The process of accounting which is used for financial transactions is classified into two different types. There is the modern approach of classification and there is the traditional approach of classification. We all know that the traditional approach is the British one and the modern approach is the American one. In the notes we have for this chapter, students are going to learn about the modern approach and the methods that are currently in use for the modern approach. With the help of these notes, they will surely be able to get good marks in the exams. Let us start by understanding the basic accounting equation in the coming section.
Understanding the Basic Accounting Equation
When it comes to the classification of accounts under the modern approach, there are some accounts that are not credit and debit. So, in that case, there is a use of the Accounting Equation to credit the account or debit it. So, the modern approach can also be considered as the Accounting Equation Approach.
The Basic Accounting Equation is: Assets = Liabilities + Capital (Owner’s Equity)
Also, the following formula when expanded looks like this, Assets = Liabilities + Capital + Revenues – Expenses
Also, Profit = Revenues – Expenses
The Accounting Equation needs to remain in a balanced form all the time. This is because every single transaction comes with a certain dual aspect. So, each one of the transactions will affect the credit side or the debit side. Also, transactions might be able to have an impact on two different accounts either on the credit side or the debit side. This is exactly what students need to know about the classification of accounts under the modern approach method.
Classifying Accounts Using the Modern Approach
Under the modern approach of classification, the accounts are classified into different groups which are mentioned below.
The assets are the possessions, economic resources, or properties of any particular business. These assets tend to play a very important role in helping out some of the essential business operations in earning some revenue for the company. The assets are sometimes measured in the terms of monetary values. Assets are classified as intangible and tangible. Also, there are current assets and fixed assets. Those assets that are held for a long time are fixed assets. Some examples might include furniture, machinery, land, and buildings. Some assets are held for a shorter period and are called current assets. Some examples might include bank balance, debtors, and bills.
Another important group in the classification of accounts under the modern approach would have to be the liabilities accounts. These are the accounts that tend to owe some amenities to the outsiders. These might be some sort of debts or obligations that the business might have. Liabilities are also Current and Long-Term.
Long-term liabilities are those that are payable after one year. For example, debentures, bank loans, etc. The term "current liabilities" refers to liabilities that must be paid within a year. For example, creditors, rent outstanding, bank overdraft, etc.
Another important part of the classification of accounts under the modern approach method would be capital accounts. This is the money that is brought to the business or the company by the owner. That is why it is also known as the Owner’s Equity.
As a result, the Capital is shown on the Balance Sheet's liabilities side. After the owner deducts the Drawings, the capital account is shown. Drawings are the amount of cash, goods, or assets taken from the business by the owner for personal use.
The amount that is earned by any business when they sell their goods or render their services is known as revenue. Also, some other incomes are included in the revenue accounts such as rents, commissions, interests, dividends and so much more. The items of revenue can be grouped under the classification using the modern approach.
There are certain costs and monetary spending that the company has to incur so that the revenue for the company can be earned. These costs are known as expenses. One of the important things to keep in mind is that when all the benefits that come from spending the money are completely exhausted within the given period of a single year, then it would be known as an expense.
As a result, the cost of goods sold is an expense, while the cost of goods purchased is an expenditure. Rent, salary, electricity, interest, and other expenses are examples of expenses. Purchases of assets, short-term investments, and other similar purchases fall under the category of expenditure.
Consider the list of accounts shown below. Our task is to classify these accounts using the modern approach of accounting.
Plant and machinery
Land and building
A loan from city bank
Here are the accounts classified using the modern approach of accounting:
Plant and machinery > Asset account
Purchases > Expense account
Sales > Revenue account
Rent expense > Expense account
Land and building > Asset account
Cash > Asset account
Sam’s capital > Capital/owner’s equity account
Loan from city bank > Liability account