Principles of Accounting – Classification of Accounts

The secondary demand is for information as to how the financial condition was brought about.

Financial condition is shown by gathering together all values of a positive character and opposing against them all values of a negative character. The difference resulting is expressed in an account called “capital” or “proprietorship.”

Financial condition is constantly changing. Scarcely a sale of goods takes place which does not effect such a change. It usually consists in substituting in place of goods on hand for sale, carried at cost, an account due from a customer, the amount of which includes in addition to the cost of the goods sold, an item of profit. Any change in the values reflecting financial condition changes the capital. A comparison of capital at two dates determines the extent of its growth or shrinkage during the period intervening. It shows the effect of having engaged in a financial undertaking. It does not show the cause of the change in capital. Whether the effect be pleasing or otherwise, curiosity might be assigned as a reason for demanding information concerning the cause of the change. As a matter of fact the reason is a far more logical one. Men have found that by getting information as to what has happened in the past they are in a better position to direct the affairs of the future.

In order to be able to express the financial condition at the proper time, it is only necessary to have accounts, the titles of which will describe individually the various values which reflect financial condition.

To trace the steps in the ever-changing financial condition is a more difficult matter. Every change alters the proprietor’s or capital account. Such changes may be due to one or more of several causes; the result of operating, or the active employment of the capital; fluctuations in values due to economic conditions; a decrease in certain material values owing to lapse of time. To record every change in the proprietor’s account would be an arduous task. In order that this may be avoided it has been found desirable, to substitute and use in place of the capital account, during the time which the account period covers, a series of accounts which will record, in a classified manner, the changes taking place in the capital account. When they have done this, they have served their purpose and they are closed, at the end of the accounting period, into a summary, the net result shown therein being subsequently closed into the proprietor’s account.

Having in mind the above remarks it may be said that accounts divide into two great kinds, or classes, namely,
real, and
nominal

definitions for which may now be constructed without any particular difficulty.
Real accounts are those which reflect financial condition.

Nominal accounts are those which reflect changes in financial condition.

It is not to be thought strange if the mind of the attentive student seeks information as to the reason for selecting the words real and nominal to describe two classes of accounts of such importance. Authority for the use of the words is difficult to find but it is probable that they were selected because of the fact that accounts showing the financial condition represent values which really and definitely exist, whereas those accounts which record the changes merely mark the course of the changes. The latter are accounts which exist in name only so far as representing anything concrete is concerned.

Whether real accounts show the financial relations of the proprietor with persons as distinguished from things would seem to be of little importance; however, in passing it is to be noted that some authors do take considerable cognizance of a classification which divides accounts into personal and impersonal. If definitions of these terms were required it might be said, although with some absurdity, that a personal account is a real account purporting to reflect the financial relation existing between the proprietor and some person, whereas an impersonal account purports to reflect the financial relation existing between the proprietor and some thing.

Attention should be directed to the fact that nominal accounts are frequently known by other names. They are sometimes referred to as, economic accounts, income and expense accounts, revenue and expense accounts, profit and loss accounts, income and outgo, etc.

Real accounts divide into two classes: those which represent positive values and those which represent negative values. The accounts in the former class are called assets; in the latter, liabilities. An asset is a possession of positive value. An asset account may be defined as one which represents an asset. An asset may be tangible or intangible. Some assets are in the form of property or funds. They are said to be tangible assets. Other assets exist in the form of rights against persons, which persons may be either real or artificial. Such assets are said to be intangible. Assets may also take the form of deferred charges to income. They are, in truth, expenses, but in view of the fact that the accounting period to which they are applicable has not yet arrived, they are considered as in the light of having value, which value is positive in its nature and they are consequently entitled to inclusion among the assets.

A liability denotes negative value. It is an offset to values possessed. It is something which must ordinarily be made good out of the assets. Further than that, it is something which the proprietor of a business, if the assets of the business are insufficient, must settle out of private funds. It is something which gives a right of action at law in favor of the creditor as against the proprietor. A liability may be defined as an indebtedness giving to the creditor a right of action at law against the debtor. A liability account may be defined as one which sets forth a liability.

A liability should be distinguished from an accountability in that an account must be stated and the amount definitely ascertained before a liability arises. Accountability is perhaps best illustrated by showing its application in agency. An agent is the representative of his principal. He may have received from the principal certain values for which he must account. He may become liable to his principal, ultimately, but technically he is not liable until such time as he has accounted to his principal for the values received and the disposition made of same. An accountability may be defined as that condition existing, where in the relation between two parties, or entities, one must account to the other for values received.