What Is Classifying in Accounting?

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Accounting would be easy if you just reduced financial statements to a few lines: money made this month, money spent, here's what's left and this is the value of our assets. Simple, but not terribly informative. While some of the principles of accounting are complicated, classification of accounts is basic: By creating different accounts for different kinds of debts, revenue and assets, accounting provides more information about the company. That makes the ledgers and financial statement more useful for executives, investors and lenders.

Recording in Accounting

In accounting, every transaction, from buying copier paper to selling $1 million worth of inventory, goes into the company's ledger. The meaning of recording in accounting is that writing down transactions keeps things accurate. The corporation's management can see how the company is performing and whether it's earning more than it spends. Investors and lenders can review the books and financial statements and decide if the company can be trusted with their money.

The simplest way to record transactions is to write them into an accounting journal, adjusting different account classifications accordingly. If, say, a customer who owes you $500 pays the bill, that affects two classes, accounts receivable (now $500 smaller) and cash ($500 larger). Entering every single transaction as it happens takes time and increases the possibility of mistakes. With accounting software, bookkeepers can simply record in the software when the company receives a vendor invoice or paychecks go out. The software then automatically debits or credits the appropriate account classifications.

Classification of accounts makes accounting more complicated, but also more informative and detailed. In some ways, it makes accounting simpler down the road. Suppose you've bought an extensive library of computer software for the company's computers. All the software is a fixed, intangible asset. When you claim depreciation on the software's loss of value due to age, all the software should depreciate at roughly the same rate. Recording all the programs in one asset classification makes it simple to apply depreciation to the whole class.

Classification of Accounts

Classifying your accounts aggregates your finances into different categories in your ledgers and financial statements. It breaks your records into several broad classifications.

  • Asset accounts: This list includes the business's property and equipment, from land to cash, patents and more.
  • Liability accounts: These include money your company owes but hasn't paid yet, such as accounts payable, mortgages, loans and other unpaid bills. 
  • Capital or owner's equity accounts: This is the ownership stake that the proprietor, owner or stockholders have in the business. The stake rises and falls with the value of the assets and the amount of debt. 
  • Withdrawal accounts: This covers money taken out by the business owners for personal use. It includes the drawings account in partnerships and the dividend account in corporations.
  • Revenue accounts: These report and track the income from sales of goods or services. They also include nonoperating revenue such as income from loans or investments.
  • Expense account: This includes salaries, rent, wages, supplies and other expenditures. 

Classification of accounts can go into much more detail. Asset classification, for example, breaks down the asset accounts into several subcategories:

  • Cash: This includes money on hand in checking accounts, deposit accounts and the company's petty cash.
  • Receivables: Unless you run your accounting strictly on a cash basis, you report money when you earn it, not when you receive it. Say you sell $1,500 worth of inventory to a customer, but you give them 30 days to pay. You report the $1,500 as soon as you earn it. It's classified as income on the income statement and accounts receivable (an asset) on the balance sheet.
  • Inventory: This category includes goods for sale, partially completed goods and raw materials.
  • Fixed assets: This asset classification covers things you buy that can't be easily turned to cash the way that inventory can. The assets are held for the long-term, unlike, say, office supplies. Examples of fixed assets include computers, cars, furniture, buildings and land. 

Classification also separates assets into current and long-term categories. Current assets are the ones that will be used up in the coming year. Long-term assets last beyond the next 12 months. Accountants also classify tangible and intangible assets separately. Tangible assets include physical items such as trucks, 3D printers and inventory. Intangible assets are nonphysical property such as patents, copyrights and customer goodwill.

Classification and Financial Statements

Another meaning of recording in accounting is that the data recorded in the ledgers eventually becomes the basis of the financial statements. The three financial statements consolidate a company's financial records in different ways and classify accounts in different ways.

The balance sheet has three large accounting classes: assets, liabilities and owner's equity, which is what's left after subtracting liabilities from assets. The classification of accounts usually divides them up further, into items such as retained earnings, accounts receivable, short-term liabilities and long-term liabilities. You aren't required to use every possible asset classification or liability classification on the balance sheet. If, say, your company has never had any intangible assets, you don't need to write "Intangible assets: $0" to point this out. By comparing the company's assets and liabilities, the balance sheet gives a snapshot of the business's financial health.

The income statement shows profitability: How much revenue does the company bring in each month? The classifications on the income statement include sales revenue, cost of goods sold and nonoperating revenue. Nonoperating revenue can be divided into classes such as interest, rent and dividend revenue. Breaking down the revenue classification this way distinguishes between revenue earned from your line of business and revenue earned from good investments. Anyone thinking of putting money into your company wants to know if your products or services earn money, so it helps to distinguish that income from other sources.

Businesses that record only cash transactions don't need a cash flow statement. Businesses using accrual-based accounting need one since the income statement records sales and purchases, not cash payments. Tracking how much cash moves in and out of the company shows whether the company has enough money on hand to make loan payments or cover payroll. If the cash flowing in is significantly less than the income, it's possible the company's not doing a good job collecting on accounts receivable. The cash-flow classifications include cash from investments, cash from operations and cash from financing.

Classification of accounts in the ledgers helps the accounting department create the financial statements. If the sale and purchase of assets have been properly recorded, that makes it easier to see the asset classifications you need to report on the balance sheet.

The chart of accounts is a key part of converting ledgers into financial statements. The chart is a list of all the accounts used in the general ledger, identifying each account by number. Your accounting software uses the chart to identify the accounts such as revenue, common stock, cash and depreciation that must be included in making up the balance sheet.

When you draw up the chart for your accounts, set it up so you won't have to change it for several years. If, say, you don't own any buildings but plan to buy one next year, it's worth including that asset class in the chart. Don't include classes you have no plans to use. If your business provides services and has no inventory, there's no point to including an inventory classification in the chart, for instance. If you have accounts that include only small amounts, see if you can roll them into other account classes. That will keep the chart from getting overly complicated.

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About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com