Financial accounting has undergone a lot of changes from the time it was initiated in India by the British. Every transaction has to be recorded and its effect is taken in its individual expense or asset account and it is also recorded in the cash or bank account. You need to thus classify accounts to record transactions.
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Classification of Accounts
There are two classifications of accounts:
The traditional classification is rarely used now. Under this classification there are two types of accounts, namely
Business transactions done with other individual or organisations or bank and recorded in their individual account created in the books of accounts of the entity is called personal account.
Example: Timothy Ltd. has a bank account in Andhra Bank and City Bank and he uses both the bank accounts for his business transactions. In such a case, two separate Bank Books will be maintained; one for Andhra Bank and the other for City Bank, and show both the bank balances in his financial statements.
Example: Timothy Ltd. buys his regular stationery items from Writing Needs Ltd. and pays them after every two months. Hence, Timothy Ltd. records every purchase of stationary in the individual account of Writing Needs Ltd. and after two months settles his payment against the amount of stationery recorded.
Impersonal accounts are related to anyone individual or an individual. They are further divided into two accounts:
Real accounts are popularly known as permanent accounts. These accounts do not disappear after the closure of the accounting period, but they continue to exist, which means they are carried forward to the next accounting period. Therefore, real accounts will always have a balance carried forward and will never have a zero balance to start with it.
Examples of some real accounts are machinery account, land account, furniture account, cash account, bank accounts, debtors account, creditors account and capital account. You see that they are mostly on the balance sheet and are also called balance sheet accounts.
Nominal accounts are popularly known as temporary accounts. These accounts are not carried forward to the next accounting period. They are closed at the end of that particular accounting period. In the new accounting period, these accounts start with no balance brought forward, they start with a zero balance. All expense accounts are only for that accounting period and same goes for the revenue or income made.
Examples of nominal accounts are printing and stationery, office expenses, rent paid, salaries paid, income received, interest received, etc. Therefore, you can see that they are items from the income and expenditure statement or trading and profit and loss account. Therefore, they are also called income statement accounts
Therefore, there is no balance brought forward or balance carried down. The total of the expense or income account is recorded in the income and expenditure statement.
Modern classification is presently used in almost all countries. This classification categorises accounts into three types namely assets, liabilities and capital. Let us discuss these three types of accounts in detail:
These are all individual assets accounts whose balances are carried forward to the next accounting period. There can be tangible and intangible assets, i.e., assets that can be seen such as land, building, machinery, furniture, and assets that cannot be seen but have a market value like goodwill, patent, trademark, etc. All appear on the assets side in the balance sheet.
These are all the liabilities of the business and appear on the liability side of the balance sheet. Individual liability accounts are accounts payable account, loan from bank, debenture account, etc. The balances of these accounts are carried forward to the next accounting period. They always have credit account balance.
Equity or Shareholder’s equity refers to the sum total of capital received from investors and the accumulated earnings of a business in form of reserves and surplus. Therefore, Equity is calculated as:
Equity = Capital (or, Share Capital) + Reserves and Surplus
Capital refers to the funds that are raised by a firm by issuing shares. The value of capital is derived by multiplying the face value of a single share by the number of shares issued (fully subscribed).
A firm earns and accumulates profits over a period of time and this accumulated amount is called as reserves and surplus. Reserves and surplus account includes different reserves such as ‘General Reserve’, ‘Profit and loss reserve’, ‘Share premium account’, etc.
Capital can be invested by sole owner or partners or shareholders. In sole proprietorship, there is only one capital account for the proprietor which is written as the owner’s capital account or only capital account.
In a partnership firm, there is a separate capital account for each partner or member which is written like Ram’s capital account, Rahim’s capital account, etc.
In corporate organisations, there is a separate capital account known as the Shareholders account. The paidup capital of a corporate would be shown as equity shares account, preference shares account, paid in capital account and so on. Retained earnings will be maintained from the corporate revenue after deducting the amount of dividends given out to shareholders. Assets minus liabilities should be equal to the capital accounts