The Balance of the Account.—As stated in Chapter VIII, the account is divided into two sections, a left and a right, for the purpose of separating items relating to the same account which are dissimilar, and thus affording a comparison between the totals of these dissimilar groups. An account containing dissimilar items may have the same total on both sides, in which case it is said to balance, i.e., the class of items on one side exactly balances or cancels those on the opposite side; or one side of the account may be larger than the other, in which case the amount of the excess is called the “balance” in the account, or of the account. An account takes its nature or classification from the larger side, on which the balance appears. The account balances are shown in summarized form on the balance sheet or the profit and loss statement.
The Account Title Indicative of Its Classification.—The account title or name should be so plain as easily to indicate its main classification. The two main classes of accounts are, as stated above, those relating to assets and liabilities, or property—things owned and things owed; and those relating to proprietorship—those showing the increases or decreases in net worth. The title of an account should clearly indicate whether the account belongs to the asset or liability class, or to the proprietorship class.
The accounts called Cash, Accounts Receivable, Mortgages Payable, Accrued Wages, clearly show assets and liabilities; while those entitled Sales, Rent Income, Wages, Expenses, indicate factors affecting proprietorship.
The Meaning of Account Balances.—In the asset accounts the larger side, and therefore the balance of the account, is normally on the left, i.e., the balance of Cash, Land, Buildings, Furniture and Fixtures, Notes Receivable, and the like are normally left-side balances. It follows, therefore, that all entries showing the acquisition or increase of assets are made on the left side of their accounts, and all entries showing the disposal or decrease of assets are made on the right side of the accounts. Very seldom are the cancellations listed on the right side in excess of the assets listed on the left.
In the liability accounts the balance is normally on the right side because liabilities are subtraction items from the assets and should, therefore, normally be on the opposite side of the account. Notes Payable, Accounts Payable, Mortgages Payable, Interest Payable, Rent Payable, and the like, have normally right-side balances. It follows, therefore, that all entries showing the assumption of liabilities are made to the right side of the account, and all entries showing the cancellation of these liabilities are made on the left side. Rarely are liability cancellations in excess of the liabilities owed.
As will be explained in Chapter XII, in the group of accounts indicating decreases in proprietorship, the balance, or larger side, is normally on the left; in the group showing increases in proprietorship the balance is normally on the right. The balances of the accounts, Wages, Salaries, Rent Expense, and all other expenses, are normally left-side balances. It follows, therefore, that entries showing the cost of such expenses to the business are made on the left side of suitably named expense accounts, and entries showing a reduction in the expenses are made on the right side. Items for wages, for example, are shown on the left side of the Wages account, and any subtractions because of overpayment or for other reasons, are shown on the right side of the account.
The balances of the accounts Sales, Rent Income, Interest Income, and other kinds of income, are normally right-side balances. From this it follows that entries showing income are made on the right side of a suitable account, and entries indicating a reduction or subtraction from the income shown are made on the left side of the account. For example, income from sales is shown on the right side of the Sales account, while any reduction of that income, as when goods are returned by customers, is shown on the left side.
Knowing, therefore, to what main class each account belongs—asset, liability, expense, or income—one always knows on which side the balance is normally, and also that the items on the opposite side are subtraction items. Subtraction can be shown in the account only by thus separating dissimilar items.
Relation of the Account to the Financial Statements.—The equation of the balance sheet is the equation of the ledger. The fundamental proprietorship equation is written in two ways:
The ledger (that is, the accounts in the ledger) is constructed in accordance with the second form of the proprietorship equation. In it are found all the accounts of the business, which are included under the classes Assets, Liabilities, and Proprietorship. Under Proprietorship are the subgroups: (a) Net Worth, or capital at the beginning of the period, and (b) Current Profit or Loss. The Current Profit or Loss is in turn shown by the two groups of accounts: (1) Income, and (2) Expense. This classification of the accounts and their relation to the balance sheet are illustrated graphically in the chart shown in Form 2.
The asset accounts have net left-side balances, as previously explained. Hence, if all the detailed accounts which record assets are brought together, the sum total of the left-side balances of these accounts will represent the total assets of the business. Liability accounts have right-side balances, as also explained. Therefore, if all the accounts that record the liabilities of the business are brought together, the sum total of their right-side balances will represent the total liabilities of the business. The proprietorship accounts have right-side and left-side balances. The net total of all the proprietorship accounts will be a right-side balance, however, and will show the present net worth of the business.
Form 2. Chart of Accounts
Accordingly, when one views the accounts in the ledger in their fundamental groupings—namely, assets, liabilities, and proprietorship—it is seen that the equation of the balance sheet is also the equation of the ledger. The account is thus seen to be an integral part of the balance sheet. It is so arranged, however, as to sort and handle additions and subtractions and to furnish a net result for use in the balance sheet.
The asset portion of the proprietorship equation is in the ledger broken up into the various kinds of assets, record of which is desirable and necessary for purposes of adequate control of the business. In keeping the record, all the transactions affecting—that is, either adding to or subtracting from—a given asset are recorded in the account kept with that asset. In this way each account brings about a sorting of the transactions affecting it. It separates these transactions into two kinds, those which add to and those which subtract from its value, and by means of its net balance at any given time it summarizes the numberless transactions which have affected it during a period and gives a net result showing its present status.
In much the same way the liability item of the proprietorship equation is broken up in the ledger for purposes of detailed information, into a large number of individual liability accounts. The sum total of the balance of these accounts is the liability item of the proprietorship equation.
The proprietorship section of the equation is a little more complex when split up, as it is in the ledger. In accordance with the chart given in Form 2, it will be seen that proprietorship is classified in the two main groups: (1) capital at the beginning of the period, and (2) changes of capital during the period. It is this latter group of accounts which, as they are carried in the ledger, have both right-side and left-side balances. The income accounts, which tend to increase capital and which, when merged with the capital accounts at the beginning of the period, add to that capital, have right-side balances. The accounts which tend to decrease capital, that is, the expense accounts, because they are subtraction items, have left-side balances. The net increase (or decrease) in capital for the period is the excess (or deficit) of the total income accounts over the total expense accounts. The summarized result therefore of current changes in capital added to the capital at the beginning of the period, gives the proprietorship of the business at any given time.
At the beginning of a business enterprise the accounts in the ledger will be an opening balance sheet of the business. Day by day by day as transactions take place, there will be a constant change in the values of the assets, liabilities, and the proprietorship account which will thus express the changing financial condition of the business. Some assets will be increased while others will be decreased; liabilities will also change; and with these changes there will be brought about a change in proprietorship—an increase or a decrease. The ledger must record these changing values as they take place, so that the condition of the business can be determined practically at any time.
The ledger is thus seen to contain and comprise the balance sheet of the business at all times. Certain groupings, summarizations, and adjustments may be necessary before a balance sheet technically correct as to form and content can be taken from the ledger, but the fundamental balance sheet equation is always contained in the ledger. This is pictured graphically in the chart shown in Form 2. A further consideration of the relationships between assets, liabilities, and proprietorship leads us to an explanation of the principles or philosophy of debit and credit, a matter which will be taken up in the next chapter.