CLASSIFICATION OF ACCOUNTS 1. Importance of correct account classification.— Accounts are the basis of any accounting system. The success with which they portray the effects of business activities indicates the value of the system itself. Accounts might be likened to separate reser voirs in which the records of the results and the effects of transactions are collected and retained.
It is evident that if an accounting system is to fulfill the purposes for which it was established, the classifi cations of the transactions and the terms applied to them form important features of the system. Incor rect or indefinite terminology of accounts will stultify the most elaborate system. The Interstate Commerce Commission, for example, requires certain informa tion about the business operations, the financial opera tions and the financial condition of the railroads in the United States. In order to obtain intelligible information, the Commission was compelled to name and to define carefully all the accounts which would be required of the railroads. A booklet issued by the Commission covered these points. It gave the title of the account and a detailed listing of every item to be charged or to be credited to it. The same care. the same study and the same thoroness will be required in the installation of a set of accounts for use in any business.
2. How to build a system of income and expense accounts.—The first step in installing a system of accounts is to analyze the business covered, and the purposes which are to be accomplished. In this analysis it is necessary first, to classify all income with reference to its source, and secondly, to classify all ex penses or costs with reference to the incomes of which they are the cost. In every business the greater part of the expense will consist in the cost of acquiring or handling some commodity which forms a part of the business operations. This cost may be the manufac turing, the purchasing, the storing or the selling cost. The classification of the sources of income permits of a separation of the activities of the business. Thru
the location of the costs connected with each source of income it is possible to divide expenses according to causes.
This classification of income and expense must be sufficiently detailed to give a clear and undisturbed record of each business activity. To a certain extent, increased classification of activities by accounts results in more detailed information, but it results also in a greater accounting expense. The question as to the extent that this detail may become of value must be answered by the management in each case. It is only possible to formulate the general rule that: Classification in account-keeping should not be carried beyond that point at which the additional de tail of information to be obtained, will not be worth the additional expense involved in obtaining it.
3. Value of detailed classification in accounts— an illustration.—The following illustration indicates the value of a detailed classification of accounts. If a merchant is buying and selling "wheat and oats," he may be losing money on his sales of wheat and mak ing money on his sales of oats. The losses on wheat may be practically off-set by the profits on oats. An examination of this account, in connection with the various expenses which had been ascribed to the pur chase, storage and sale of wheat and oats, would indi cate that it was unprofitable for the dealer to handle them as a part of his business.
On the other hand, if he carried one account for wheat and another for oats and had allocated to each commodity its proportionate expenses, he would im mediately recognize that it would be unprofitable for him to continue handling wheat, but that he should push his sales on oats because he was making a profit on them. If he did not discontinue the sale of wheat he would then wish to take such measures as would result in his securing a profit on it. To secure this result he would either increase the price charged to customers or reduce the expense of handling wheat.