Classification of Accounts Based on Accounting Equation Principle

ASSETS = Liabilities + Equity.

Based on this Accounting Equation principle, all accounts have been classified into Five Types of Accounts.

This accounting equation principle assumes that whatever we spend, we spend it from the money we invest in the business, known as Capital/Equity, as well as from the loans we take, known as Liabilities, and from 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. 

• During any year, the excess of Expenses over Income becomes the Loss, and the Excess of Income over Expenses becomes the Profit of the business. 

Ultimately, on finalisation of the Profit and Loss Account, the difference between expenses and income gets added either to Assets or Liabilities. When there is a loss, it is added to the Assets side because it was incurred (and to be recovered from future profits), and the profit is treated as a liability to be paid to the Owner and Shareholders.

  

When it is done, the net effect is Assets = Equity + Liabilities.

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 each group of accounts consists of.

EQUITY
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

Liabilities are also a kind of investment in the business. For example, you may take a 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 the 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

Assets are of fixed or permanent nature and of current/ temporary nature. Any business owns Land, Building, Furniture, and Equipment like computers, calculators, printers, 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.

INCOME/ REVENUE

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.

EXPENDITURE

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

Summary:

• 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 from 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.