Tuesday, 3 June 2014

Classification of Accounts into 5 major groups as per Accounting Equation Principle

According to a modern classification of accounts, ASSETS = Liabilities + Equity.

Based on this Accounting Equation principle, in a wider sense, all accounts have been classified into 5 main types of accounts.

This accounting equation principle assumes that whatever we spend, we spend it from the money invested by us in the business known as Capital/ Equity as well as from the loans taken by us known as Liabilities and the Income generated by us through the business. So, we spend from these three types of sources. Now, coming to the spending aspect, whatever we may be spending, we spend either for procuring Assets or for running the business through various expenses.

So, according to this notion, Assets + Expenses = Equity + Liabilities + Income

Naturally, the sum total of Assets + Expenses will be equal to the sum total of all Liabilities + Equity + Income. The excess of Expenses over Income becomes the Loss and the Excess of Income over Expenses becomes the Profit of the business during any year. So, ultimately, only the difference of the expenses or income gets added either in Assets or Liabilities. And the net effect is Assets = Equity + Liabilities.

But, you may ask how to treat the profit that I generate in my business or the loss if any?

If your business generates profit, it is an income and gets included in the Income group. Otherwise, if there is a loss, it is an expense for your business and so it gets included in the Expenses group. So, ultimately both sides tally. 

This classification into  5 basic types of accounts is derived from the concept of the Trial Balance also. In a Trial balance, you enter all debit balances in the left-hand side column and all credit balances in the right-hand side column. And if a trial balance does not tally, it means that some entry is wrong in your books. This is the inherent principle applied by the Accounting Equation in all books of accounting.

Now let us examine which type of accounts or what kind of elements does each group of accounts consist.

Equity or Capital is the money invested in the business. Any business requires some capital to start with. The businessman invests some money to establish and run the business. It is known as Capital. If it is a big company, it will have many promoters or shareholders in the business, who are allotted shares according to their shares. This is known as share capital or Equity. So accounts maintained under this group include Capital a/c or Proprietor Capital, ShareHolders' money a/c, Equity a/c and Preferential Share a/c, etc.

Liabilities are also a kind of investment in the business. For example, you may take some loan to run the business from Banks or Financial Institutions. This money is repayable to them in installments with interest. So it is a liability. Further, you may collect advances from customers for supplying goods or services to them. So it is a liability as you will have to supply to them the goods and services required by them. Another kind of liability is that you will be paying some accrued expenses due for the period up to March, but it is payable after 1st April. As on 31st March, it is a liability for the business. So all these are company's dues to outsiders. Accounts included under this group are naturally Customers a/c, Loan a/c, Interest payable a/c, Expenses Payable a/c, Bank Overdraft, etc.

Assets are of fixed or permanent nature and of current/ temporary nature. Any business owns Land, Building, Furniture, and Office Equipment like Computer, Calculator, Printer, etc. These are Fixed Assets as they run for some years. Current Assets are Cash Balance, Bank Balance, Stock-in-trade, Investments, Amounts Receivable etc. All these are assets to the company.

Any kind of income received by the business during a particular year is known as its income or revenue for the year. This income is generated through its transactions. So INCOME group includes accounts like Sales a/c, Interest received on Investments, Interest from Bank, Interest received from others like scrap sales, late payment or late supply interest, etc. Profit of the business during the year also is an income and comes under this group.

All expenses incurred for running the business during a particular year are grouped into this group. So this group consists expenditure heads like Stationary, Printing Charges/ Xerox Charges, Postage/ Courier charges, Tour Exp., Advertisement, Salaries & Allowances, etc. If there is any loss in running the business it also is an expenditure and comes under this group.

  • To sum up, there are five major groups or elements of accounts based on the Accounting Equation principle of Classification of Accounts.
  • Amounts invested in the business are treated as Equity/ Capital.
  • Amounts received from Financiers and other parties as advances against supplies and services are returnable, hence Liabilities of the business.
  • Cash and Bank Balances, Investments and Fixed Assets and other Stocks are all Assets of the company.
  • All incomes against business transactions for a particular year are INCOME/REVENUE of the business for that particular year including the profit of that year.
  • All expenses spent for running the business during a particular year are Expenses of the business including loss, if any, for that particular year. 

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