basic accounting - rephrased notes
TRANSCRIPT
Chapter – 1
Introduction to Accounting
Origin and history of Accounting can be traced back to some 10,000 years ago. The population
in the area known as Mesopotamia, later Persia, and today the countries of Iran and Iraq had an
active trading between towns and cities up and down the two rivers started the accounting
concepts. At that time there were no letters or numbers.
The merchants had to ship their merchandise up and down the rivers. They have to trust
the boat man with their goods. There were a lot of disagreements about how much was shipped
versus what was received at the other end between the merchants and the shippers. To deal such
problem, merchants came up with small clay tokens, in various shapes and with various
markings, to indicate different products, which would mean a basket of grain, another would
mean a pot of oil, etc. They had over 200 such tokens to indicate a large variety of common
goods, including food, leather, clothing, utensils, tools, jewelry, etc. Before shipping their
goods, a merchant would take one token for each item in the shipment, and encase the tokens in a
ball of clay, called a "bollae" (pronounced "bowl-eye") - meaning ball. The ball would be dried
in the sun, given to the boatman, and then broken by the buyer on the other end of the
transaction. The buyer would match the tokens with the items in the shipment, to verify that
everything sent was accounted for.
Early references to accounting concepts are found in the Vedas, In atharvaveda and the
Nirukta denoting ‘sale’. Sulka in the Rig veda clearly means ‘price’ are found indicating the
accounting practices.
In the Dharma Sutras it denotes a ‘tax’. Roman history also gives traces of accounting. The Res
Gestae Divi Augusti (Latin: "The Deeds of the Divine Augustus") is a remarkable account to the
Roman people of the Emperor Augustus' stewardship. It listed and quantified his public
expenditure, which encompassed distributions to the people, grants of land or money to army
veterans, subsidies to the treasury, building of temples, religious offerings, and expenditures on
theatrical shows and gladiatorial games. The significance of the Res Gestae Divi Augusti from
an accounting perspective lies in the fact that it illustrates that the executive authority had access
to detailed financial information, covering a period of some forty years, which was still
retrievable after the event. The scope of the accounting information at the emperor's disposal
suggests that its purpose encompassed planning and decision-making.
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In the Qur’an, the word "account" (Arabic: hesab) is used in its generic sense, relating to one's
obligation to account to God on all matters pertaining to human endeavour. According to the
Qur’an, followers are required to keep records of their indebtedness (Sura 2, ayah 282), thus
Islam provides general approval and guidelines for the recording and reporting of transactions.
The Islamic law of inheritance (Sura 4, ayah 11) defines exactly how the estate is calculated after
death of an individual.
However the development was fast after the invention of symbols and numbers. Luca
Pacioli (pot-chee-O-lee) set down in writing for the first time a description of the double-entry
system of accounting, which we still use today in much the same form. Although he didn't
actually invent the system he is called "the father of accounting" for his contributions and for
documenting the system in his fifth book on mathematics Summa de Arithmetica, Geometria,
Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion).
Modern accounting follows the principles set down by Luca Pacioli over 500 years ago. Today it
is a highly organized profession, with a complex set of rules for the fair disclosure and
presentation of information in financial statements. In modern times, trillions of dollars in
transactions are recorded by business, government and financial institutions world-wide
following the same general set of rules.
In India, we follow Generally Accepted Accounting Principles (GAAP) as specified by the
institute of Chartered Accountants of India. It is mandatory for all businesses to follow these
guidelines. We use Indian Rupee for all financial statements and transactions. Other countries
use similar accounting rules as the US use US GAAP, but there are differences from country to
country. If you had a business in France, you would use the French equivalent to our GAAP.
GAAP developed over 500 years from the basic concepts Luca Pacioli set forth in the
1400s. There is a great deal of similarity in accounting practices around the world because they
all have a common origin.
Many people incorrectly believe that accountants' work primarily consists of bookkeeping. There
is a difference between book keeping and accounting. Book keeping is recording of transactions
in a systematic pattern where as accounting is design o records that is classify, summarize and
analyze the records for communication to various stake holders Most professional accountants do
little or no bookkeeping. Accountants are involved in the preparation of financial statements, and
the interpretation of financial information, rather than day-to-day recording of routine
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transactions. This work includes making sure the financial statements comply with GAAP,
provide adequate disclosure of essential financial information, and are free from material errors
and misstatements. In the coming chapters we will cover the various concept of book keeping
and leading to the accounting practices followed by business and firms.
Need and Importance of Accounting
The main aim of a person starting a business is to earn profit. During the normal course
of business sale of goods, interest on bank deposits etc brings in money whereas purchase of
goods, salary, rent, etc leads to outflow of cash.
Business transactions tend to be numerous during the year which cannot be retained by
memory. If it were documented, then it is easier to assess the progress of the business. He may
have to keep a track of his investments, earnings, expenses, receivables, payables, value of assets
and liabilities, etc in an understandable and methodical manner which in turn is nothing but
book-keeping.
Book-keeping
Book-keeping is that branch of knowledge which tells us how to keep a record of
business transactions. It comprises making a record of the monies received by a business plus the
monies paid out. It includes money a company owes to vendors, employees, tax agencies,
contractors and any other individual or entity. Also amounts owed to the company by outside
individuals and organizations are recorded in it. These are presented by recording in the journal,
posting to the ledger and balancing of accounts.
Definition
R.N. Carter says, “Book-keeping is the science and art of correctly recording in the books
of account all those business transactions that result in the transfer of money or money’s worth”.
Accounting
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Accounting is considered as a system which collects and processes financial information
of a business. Book-keeping does not present a clear financial picture of the state of affairs of the
business. When one has to make a judgment regarding the financial position of the firm, the
information contained in these books of accounts has to be analyzed and interpreted. It is with
the purpose of giving such information that accounting came into being.These information are
reported to the users to enable them to make appropriate decisions.
Key Characteristics of Accounting Information
There is general agreement that, before it can be regarded as useful in satisfying the needs of
various user groups, accounting information should satisfy the following criteria:
Criteria What it means for the preparation of accounting information
Understandability This implies the expression, with clarity, of accounting information in such a
way that it will be understandable to users - who are generally assumed to
have a reasonable knowledge of business and economic activities
Relevance This implies that, to be useful, accounting information must assist a user to
form, confirm or maybe revise a view - usually in the context of making a
decision (e.g. should I invest, should I lend money to this business? Should I
work for this business?)
Consistency This implies consistent treatment of similar items and application of
accounting policies
Comparability This implies the ability for users to be able to compare similar companies in
the same industry group and to make comparisons of performance over time.
Much of the work that goes into setting accounting standards is based around
the need for comparability.
Reliability This implies that the accounting information that is presented is truthful,
accurate, complete (nothing significant missed out) and capable of being
verified (e.g. by a potential investor).
Objectivity This implies that accounting information is prepared and reported in a
"neutral" way. In other words, it is not biased towards a particular user group
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or vested interest
Users of Accounting Information
Investors and lenders are the most obvious users of accounting information. Their decisions and
uses of information have been studied and described to a much greater extent than those of other
user groups. Therefore, for reasons that are largely pragmatic, financial reports focus on
providing information for investment and loan decisions. However, other individuals and groups
also extensively use financial reports and rely on them as their major source of financial
information. They include present and potential investors, lenders, security analysts and advisers,
management employees and trade unions, suppliers and other trade creditors, customers,
governments and regulatory agencies, and the public.
Investors
Investors are the major recipients of the financial statements of business enterprises.
They may be retail investors with small shareholdings or large mutual funds and private equity
firms.
As chief providers of risk capital, investors are keen to understand the return (or profit) from
their investments and the associated risk (or likelihood of loss or low profit).
Accounting information enables investors to identify promising investment opportunities.
Investors need information to decide which investments to buy, retain, or sell, as well as the
timing of the purchases or sales of those investments.
They also need information to monitor management performance and to assess the ability of the
enterprise to pay dividends.
While present investors have a legal right to receive periodic financial reports, potential investors
too are interested in financial information.
In a survey of investors, 90 per cent of the respondents stated that they looked forward Private
equity funds are on the lookout for investing in ailing businesses that they can restructure and
sell at a substantial profit.
Lenders
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Lenders such as banks and debenture holders need to know about the financial stability of a
business that approaches them for funds.
They are interested in information that would enable them to determine whether their borrowers
will be able to repay the loans and pay the related interest on time.
Banks use credit evaluation benchmarks based on information derived from financial statements
when deciding on the amount of the loan, interest rate, repayment period, and security.
They also use the information for monitoring the financial condition of borrowers.
Thus, many lenders stipulate dos and don’ts, or covenants, for borrowers that often require the
use of accounting information.
For example, a loan agreement may impose an upper limit on a borrower’s total debt from all
sources or compel the borrower to keep a minimum level of cash.
If a borrower fails to comply with the stipulations, the lender may raise the interest rate, ask for
additional security, and even demand repayment of the loan.
Security Analysts, Rating Agencies and Other Information Specialists
Investors and creditors seek the assistance of information specialists in assessing prospective
returns.
Equity analysts and bond analysts, stockbrokers, and credit rating agencies offer a wide array of
information services.
These information specialists serve the needs of investors by providing them with skilled
analyses and interpretation of financial reports.
Security analysts collect information about firms also through other means such as face-to-face
meetings and conferences calls with company executives and field visits.
Sell-side analysts work for brokerage houses, investment banks and independent research firms
who use their reports to recommend to their clients whether to buy, sell or hold their investments.
In contrast, buy-side analysts produce research reports for in-house use by mutual funds and
other investment firms where they are employed.
A survey of business and financial leaders by Louis Harris & Associates highlights the
importance of security analysts as users of financial statements. In that survey, when asked who
the highly important users of financial reports are, 82 per cent indicated security analysts and
their clients (institutional investors), whereas only 39 and 33 per cent mentioned present and
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potential investor, respectively, as highly important users. When asked who the most important
users should be, the respondents indicated a much stronger preference for security analysts rather
than for individual investors.
Managers
Managers produce financial information for use by others and also use it in many of their
decisions. They need information for planning and controlling operations, for making special
decisions, and for formulating major plans and polices. Some of this information is available
from the accounting system which they use to evaluate potential investment projects. Since
managers are responsible for reporting enterprise performance to owners and others, they
monitor the key financial indicators that appear in the financial reports. Besides, they compare
their firm’s performance with that of their competitor’s performance.
Sometimes, the managers of a business may be interested in acquiring firms of other business
– often undervalued firms – from its current owners.
When managers receive a commission or bonus related to profit or other accounting measures,
they have a natural interest in understanding how those numbers are computed. Further, when
faced with a hostile takeover attempt, they communicate additional financial information with a
view to boosting the firm’s stock price. In such instances, they use financial information relating
to such firms for valuing them.
Employees and Trade Unions
Employees are keen to know about the enterprise’s general operations, stability and profitability.
Current employees have a natural interest in the financial condition of the enterprise because,
often, their compensation will depend on the financial performance of the firm. Potential
employees may use financial information in order to gauge the enterprise’s prospects. Past
employees, who depend on their former employer for their post-retirement benefits, such as
pensions and healthcare, have a continuing interest in the enterprise’s performance and
prospects. Trade unions use financial reports for negotiating enhancements in wages, bonus and
other benefits.
Suppliers and Trade Financiers
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Suppliers regard the enterprise as an outlet for their products or services. They use financial
information to assess the likelihood of the enterprise continuing to buy from them, especially if it
is a major customer. Consider this example. In 2002, an accounting scandal hit the US
telecommunication firm, WorldCom, following which it was expected to file for bankruptcy.
There were concerns about its impact on the business of telecommunication equipment
manufacturers and other vendors, such as Wipro, who supplied to the company, either directly or
indirectly.
Trade financiers provide short-term financial support. Both suppliers and trade financiers want
information that enables them to determine whether the enterprise will pay them on the dot.
While lenders take a long-term view, suppliers and trade financiers usually focus on the
enterprise’s near-term financial condition
Customers
Present, prospective and past customers use information about the financial affairs of an
enterprise in deciding whether business has anything to do with it and how much. Customers
would like to know if they can count on their suppliers not only as a source of their future
purchases but also to provide after-sales support. For example, car owners depend on the
manufacturer for warranty repairs and continued supply of spare parts. The users of a computer
software look to the software firm for periodic upgrade of the product. Those who have taken
insurance need confidence that the insurer will have the financial resources to pay their claims.
In all these cases, the supplier’s financial reports can be useful to the customers. At the same
time, when suppliers financial reports can be useful to the customers. At the same time, when
suppliers make large profits, customers may suspect that they are being overcharged. For
example, if you mobile phone company makes huge profits, you would like the company to cut
call charges.
Government and Regulatory Authorities
The three levels of government in India – Central, state and local – allocate resources and are
concerned with the activities of enterprises. They require information in order to regulate the
business practices of enterprises, determine taxation policies and provide a basis for national
income and similar statistics.
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The Ministries of Finance and Corporate Affairs are amount those in the Government of India
that take a keen interest in the financial affairs of business enterprises. A number of regulatory
agencies are government or quasi-government bodies, such as the Securities and Exchange
Board of India (SEBI), the Reserve Bank of India (RBI), the Insurance Regulatory and
Development Authority (IRDA), the Telecom Regulatory Authority of India (TRAI), and the
Competition Commission of India (CCI). These agencies use financial reports in order to take
action on abuses and violations. Others such as stock exchange have a legitimate interest in
financial reports of publicly-held enterprises to ensure efficient operation of capital markets.
Accounting regulators also have a broad interest in the current reporting practices of business
and non business organizations, and their review of annual and quarterly reports contributes to
improving financial reporting standards.
The Public
Enterprises affect members of the public in a variety of ways. For example, they employ people
from the local community and patronize local suppliers; so the prosperity of the local community
depends on their success. As an illustration, when the software industry slowed down in 2001. It
was said that business in up market restaurants and pubs in Bangalore was down. Financial
statements assist the public by providing information about the trends and recent developments
in the prosperity of the consumer groups, newspapers and magazines, television channels, and
environment protection groups also have a general interest in the affairs of business enterprises.
The nature and extent of their interest often varies considerably.
Exhibit 1.1 summarizes the major users of accounting information and some typical questions
for which they look for answers in accounting reports. Whether someone is a legitimate user of
accounting information differs from one country to another. For example, in the US and the UK,
financial statements are meant primarily for shareholders and lenders. But countries in
Continental Europe, such as Germany, France and Sweden, explicitly recognize employees and
trade unions as having a stake in financial reports.
ACCOUNTING AS AN ACADEMIC DISCIPLINE
Accounting is a profession just as any other – medicine, law, architecture, on engineering.
Accountants apply the principles and concepts of accounting to solve practical problems.
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Accounting is also a field of intellectual enquiry, as are medicine, law, architecture, and
engineering. Accounting academics publish their research in scholarly journals, such as The
Accounting Review, the Journal of Accounting and Economics, and the Journal of Accounting
Research. Accounting researchers apply economic and behavioural theories to financial reporting
and disclosure, and other areas of accounting.
Examples of problems that researchers have examined include:
How do financial results influence stock markets? How do firms achieve greater transparency in disclosure? How do we distinguish between accrual accounting and cash accounting? Why do accountants be conservative when it comes to reporting gains & liberal when comes to reporting losses?
Research Insight
Accounting and stock prices
Here are some questions that you may be asking: Do accounting numbers influence stock prices? How important is accounting to the capital market?
Are accounting reports a timely source of information to the capital market?
Professors Ray Ball and Philip Brown investigated these questions and reported their findings in
a paper that holds the world record for being the most cited research in accounting.
They found that stock prices reacted to firms’ announcements of financial results. However,
most of the changes in the stock prices occurred prior to the month in which annual results were
announced. They noted that one-half or more of all the information is captured in that year’s net
profit. However, about 85-90 per cent of the change is captured by more prompt media that
would include accounting and non-accounting sources of information. Thus, while the capital
market anticipates much of the information contained in the annual financial statement, full
anticipation does not occur.
Basic Accounting Terms
Accounting TermsIt will be appropriate to get familiarized with certain basic terms which are used in accounting
before proceeding with the technique of recording of business transactions. It is necessary for the
readers to go through these basic terms and understand them clearly; since it will be then
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convenient for them to understand clearly the contents of the chapters which are to follow:
1. Assets: The terms 'assets' include the resources acquired by a business from the funds made
available either by the owners or by others. They are "tangible objects or intangible rights owned
by an enterprise and carrying probable future benefits". In other words, property of all kinds
owned by a business comes within the category of the term 'assets'.
Assets may be classified into the following categories:
I. Fixed assets: These are assets which are acquired for relatively long period for carrying
on the business of the enterprise. They are not meant for resale. The examples of such
assets are land, buildings, plant, machinery, etc.
II. Current assets: These are assets which are acquired with the intention of converting
them into cash during the normal business operations of the company. They include "cash
and other assets that are expected to be converted into cash or consumed in the
production of goods or rendering of services in the normal course of business". The
essential difference between current assets and fixed assets is that the current assets are
held essentially for a short period and they are meant for converting into cash. Examples
of such assets are cash, inventories (i.e., stocks of raw material, into cash. Examples of
such assets are cash, inventories (i.e., stocks of raw material, work-in-progress and
finished goods), bills receivable, debtors, etc. These assets are also termed as 'Floating' or
'Circulating' Assets.
III. Liquid assets: These are assets which are immediately convertible into cash without
much loss. As a matter of fact, all current assets excluding prepaid expenses and
inventories are including in the definition of liquid assets.
IV. Fictitious assets: These are assets which have no real value but are shown in the books
of accounts only for technical reasons. Examples of such assets are preliminary expenses
incurred in connection with the establishment of a business or discount allowed on issue
of shares by a company, etc.
V. Wasting assets: These are the assets which are exhausted with, or which lose themselves
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in the goods they produce. Mines and quarries are common examples of such assets. The
term is also used for describing such assets which get exhausted with the lapse of time,
e.g. copyright, patents, trademark, etc.
2. Liabilities: The term 'Liabilities' is used to denote amounts which a business owes and has to
return or account for. They are present obligations whose amounts can be ascertained with
substantial accuracy. They can be divided into two categories:
i. Current liabilities: The term 'Current liabilities' is used to denote liabilities which will
be due within a short time (usually one year or less) and that are to be paid out of current
assets or by creation of other current liabilities. Creditors for goods, bills payable,
outstanding expenses are some of the examples of current liabilities.
ii. Fixed liabilities: Liabilities that will not be due for a comparatively long time (usually
more than one year) are termed as 'Fixed Liabilities' or 'Long-term Liabilities'. These
liabilities would continue to be treated as Fixed Liabilities if they are renewed rather than
paid at maturity.
3. Capital: The term ‘Capital' is used to denote the owners' equity in the business. It is a residual
claim against the assets of the business after the total liabilities are deducted. Owners' Equity,
proprietorship and Net-worth are some of the other terms which are also used to denote capital.
Capital may be classified into the following categories:
i. Fixed capital: It is the capital invested in or represented by Fixed Assets.
ii. Circulating Capital: It is the capital in the form of current or floating assets.
iii. Working Capital: It is the excess of current assets over current liabilities.
4. Contingent Asset: An asset, the existence, ownership value of which may be known or
determined only on the occurrence or non-occurrence of one more future uncertain events. It is
usually raised from unexpected events that give rise to possibility of inflow of economic benefits
to the business enterprise. For example, a claim that the firm is pursing the outcome of which is
uncertain is a contingent asset.
A contingent asset is not recognized in the books of an enterprise. It also does not require any
disclosure in the financial statements. Such an asset is assessed continuously and when it
becomes virtually certain that it will result in inflow to economic benefits to the enterprise, the
asset and the related income may be recognized in the financial statements of the firm in which
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such change occurs.
5. Contingent Liability: It is an obligation relating to existing conditions or situation which may
arise in future depending upon the occurrence or non-occurrence of one or more uncertain future
events. It is a possible obligation which may or may not arise depending upon the situation.
Following are the examples of contingent liabilities:
a.A Claim against the enterprise not acknowledged as debt
b. Uncalled liability on shares partly paid
c.Arrears of fixed cumulative dividends
d. Estimated amount of contracts remaining to be executed on capital
account and not provided for
An enterprise should not recognize a contingent liability. However, it may be disclosed as a note
to the financial statements. Such liabilities are assessed on a continuing basis to determine
whether an outflow of economic resources has become probable, if so to the extent of the
probable amount, the liability will have to be recognized in the books and a provision will have
to be created.
6. Provision: An amount written off or retained by way of providing for depreciation or
diminution in value of assets or for providing any known liability, the amount of which cannot
determined with substantial accuracy. Examples of a provision are provision for bad and
doubtful debts, a provision for discount on debtors, etc.
Different between a Contingent Liability, a Provision and a Liability:
This can be understood with the following example:
A lawsuit has been filed against a firm claiming damages of Rs 1, 00,000. 00 The form feels that
the case against the firm may or may not be dismissed by the court. Such a liability is a
contingent liability and may be disclosed by way of a note to the financial statements. However,
if the firm feels that it may be required to pay the damages of around Rs 20,000 in the suit in all
probabilities, the provision to the extent of Rs 20,000 for the lawsuit will be created. Finally if
the court fixes the damaged payable of Rs 25,000 against the firms, a liability of Rs 25,000 will
be recognised in the books of the firm.
7. Transaction and Event: Every economic activity is performed through transactions and
events. A transaction may be a business, performance of an act or an agreement, while an event
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is the happening, consequence or result of a transaction.
For example, A starts business with a capital of Rs 1, 00,000.00. He makes cash purchases of Rs
80,000.00 and makes cash sales of Rs 90,000.00 of goods costing Rs 60,000.00. He also pays Rs
10,000.00 as rent of the warehouse.
The following results can be drawn from the above:
8. Revenue: The term 'Revenue' means income of recurring nature from any source. The source
may be sale of goods, performance of services for a customer or a client, the rental of a property,
the lending of money and any other business or professional activity carried on for the purpose of
earning income.
9. Expenditure: The term includes incurring a liability disbursement of cases of transfer of
property for the purpose of obtaining assets goods or services. It may be of three types:
i. Capital expenditure: Expenditure incurred for obtaining a long-term advantage for the
business.
ii. Revenue expenditure: An expenditure where benefits expire within a year or which has
been incurred merely to maintain the business or keep the assets in good working
condition.
iii. Deferred expenditure: An expenditure or liability for which payment has been made or
incurred but which is carried forward on the presumption that it will be of benefit over a
subsequent period or periods. This is also referred to as deferred revenue expenditure.
10. Expense: The term 'Expense' denotes the cost of services and things used for generating
revenue. An 'Expense' is to be distinguished from a Loss. An Expense is supposed to bring some
benefit to the firm, whereas a Loss brings no benefit to the firm, e.g., loss by theft, loss by fire,
etc.
The terms 8 to 10 discussed above have been explained in detail later in a separate chapter,
"Capital and Revenue".
11. Goods: The term 'goods' means the property in which the business deals. In other words,
'Goods' are properties for resale. For example, if a furniture dealer purchases furniture for sale,
the furniture so purchased will come within the definition of the term 'Goods'. However, if the
furniture has been purchased by a furniture dealer for using it in his business, such furniture will
come within the definition of the term 'Fixed Assets'.
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12. Debtor: The person who owes money to the business is called a debtor.
13. Creditor: A person who has a claim for money against the business is termed as creditor.
14. Bill of Exchange: It is a document in writing directing a certain person to pay a certain sum
of money to the order of a certain person or to the bearer of the instrument. For example, if A, a
creditors by a document in writing asks his debtors B to pay a sum of Rs10,000 (owed by B on
account of purchase of certain goods) after 3 months, such a document is termed as 'Bill of
Exchange'.
The document will be termed as 'Bill Receivable' for A (i.e., the person entitled to get the
payment) and a 'Bill Payable' for B (i.e., the person who is liable to pay the money under the
document).
15. Accounts Receivable: The term includes both Debtors and Bills Receivable.
16. Accounts Payable: The term included both Creditors and Bills Payable.
17. Discount: An allowance or a deduction allowed from an amount due is termed as 'Discount'.
It may be of three types:
i. Trade discount: A deduction allowed to the buyers from the gross or catalogue
price is termed as 'Trade Discount'.
ii. Quantity discount: A deduction allowed to the buyers from the gross catalogue
price on making bulk purchases is termed as 'Quality Discount'.
iii. Cash discount: A discount allowed to a debtor on prompt payment of cash is
termed as 'Cash Discount'.
Trade or quality discount is not taken into account evolutes recording accounting transaction.
The transactions are recorded at 'net' while cash discount is recorded in the books of account.
18. Commission: Commission may be termed as remuneration payable to an employee for his
services to the firm or to the agent for purchasing or selling goods collection of debtors on behalf
of the firm, etc. The commission is computed as a percentage of the amount involved. The
commission earned is considered as an income while commission allowed is considered as an
expense for the business.
Following are examples of persons to whom commission may be allowed:
a.Selling or buying agents.
b. Brokers and bankers.
c.Property dealers for helping in renting out or purchase or sale of properties.
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d. Import-export agent in foreign trade.
19. Merchandise Cost: It is the same as cost of goods sold. It is computed as follows:
Opening Inventory
Add: Net Purchases (i.e., Purchases less returns)
Direct Expenses (ie. expenses incurred for acquiring the goods and making them fit for
sale)
Less: Closing Inventory
Cost of goods sold
20. Gross Profit: It is the excess of the selling price over the cost of goods sold (without
deducting any expenses incurred in selling the goods).
21. Net Profit/Income: It is the profit left after deducting all business expenses from the gross
profit made by the business.
Illustration 3.1: Find out merchandise cost, gross profit and net income from the following
transactions:
22. Drawings: The withdrawal of goods or cash from the business by the owner for personal use
is called 'Drawings'.
23. Entry: Recording of a transaction in any book of account is called an 'Entry'
24. Insolvent: A person who is not in a position to pay his debts is full. It means that the
liabilities of such a person are more than his assets.
25. Solvent: A person who is in a position to pay his debts as they become due.
26. Bad Debts: The amount lost from a debtor on account of his inability to pay his debts.
27. Net Assets: The excess of the book value of assets (other than fictitious assets) of an
enterprise over its liabilities. This is also referred to as Net Worth or Shareholders Funds.
28. Working Capital: The funds available for day-to-day operations of an enterprise also
represented by the excess of current assets over current liabilities including short-term loans.
Key Terms
I. Asset: A tangible object or an intangible right owned by an enterprise and carrying
probable future benefits.
II. Capital: Owners equity in the business.
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III. Capital Expenditure: Expenditure incurred for the purpose of obtaining a long-term
advantages for the business.
IV. Goods: The property in which the business deals.
V. Liability: An amount which business owes and has to return or account for.
VI. Revenue: An income of a recurring nature from any source.
VII. Revenue Expenditure: An expenditure whose benefit expires within a year or which is
incurred merely to maintain the business or keeping the assets in good working condition.
Chapter -2
ACCOUNTING PRINCIPLES
LEARNING OBJECTIVES
After studying this chapter you should be able to:
I. Explain the meaning of accounting principles
II. Differentiate between accounting concepts and conventions
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III. Appreciate the importance of different accounting concepts and conventions
IV. Name the accounting standards issued by the Institute of Chartered Accountants of India
V. Describe the different systems of accounting, and
VI. Explain the meanings of certain key terms.
MEANING OF ACCOUNTING PRINCIPLES
It has already been stated in the first chapter that accounting is the language of business through
which normally a business house communicates with the outside world. In order to make this
language intelligible and commonly understood by all, it is necessary that it should be based on
certain uniform scientifically laid down standards. These standards are termed as accounting
principles.
Accounting principles may be defined as those rules of action adopted by the
accountants universally while recording accounting transaction. “They are a body of doctrines
commonly associated with the theory and procedures of accounting, serving as an explanation of
current practices and as a guide for selection of conventions or procedures where alternatives
exist”. These principles can be classified into two categories:
I. Accounting Concepts.
II. Accounting Conventions.
Accounting Concepts
The term ‘concepts’ includes those basic assumptions or conditions upon which the science
of accounting is based. The following are the important accounting concepts:
1. Separate Entity Concept
2. Going Concern Concept
3. Money Measurement Concept
4. Cost Concept
5. Dual Aspect Concept
6. Accounting Period Concept
7. Periodic Matching of Cost and Revenue Concept
8. Realization Concept or Revenue recognition concept
Accounting Conventions
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The term ‘conventions’ includes those customs or traditions which guide the accountant
while preparing the accounting statements. The following are the important accounting
conventions.
1. Convention of Conservatism
2. Convention of Full Disclosure
3. Convention of Consistency
4. Convention of Materiality
ACCOUNTING PRINCIPLES
ACCOUNTING CONCEPTS ACCOUNTING CONVENTIONS
i. Separate entity. i. Conservatism.
ii. Going concern. ii. Full disclosure.
iii. Money measurement. iii. Consistency.
iv. Cost. iv. Materiality
v. Dual aspect.
vi. Accounting period.
vii. Periodic matching of cost & revenue.
viii. Realisation.
All the above concepts and conventions are being explained below.
Accounting concept and conventions
In drawing up accounting statements, whether they are external "financial accounts" or
internally-focused "management accounts", a clear objective has to be that the accounts fairly
reflect the true "substance" of the business and the results of its operation.
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The theory of accounting has, therefore, developed the concept of a "true and fair view". The
true and fair view is applied in ensuring and assessing whether accounts do indeed portray
accurately the business' activities.
To support the application of the "true and fair view", accounting has adopted certain concepts
and conventions which help to ensure that accounting information is presented accurately and
consistently.
ACCOUNTING CONCEPTS
1. Separate Entity Concept: In accounting, business is considered to be a separate entity from
the proprietor(s). It may appear to be ludicrous that one person can sell goods to himself but this
concept is extremely helpful in keeping business affairs strictly free from the effect of private
affairs of the proprietor(s). Thus, when one person invests Rs.10,000 into business, it will be
deemed that the proprietor has given that much of money to the business which will be shown as
a ‘liability’ in the books of the business. In case the proprietor withdraws Rs.2,000 from the
business, it will be charged to him and the net amount payable by the business will be shown
only as Rs.8,000.
The concept of separate entity is applicable to all forms of business organisations.
For example, in case of a partnership business or sole proprietorship business, though the
partners or sole proprietor are not considered as separate entities in the eyes of law, but for
accounting purposes they will be considered as separate entities.
2. Going Concern Concept: According to this concept it is assumed that the business will
continue for a fairly long time to come. There is neither the intention nor the necessity to
liquidate the particular business venture in the foreseeable future. On account of this concept, the
accountant while valuing the assets does not take into account forced sale value of assets.
Moreover, he charges depreciation on fixed assets on the basis of their expected lives rather than
on their market value.
It should be noted that the ‘going concern concept’ does not imply permanent
continuance of the enterprise. It rather presumes that the enterprise will continue in operation
long enough to charge against income, the cost of fixed assets over their useful lives, to amortise
20
over appropriate period other costs which have been deferred under the actual or matching
concept, to pay liabilities when they become due and to meet the contractual commitments.
Moreover, the concept applies to the business as a whole. When an enterprise liquidates a branch
or one segment of its operations, the ability of the enterprise to continue as a going concern is
normally not impaired.
The enterprise will not be considered as a going concern when it has gone into
liquidation or it has become insolvent. Of course, the receiver or the liquidator may endeavour to
carry on business operations for some period pending arrangement with the creditors or the final
buyer for the sale of the business as a going concern, the going concern status of the concern will
stand terminated from the date of his appointment or will be at least regarded as suspended,
pending the results of his efforts.
3. Money Measurement Concept: Accounting records only monetary transactions. Events or
transactions which cannot be expressed in money do not find place in the books of accounts
though they may be very useful for the business. For example, if a business has got a team of
dedicated and trusted employees, it is definitely an asset to the business but since their monetary
measurement is not possible, they are not shown in the books of the business.
Measurement of business event in money helps in understanding the state of affairs of the
business in a much better way. For example, if a business owns Rs.10,000 of cash, 600 kg of raw
materials, two trucks , 1,000 square feet of building space etc., these amounts cannot be added
together to produce a meaningful total of what the business owns. However, if these items are
expressed in monetary terms such as Rs 10,000 of cash, Rs 12,000 of raw materials, Rs 2,00,000
of trucks and Rs 50,000 of building, all such items can be added and much more intelligible and
precise estimate about the assets of the business will be available.
4. Cost Concept: The concept is closely related to going concern concept. According to this
concept:
(a) An asset is ordinarily entered in the accounting records at the price paid to acquire it,
and
(b) This cost is the basis for all subsequent accounting for the assets.
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If a business buys a plot of land for Rs.50,000 even if its market value at that time
happens to be Rs.60,000. In case a year later the market value of this assets comes down to
Rs.40,000 it will ordinarily continue to be shown at Rs 50,000 and not at Rs.40,000.
The cost concept does not mean that the asset will always be shown at cost. It has also
been stated above that cost becomes the basis for all future accounting for the asset. It means that
asset is recorded at cost at the time of its purchase, but it may systematically be reduced in its
value by charging depreciation.
Cost concept has the advantage of bringing objectivity in the preparation
and presentation of financial statements. In the absence of this concept the figures shown in the
accounting records would have depended on the subjectivity views of a person. However, on
account of continued inflationary tendencies the preparation of financial statements on the basis
of historical costs has become largely irrelevant for judging the financial position of the business.
This is the reason for the growing importance of inflation accounting.
5. Dual Aspect Concept: This is the basic concept of accounting. According to this concept
every business transaction has dual effect. For example, if A starts a business with a capital of
Rs. 10,000, there are two aspects of the transaction. On the one hand, the business has asset of Rs
10,000 while on the other hand the business has to pay to the proprietor a sum of Rs 10,000
which is taken as proprietor’s capital. This expression can be shown in the form of following
equation:
Capital (Equities) = Cash (Assets)
10,000 = 10,000
The term ‘assets’ denotes the resources owned by a business owned by a business while
the term “Equities” denotes the claims of various parties against the assets. Equities are of two
types. They are: owners’ equity and outsiders’ equity. Owners’ equity (or capital) is the claim of
owners against the assets of the business while outsiders’ equity (for liabilities) is the claim of
outside parties, such as creditors, debenture – holders, etc., against the assets of the business.
Since all assets of the business are claimed by someone (either owners or outsiders), the total of
assets will be equal to total of liabilities, thus:
Equities = Assets
Or Liabilities + Capital = Assets
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In the example given above, if the business purchases furniture worth Rs 5,000 out of the
money provided by A, the situation will be as follows:
Equities = Assets
Capital Rs 10,000 = Cash Rs 5,000 + Furniture Rs 5,000.
Subsequently, if the business borrows Rs 30,000 from a bank, the new position would be
as follows:
Equities = Assets
Capital Rs 10,000 + Bank loan Rs 30,000 = Cash Rs 35,000 + Furniture Rs 5,000.
The term ‘accounting equation’ is also used to denote the relationship of equities to
assets. The equation can be technically stated as “For each Debit, there is an equivalent Credit”.
As a matter of fact, the entire system of double entry book-keeping is based on this concept.
6. Accounting Period Concept: According to this concept, the life of the business is divided
into appropriate segments for studying the results shown by the business after each segment.
This is because though the life of the business is considered to be indefinite (according to going
concern concept), the measurement of income and studying the financial position of the business
after a very long period would not be helpful in taking proper corrective steps at the appropriate
time. It is, therefore, absolutely necessary that after each segment or time interval the business
man must ‘stop’ and ‘see back’, how things are going. In accounting such a segment or time
interval is called ‘Accounting period’. It is usually of a year.
At the end of each accounting period an income statement and a balance sheet are
prepared. The income statement discloses the profit or loss made by the business during the
accounting period while the balance sheet depicts the financial position of the business as on the
last day of the accounting period. While preparing these statements a proper distinction has to be
made between capital and revenue expenditure.
7. Period matching of Costs and Revenue Concept: This is based on the accounting period
concept. The paramount objective of running a business is to earn profit. In order to ascertain the
profit made by the business during a period, it is necessary that ‘revenues’ of the period should
be matched with the costs (expenses) of the period. The term matching, means appropriate
association of related revenues and expenses. In other words, income made by the business
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during a period can be measured only when the revenue earned during a period is compared with
the expenditure incurred for earning that revenue. The question when the payment was received
or made is ‘irrelevant’. For example, if a salesman is paid commission in January, 2007, for sales
made by him in December, 2006, the commission paid to the salesman in January, 2007 should
be taken as the cost for sales made by him in December, 2006. This means that revenues of
December, 2006 (i.e., sales) should be matched with the costs incurred for earning that revenue
(i.e., salesman’s commission) in December, 2006 (though paid in January, 2007). On account of
this concept, adjustments are made for all outstanding expenses, accrued incomes, prepaid
expenses and unearned incomes, etc., while preparing the final accounts at the end of the
accounting period.
8. Realisation Concept: According to this concept revenue is recognized when a sale is made.
Sale is considered to be made at the point when the property in goods passes to the buyer and he
becomes legally liable to pay. This can be well understood with the help of the following
example:
A places an order with B for supply for certain goods yet to be manufactured. On receipt
of order, B purchases raw materials, employs workers, produces the goods and delivers them to
A. A makes payment on receipt of goods. In this case the sale will be presumed to have been
made not at the time of receipt of the order for the goods but at the time when goods are
delivered to A.
However, there are certain exceptions to this concept:
1. In case of hire purchase the ownership of the goods passes to the buyer only when the last
installments is paid, but sales are presumed to have been made to the extent of
installments received and installments outstanding (i.e., installments due but not
received).
2. In case of contracts accounts, though the contractor is liable to pay only when the whole
contract is completed as per terms of the contract, the profit is calculated on the basis of
work certified year after year as per certain accepted accounting norms.
ACCOUNTING CONVENTIONS
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1. Conservatism: In the initial stages of accounting, certain anticipated profits which were
recorded, did not materialize. This resulted in less acceptability of accounting figures by the end-
users. On account of this reason, the accountants follow the rule ‘anticipate no profit but provide
for all possible losses’ while recording the business transactions. In other words, the accountant
follows the policy of “playing safe”. On account of this convention, the inventory is valued ‘at
cost or market price whichever is less’. Similarly, a provision is made for possible bad and
doubtful debts out of current years’ profits. This concept affects principally the category of
current assets.
This convention of conservatism has become the target of serious criticism these days
especially on the ground that it goes against the convention of full disclosure. It encourages the
accountant to create secret reserves (e.g., by creating excess provision for bad and doubtful
debts, depreciation etc.), and the financial statements do not depict a true and fair view of the
state of affairs of the business. The income statement shows a lower net income, the balance
sheet understates assets and overstates liabilities.
The research studies conducted by the American Institute of Certified Public Accountants
have indicated that conservatism concept needs to be applied with much more caution and care if
the results reported are not to be distorted.
2. Full Disclosure: According to this convention accounting reports should disclose fully and
fairly the information they purport to represent. They should be honestly prepared and
sufficiently disclose information which is of material interest to proprietors, present and potential
creditors and investors. The convention is gaining more importance because most of the business
are run by joint stock companies where ownership is divorced from management. The companies
act, 1956 not only requires that income statement and balance sheet of a company must give a
true and fair view of the state of affairs of the company but it also gives the prescribed forms in
which these statements are to be prepared. The practice of appending notes to the accounting
statements (such as about contingent liabilities or market value of investments) is in pursuance to
the convention of full disclosure.
3. Consistency: According to this convention, accounting practices should remind unchanged
from one period to another. For example, if stock is valued at “cost or market price whichever is
less”, this principle should be followed year after year. Similarly if depreciation is charged on
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fixed assets according to diminishing balance method, it should be done year after year. This is
necessary for the purposes of comparison. However, consistency does not mean inflexibility. It
does not forbid introduction of improved accounting techniques. However, if adoption such a
technique results in inflating or deflating the figures of profit as compared to the previous period,
a note to that effect should be given in the financial statements.
4. Materiality: According to this convention, the accountant should attach importance to
material details and ignore insignificant details. This is because otherwise accounting will be
unnecessarily overburdened with minute details. The question what constitutes a material detail,
is left to the description of the accountant. Moreover, an item may be material for one purpose
while immaterial for another. For example, while sending each debtor “a statement of his
account”, complete details upto paise have to be given. However, when a statement of
outstanding debtors is prepared for sending to top management, figures may be rounded to the
nearest ten or hundred. The companies act also permits ignoring of ‘paise’ while preparing
financial statements. Similarly, for tax purposes, the income has to be rounded to nearest ten.
Chapter - 3
BASIC ACCOUNTING PROCEDURES (DOUBLE ENTRY SYSTEM OF BOOK
KEEPING)
Learning objectives:
After studying this chapter, you will be able to:
i. Understand the meaning, features and advantages of Double Entry System
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ii. Know the meaning and types of accounts
iii. Identify the accounting rules
Recording of business transactions has been in vogue in the countries of the world. In India,
maintenance of accounts was practiced not in such a developed form as we have today,
Kautilya’s famous Arthasatra not only relates to Politics and Economics, but also explains the
art of account keeping in a separate chapter. Written in 4 th century BC, the book gives details
about account keeping, methods of supervising and checking of accounts and also about the
distinction between capital and revenue, income and expenses etc.
Double entry system was introduced to the business world by an Italian merchant named
Lucas Pacioli in 1494 A.D. Though the system of recording business transactions in a systematic
manner has originated in Italy, it was perfected in England and other European countries
during the 18th century only i.e., after the Industrial Revolution. Many countries have adopted
this system today.
Double Entry System
There are numerous transactions in a business concern. Each transaction, when closely
analysed, reveals two aspects. One aspect will be “receiving aspect” or “incoming aspect” or
“expenses/loss aspect”. This is termed as the “Debit aspect”. The other aspect will be “giving
aspect” or “outgoing aspect” or “income/gain aspect”. This is termed as the “Credit aspect”.
These two aspects namely “Debit aspect” and “Credit aspect” form the basis of Double Entry
System. The double entry system is so named since it records both the aspects of a transaction.
In short, the basic principle of this system is, for every debit, there must be a corresponding
credit of equal amount and for every credit, there must be a corresponding debit of equal amount.
Definition
According to J.R.Batliboi “Every business transaction has a two-fold effect and that it
affects two accounts in opposite directions and if a complete record were to be made of each
such transaction, it would be necessary to debit one account and credit another account. It is this
recording of the two fold effect of every transaction that has given rise to the term Double Entry
System”.
Features
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i. Every business transaction affects two accounts.
ii. Each transaction has two aspects, i.e., debit and credit.
iii. It is based upon accounting assumptions concepts and principles.
iv. Helps in preparing trial balance which is a test of arithmetic accuracy in accounting.
v. Preparation of final accounts with the help of trial balance.
Approaches of Recording
There are two approaches for recording a transaction.
i. Accounting Equation Approach
ii. Traditional Approach
Accounting Equation Approach
This approach is also called as the American Approach. Under this method transactions are
recorded based on the accounting equations. i.e.,
Assets = Liabilities + Capital
Traditional Approach
This approach is also called as the British Approach. Recording of business transactions
under this method are formed on the basis of the existence of two aspects (debit and credit) in
each of the transactions. All the business transactions’ are recorded in the books of accounts
under the ‘Double Entry System’.
Advantages
The advantages of this system are as follows:
i. Scientific System: This is the only scientific system of recording business transactions. It
helps to attain the objectives of accounting.
ii. Complete record of transactions: This system maintains a complete record of all businss
transactions.
iii. A check on the accuracy of accounts: By the use of this system the accuracy of the
accounting work can be established by the preparation of trial balance.
iv. Ascertainment of profit or loss: The profit earned or loss occurred during a period can be
ascertained by the preparation of profit and loss account.
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v. Knowledge of the financial position: The financial position of the concern can be
ascertained at the end of each period through the preparation of balance sheet.
vi. Full details for control: This system permits accounts to be kept in a very detailed form,
and thereby provides sufficient information for the purpose of control.
vii. Comparative study: The results of one year may be compared with those of previous years
and the reasons for change may be ascertained.
viii. Helps in decision making: The management may be able to obtain sufficient information
for its work, especially for making decisions. Weakness can be detected and remedial
measures may be applied.
ix. Detection of fraud: The systematic and scientific recording of business transactions on the
basis of this system minimizes the chances of fraud.
Account
Every transaction has two aspects and each aspect has an account. It is stated that ‘an account is
a summary of relevant transactions in one place relating to a particular head’.
Classification of Accounts
Transaction can be divided into three categories.
i. Transactions relating to individual and firms
ii. Transactions relating to properties, goods or cash
iii. Transactions relating to expenses or losses and income or gains.
Therefore, accounts can also be classified into Personal, Real and Nominal. The classification
may be illustrated as follows
Accounts
Personal Impersonal
Natural Artificial Representative Real Nominal
Tangible Intangible
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Personal Accounts: The accounts which relate to persons are known as personal accounts. It
includes the following.
i. Natural Persons: Accounts which relate to individuals. For example, Mohan’s A/c,
Shyam’s A/c etc.
ii. Artificial Persons: Accounts which relate to a group of persons or firms or institutions. For
example, HMT Ltd., Indian Overseas Bank, Life Insurance Corporation of India,
Cosmopolitan club etc.
iii. Representative persons: Accounts which represent a particular person or group of persons.
For example, outstanding salary account, prepaid insurance account, etc.
The business concern may keep business relations with all the above personal accounts, because
of buying goods from them or selling goods to them or borrowing from them or lending to them.
Thus they become either Debtors or Creditors.
The proprietor being an individual his capital account and drawings account are also
personal accounts.
Impersonal Accounts: All those accounts which are not personal accounts. This is further
divided into two types viz. Real and Nominal accounts.
i. Real Accounts: Accounts relating to properties and assets which are owned by the
business concern. Real accounts include tangible and intangible accounts. For example,
Land, Building, Goodwill, Purchases, etc.
ii. Nominal Accounts: These accounts do not have any existence, form or shape. They
relate to incomes and expenses and gains and losses of a business concern. For
example, Salary Account, Dividend Account, etc.
Illustration : 1
Classify the following items into Personal, Real and Nominal Accounts.
1. Capital 2. Sales
3. Drawings 4. Outstanding salary
5. Cash 6. Rent
7. Interest paid 8. Indian Bank
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9. Discount received 10. Building
11. Bank 12. Chandrasekar
13. Murugan Lending Library 14. Advertisement
15. Purchases
Solution:
1. Personal account 2. Real account
3. Personal account 4. Personal (Representative) account
5. Real account 6. Nominal account
7. Nominal account 8. Personal (Legal Body) account
9. Nominal account 10. Real account
11. Personal account 12. Personal account
13. Personal account 14. Nominal account
15. Real account
Golden Rules of Accounting
All the business transactions are recorded on the basis of following rules.
S.No. Name of Account Debit Aspect Credit Aspect
1. Personal The receiver The giver
2. Real What comes in What goes out
3. Nominal All expenses and losses All incomes and gains
Answer for the following
Fill in the blanks:
1. The author of the famous book “Arthasastra” is __________.
2. Every business transaction reveals __________ aspects.
3. The incoming aspect of a transaction is called __________ and the outgoing aspect of a
transaction is called __________.
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4. Traditional approach of accounting is also called as ________ approach.
5. The American approach is otherwise known as __________ approach.
6. Impersonal accounts are classified into ___________ types.
7. Plant and machinery is an example of __________ account.
8. Capital account is an example of __________ account.
9. Commission received will be classified under __________ account.
Choose the correct answer:
1. The receiver aspect in a transaction is called as
a) Debit aspect b) Credit aspect c) neither of the two
2. The giving aspect in a transaction is called as
a) Debit aspect b) credit aspect c) neither of the two
3. Murali account is an example for
a) Personal A/c b)Real A/c c)Nominal A/c
4. Capital account is classified under
a) Personal A/c b)Real A/c c)Nominal A/c
5. Goodwill is an example of
a) Tangible real A/c b) intangible real A/c c) nominal A/c
6. Commission received is an example for
a) Real A/c b)Personal A/c c)Nominal A/c
7. Outstanding rent A/c is an example for
a) Nominal account b)Personal account c)Representative personal account
8. Nominal account is classified under
a) Personal A/c b) Impersonal A/c c) Neither of the two
9. Drawings account is classified under
a) Real A/c b)Personal A/c c)Nominal A/c
II. Other Questions:
1. Explain the meaning of Double Entry System.
2. Define Double Entry System.
3. What are the advantages of Double Entry System?
32
4. How are accounts classified?
5. Write notes on real accounts.
6. Explain nominal accounts.
7. What are the golden rules of Accounting?
8. Classify the following items into real, personal and nominal accounts
a. Capital
b. Purchases
c. Goodwill
d. Copyright
e. Latha
f. State Bank of India
g. Electricity Charges
h. Dividend
i. Ramesh
j. Outstanding rent
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RECORDING TRANSACTIONS
The Journal
The journal is a chronological record of transactions entered into by a business. The word
‘journal’ derives from the Latin root, dies meaning ‘day’. The journal is called the book of
original entry or primary book because this is the accounting record where we first record
transactions. It provides in one place a complete record of all transactions with necessary
explanations. The journal entry for a transaction has the date of the transaction, the individual
accounts and the related debit and credit amounts, and a brief explanation of the transaction. The
process of recording transactions in the journal is called journalizing.
The General Journal
Companies usually maintain several kinds of journals. The nature of operations and the
frequency of a particular type of transaction in a company determine the number and design of
journals. In this chapter, we use the general journal, which is the simplest type of journal. It has
separate columns to record the following information about each transaction:
1. Date2. Individual accounts3. Debit and credit amounts4. Brief explanation of the transaction5. Posting reference.
The procedure for recording transactions in the general journal is as follow:
1. Enter the year, month, and date of the transaction on the date column.
There is no need to repeat the year and month for subsequent entries until the start of a new page or a new month.
2. Write the account titles under the Descriptions column.
Enter the account to debit on the first line of the entry next to the left margin. If there are several accounts to debit, enter them one after the other.
Enter the account to credit on the line below the account(s) to debit and indent it to set the account apart from the account(s) to debit. If there are several accounts to credit, enter them one after the other.
Use the account titles from the company’s chart of accounts.
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A compound entry is a journal entry that has more than one debit and/or credit items.
3. Enter the amount of the debit in the debit column alongside the account to debit, and the amount of the credit in the credit column alongside the account to credit.
4. Write a brief explanation of the transaction.5. The Post. Ref. (Posting reference) is left blank at the time of making the journal entry.
Journalise the following transactions in the books of Amar post them in the Ledger: -
2011
March 1 Bought goods for cash Rs. 25,000
2 Sold goods for cash Rs. 50,000
3 Bought goods for credit from Gopi Rs. 19,000
5 Sold goods on credit to Robert Rs. 8,000
7 Received from Robert Rs. 8,000
9 Paid to Gopi Rs. 5,000
20 Bought furniture for cash Rs. 7,000
Solution:Journal of Amar
Date Particulars L.F
Debit Rs. P.
Credit Rs. P.
2011 Mar 1
Purchases A/c Dr To Cash A/c (Cash Purchases)
25,000
-- 25,000 --
2 Cash A/c Dr. To Sales A/c (Cash Sales)
50,000 -- 50,000 --
3.
Purchases A/c Dr. To Gopi A/c(Credit purchases)
19,000 -- 19,000
--
4. Robert A/c Dr. To Sales A/c(Credit Sales)
8,000 -- 8,000 --
5. Cash A/c Dr. To Robert A/c(Cash received)
6,000 -- 6,000
--
6. Gopi A/c Dr. To Cash A/c
5,000 -- 5,000
--
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(Cash Paid ) 7. Furniture A/c Dr.
To Cash A/c(furniture purchased)
7,000 -- 7,000 --
Questions
I. Objective Type:
a) Fill in the blanks:
1. The source document gives information about the nature of _________.
2. The accounting equation is a statement of _________ between the debits and credits.
3. In double entry book-keeping, every transaction affects at the two________.
4. Assets are always equal to liabilities plus _________.
5. A transaction which increases the capital is called _________.
6. The journal is a book of _________.
7. Recording of transaction in the journal is called _________.
8. The _________ column of journal represents the place of
9. _________ account is debited for the amount not recovered the customer.
10. The assets of a business on 31st December, 2002 were Rs. 50,000 and its capital was Rs.
35,000. Its liabilities date were Rs. _________.
b) Choose the correct answer:
1. The origin of a transaction is derived from the
a) Source document b) Journal c) Accounting equation
2. Which of the following is correct?
a) Capital = Assets + Liabilities
b) Capital = Assets – Liabilities
c) Assets = Liabilities – capital
3. Amount owned by the proprietor is called
a) Assets b)Liabilities c)Capital
4. The Accounting Equation is connected with
a) Assets only
b) Liabilities only
c) Assets, liabilities and capital
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5. Goods sold to Srinivasan should be debited to
a) Cash A/c b) Srinivasan A/c c) Sales A/c
6. Purchased goods from Venkat for cash should be credited to
a) Venkat A/c b) Cash A/c c) Purchases A/c
7. Withdrawals of cash from bank by the proprietor for office use should be credited to
a) Drawings A/c b) Bank A/c c) Cash A/c
8. Purchased goods from Murthy on credit should be credited to
a) Murthy A/c b) Cash A/c c) Purchased A/c
9. An entry is passed in the beginning of each current year is called
a) Original entry b) Final entry c) Opening entry
10. Correct the following entries wherever you think:
i) Brought capital in to business:
Capital A/c Dr.
To cash A/c
ii) Cash Purchases:
Cash A/c Dr.
To sales A/c
iii) Salaries paid to clerk Mr.kanniyappan:
Salaries A/c Dr.
To Kanniyappan A/c
iv) Paid carriage:
Carriage A/c Dr.
To cash A/c
7. What do the following Journal Entries mean?
i) Cash A/c Dr.
To Furniture A/c
ii) Rent A/c Dr.
To Cash A/c
iii) Bank A/c Dr.
To Cash A/c
37
iv) Tamilselvi A/c Dr.
To Sales A/c
8. Show the accounting equation on the basis of the following transactions.
Rs.
i. Ramya started business with cash 25,000
ii. Purchased goods from Shobana 20,000
iii. Sold goods to Amala costing Rs.18,000 25,000
iv. Ramya withdrew from business 5,000
9. Prepare accounting equation and balance sheet on the basis of the following:
i. Pallavan started business with cash 60,000
ii. He purchased furniture 10,000
iii. He paid rent 2,000
iv. He purchased goods on credit from Mr.Mahendran 30,000
v. He sold goods (cost price Rs. 20,000) for cash 25,000
10. Journalise the following opening entry:
Rs.
Cash in hand 2,000
Plant 50,000
Furniture 5,000
Creditors 13,000
Debtors 18,000
11. Journalise the following transactions in the books of Tmt. Amutha
Rs.
2011, Jan. 1 Tmt.Amutha commenced business with cash 50,000
2 Purchased goods for cash 10,000
5 Purchased goods from Mohan on credit 6,000
7 Paid into Bank 5,000
10 Purchased furniture 2,000
38
20 Sold goods to Suresh on credit 5,000
25 Cash Sales 3,500
26 Paid to Mohan on account 3,000
31 Paid Salaries 2,800
12. Journalise the following transactions of Mrs. Rama
Rs.
2011 Jan, 1 Mrs. Rama commenced business with cash 30,000
2 Paid into cash 21,000
3 Purchased goods by cheque 15,000
7 Drew cash from bank for office use 3,000
15 Purchased foods from Siva 15,000
20 Cash sales 30,000
25 Paid to Siva 14,750
Discount Received 250
31 Paid rent 500
Paid Salaries 2,000
13. Journalise the following transactions of Mr. Moorthi
Rs.
2011 June 3, Received cash from Ramkumar 60,000
4 Purchased goods for cash 15,000
11 Sold goods to Damodaran 22,000
13 Paid to Ramkumar 40,000
17 Received from Damodaran 20,000
20 Bought furniture from jagadeesan 5,000
27 Paid rent 1,200
30 Paid salary 2,500
39
14. Journalise the following in the Journal of Thiru.Gowri Shankar
Rs.
2011, Oct. 1 Received cash from Siva 75,000
7 Paid cash to Sayeed 45.000
10 Bought goods for cash 27,000
12 Bought goods on credit from David 48,000
15 Sold goods for cash 70,000
15. Record the following transactions in the Journal of Tmt.Bhanumathi 2011, Feb.
3 Bought goods for cash Rs.84,500
7 Sold goods to Dhanalakshmi on credit Rs.55,000
9 Received commission Rs.3,000
10 Cash Sales Rs.1,09,000
12 Bought goods from Mahalakshmi Rs.60,000
15 Received five chairs from Revathi & co. at Rs.400 each
20 Paid Revathi & co., cash for five chairs
28 Paid Salaries Rs.10,000
Paid Rent Rs.5,000
16. Journalise the following transactions in the books of Thiru.Kalyanasundaram.
2011,March
1 Sold goods on credit to Mohanasundaram Rs.75,000.
12 Purchased goods on credit from Bashyam Rs.70,000.
15 Sold goods for cash from David Rs.50,000.
20 Received from Mohanasundaram Rs.70,000.
25 Paid to Bashyam Rs.50,000.
40
Chapter - 4
Ledger
Ledger is the principal book which contains various accounts. It is a summary of the
transactions journalized. Each and every transaction flows from the journal to one or more
ledgers. All accounts of the business enterprise whether Real, Nominal or Personal are contained
in the ledger. It may be kept in any of the following two forms:
1. Bound Ledger
2. Loose-leaf Ledger
Posting
Posting is the task of writing up a ledger based on the entries in the journal. It means
transferring the debit and credit items from the journal to their respective accounts in the Ledger.
One should use exact names of accounts used in the journal while posting in the ledger. For
example, a journal entry to the debit of ‘expense’ account should not get posted in the ‘office
expense’ account in the ledger.
The posting may be done from the journal to the ledger by any of the following methods:
i. Take a particular side first, say debit side make the complete postings of all debits from
the journal to the ledger or
ii. Take a particular account and post all debits and credits relating to that account appearing
on the journal. Take another account and follow the same procedure or
iii. Complete postings of each journal entry – both debit and credit before proceeding to the
next journal entry.
It is advisable to follow the last method since is saves errors happening due to omission of one
side of a journal entry or the entry all together. One should see to it that the posting of the journal
entries are complete before the financial statements are prepared.
A Journal Folio (J.F) column in the ledger and a Ledger Folio (L.F) column in the journal serve
as a cross reference to the journal and ledger respectively.
41
Journalise the following transactions in the books of Amar post them in the Ledger: -
2011March 1 Bought goods for cash Rs. 25,000
2 Sold goods for cash Rs. 50,0003 Bought goods for credit from Gopi Rs. 19,0005 Sold goods on credit to Robert Rs. 8,0007 Received from Robert Rs. 8,0009 Paid to Gopi Rs. 5,000
20 Bought furniture for cash Rs. 7,000
Solution:Journal of Amar
Date Particulars L.F
Debit Rs. P.
Credit Rs. P.
2011Mar 1
Purchases A/c Dr To Cash A/c (Cash Purchases)
25,000 -- 25,000 --
2 Cash A/c Dr. To Sales A/c (Cash Sales)
50,000 -- 50,000 --
3.
Purchases A/c Dr. To Gopi A/c(Credit purchases)
19,000 -- 19,000
--
4.
Robert A/c Dr. To Sales A/c(Credit Sales)
8,000 -- 8,000 --
5.
Cash A/c Dr. To Robert A/c(Cash received)
6,000 -- 6,000
--
6.
Gopi A/c Dr. To Cash A/c(Cash Paid )
5,000 -- 5,000
--
7.
Furniture A/c Dr. To Cash A/c(furniture purchased)
7,000 -- 7,000 --
42
Explanation: There are six accounts involved: Cash, Purchases, Sales, Furniture,
Gopi & Robert, so six accounts are to be opened in the ledger.
Ledger of Amar
Cash Account
Dr. Cr.Date Particulars J.
FAmount Rs.
Date Particulars J.f Amount Rs.
2011Mar
5 7
To Sales A/c
To Robert A/c
50,000
6,000
2011Mar 1 9 20
By Purchases A/cBy Gopi A/cBy Furniture A/c
25,000 5,000 7,000
Purchases AccountDr. Cr.Date Particulars J.F Amount
Rs.Date Particulars J.F Amount
Rs.2011Mar 1 3
To Cash A/cTo Gopi A/c
25,000 19,000
Sales AccountDr. Cr.Date Particulars J.F Amount
Rs.Date Particulars J.
FAmount Rs.
2011Mar 2 5
By Cash A/cBy Robert A/c
50,000 8,000
Furniture AccountDr. Cr Date Particulars J.
FAmount Rs.
Date Particulars J.F
Amount Rs.
2011
43
Mar 20 To Cash A/c 7,000
Gopi AccountDr. Cr.Date Particulars J.
FAmount Rs.
Date Particulars J.F
Amount Rs.
2011Mar 9 To Cash A/c 5,000 2011
Mar 3By Purchase A/c 19,000
Robert AccountDr. Cr. Date Particulars J.
FAmount Rs.
Date Particulars J.F
Amount Rs.
2011Mar 5 To Sales A/c 8,000
2011Mar 7 By Cash A/c 6,000
Relationship between Journal and Ledger
Both journal and ledger are the most important books used under Double Entry Systems of book-
keeping. Their relationship can be expressed as follows:
i. The transactions are recorded first of all in the journal and then they are posted to the ledger.
Thus, the journal is the book of first or original entry, while the ledger is the book of second
entry.
ii. Journal records transactions in a chronological order, while the ledger records transactions in
an analytical order.
iii. Journal is more reliable as compared to the ledger since it is the book in which the entry is
passed first of all.
iv. The process of recording transactions is termed as "Journalising" while the process of
recording transactions in the ledger is called as "Posting".
44
Subsidiary Books
For a business having a large number of transactions it is practically impossible to write all
transactions in one journal, because of the following limitations.
i. Periodical details of some important business transactions cannot be known, from the
journal easily, e.g., monthly sales, monthly purchases.
ii. Such a system does not facilitate the installation of an internal check system since the
journal can be handled by only one person.
iii. The journal becomes bulky and voluminous.
Need
Moreover, transactions can be classified and grouped conveniently according to their
nature, as some transactions are usually of repetitive in nature. Generally, transactions are of two
types: Cash and Credit. Cash transactions can be grouped in one category whereas credit
transactions can be grouped in another category. Thus, in practice, the main journal is sub-
divided in such a way that a separate book is used for each category or group of transactions
which are repetitive and sufficiently large in number.
Each one of the subsidiary books is a special journal and a book of original or prime
entry. Though the usual type of journal entries are not passed in these sub-divided journals, the
double entry principles of accounting are strictly followed.
Kinds of Subsidiary Books
The number of subsidiary books may vary according to the requirements of each
business. The following are the special purpose subsidiary books.
Purpose:
i. Purchases Book records only credit purchases of goods by the trader.
ii. Sales Book is meant for entering only credit sales of goods by the trader.
iii. Purchase Return Book records the goods returned by the trader to suppliers.
iv. Sales Return Book deals with goods returned (out of previous sales) by the customers.
v. Bills Receivable Book records the receipts of bills (Bills Receivable).
45
vi. Bills Payable Book records the issue of bills (Bills Payable).
vii. Cash Book is used for recording only cash transactions i.e., receipts and payments of
cash.
viii. Journal Proper is the journal which records the entries which cannot be entered in any
of the above listed subsidiary books.
Advantages
The advantages of maintaining subsidiary books can be summarized as under:
i. Division of Labour: The division of journal, resulting in division of work, ensures
more clerks working independently in recording original entries in the subsidiary
books.
ii. Efficiency: The division of labour also helps the reduction in work load, saving in
time and stationery. It also gives advantages of specialization leading to efficiency.
iii. Prevents Errors and Frauds: The accounting work can be divided in such a manner
that the work of one person is automatically checked by another person. With the use
of internal check, the possibility of occurrence of errors and frauds may be avoided.
iv. Easy Reference: It facilitates easy references to any particular item. For instance total
credit sales for a month can be easily obtained from the Sales Book.
v. Easy Posting: Posting from the subsidiary books are made at convenient depending
upon the nature of the business.
46
Purchases Book
Purchases book also known as Bought Day Book is used to record all credit purchases of
goods which are meant for resale in the business. Cash purchases of goods, cash and credit
purchases of assets are not entered in this book.
Diagram
Date Particulars Inward Invoice No.
L.F. AmountTotalRs.
Amount TotalRs.
Remarks
Date Column – Represents the date on which the transaction took place.
Particulars Column – This column includes the name of the seller and the particulars of goods
purchased.
Inward Invoice No. Column – Reveals the serial number of the inward voice.
L.F. Column – This column shows the page number of the suppliers account in the ledger
accounts.
Details Column – Reveals the amount of goods purchased and the amount of trade discount.
Total Column – This column represents the net price of the goods, i.e, the amount which is
payable to the creditors after adjusting discount and expenses if any.
Remarks Column – Contains any extra information.
At the end of each month, the purchase book is totaled. The total shows the total amount of
goods or materials purchased on credit.
Sales Book
The sales book is used to record all credit sales of goods dealt with by the trader in his
business. Cash sales, cash and credit sales of assets are not entered in this book. The entries in
the sales book are on the basis of the invoices issued to the customers with the net amount of
sale. The format of sales book is shown below:-
47
Diagram
Date Particulars Outward Invoice No.
L.F. AmountTotalRs.
Amount TotalRs.
Remarks
Date Column – Represents the date on which the transaction took place.
Particulars Column – This column includes the name of the purchaser and the particulars of
goods purchased.
Outward Invoice No. Column – Reveals the serial number of the outward voice.
L.F. Column – This column shows the page number of the customer’s account in the ledger
accounts.
Details Column – Reveals the amount of goods sold and the amount of trade discount if any.
Total Column – This column represents the net price of the goods, i.e, the amount which is
receivable to the customers.
Remarks Column – Any other extra information’s will be recorded.
Cash Book
In every business house there are cash transactions as well as credit transactions. All credit
transactions will become cash transactions when payments are made to creditors or cash received
from debtors. Since, cash transactions will be numerous, it is better to keep a separate book to
record only the cash transactions.
Features
A cash book is a special journal which is used to record all cash receipts and cash
payments. The cash book is a book of original entry or prime entry since transactions are
recorded for the first time from the source departments. The cash book is a ledger in the sense
that it is designed in the form of a cash account and records cash receipts on the debit side and
cash payments on the credit side. Thus, the cash book is both a journal and a ledger. Cash Book
48
will always show debit balance, as cash payments can never exceed cash available. In short, cash
book is a special journal which is used for recording all cash receipts and cash payments.
Advantages
Saves time and labour: when cash transactions are recorded in the journal a lot of time and
labour will be involved. To avoid this all cash transactions are straight away recorded in the cash
book which is in the form of a ledger.
To know cash and bank balance: It helps the proprietor to know the cash and bank balance at any
point of time.
Mistakes and frauds can be prevented: Regular balancing of cash book reveals the balance of
cash in hand. In case the cash book is maintained by business concern, it can avoid frauds.
Discrepancies if any can be identified and rectified.
Effective cash management: Cash book provides all information regarding total receipts and
payments of the business concern at a particular period. So, that effective policy of cash
management can be formulated.
Kinds of Cash Book
The various kinds of cash book from the point of view of uses may be follows:
1) Single column cash book
2) Double column cash book
3) Triple column cash book
4) Petty cash book
Single Column Cash Book
Single column cash book (simple cash book) has one amount column in each side. All cash
receipts are recorded on the debit side and all cash payments on the credit side. In fact, this book
is nothing but a Cash Account. Hence, there is no need to open cash account in the ledger. The
format of a single column cash book is given below.
49
Debit side Single Column Cash Book of XXXX Credit side
Date Particulars
R.N. L.F.
AmountRs.
Date Particulars V. N. L.F. AmountRs.
Explanation:
Date – This column appears in both the debit and credit side. It records the date of receiving cash
at debit side and paying cash at credit side.
Particulars – This column is used to both debit and credit side. It records the name of parties
(personal account), heads (nominal account) and items (real account) from whom payment has
been received and to whom payment has been made.
Receipt Number (R.N) – This refers to the serial number of the cash receipt.
Voucher Number (V.N) – This refers to the serial number of the voucher for which payment is
made.
Ledger Folio – This column is used in both the debit and credit side of cash book. The ledger
page (folio) of every account in the cash book is recorded against it.
Amount – This column appears in both sides of the cash book. The actual amount of cash receipt
is recorded on the debit side. The actual payments are entered on the credit side.
Double Column Cash Book
The most common double column cash books are
i. Cash book with discount and cash columns.
ii. Cash book with cash and bank columns.
iii. Cash book with discount and cash columns
On either side of the single column cash book, another column is added to record discount
allowed and discount received. The format is given below.
50
Debit side Double Column Cash Book of XXXX Credit side
Date Particulars R.N
L.F.
Disc.Allow.
AmountRs.
Date Particulars
V. N.
L.F.
Disc. Rece.
AmountRs.
It should be noted that in the double column cash book, cash column is balanced like any other
ledger account. But the discount column on each side is merely totaled. The total of the discount
column on the debit side shows the total discount allowed to customers and is debited to
Discount Allowed Account. The total of the discount column on the credit side shows total
discount received and is credited to Discount Received Account.
Cash book with Cash and Bank Columns
When bank transactions are more in number, it is advisable to open a cash book by
providing a separate column on either side of the cash book to record the bank transactions
therein.
In such case, it is not necessary to open a separate Bank Account in the Ledger because
the two columns in the cash book serve the purpose of Cash Account and Bank Account
respectively. It is a combination of Cash Account and Bank Account. The format of this cash
book is given below.
Debit side Double Column Cash Book of XXXX Credit side
Date Particulars R.N
L.F.
CashRs.
BankRs.
Date Particulars V. N.
L.F.
Cash Rs.
BankRs.
51
There are two amount columns on debit side one for cash receipts and the other for bank deposits
(i.e., payment made into Bank Account). Similarly there are two amount columns on the credit
side, one for payments in cash and the other for payments by cheques respectively.
Triple Column Cash Book
Large business concerns receive and make payments in cash and by cheques. Where cash
discount is a regular feature, a Triple Column Cash Book is more advantageous. This cash book
has three amount columns (cash, bank and discount) on each side. All cash receipts, deposits into
bank and discount allowed are recorded on debit side and all cash payments, withdrawals from
bank and discount received are recorded on credit side
Debit side Triple Column Cash Book of XXXX Credit side
Date Particulars R.N
L.F.
Dis. All.
CashRs.
BankRs.
Date Particulars V. N.
L.F.
Dis.Rec
Cash Rs.
BankRs.
52
Chapter – 5
Trial Balance
After making the journal entries and posting them in their ledger accounts, the balancing figures
in the ledgers – debit or credit will be captured in the Trial Balance. The balancing figures are
arrived at on a particular date say 31st March. The Trial Balance is basically prepared to verify
the accuracy of the journal entries and ledger accounts by balancing the debit and credit side. It
only confirms the arithmetical accuracy of the transactions and not the correctness of the
transaction.
Objects of Preparing a Trial Balance
1. Checking of the arithmetical accuracy of the transactions: The trial balance is nothing
but a summary of all the ledger balances and so eventually the two sides of the trial balance
should tally to accentuate its arithmetical accuracy. The dual aspect concept of accounting
calibrates the debit and credit side of the trial balance thus ensuring arithmetical accuracy. Those
errors such as omission of journal entries all together and reversing the entries posted, error of
commission, error of principle, etc may still be prevalent in spite of the Trial Balance tallying.
2. Basis for financial Statements: Income statement to know the profit or loss of the
business and position statement to know the financial position of the business are prepared with
the Trial Balance as the base. It is virtually impossible to prepare these financial statements if the
Trial Balance is not prepared in the first place.
3. Summarised ledger: The ledger gives a detailed position of the account whereas one can
get a glimpse of the position of the account just by looking at the trial balance since it is nothing
but a summarized form of the ledger balances.
Methods of Preparation of a Trial Balance
A Trial Balance may be prepared according to any of the two methods:
1. Total Method: In case of this method after totaling each side of the ledger account, the
respective debit and credit totals of the ledger accounts are transferred to the respective sides of
the trial balance. Thus, in case of this method, the trial balance can be prepared soon after
53
totaling various accounts and the time taken in balancing the account is saved to that extent. This
method is not generally followed since it does not help in preparation of financial statements.
2. Balance Method: According to their method, every ledger account is balanced and only the
balance of the ledger account is carried forward to the trial balance. This method is generally
used since the preparation of the financial statements where only balances are to be taken.
3. Total and Balance Method: This method combines the first two methods explained above. In
case of this method, the trial balance contains both the totals of both sides of the respective
accounts as well as their final balances. This methods has the advantage that it helps in
immediate location of a mistake incurred, if any in the balancing the account. However, it has
disadvantage of increasing the workload of the staff.
FORMAT
Trial balance of ABC Ltd as on ……………
SL.NO NAME OF ACCOUNT L.F DEBITRs
CREDITRs
Points to be noted:
i. Date on which trial balance is prepared should be mentioned at the top.
ii. Name of Account column contains the list of all ledger accounts.
iii. Ledger folio of the respective account is entered in the next column.
iv. In this debit column, debit balance of the respective account is entered.
v. Credit balance of the respective account is written in the credit column.
vi. The last two columns are totaled at the end.
54
Illustration 1
The following balances were extracted from the ledger of Rahul on 31st March, 2011. You
are requested to prepare a trial balance as on that date in the proper form.
Rs. Rs. Salaries 36,320 Purchases 1,44,670 Sales 1,73,500 Sundry Debtors 1,430 Plant & Machinery 34,300 Travelling Expenses 2,630 Commission paid 1,800 Carriage Inward 240 Stock on 1.4.2002 11,100 Sundry Creditor 14,260 Repairs 1,670 Capital, 1.4.2002 62,500
Sundry Expenses 460 Drawings 3,500 Returns Inward 1,000 Cash at Bank 1,090 Discount Allowed 1,150 Returns Outward 400
Rent and Rates 3,220 Investments 6,000
Solution:
Trial Balance of Rahul as on 31st March, 2011
S.No.
Name of the Account L.F.
Dr.Rs.
Cr.Rs.
Nature of Balance(Why Dr. or Cr.)
1.2.3.4.5.6.7.8.9.10.11.12.13.14.15.16.17.18.1920.
SalariesSalesPlant and MachineryCommission PaidStock on 1.4.2002RepairsSundry ExpensesReturns InwardDiscount AllowedRent & RatesPurchasesSundry DebtorsTravelling ExpensesCarriage InwardSundry creditorsCapital 1.4.2002DrawingsCash at BankReturns OutwardInvestments
36,320-34,3001,88011,1001,6704601,0001,1503,2201,44,6701,4302,630240--3,5001,090-6,000
-1,73,500------------14,26062,500--400-
Nominal A/c-expenseReal A/c – goodsReal A/c – assetNominal A/c-expenseReal A/c – goodsNominal A/c-expenseNominal A/c-expenseReal A/c – goodsNominal A/c – lossNominal A/c-expenseReal A/c – goodsPersonal A/c - customersNominal A/c-expenseNominal A/c-expensePersonal A/c -SuppliersPersonal A/c –ownerPersonal A/c -ownerReal A/c – assetReal A/c – goodsReal A/c – asset
55
TOTAL 2,50,660 2,50,660Note: The last column given in the solution does not appear in practice. It is included here to
illustrate the following generalized rules, that
i. a debit balance is either an asset or loss or expense; and
ii. a credit balance is either a liability or income or gain.
2. The following balances are extracted from the books of Mr.Senthil. Prepare Trial Balance as
on 30.6.2011.
Rs. Rs. Capital 4,70,200 Machinery 1,58,800 Cash in hand 6,000 SundryDebtors 48,000
Building 3,20,000 Repairs 5,400 Stock 33,000 Insurance premium 3,300
Sundry creditors 26,000 Sales 2,90,000 Commission paid 750 Telephone Charges 6,450 Rent & Taxes 6,300 Furniture 11,000
Purchases 1,65,000 Discount earned 1,100 Salaries 70,600 Loan from Mohammed 51,000 Discount allowed 650 Reserve fund 5,900 Drawings 5,000 Bills receivable 8,600 Bad debts 1,350 Bills payable 6,000
3. Prepare Trial Balance as on 31.3.2010 from the books of Mrs.Chitra.
Rs. Rs. Capital 2,49,000 Drawings 24000 General expenses 97,000 Building 78,000 Machinery 1,18,680 Stock 1,32,400
Wages 14,400 Insurance 2,610 Bad debts 1,100 Creditors 5,000 Sales 3,30,720 Loam(Cr.) 75,000 Commission 5,500 Purchases 2,10,800 Bills payable 7,700 Reserve Fund 15,000 Bank overdraft 28,600 Cash in hand 25,320 Discount 1,210
56
4. Prepare Trial Balance as on 31.12.2011 from the following balances ofMs. Fathima.
Rs. Rs. Drawings 74,800 Purchases 2,95,700 Stock(1.1.2000) 30,000 Discount received 1,000 Capital 2,50,000 Discount allowed 950 Furniture 33,000 Sales 3,35,350 Sundry creditors 75,000 Rent 72,500 Printing charges 1,500 Sundry expenses 21,000 Bank loan 1,20,000 Bills receivable 52,500 Freight 3,500 Carriage outwards 1,500 Income tax 9,500 Insurance 1,200 Machinery 2,15,400 Bills payable 31,700
5. Prepare trial balance as on 31.3.2010 from the following balances of Mrs.Sujatha.
Rs. Rs. Drawings 43,000 Purchases 2,98,000 Capital 2,12,000 Sales 3,64,000 Sundry creditors 61,500 Salaries 44,950 Bills Payable 22,000 Sales return 500 Sundry Debtors 55,000 Purchases return 2,550 Bills Receivable 72,600 Travelling expenses 12,300 Loan from Shameem 2,50,000 Commission paid 250 Furniture & Fittings 12,250 Discount earned 2,000 Opening stock 2,23,500 Cash in hand 65,450 Cash at bank 86,250
6. Prepare Trial Balance from the following balances of Mrs.Dilshad as on 31.12.2010.
Rs. Rs. Capital 4,20,000 Cash in hand 25,000 Building 1,15,000 Cash at bank 84,700 Machinery 60,000 Salaries 94,000 Furniture 11,000 Rent 48,000 Car 68,000 Commission 1,400 Opening stock 86,000 Rates and Taxes 2,600 Purchases 94,000 Bad debts 3,200 Sales 1,96,000 Insurance 2,400 Sundry debtors 16,200 General Expenses 800 Reserve for doubtful debts 7,300 Sundry Creditors 68,000
57
Chapter - 6
Final Accounts
The ultimate aim of recording financial transactions is to assess the profitability position of the
business. Trial balance proves only the arithmetical accuracy of the business transactions,
whereas the final accounts prepared from the Trial Balance ascertains the profit or loss and
financial soundness of the business during the given period. The financial statements are
prepared at the yearend for which the trial balance is the base. In other words, the trial balance
serves as a connecting link between the ledger accounts and the final accounts.
Final Accounts
Trading and Balance Sheet
Profit and Loss Account
Parts of Final Accounts
The final accounts of business concern generally include two parts. The first part is Trading and
Profit and Loss Account. This is prepared to find out the net result of the business. The second
part is Balance Sheet which is prepared to know the financial position of the business. However
manufacturing concerns, will prepare a Manufacturing Account prior to the preparation of
trading account, to find out cost of production.
Trading Account
Trading means buying and selling. The trading account shows the result of buying and selling of
goods.
Need
At the end of each year, it is necessary to ascertain the net profit or net loss. For this purpose, it is
first necessary to know the gross profit or gross loss. The trading account is prepared to ascertain
this. The difference between the selling price and the cost price of the goods is the gross earning
of the business concern. Such gross earning is called as gross profit. However, when the selling
price is less than the cost of goods purchased, the result is gross loss.
58
Items appearing in the debit side
1. Opening stock: Stock on hand at the beginning of the year is termed as opening stock.
The closing stock of the previous accounting year is brought forward as opening stock of the
current accounting year. In the case on new business, there will not be any opening stock.
2. Purchases: Purchases made during the year, includes both cash and credit purchases of
goods. Purchase returns must be deducted from the total purchases to get net purchases.
3. Direct Expenses: Expenses which are incurred from the stage of purchase to the stage of
making the goods in saleable condition are termed as direct expenses. Some of the direct
expenses are:
i. Wages: It means remuneration paid to workers.
ii. Carriage or carriage inwards: It means the transportation charges paid to bring the goods
from the place of purchase to the place of business.
iii. Octroi Duty: Amount paid to bring the goods within the municipal limits.
iv. Customs duty, dock dues, clearing charges, import duty etc.: These expenses are paid to
the Government on the goods imported.
v. Other expenses: Fuel, power, lighting charges, oil, grease, waste related to production and
packing expenses.
Items appearing in the credit side
i. Sales: This includes both cash and credit sale made during the year. A net sale is derived by
deducting sales return from the total sales.
ii. Closing stock: Closing stock is the value of goods which remain in the hands of the trader at
the end of the year. It does not appear in the trial balance. It appears outside the trial balance. (As
it appears outside the trial balance, first it will be recorded in the credit side of the trading
account and then shown in the assets side of the balance sheet).
Balancing
The difference between the two sides of the Trading Account indicates either Gross Profit or
Gross Loss. If the credit side total is more, the difference represents Gross Profit. On the other
hand, if the total of the debit side is more, the difference represents Gross Loss. The Gross Profit
or Gross Loss is transferred to Profit & Loss Account.
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Profit and Loss Account
After calculating the gross profit or gross loss the next step is to prepare the profit and loss
account. To earn net profit a trader has to incur many expenses apart from those spent for
purchases and manufacturing of goods. If such expenses are less than gross profit, the result will
be net profit. When total of all these expenses are more than gross profit the result will be net
loss.
Need:
The aim of profit and loss account is to ascertain the net profit earned or net loss suffered during
a particular period.
Items appearing in the debit side
Those expenses which are chargeable to the normal activities of the business are recorded in the
debit side of profit and loss account. They are termed as indirect expenses.
i. Office and Administrative Expenses: Expenses incurred for the functioning of an office are
office and administrative expenses – office salaries, office rent, office lighting, printing and
stationery, postages, telephone charges etc.
ii. Repairs and Maintenance Expenses: These expenses relates to the maintenance of assets -
repairs and renewals, depreciation etc.
iii. Financial Expenses: Expenses incurred on borrowings – Interest paid on loan.
iv. Selling and Distribution Expenses : All expenses relating to sales and distribution of goods
- advertising, travelling expenses, salesmen salary, commission paid to salesmen, discount
allowed, repacking charges etc.
Items appearing in the credit side
Besides the gross profit, other gains and incomes of the business are shown on the credit side.
The following are some of the incomes and gains.
I. Interest received on investment
II. Interest received on fixed deposits.
III. Discount earned.
IV. Commission earned.
V. Rent Received
Balancing
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The difference between the two sides of profit and loss account indicates either net profit or net
loss. If the total on the credit side is more the difference is called net profit. On the other hand if
the total of debit side is more the difference represents net loss. The net profit or net loss is
transferred to capital account.
Balance Sheet:
This forms the second part of the final accounts. It is a statement showing the financial position
of a business. Balance sheet is prepared by taking up all personal accounts and real accounts
(assets and properties) together with the net result obtained from profit and loss account. On the
left hand side of the statement, the liabilities and capital are shown. On the right hand side, all
the assets are shown. Balance sheet is not an account but it is a statement prepared from the
ledger balances. So we should not prefix the accounts with the words ‘To’ and ‘By’.
Balance sheet is defined as ‘a statement which sets out the assets and liabilities of a business
firm and which serves to ascertain the financial position of the same on any particular date’.
Need:
The need for preparing a Balance sheet is as follows:
i. To know the nature and value of assets of the business
ii. To ascertain the total liabilities of the business.
iii. To know the position of owner’s equity.
Format
The Balance sheet of a business concern can be presented in the following two forms
i. Horizontal form or the Account form
ii. Vertical form or Report form
Vertical form of Balance Sheet
In this, Balance Sheet is presented in a statement form.
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Balance sheet as on…………
Particulars Rs. Rs
Current Assets:
Stock-in-Trade
Sundry Debtors
Prepaid Expenses
Accrued Income
Bills Receivable
Cash at Bank
Cash in Hand
Total Current Assets
Less: Current Liabilities:
Sundry Creditors
Bills Payable
Bank Overdraft
Outstanding Expenses
Total Current Liabilities
Net Working Capital:
Add: Fixed Assets:
Goodwill
Plant and Machinery
Furniture
Investment
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
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Total Fixed Assets
Capital Employed
(Both owner’s and outsiders)
Less: Long Term Liabilities
Debentures
Loans
Total Long Term Liabilities
Net Assets
Represented by:
Owner’s Capital
Reserves and surplus
Shareholders’ Funds
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
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Classification of Assets and Liabilities
Assets
Assets represents everything which a business owns and has money value. In other words, asset
includes possessions and properties of the business. Assets are classified as follows:
Assets
Tangible Intangible Fictitious
Fixed Current
a) Tangible Assets:
Assets which have some physical existence are known as tangible assets. They can be seen,
touched and felt, e.g. Plant and Machinery. Tangible assets are classified into
i. Fixed assets:
Assets which are permanent in nature having long period of life and cannot be converted into
cash in a short period are termed as fixed assets.
ii. Current assets:
Assets which can be converted into cash in the ordinary course of business and are held for a
short period are known as current assets. This is also termed as floating assets. For example, cash
in hand, cash at bank, sundry debtors etc.
b) Intangible Assets
The assets which have no physical existence and cannot be seen or felt. They help to generate
revenue in future, e.g. goodwill, patents, trademarks etc.
c) Fictitious Assets
These assets are nothing but the unwritten off losses or non-recoupable expenses. They are really
not assets but are worthless items. For example, Preliminary expenses.
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Liabilities
The amount which a business owes to others is liabilities. Credit balances of personal and real
accounts together with the capital account are liabilities.
Liabilities
Long Term Current
Contingent
a) Long Term Liabilities
Liabilities which are repayable after a long period of time are known as Long Term
Liabilities. For example, capital, long term loans etc.
b) Current Liabilities
Current liabilities are those which are repayable within a year. For example, creditors for goods
purchased short term loans etc.
c) Contingent liabilities
It is an anticipated liability which may or may not arise in future. For example, liability arising
for bills discounted. Contingent liabilities will not appear in the balance sheet but shown as foot
note.
Marshalling of Assets and Liabilities
The term ‘Marshalling’ refers to the order in which the various assets and liabilities are shown in
the balance sheet. The assets and liabilities can be shown either in the order of liquidity or in the
order of permanence.
a) In order of liquidity
Liquidity means convertibility into cash. Assets will be said to be liquid if it can be converted
into cash easily, they are placed at the top of the balance sheet. Liabilities are arranged in the
order of their urgency of payment. The most urgent payment to be made is listed at the top of the
balance sheet.
b) In order of permanence
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This order is exactly the reverse of the above. Assets and liabilities are recorded in the order of
their life in the business concern.
Balance Sheet Equation
An important thing to note about the Balance Sheet is that, the total value of the assets is always
equal to the total value of the liabilities. This is because the liability to the owner - capital, is
always made up of the difference between assets and liabilities. Thus,
Assets = Liabilities + Capital
Or
Capital = Assets - Liabilities
While preparing the trial balance in case it does not tally the difference is transferred to an
imaginary account called as suspense account. In case the suspense account is not closed before
the preparation of the final accounts then it has to be placed in the balance sheet, so that it can be
rectified later. If suspense account has a debit balance, it will appear as the last item in asset side.
In case it shows a credit balance it will appear as the last item in the liability side.
Difference between Trial Balance and Balance Sheet
S.No. BasisDistinction Trial balance Balance sheet
1. Objective To know the arithmetical accuracy of the accounting work.
To know the true and fair financial position of a business.
2. Format The columns are debit balances and credit balances.
The two sides are assets and liabilities
3. ContentIt is a summary of all the ledger balances – personal, real and nominal accounts.
It is a statement showing closing balances of personal & real accounts.
4. Stage It is the middle stage in the preparation of accounts.
It is the last stage in the preparation of accounts.
It can be prepared periodically, It is generally prepared at the
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5. Period say at the end of the month, quarterly or half yearly, etc.
end of the accounting period.
6. Preparation It is prepared before the preparation of trading, profit and loss account.
It is prepared after the preparation of trading, profit and loss account.
7. Stock It shows opening stock only. It shows closing stock only
8. Order Balances shown in the trial balance are not in order.
Balances shown in the balance sheet must be in order.
9. Evidence It cannot be produced as documentary evidence in the court.
It can be produced as documentary evidence.
10. Compulsion Preparation of trial balance is not compulsory.
Preparation of the balance sheet is a must.
Application of Schedule VI of the Companies Act:
The form and contents of Balance Sheet and Profit and Loss Account are governed by Section
211 of the Companies Act, 1956.
Section 211 (1): According to this section every Balance Sheet must give true and fair
view of the state of affairs of the company as at the end of the financial year and to be in
the form set out in Part I of Schedule VI or as near thereto as circumstances permit or in
such form as may be approved by the Central Government.
Section 211 (2): According to this section every Profit and Loss Account must give true
and fair view of the profit or loss of the company for the financial year and shall comply
to with the requirement of Part II of Schedule VI, so far they are applicable. Note: It must
be noted here that Schedule VI has prescribed a form in which Balance Sheet is to be
prepared; it has not prescribed any form for Profit and Loss Account.
The Companies Act, 1956 has not recognised Trading Account and Profit and Loss
Appropriation Account, yet there is no bar to prepare these accounts. It is so because Schedule
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VI has not prescribed any form for Profit and Loss Account. But, it must be remembered that the
Trading Account, Profit and Loss Account and Profit and Loss Appropriation Account must
comply with the requirements of Part II of Schedule VI of Companies Act, 1956.
Test your Understandings
1. Define account and ledger.
2. What determines he number and type of accounts a business will need?
3. "Debits = Credits". Explain.
4. Why do we enter transactions first in the journal and then post them to the ledger?
5. State the rules of debits and credits for (a) assets, (b) liabilities, and (c) equity.
6. What is the meaning of a debit balance and a credit balance? Is a debit balance always
favourable and a credit balance always unfavourable?
7. "Debit means increase and credit means decrease." Comment.
8. Why are the rules of debit and credit the same for liabilities and equity?
9. Why is indentation used in the journal?
10. What is the normal balance of debtors? When can it have an abnormal balance?
11. What is a chart of accounts?
12. What is a compound entry?
13. State whether each of the following is an asset account, a liability account, or an equity
account:
a) Salaries Expense
b) Bills Payable
c) Supplies
d) Dividends
e) Cash
f) Debtors
g) Prepaid Insurance
h) Interest Income
i) Interest Expense Payable
14. Why do we prepare a trial balance? Name the types of errors it cannot detect.
15. When do we open a suspense account? How do we clear it?
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16. What is XBRL? How is it useful?
Problem: Identification of Accounts. Identify the account(s) to be debited and credited for the
following transactions:
Transaction Debit Credit
(a) Paid creditors on account Cash Creditors
(b) Paid insurance premium for the next year
(c) Bought office supplies on credit
(d) Paid rent for the proprietor's home
(e) Bought equipment on part payment
(f) Billed customers for services provided
(g) Collected cash from customers for future services
(h) Collected cash from customers on account
(i) Declared and paid a dividend
(j) Paid telephone rent
(k) Paid interest charges
(l) Received but did not pay electricity bill
(m) Paid creditors for office supplies bought earlier
(n) Paid one month's rent in advance
(o) Paid assistant's wages
Problem: Using T Accounts. Record the following transactions by entering debits and credits
directly in the accounts. Use the transaction letters to identify amounts entered in the accounts.
1. Shekar invested cash Rs 6,500 in Shekar Arts Limited in exchange for 650 shares.
2. Bought office supplies for cash, Rs 430
3. Bought office equipment on credit, Rs 3,200
4. Received fees for services provided, Rs 6,700
5. Billed customers for services provided, Rs 2,100
6. Paid creditors in (c), Rs 3,200
7. Paid assistants' salaries Rs 800
8. Paid office rent for the month, Rs 500
9. Declared and paid dividends, Rs 600
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Prepare journal entries to record the transactions.
True or False Type Questions
1. Depreciation is an amortized expenditure.
2. Pre-operative expenses are revenue expenses.
3. Reducing Balance Method of Depreciation is followed to have a uniform charge for
depreciation and repairs and maintenance together.
4. Heavy expenditure incurred on advertisement at the time of introducing a new product is
deferred revenue expenditure.
5. When we buy furniture on cash we debit cash account.
6. Capital + Long-term liabilities = Fixed assets + Current assets + Cash – Current
liabilities.
7. Net profit is reflected in higher cash balance and net loss is reflected in lower net worth.
8. Profit and Loss Account shows the financial position of the concern.
9. Expenses incurred to keep the machine in working condition are a capital expenditure.
10. Providing depreciation ensures sufficient cash for asset replacement.
11. Fixed costs remain relatively unaffected in a defined period of time.
12. An expenditure intended to benefit the current period is revenue expenditure.
13. A withdrawal of cash from the business by the proprietor should be charged to Profit and
Loss Account as expense.
14. The Trial Balance ensures the arithmetical accuracy of the books.
15. The allowance made for prompt payment is called trade discount.
16. Finished goods are normally valued at cash or market price whichever is higher.
17. Accrual concept implies accounting on cash basis.
18. Depreciation cannot be provided in case of loss, in a financial year.
19. Wages paid to workers to produce a tool to be captively consumed is capital expenditure.
20. Amounts written off from the cost of fixed assets is capital expenditure.
21. Deferred Revenue Expenditure is current year’s revenue expenditure to be paid in later
years.
22. Rectification of errors will not necessarily balance a Trial Balance.
23. Profit and Loss Account shows the financial position of the concern.
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24. Providing depreciation in the accounts reduces the amount of profit available for
dividend.
25. Fixed assets are stated in the balance sheet at their market value.
26. Scholarships granted to students out of funds provided by Government will be debited to
Income and Expenditure Account.
27. A Profit and Loss Account is a point statement whereas a Balance Sheet is a period
statement.
28. M/s Ram & Co. did not provide any depreciation on Plant and Machinery as its market
value is much higher than the cost of purchase.
29. Finished goods are normally valued at cost or market price whichever is higher.
30. Trial balance is prepared after preparing the Profit and Loss Account.
31. Sale of Office Furniture should be credited to Sales Account.
32. Wages paid of erection of machinery are debited to Profit and Loss Account.
33. Amount paid for acquiring Goodwill is deferred revenue expenditure.
34. Receipts and Payments Account is a summary of all capital receipts and payments.
35. The Provision for discount on Debtors is calculated before deducting the provision for
doubtful debts from debtors.
36. Patent Rights is in the nature of Nominal Account.
37. A bill given to a creditor is called bills payable.
38. The trial balance checks the honesty of the book-keeper.
39. The balance in the Cash Book show net income.
40. Goodwill is not a fictitious asset.
41. The Receipts and Payments Account records receipts and payments of revenue nature
only.
42. There exists difference between the Written down Value method and Diminishing
Balance method of depreciation.
43. Purchases Book records all purchases of goods.
44. The debts written off as bad, if recovered subsequently, are credited to debtors account.
45. Discount Account should be balanced in the Cash Book.
46. An expenditure intended to benefit the current period is revenue expenditure.
47. The Trial Balance ensures the arithmetical accuracy of the books.
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48. Depreciation cannot be provided in case of loss, in financial year.
49. Profit and Loss Account shows the financial position of the concern.
50. Sale of Office furniture should be credited to Sales Account.
51. Receipts and Payments Account is a summary of all capital receipts and payments.
52. Goodwill is current asset.
53. A tallied Trial balance will not reveal compensating errors and errors on account of
wrong balancing.
54. Goodwill is in the nature of Personal Account.
55. Nominal accounts are balance at the end of the accounting year.
56. Higher depreciation will not affect cash profit of the business.
57. Companies can keep their accounts under cash basis.
58. Heavy advertising to introduce a new product is capital expenditure.
59. Receipts and Payments Account highlights total income and expenditure.
60. Legal fees paid to acquire a property are capital expenditure.
61. Expenditure on renovation of a theatre which has increased the seating capacity by 10%
is deferred revenue expenditure.
62. Outstanding expenditure is a nominal account.
63. Provision for Bad Debits is debited to Sundry Debtors Account.
64. There is no difference between the written down value method and diminishing balance
method of depreciation.
65. The debit balance in the Profit and Loss Account is surplus.
66. Partners can share profits or losses in their capital ratio, when there is no agreement.
67. Goodwill is fictitious asset.
68. Land is also a depreciable asset.
69. Capital is all assets less fictitious assets.
70. Finished goods are normally valued at cost of market price, whichever is lower.
71. Patent Right is in the nature of Real Account.
72. A bill given to a creditor is called Bills Receivable.
73. Purchase Book records all credit purchases of goods.
74. Legal fees paid to acquire a building are a capital expenditure.
75. Debit balance of profit and loss account is real asset.
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76. Depreciation is cash expenditure like other normal expenses.
77. The Sales Book is kept to record both cash and credit sales.
Classify the following accounts according to their types: asset, liability, or equity:
a) Interest Expense
b) Commission Income
c) Prepaid Rent
d) Office Supplies
e) Proprietor’s Drawings
f) Fines and Penalties Paid to Government
g) Advances to Suppliers
h) Unearned Insurance Premium
i) Income Tax Expense
j) Income Tax Payable
k) Dividend Paid
l) Dividend Received
m) Advances from Customers
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