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All the accounts for a business or organisation are classified into five types of accounts, which are also known as financial categories. It helps you to summarise the information of these accounts into useful financial information. These five types of accounts are summarised in the Income Statement and the Balance Sheet. The effect of the Accounting Equation will be discussed in the following sections of this topic:

  1. Accounting Equation - Income Statement Financial Categories

  2. Accounting Equation - Balance Sheet Financial Categories

  3. Accounting Equation - Financial Categories (Income Statement and Balance Sheet)


  1. Accounting Equation - Income Statement Financial Categories

    The income and expense accounts are reflected in the income statement and it has an effect on the accounting equation. These accounts are used to record and report on the financial performance of the business entity or organisation. The income statement reflects all the income accounts and expense accounts of the business. These income and expense accounts are also known as the nominal accounts. It consists of two basic Financial Categories:

    Financial Category

    What do they tell us?

    Examples of accounts

    Income accounts

    (Nominal accounts)

    These accounts reflect the income sources of the business.

    Sales

    Interest received

    Expense accounts

    (Nominal accounts)

    These accounts reflect the expenses that the business incurs to generate the income.

    Motor vehicle expenses

    Rent

    Telephone

    Salaries and wages

    Water and Lights

    The difference between the total of the income and the total of the expense accounts will reflect how much profit the business made or how much is the losses (if the Expenses are more than the Income) that the business has made.

    The profit is the return or remuneration the owner or owners of the business receives on their investment in the business. This difference or Profit / (Loss) is transferred to the Balance Sheet (Retained Earnings Account) as it will increase the owner / owners equity (interest) in the business.

     PROFIT = INCOME - EXPENSES


     

  2. Accounting Equation - Balance Sheet Financial Categories

    There are three types of accounts which are normally reflected in the balance sheet (i.e. proprietary accounts, asset accounts and liabilities accounts). These accounts will reflect a snap shot (picture) of what the business is worth as at a specific date. This will also reflect what interest the owner has in the business or how much the business owes to the owner of the business. It will also indicate any monies owed to other parties, businesses or organisations as well as what assets the business owns and what it is worth.

    Financial Category

    What do they tell us?

    Examples of accounts

    Proprietary Accounts

    These accounts are used to enter all the personal transactions between the owner(s) of the business and themselves. This reflects how much the owner(s) has invested in the business and how much they have taken out of the business.

    Capital

    Drawings

    Retained Earnings

    Asset Accounts

    These accounts will reflect all the assets owned by the business, which is used in the activities of the business.

    Land and buildings

    Vehicles

    Equipment

    Furniture and fittings

    Machinery

    Debtors

    Bank

    Petty cash

    Trading stock

    Liability Accounts

    These accounts will reflect all the liabilities of the business, to which the business owes money.

    Loans

    Bank overdrafts

    Creditors

    CAPITAL = ASSETS - LIABILITIES

    The balance sheet is a snapshot of the business as at the date after all these transactions are recorded. It reflects a list of all the assets that the business owns and a list of how these assets are financed by own capital and money borrowed from the bank and credit granted by the suppliers. The balance sheet is nothing more than a list of the sources used to finance the assets of the business and a list of the assets which were financed or funded by these sources of financing.

    All capital that the owner invests in a business is also known as the owner's equity or the owner's interest in the business. Capital and liabilities finance all assets the business has acquired. This capital and liabilities are known as the sources of financing or capital employed. On the other hand, the assets that the business owns, is known as the employment of capital.


  3. Accounting Equation - Financial Categories (Income Statement and Balance Sheet)

Income and expense transactions have an influence on the assets. Sales will definitely increase the assets (the bank or debtors) and will also increase the income. On the other hand expenses, such as advertisements, will definitely increase the expenses and decrease the assets (cash in the bank) or increase the liabilities (creditors). Income will increase the profit and expenses will decrease the profit.

Since most of the transactions a business encounters have an effect on both the Income Statement and the Balance Sheet, we have to look at the full accounting equation or expand the accounting equation. The accounting equation will then reflect as follows:

  ASSETS + EXPENSES = INCOME + CAPITAL + LIABILITIES

Assets and Expenses have debit balances, which are equal to Income, Capital and Liabilities, which have credit balances.