification of Accounts

Q 1. What do you mean by classification of accounts? Explain different types of accounts as used in books of original entry with their rules?

Accounting is a business language. We can use this language to communicate financial transactions and their results. Accounting is comprehensive systems to collect, analyzes, and communicate financial information.

The origin of accounting is as old as money. In early days, the number of transactions were very small, so every concerned person could keep the record of transactions during a specific period of time. Twenty-three centuries ago, an Indian scholar named Kautilya alias Chanakya introduced the accounting concepts in his book Arthashastra. In his book, he described the art of proper account keeping and methods of checking accounts. Gradually, the field of accounting has undergone remarkable changes in compliance with the changes happening in the business scenario of the world.

A book-keeper may record financial transactions according to certain accounting principles and standards and as prescribed by an accountant depending upon the size, nature, volume, and other constraints of a particular organization.

With the help of accounting process, we can determine the profit or loss of the business on a specific date. It also helps us analyze the past performance and plan the future courses of action.

Definition of Accounting

The American Institute of Certified Public Accountant has defined Financial Accounting as: “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which in part at least of a financial character and interpreting the results thereof.”

Objectives and Scope of Accounting

Let us go through the main objectives of Accounting:

·        To keep systematic records - Accounting is done to keep systematic record of financial transactions. The primary objective of accounting is to help us collect financial data and to record it systematically to derive correct and useful results of financial statements.

·        To ascertain profitability - With the help of accounting, we can evaluate the profits and losses incurred during a specific accounting period. With the help of a Trading and Profit & Loss Account, we can easily determine the profit or loss of a firm.

·        To ascertain the financial position of the business - A balance sheet or a statement of affairs indicates the financial position of a company as on a particular date. A properly drawn balance sheet gives us an indication of the class and value of assets, the nature and value of liability, and also the capital position of the firm. With the help of that, we can easily ascertain the soundness of any business entity.

·        To assist in decision-making - To take decisions for the future, one requires accurate financial statements. One of the main objectives of accounting is to take right decisions at right time. Thus, accounting gives you the platform to plan for the future with the help of past records.

·        To fulfill compliance of Law - Business entities such as companies, trusts, and societies are being run and governed according to different legislative acts. Similarly, different taxation laws (direct indirect tax) are also applicable to every business house. Everyone has to keep and maintain different types of accounts and records as prescribed by corresponding laws of the land. Accounting helps in running a business in compliance with the law.

It is necessary to know the classification of accounts and their treatment in double entry system of accounts. Broadly, the accounts are classified into three categories:

• Personal accounts
• Real accounts
• Tangible accounts
• Intangible accounts

Personal Accounts

Personal accounts may be further classified into three categories:

Natural Personal Account

An account related to any individual like David, George, Ram, or Shyam is called as a Natural Personal Account.

Artificial Personal Account

An account related to any artificial person like M/s ABC Ltd, M/s General Trading, M/s Reliance Industries, etc., is called as an Artificial Personal Account.

Representative Personal Account

Representative personal account represents a group of account. If there are a number of accounts of similar nature, it is better to group them like salary payable account, rent payable account, insurance prepaid account, interest receivable account, capital account and drawing account, etc.

Real Accounts

Every Business has some assets and every asset has an account. Thus, asset account is called a real account. There are two type of assets:

·        Tangible assets are touchable assets such as plant, machinery, furniture, stock, cash, etc.

·        Intangible assets are non-touchable assets such as goodwill, patent, copyrights, etc.

Accounting treatment for both type of assets is same.

Nominal Accounts

Since this account does not represent any tangible asset, it is called nominal or fictitious account. All kinds of expense account, loss account, gain account or income accounts come under the category of nominal account. For example, rent account, salary account, electricity expenses account, interest income account, etc.

Double Entry System

Double entry system of accounts is a scientific system of accounts followed all over the world without any dispute. It is an old system of accounting. It was developed by ‘Luco Pacioli’ of Italy in 1494. Under the double entry system of account, every entry has its dual aspects of debit and credit. It means, assets of the business always equal to liabilities of the business.

Assets = Liabilities

If we give something, we also get something in return and vice versa.

Rules of Debit and Credit under Double Entry System of Accounts

The following rules of debit and credit are called the golden rules of accounts:

Example

Mr A starts a business regarding which we have the following data:

Introduces Capital in cash	Rs	50,000
Purchases (Cash)	Rs	20,000
Purchases (Credit) from Mr B	Rs	25,000
Freight charges paid in cash	Rs	1,000

It is very clear from the above example how the rules of debit and credit work. It is also clear that every entry has its dual aspect. In any case, debit will always be equal to credit in double entry accounting system.

As already stated every transaction involves give and take aspect. In double entry accounting, every transaction affects and is recorded in at least two accounts. When recording each  ransaction, the total amount debited must  equal to the total amount credited. In accounting, the terms — debit and credit indicate whether the transactions are to be recorded on the left hand side or right hand side of the account. In its simplest form, an account looks like the letter T. Because of its shape, this simple form called a T-account . Notice that the T format has a left side and a right side for recording increases and decreases in the item. This helps in ascertaining the ultimate position of each item at the end of an accounting period. For example, if it is an account of a customer all goods sold shall appear on the left (debit) side of customer’s account and all payments received on the right side. The difference between the totals of the two sides called balance shall reflect the amount due to the customer. In a T account, the left side is called debit (often abbreviated as Dr.) and the right side is known as credit (often abbreviated as Cr.). To enter amount on the left side of an account is to debit the account. To enter amount on the right side is to credit the account. Rules of Debit and Credit All accounts are divided into five categories for the purposes of recording the transactions:

(a) Asset

(b) Liability

(c) Capital

 (d) Expenses/Losses, and

 (e) Revenues/Gains.

Two fundamental rules are followed to record the changes in these accounts:

(1) For recording changes in Assets/Expenses (Losses):

(i) “Increase in asset is debited, and decrease in asset is credited.”

(ii) “Increase in expenses/losses is debited, and decrease in expenses/losses is credited.”

(2) For recording changes in Liabilities and Capital/Revenues (Gains):

(i) “Increase in liabilities is credited and decrease in liabilities is debited.”

(ii) “Increase in capital is credited and decrease in capital is debited.”

(iii) “Increase in revenue/gain is credited and decrease in revenue/gain is debited.”

The rules applicable to the different kinds of accounts have been summarised in the following chart:

The transactions in Example  will help you to learn how to apply these debit and credit rules. Observe the analysis  given carefully to be sure that you understand before you go on to the next one.

To illustrate different kinds of events, three more transactions have been added

1. Rohit started business with cash Rs. 5,00,000

Analysis of Transaction : The transaction increases cash on one hand and increases capital on the other hand. Increases in assets are debited and increases in capital are credited. Therefore record the transaction with debit to Cash and credit to Rohit’s Capital.

2. Opened a bank account with an amount of Rs. 4,80,000

Analysis of Transaction: The transaction increases the cash at bank on one hand and decreases cash in hand on the other hand. Increases in assets are debited and a decreases in assets are credited. Therefore, record the transactions with debit to Bank account and credit to Cash account.