Accounting for financial transactions can be classified into two types of approaches. One is the Traditional Approach and another one is the Modern Approach. Traditional Approach is also known as the British Approach. While the Modern Approach is also known as the American Approach. Let us learn more about it.
Modern Approach to Accounting
Under the Modern Approach, the accounts are not debited and credited. Hence, the Accounting Equation is used to debit or credit an account. Thus, it is also known as the Accounting Equation Approach.
The Basic Accounting Equation is: Assets = Liabilities + Capital (Owner’s Equity)
Furthermore, it can be expanded as Assets = Liabilities + Capital + Revenues – Expenses
Also, Profit = Revenues – Expenses
The Accounting Equation should remain balanced every time. Because we know that each transaction has a Dual aspect. Thus, each transaction will either affect the debit side and credit side. Also, a transaction may affect two accounts on the debit side or two accounts on the credit side.
Also, the profits will increase the Capital and losses will decrease it.
Classification of Accounts under the Modern Approach
Under the Modern Approach the accounts can be classified as follows:
I. Assets Accounts
Assets are the properties, possessions or economic resources of a business. They help in business operations and help in earning revenues. They can be measured in terms of money.
Assets can be tangible or intangible. Also, assets can be classified as Fixed Assets and Current Assets. Fixed Assets are held for the long-term.
They help in carrying out the normal operations of the business. For example, land, building, furniture, machinery, vehicles, etc. Current Assets are held for short-term. They are realizable within a year usually. For example, debtors, bills receivable, bank balance, cash, stock, etc.
II. Liabilities Accounts
Liabilities are the amounts that an entity owes to the outsiders. These are the obligations or the debts payable by the business. Liabilities can also be classified as Long-term and Current.
Long-term Liabilities are payable after a period of one year. For example, debentures, bank loans, etc. Current liabilities are payable within one year. For example, creditors, bills payable, rent outstanding, bank overdraft, etc.
III. Capital Accounts
The money brought into the business by the owner is called Capital or Owner’s Equity. The Capital can be brought in cash or assets by the owner.
Capital is an obligation of the business that has to be paid back to the owner. Because business is a separate entity from its owner.
Therefore, the Capital is shown on the liabilities side of the Balance Sheet. The capital account is shown after deducting the Drawings by the owner. Drawings are the amount of cash, goods or assets taken by the owner for personal use from the business.
IV. Revenue Accounts
Revenue is the amount earned by the business by selling goods or rendering of services. Also, it includes other incomes such as rent received, the commission received, interest received, dividend earned, etc. All items of revenue are also clubbed together under the Modern Approach.
V. Expenses Accounts
All costs incurred or money spent by a business in order to earn revenues is called expenses. It is noteworthy here that when the benefits of the money spent are exhausted within a period of one year, it is called an Expense. While in case the benefit lasts for more than a year it is called Expenditure.
Therefore, the purchase of goods is expenditure while the cost of goods sold is an expense. For example, rent paid, salary paid, electricity charges, interest paid, etc. are expenses. While the purchase of assets, purchase of short-term investments, etc. fall under the category of expenditure.
Rules of Debit and Credit under the Modern Approach
|Asset Accounts||Debit the increase; Credit the decrease|
|Liabilities Accounts||Credit the Increase; Debit the decrease|
|Capital Accounts||Credit the Increase; Debit the decrease|
|Revenue Accounts||Credit the Increase; Debit the decrease|
|Expense Accounts||Debit the increase; Credit the decrease|
Solved Example on Modern Approach of Classification
Q: Analyze the following transactions and also show their effects on the assets and liabilities using the Modern Approach to Accounting.
- Commenced business with cash ₹100000
- Paid rent ₹1000
- Received commission ₹500
- Introduced additional capital ₹10000 in cash and 5000 in goods.
- Purchased goods ₹20000 from B
- Sold goods costing ₹10000 at a profit of 25% on the cost
- Purchased office furniture ₹15000
- Paid salary in advance ₹1000
The analysis of each transaction is given below. Their effect on the Assets and Liabilities is also shown in the form of Accounting Equation:
- Cash is increasing and thus, cash should be debited. Also, Capital is increasing, hence, Capital should be credited.
- Rent is paid. Therefore cash is decreasing. Rent is an expense. Directly deduct rent from Capital. Therefore, capital should be debited and cash should be credited.
- Commission is an income. Thus, add it to the Capital. Also, cash will increase.
- Cash and goods are coming in. Also, Capital is increasing. Hence, cash and goods should be debited and Capital should be credited.
- Goods are coming in. Thus, they are increasing. Therefore, goods should be debited. B has become a creditor.
- Goods are going out thus, credit goods. Cash is coming in thus, cash must be debited. Also, add the profit of ₹ 2500 to Capital.
- Cash is decreasing while the furniture is increasing. Therefore, cash must be credited and furniture should be debited.
- Salary paid in advance is a current asset. Cash is decreasing so cash must be credited.