CHAPTER XXVI
THE CLASSIFICATION OF ACCOUNTS
Accounting Routine Related to Account Classification.—The basic relationships between the accounts and the statements of financial condition were explained in [Chapter IX], where a chart of accounts was given to illustrate the fundamental equation of the ledger. The complete record-making routine, comprising the use of business papers for memorandum entry, the use of the journals for the first formal record of transactions, and the use of the ledger for the classified entry, has now been explained. There remain, however, two classes of entries, the adjusting and closing, whose relationship to the journal-ledger routine has not yet been fully discussed although their relationship to each record has been separately considered. Since the closing of the books contemplates the drawing up of financial statements and since all record-keeping must have in view from the very beginning a proper classification of accounts giving the desired information to be reflected finally in the statements, it seems best at this point to consider some phases of account classification before proceeding with a detailed explanation of the method used in adjusting and closing the books.
The Need for Classification.—As explained in preceding chapters, accounts may be broadly classified into the three main divisions of assets, liabilities, and proprietorship. This threefold division, however, is inadequate for the purpose of presenting detailed information as to the kinds of assets owned by the proprietor, the nature of his liabilities, and the causes that have produced increases or decreases of proprietorship. Subdivisions of the three main groups must, therefore, be made, the minuteness of subdivision being determined by the amount of detailed information desired.
One of the main purposes of account-keeping is to summarize results on the financial statements. The items which appear on these statements represent the balances of one or more groups of accounts. Items, for instance, such as “Land” and “Buildings,” may each represent a single ledger account recording the value of the land, the factory, and the office buildings respectively; whereas the item “Accounts Receivable” represents the group of customers’ accounts, the number of which may run into the hundreds and even thousands and which may be kept in a ledger devoted exclusively to the recording of their detail. The reasons for grouping assets and liabilities on the basis of degree of liquidity, and the advantages resulting from such grouping when drawing up the summary statements of the period, were discussed and illustrated in [Chapter III].
It is evident from the above that the classification or grouping of the ledger accounts is reflected in the items on the financial statements; and that, conversely, the kind of information which it is desirable to present on the statements will to a large extent govern the groupings in the ledger. This dependence of the account titles and groupings in the ledger upon the end and aim in view makes it necessary to draw up the original classification with great care. To aid in securing a record correct in the first instance, certain fundamental groupings or classification of accounts must always be made.
Basic Classification.—While other groupings of accounts have been made, the classification used here has been from the beginning a three-phase one, consisting of an asset, liability, and proprietorship nomenclature. The third group of accounts, proprietorship, is further divided into the two subclasses, temporary and vested, as explained in [Chapter XII]. At the end of the fiscal period, after the ledger has been closed, there appear only asset, liability, and vested proprietorship accounts; but during the fiscal period, the temporary proprietorship accounts come into being and certain asset and liability accounts take on a mixed character resulting from the method in which the record is kept. This method is dictated not by a pure accounting theory, but by a theory designed to accommodate itself to the practical requirements of the average business. It is because the practical method of making the record falls short of the theoretically exact method, that adjustments must be made before summarizing.
For this reason, a record is not made daily of the portion of assets which has been consumed each day, but the asset accounts are adjusted at the close of each fiscal period to separate their asset and proprietorship elements. Also, when a note is discounted at the bank, its entire face value is set up as a liability. From the standpoint of accurate accounting, however, the face value of the note overstates the liability for the current fiscal period, if the note falls due in the following period, by the amount of the prepaid interest charge belonging to that next period. Only on the due date of the note does the record show the true condition of the liability. Thus, a “practical” method of keeping the record necessitates the use of certain “mixed” accounts. Fundamentally, however, the three-group classification given answers every necessary purpose.
Fundamentals of a Good Classification.—In judging the fitness of a particular classification, the end and purpose for which it is made must always be the criterion. Any classification of accounts must, therefore, have in view the fact that all accounts lead up to the balance sheet and profit and loss statement, and that they must provide the data necessary for the summaries of these statements. Classifications may be made from many different viewpoints and for many different purposes, but a classification which is logical and carries titles clearly indicating the purpose for which the accounts are intended, and which therefore needs little or no explanation, is a satisfactory classification. The three-group classification—assets, liabilities, and proprietorship—meets these requirements.
A two-group classification—real and nominal—is frequently used. Under this classification, asset and liability accounts are grouped as real, and proprietorship accounts comprise the nominal class. This is the standard classification. The student should be familiar with it, although the meaning of the groups is not so apparent as in the case of the three-group classification, referred to above.
Classifying Business Transactions.—When making the record of business transactions on the books of account, it is necessary, first, to determine the main account group or groups affected by the transaction. After this is done, it is usually easy to determine which particular account in the group is affected. Great care must be used in the determination of the main groups, since a wrong classification results in an incorrect showing in the summary statements at the close of the fiscal period.