An Introduction
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.
Assets Accounts
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.
Liabilities Accounts
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.
Capital Accounts
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.
Revenue Accounts
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.
Expenses Accounts
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.
Example
Consider the list of accounts shown below. Our task is to classify these accounts using the modern approach of accounting.
Plant and machinery
Purchases
Sales
Rent
Land and building
Cash
Sam’s capital
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
FAQs on Modern Approach to Classification in Business
1. What is the Modern Approach to the classification of accounts in business?
The Modern Approach, also known as the American Approach or the Accounting Equation Approach, is a method of classifying financial transactions based on their effect on the accounting equation. Instead of grouping accounts as personal, real, or nominal, this approach categorises them into five fundamental types: Assets, Liabilities, Capital, Revenue, and Expenses.
2. What are the five main types of accounts under the Modern Approach of Accounting?
Under the Modern Approach, all business accounts are classified into one of the following five categories:
- Assets: Economic resources owned by the business, such as cash, machinery, and buildings.
- Liabilities: Financial obligations or debts the business owes to outsiders, like bank loans or creditors.
- Capital: The owner's investment in the business, also known as Owner's Equity.
- Revenue: Income earned from the sale of goods, services, or other business activities like interest or commission received.
- Expenses: Costs incurred in the process of earning revenue, such as salaries, rent, and the cost of goods sold.
3. What is the basic accounting equation that forms the basis of the Modern Approach?
The fundamental accounting equation for the Modern Approach is Assets = Liabilities + Capital (Owner's Equity). This equation must always remain in balance. An expanded version of this equation, incorporating income and expenses, is Assets = Liabilities + Capital + Revenue – Expenses. Every transaction affects at least two accounts, ensuring the equation stays balanced.
4. Can you provide examples for each type of account under the Modern Approach?
Certainly. Here are common examples for each of the five account categories:
- Asset Accounts: Cash, Bank Balance, Land and Building, Plant and Machinery, Furniture, Debtors.
- Liability Accounts: Bank Loan, Creditors, Rent Outstanding, Debentures, Bank Overdraft.
- Capital Account: The initial investment made by the owner, any additional capital introduced, less any drawings made for personal use.
- Revenue Accounts: Sales, Commission Received, Rent Received, Interest Earned, Dividends Received.
- Expense Accounts: Purchases, Salaries Paid, Rent Paid, Electricity Bills, Cost of Goods Sold.
5. How does the Modern Approach differ from the Traditional Approach for classifying accounts?
The primary difference lies in their classification systems. The Traditional (British) Approach classifies accounts into three types: Personal, Real, and Nominal, based on their nature. In contrast, the Modern (American) Approach classifies accounts into five functional categories—Assets, Liabilities, Capital, Revenue, and Expenses—based on their effect on the accounting equation, making it easier to prepare financial statements like the Balance Sheet.
6. How does the Modern Approach help in determining whether to debit or credit an account?
The Modern Approach uses a simple set of rules based on whether an account is increasing or decreasing. The rules are as follows:
- For Assets and Expenses: An increase is recorded as a Debit, and a decrease is recorded as a Credit.
- For Liabilities, Capital, and Revenue: An increase is recorded as a Credit, and a decrease is recorded as a Debit.
This system directly links transaction analysis to the accounting equation.
7. Why is Capital considered a liability to the business under the Modern Approach?
Capital is treated as a liability because of the Business Entity Concept in accounting. This principle states that the business is an entity separate and distinct from its owner. Therefore, the money invested by the owner (capital) is considered a loan or an obligation that the business owes back to the owner. It is an internal liability, as opposed to external liabilities owed to outsiders.
8. What is the difference between an 'Expense' and an 'Expenditure' in the context of accounting?
While often used interchangeably, these terms have distinct meanings. An Expense refers to a cost whose benefit is fully consumed within a single accounting period, like paying salaries or rent for the month. An Expenditure is a broader term for any spending of funds, which includes both expenses and the acquisition of an asset whose benefit extends over multiple periods, such as purchasing new machinery.
