MGT101 - Financial Accounting - I - Lecture Handout 05

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CLASSIFICATION OF ACCOUNTS

Learning Objective

This lecture will cover

Classification of accounts into Assets, Liabilities, Income and Expenses, and
Rules of Debit and Credit for these classes.

Account

An accounting system keeps separate record of each item like assets, liabilities, etc. For example, a separate record is kept for cash that shows increase and decrease in it.

This record that summarizes movement in an individual item is called an Account.

Classification of Accounts

The accounts are classified into following heads:

Assets
Liabilities
Income
Expenses (further divided into capital and revenue expenses)

Assets

Assets are the properties and possessions of the business to pay in future. Can be amount payable for material purchased, expenses etc.

Properties and possessions can be of two types:

Tangible Assets that have physical existence (are further divided into Fixed Assets and Current Assets).
Intangible Assets that have no physical existence

Examples of both are as follows:

Tangible Assets – Furniture, Vehicle etc.
Intangible Assets – Right to receive money, Good will etc.

Liabilities

Liabilities are the debts and obligations of the business. Liability is the obligation of the business to provide a benefit or asset on a future date.

Asset is a right to receive and liability is an obligation to pay, therefore, these are opposite to each other.

Accounting Equation

Assets are created out of capital invested plus liability to third party.

Assets = Liabilities + Owner’s equity

Income

Income / Revenue is the value of goods or services that a business charges from its customers Or the reward / return received from the resources committed in the business.

Expenses

Expenses are the costs incurred to earn the revenue. The resources spent and the efforts made to earn the income, when translated in money terms are the expenses of the business

Profit

Profit is the excess of income over expenses in a specific period.

Loss

Loss is the excess of expenses over income in a specific period.

Capital Expenditure

It is the expenditure to create an asset that helps in generating future income and its life is more than 12 month. For example machinery purchases, furniture purchases etc.

Capital Expenditure is the amount used during a particular period to acquire or improve long-term assets such as property, plant or equipment.

Revenue Expenditure

It is the day to day expenses whose benefit is drawn immediately. For example, salary of the employee, rent of the building, etc.

Revenue Expenditure is the cost of resources consumed or used up in the process of generating revenue, generally referred to as expenses.

Rules of Debit and Credit

From our discussion up to this point, we have established following rules for Debit and Credit:

Any account that obtains a benefit is Debit.
OR
Anything that will provide benefit to the business is Debit.

Both these statements may look different but in fact if we consider that whenever an account benefits as a result of a transaction, it will have to return that benefit to the business then both the statements will look like different sides of the same picture.
For credit,

Any account that provides a benefit is Credit.
OR
Anything to which the business has a responsibility to return a benefit in future is Credit.

As explained in the case of Debit, whenever an account provides benefit to the business the business will have a responsibility to return that benefit at some time in future and so it is Credit.

Rules of Debit and Credit for Assets

Similarly we have established that whenever a business transfers a value / benefit to an account and as a result creates some thing that will provide future benefit; the ‘thing’ is termed as Asset. By combining
both these rules we can devise following rules of Debit and Credit for Assets

When an asset is created or purchased, value / benefit is transferred to that account, so it is Debited
i.Increase in Asset is Debit
Reversing the above situation if the asset is sold, which is termed as disposing off, for say cash, the asset account provides benefit to the cash account. Therefore, the asset account is Credited

ii. Decrease in Asset is Credit

Rules of Debit and Credit for Liabilities

Anything that transfers value to the business, and in turn creates a responsibility on part of the business to return a benefit, is a Liability. Therefore, liabilities are the exact opposite of the assets.

When a liability is created the benefit is provided to business by that account so it is Credited

iii. Increase in Liability is Credit

When the business returns the benefit or repays the liability, the liability account benefits from the business. So it is Debited

iv. Decrease in Liability is Debit

Rules of Debit and Credit for Expenses

Just like assets, we have to pay for expenses. From assets, we draw benefit for a long time whereas the benefit from expenses is for a short run. Therefore, Expenditure is just like Asset but for a short run. Using our rule for Debit and Credit, when we pay cash for any expense that expense account benefits from cash, therefore, it is debited.

Now we can lay down our rule for Expenditure:

v. Increase in Expenditure is Debit

Reversing the above situation, if we return any item that we had purchased, we will receive cash in return. Cash account will receive benefit from that Expenditure account. Therefore, Expenditure account will be credited

vi. Decrease in Expenditure is Credit

Rules of Debit and Credit for Income

Income accounts are exactly opposite to expense accounts just as liabilities are opposite to that of assets. Therefore, using the same principle we can draw our rules of Debit and Credit for Income