Modern Classifications of Accounts

According to modern approach, accounts are classified into six categories: (1) Assets Account; (2) Liabilities Account; (3) Capital Account; (4) Revenue Account; (5) Expenses Account; and (6) Withdrawal Account.

Assets Account:  These accounts are accounts of assets and properties such as land, building, plant, machinery, patents, cash investments, inventory, etc.

Liabilities Account: These accounts are accounts of lenders, creditors for goods, creditors for expenses, etc.

Capital Account:  It is the account of the proprietor/partner who invested money in the business.

Revenue Account:  These are account of incomes and gains.  Examples are: sales, discount received, interest received, etc.  These accounts accumulate data required for preparation of Trading, Profit and Loss Account.

Expenses Account:  These are accounts of expenses and losses.  Examples are purchase, wages paid, depreciation, rent, rates and taxes, etc.  Like Revenue Account, these accounts accumulate data required for preparation of Trading, Profit and Loss Account.

Withdrawal Account:  It is the account related to drawings by the proprietor/partners.

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Financial Accounting : Types of Accounts

Personal Account:  It deals with accounts of individuals like creditors, debtors, bank, etc.  It shows the balance due to these individuals or due from them on a particular date.

Real Account:  It presents assets like plant and machinery, land and buildings, goodwill, etc. as on a particular date, this account shows the worth of the asset.

Nominal Account:  It consists of different types of expenses or incomes or loss or profit.  These accounts show the amount of income earned or expenses incurred for a particular period say a month, a year, etc.

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Rules of Debit and Credit

There are just six simple rules to be followed in Debit and Credit

1. Debit what comes in
2. Credit what goes out
3. Debit the receiver
4. Credit the giver
5. Debit all expenses, losses and assets
6. Credit all incomes, profit and liabilities

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Financial Accounting: Accounting Equation

     Financial accounting is based on accounting equation.  The resources are possessed by the firm as assets.  Some of the resources will have to be supplied to the firm by the owner of the business.  The total amount supplied by him is known as his capital.  Some of the assets of the business have been provided by someone other than the owner.  The indebtedness of the firm for these resources is known as liabilities.  The capital must be equal to assets minus liabilities.

     So the accounting equation has two sides and they must be equal.  The equity of the twosides will always be true.  Capital is often called the owner's equity or net worth.  Keeping in view the two types of equities, the equation given above can be stated as below:

Assets = Liabilities + Capital

OR

Assets = Liabilities + Capital

OR

Liabilities = Assets - Capital

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Financial Accounting : Conventions and Concepts

                While the conventions are based on what is practicable, there are certain accounting concepts which are based on logical considerations.  Accounting concepts are ideas and assumptions which are fundamental to accounting practice.  Some of the important concepts are money measurement  concepts, business entity concept, going concern concept, duality concept, cost concept, matching concept, realization concept and accrual concept.  The generally accepted accounting principles which are followed in several countries (including India) are as follows:

1.  Materiality Concept:  The criterion of ‘True and Fair’ in the preparation of the financial statement is necessary for arriving at a reasonable conclusion on the financial health of the company.  This condition brings us to the relative concept of materiality, which by its very nature can be subject to variations.  An error of Rs. 1000 in finished goods inventory whose total is valued at a few lakhs of rupees is definitely meager to warrant special attention while the same will have to be attended in the case of the total stock being valued at any of few thousands.
2.  Money Measurement Concept:  In financial accountancy, a record is made only of information that can be expressed in monetary terms.  Recording, classification and summarization of business transactions requires a common unit of measurement which is taken as money.  If events cannot be quantified in monetary terms then they do not facilitate accounting. Hence, all transactions are recorded through a common denominator, namely the monetary unit.  Thus, if a certain event, no matter how significant for the health or even existence of the business, cannot be measured in monetary terms, such an event is not recorded in accounting.
3.  Cost Concept:  Cost concept implies that in accounting, all transactions are generally recorded at cost, and not at market value.  For example, if a piece of land is acquired for Rs.10 lakh, it would continue to be shown in the balance sheet at Rs.10 lakhs, even when the market value of the land rises to say Rs.20 lakhs.  Why should this be so? This is because, cost concept is in fact closely related to the going concern concept.  If the land is acquired for the operations of the business and would continue to be used for its operations and would not be sold shortly, then it is largely immaterial what the land’s market value is, since it is not going to be sold anyway.  Thus, it is consistent with going concern concept to keep recording the land at cost, i.e. Rs.10 lakhs on an on-going basis.
4.  Time Period Concept:  Income (or) loss of the business is measured periodically.  This is measured for a specified interval of time, called the accounting period.  For the purpose of reporting to outsiders, one year is the usual accounting period.
5.  Conservatism Concept:  According to this principle, the principle of “anticipate no profit but provide for all probable losses” should be applied.  The valuation of stock-in-trade at a lower of cost or market value and making and making the provision for doubtful debts and discount on debtors are the applications of this principle.  In other words, the principle of conservatism requires that in the situation of uncertainty and doubt, the business transactions should be recorded in such a manner that the profits and assets are not overstated and the losses and liabilities are not understand.
6.  Consistency Concept:  Several ways of treating an event are in practice that may be recorded in accounts.  The consistency concept requires that once an entity has decided on one method, it will treat all subsequent events of the same character in the same fashion unless it has a sound reason to change the method of treatment of that event.  For example, if a concern is valuing its inventory by a particular method in one year it is expected to value its inventory in the subsequent years also in the same method unless there is a strong reason to change the same.  Similarly, if it is charging depreciation by one method it is expected to follow the same method in the subsequent years also.
7.  Business entity concept:  According to this assumption, a business is treated as a separate entity that is distinct from the owner(s), and all other economic proprietors.  For example, in case of proprietary concern, through the legal entity of the business and its proprietor is the same, for the purpose of accounting.  They are to be treated as separate from each other.  If this assumption is not followed, the financial position and operating results of a business entity cannot be ascertained.  In other words, this assumption requires that for accounting purposes, a distinction should be made between (i) personal transactions and business transactions and (ii) transaction of one business entity and those of another business entity.  For example, if the household expenses (Rs.5,000) of the proprietor are shown as business expenses, the profits of a business will understated to the extent of Rs.5,000.
8.  Duality or accounting Equivalence concept:  It is the basic principle of accounting.  Every business transactions have a dual effect, i.e., the two fold effect of benefit giving and benefit receiving.  The recording of both these is considered as the core of double-entry.  This assumes that total assets are equal to total liabilities.  This is called as the Balance sheet equation or Accounting equation.  It can be stated a 
 
                                 Owner’s Equity + Outside Liability = Assets       
                                 Owner’s Equity = Assets – Outside liabilities

9.   Accounting Period Concept:  To be able to prepare the income statement for a business, the period for which it is to be prepared must be specified first.  Very often the accounting period chosen is a calendar year (January 1 – December 31) or a fiscal year (April 1 – March 31).  It is also not uncommon to synchronize one’s accounting period with one’s operating periods.  In some businesses such as trading, the operating period may be relatively small, say a month or even less; while in other cases it may stretch well beyond a year.  Depending on one’s nature of business, one may adopt a Hindu year, or the period beginning with Diwali or any other period as one’s accounting period.  Under the Companies Act, a company is normally not permitted to have an accounting period extending beyond fifteen months.

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Users of Financial Accounting Information

Name of User	Decision-Making Purpose
Owners	As the owners (Shareholders) have entrusted their financial resources (Capital and reserve etc.) to the entity i.e. (Capital management of the entity) their interest is immense.  They are inclined to know periodically its performance.  Managers are the custodians of their capital.  The management has every responsibility to submit periodical financial reports to the proprietors.
Managers	Managers are responsible for the overall performance of the company.  Managers make several decisions and, therefore, need information.  Financial accounting provides relevant data and information in which managers have a direct interest.
Creditors	Creditors supply financial resources to the concern. Creditors are interested in the continuing profitable performance of the entity in order that they may continuously receive their interest and repayment of principal amount.  Creditors required financial accounting information to evaluate the performance enterprise and determine the degree of risk to which they are exposed.
Employees	Employees of a company make use of financial accounting information revealed in the annual reports.  They can bargain on matters regard to salary enhancement, bonus, fringe benefits, or working conditions, employee stock options (ESOP) etc.  They get insight into matters affective their economic and social interests.  They get satisfaction, both economically, socially and brand satisfaction.
Investors	Potential investors (i.e. Creditors or owners) get an idea about the company’s performance from its annual reports.  They are generally interested in the earnings, dividend and growth trends, potential investors take the services of financial analysts in evaluating the performance of the company.
Customers	Customers might be very much interested in the financial and accounting information would help them to estimate and evaluate the prices being changes on the products the company usually sells out to customers and consumers.
Government	Government is interested to look into the financial reports of a company for regulatory purposes.  The Income Tax department of the Government has an interest to evaluate the accounting information in determining the taxable income of the entity.  Taxation authorities need financial information to ascertain tax liability of a company.  Government and regulatory authorities are concerned with the financial activities of business organizations for the purposes of regulation to protect the public interest.

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Basis of Accounting

                For recording business transactions, there are three approaches to accounting which are widely accepted

(a) Cash basis

(b) Accrual basis

(c) Hybrid or Mixed basis.

As you know, all business transactions ultimately result into realization of revenue or incurring of expense.  Truly speaking, the approaches to accounting which are to be discussed here tell how revenues and expenses are to be recognized.

             Cash basis Accounting:

                Under the cash basis of accounting actual actual cash receipts and cash payments are recorded.  Credit transactions are not recorded at all and are ignored till the cash is actually received or paid.  Income is merely the difference between the cash receipts and cash payments.  The Receipts and Payments Account prepared in case of non – trading concerns such as a charitable institution, a club, a school, a college etc. and professional men like lawyer, doctor, a chartered accountant etc. can be cited as the best example of cash basis.

Accrual Basis of Accounting:

                Other name for this is mercantile basis of accounting.  In this method, incomes are recorded or credited to the period in which they are earned irrespective of the fact that, whether the same has actually been received or not.  Similarly expenses are charged to the period in which they relate, irrespective of the fact that they actually been paid or not.  So the difference between total income earned and total expenses incurred, represents the profit or loss for the period.  To arrive at the correct result of the operation, adjustments for outstanding and prepaid expenses and actual incomes are to be made.

Hybrid or Mixed Basis of Accounting:

                Cash basis of accounting is by far the simplex system whereas the accrual basis of accounting is scientific and reliable.  So accountants have tried to club these advantages of the two systems and have come up mixed or hybrid basis of accounting.  Under mixed basis of accounting both cash basis and accrual basis are followed.  Incomes are recorded on cash basis whereas expenses are taken on accrual basis.  The net income is ascertained by matching expenses on accrual basis with income on cash basis.  This is the most conservative basis of ascertaining income because all possible expenses relating to the period whether actually paid or not are considered whereas income only received in cash taken into consideration.  When all the expenses are taken into account, there is reduction in taxable income and hence this system is popular among professionals like doctors, lawyers, chartered accountants etc.

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