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 Quran, 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 Quran, 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 moneys worth.

Accounting

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

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 donts, or covenants, for borrowers that often require the use of accounting information. For example, a loan agreement may impose an upper limit on a borrowers 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 firms performance with that of their competitors 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 firms 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 enterprises 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 enterprises 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 enterprises performance and prospects. Trade unions use financial reports for negotiating enhancements in wages, bonus and other benefits.

Suppliers and Trade Financiers

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 enterprises 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 suppliers 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 years 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 Terms It 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. ii. iii. Fixed capital: It is the capital invested in or represented by Fixed Assets. Circulating Capital: It is the capital in the form of current or floating assets. 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. V. VI. VII.

Goods: The property in which the business deals. Liability: An amount which business owes and has to return or account for. Revenue: An income of a recurring nature from any source. 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. II. Explain the meaning of accounting principles Differentiate between accounting concepts and conventions
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III. IV. V. VI.

Appreciate the importance of different accounting concepts and conventions Name the accounting standards issued by the Institute of Chartered Accountants of India Describe the different systems of accounting, and 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. ii. Going concern. iii. Money measurement. iv. Cost. v. Dual aspect. vi. Accounting period. vii. Periodic matching of cost & revenue. viii. Realisation.

i. Conservatism. ii. Full disclosure. iii. Consistency. iv. Materiality

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
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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.

21

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 proprietors 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
22

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
23

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., salesmans 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

24

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 endusers. 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
25

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
26

ii. iii.

Know the meaning and types of accounts 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, Kautilyas famous Arthasatra not only relates to Politics and Economics, but also explains the art of account keeping in a separate chapter. Written in 4th 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
27

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.

28

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 Natural Artificial Representative Tangible Real

Impersonal Nominal Intangible

29

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, Mohans A/c, Shyams 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 3. Drawings 5. Cash 7. Interest paid 2. Sales 4. Outstanding salary 6. Rent 8. Indian Bank
30

9. Discount received 11. Bank 13. Murugan Lending Library 15. Purchases

10. Building 12. Chandrasekar 14. Advertisement

Solution: 1. Personal account 3. Personal account 5. Real account 7. Nominal account 9. Nominal account 11. Personal account 13. Personal account 15. Real account 2. Real account 4. Personal (Representative) account 6. Nominal account 8. Personal (Legal Body) account 10. Real account 12. Personal account 14. Nominal account

Golden Rules of Accounting All the business transactions are recorded on the basis of following rules. S.No. Name of Account 1. 2. 3. Personal Real Nominal Debit Aspect The receiver What comes in All expenses and losses Credit Aspect The giver What goes out All incomes and gains

Answer for the following Fill in the blanks: 1. 2. 3. The author of the famous book Arthasastra is __________. Every business transaction reveals __________ aspects. The incoming aspect of a transaction is called __________ and the outgoing aspect of a

transaction is called __________.

31

4. 5. 6. 7. 8. 9.

Traditional approach of accounting is also called as ________ approach. The American approach is otherwise known as __________ approach. Impersonal accounts are classified into ___________ types. Plant and machinery is an example of __________ account. Capital account is an example of __________ account. Commission received will be classified under __________ account.

Choose the correct answer: 1. a) 2. a) 3. a) 4. a) 5. a) 6. a) 7. a) 8. a) 9. a) The receiver aspect in a transaction is called as Debit aspect b) Credit aspect c) neither of the two The giving aspect in a transaction is called as Debit aspect b) credit aspect c) neither of the two Murali account is an example for Personal A/c b)Real A/c c)Nominal A/c Capital account is classified under Personal A/c b)Real A/c c)Nominal A/c Goodwill is an example of Tangible real A/c b) intangible real A/c c) nominal A/c Commission received is an example for Real A/c b)Personal A/c c)Nominal A/c Outstanding rent A/c is an example for Nominal account b)Personal account c)Representative personal account Nominal account is classified under Personal A/c b) Impersonal A/c c) Neither of the two Drawings account is classified under Real A/c b)Personal A/c c)Nominal A/c

II. Other Questions: 1. 2. 3. Explain the meaning of Double Entry System. Define Double Entry System. What are the advantages of Double Entry System?
32

4. 5. 6. 7. 8.

How are accounts classified? Write notes on real accounts. Explain nominal accounts. What are the golden rules of Accounting? 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

33

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. 2. 3. 4. 5. Date Individual accounts Debit and credit amounts Brief explanation of the transaction 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 companys chart of accounts.
34

 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 2 3 5 7 9 20 Bought goods for cash Rs. 25,000 Sold goods for cash Rs. 50,000 Bought goods for credit from Gopi Rs. 19,000 Sold goods on credit to Robert Rs. 8,000 Received from Robert Rs. 8,000 Paid to Gopi Rs. 5,000 Bought furniture for cash Rs. 7,000

Solution: Journal of Amar

Date 2011 Mar 1 Particulars Dr 25,000 Dr. 50,000 -50,000 Dr. 19,000 -19,000 Dr. 8,000 -8,000 Dr. 6,000 -6,000 Dr. 5,000 -5,000 -35 ---

L. F

Debit Rs. --

P.

Credit Rs. P. 25,000

--

Purchases A/c To Cash A/c (Cash Purchases) 2 Cash A/c To Sales A/c (Cash Sales) Purchases A/c 3. To Gopi A/c (Credit purchases) 4. Robert A/c To Sales A/c (Credit Sales) 5. Cash A/c To Robert A/c (Cash received) 6. Gopi A/c To Cash A/c

--

--

(Cash Paid ) 7. Furniture A/c To Cash A/c (furniture purchased) Questions I. a) 1. 2. 3. 4. 5. 6. 7. 8. 9. Objective Type: Fill in the blanks:

Dr.

7,000

-7,000 --

The source document gives information about the nature of _________. The accounting equation is a statement of _________ between the debits and credits. In double entry book-keeping, every transaction affects at the two________. Assets are always equal to liabilities plus _________. A transaction which increases the capital is called _________. The journal is a book of _________. Recording of transaction in the journal is called _________. The _________ column of journal represents the place of _________ 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. a) 2. a) b) c) 3. a) 4. a) b) c) The origin of a transaction is derived from the Source document b) Journal c) Accounting equation Which of the following is correct? Capital = Assets + Liabilities Capital = Assets Liabilities Assets = Liabilities capital Amount owned by the proprietor is called Assets b)Liabilities c)Capital The Accounting Equation is connected with Assets only Liabilities only Assets, liabilities and capital
36

5. a) 6. a) 7. a) 8. a) 9. a)

Goods sold to Srinivasan should be debited to Cash A/c b) Srinivasan A/c c) Sales A/c Purchased goods from Venkat for cash should be credited to Venkat A/c b) Cash A/c c) Purchases A/c Withdrawals of cash from bank by the proprietor for office use should be credited to Drawings A/c b) Bank A/c c) Cash A/c Purchased goods from Murthy on credit should be credited to Murthy A/c b) Cash A/c c) Purchased A/c An entry is passed in the beginning of each current year is called 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 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. 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 To Sales A/c

Dr.

8. Show the accounting equation on the basis of the following transactions. Rs. i.Ramya started business with cash ii.Purchased goods from Shobana iii.Sold goods to Amala costing Rs.18,000 iv.Ramya withdrew from business 25,000 20,000 25,000 5,000

9. Prepare accounting equation and balance sheet on the basis of the following: i.Pallavan started business with cash ii.He purchased furniture iii.He paid rent 60,000 10,000 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 Plant Furniture Creditors Debtors 2,000 50,000 5,000 13,000 18,000

11. Journalise the following transactions in the books of Tmt. Amutha Rs. 2011, Jan. 1 Tmt.Amutha commenced business with cash 2 Purchased goods for cash 5 Purchased goods from Mohan on credit 7 Paid into Bank 10 Purchased furniture 50,000 10,000 6,000 5,000 2,000
38

20 Sold goods to Suresh on credit 25 Cash Sales 26 Paid to Mohan on account 31 Paid Salaries

5,000 3,500 3,000 2,800

12. Journalise the following transactions of Mrs. Rama Rs. 2011 Jan, 1 Mrs. Rama commenced business with cash 2 Paid into cash 3 Purchased goods by cheque 7 Drew cash from bank for office use 15 Purchased foods from Siva 20 Cash sales 25 Paid to Siva Discount Received 31 Paid rent Paid Salaries 30,000 21,000 15,000 3,000 15,000 30,000 14,750 250 500 2,000

13. Journalise the following transactions of Mr. Moorthi Rs. 2011 June 3, Received cash from Ramkumar 4 Purchased goods for cash 11 Sold goods to Damodaran 13 Paid to Ramkumar 17 Received from Damodaran 20 Bought furniture from jagadeesan 27 Paid rent 30 Paid salary 60,000 15,000 22,000 40,000 20,000 5,000 1,200 2,500

39

14. Journalise the following in the Journal of Thiru.Gowri Shankar Rs. 2011, Oct. 1 Received cash from Siva 7 Paid cash to Sayeed 10 Bought goods for cash 12 Bought goods on credit from David 15 Sold goods for cash 75,000 45.000 27,000 48,000 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: 2011 March 1 2 3 5 7 9 20 Bought goods for cash Rs. 25,000 Sold goods for cash Rs. 50,000 Bought goods for credit from Gopi Rs. 19,000 Sold goods on credit to Robert Rs. 8,000 Received from Robert Rs. 8,000 Paid to Gopi Rs. 5,000 Bought furniture for cash Rs. 7,000

Solution:
Journal of Amar Date Particulars L . F Dr Debit Rs. 25,000 Credit Rs.

P. --

P.

2011 Mar 1

Purchases A/c To Cash A/c (Cash Purchases) Cash A/c To Sales A/c (Cash Sales) Purchases A/c To Gopi A/c (Credit purchases) Robert A/c To Sales A/c (Credit Sales) Cash A/c To Robert A/c (Cash received) Gopi A/c To Cash A/c (Cash Paid ) Furniture A/c To Cash A/c (furniture purchased)

25,000

--

Dr.

50,000

-50,000 --

Dr.

19,000

-19,000 --

3.

Dr.

8,000

-8,000 --

4.

Dr.

6,000

-6,000 --

5.

Dr.

5,000

-5,000 --

6.

Dr.

7,000

-7,000 --

7.

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 2011 Mar 5 7 To Sales A/c To Robert A/c 50,000 6,000

Particulars

J. F

Amount Rs.

Date 2011 Mar 1 9 20

Particulars

J.f Amount Rs.

By Purchases A/c By Gopi A/c By Furniture A/c

25,000 5,000 7,000

Purchases Account Dr. Date Particulars J.F Amount Rs. 25,000 19,000 Date Particulars Cr. J.F Amount Rs.

2011 Mar 1 To Cash A/c To Gopi A/c 3

Sales Account Dr. Date Particulars J.F Amount Rs. Date Particulars J. F Cr. Amount Rs. 50,000 8,000

2011 Mar 2 By Cash A/c By Robert A/c 5

Furniture Account Dr. Date Cr Particulars J. F Amount Rs. 7,000

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Date

Particulars

J. F

Amount Rs.

2011 Mar 20 To Cash A/c

Gopi Account Dr. Date 2011 Mar 9 Particulars J. F Amount Rs. 5,000 Date Particulars J. F Cr. Amount Rs. 19,000

To Cash A/c

2011 By Purchase A/c Mar 3

Robert Account Dr. Date Particulars J. F Amoun t Rs. 8,000 Date Particulars J. F Cr. Amount Rs.

2011 Mar 5

To Sales A/c

2011 Mar 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 bookkeeping. 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".

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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 subdivided 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. ii. iii. iv. v. vi. Purchases Book records only credit purchases of goods by the trader. Sales Book is meant for entering only credit sales of goods by the trader. Purchase Return Book records the goods returned by the trader to suppliers. Sales Return Book deals with goods returned (out of previous sales) by the customers. Bills Receivable Book records the receipts of bills (Bills Receivable). Bills Payable Book records the issue of bills (Bills Payable).
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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.

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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. Amount Total Rs. Amount Total Rs. 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:-

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Diagram Date Particulars Outward Invoice No. L.F. Amount Total Rs. Amount Total Rs. 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 customers 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 informations 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

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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) 2) 3) 4) Single column cash book Double column cash book Triple column cash book 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.

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Debit side

Single Column Cash Book of XXXX L.F.

Credit side Amount Rs.

Date Particulars R.N. L.F. Amount Date Particulars V. N. Rs.

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. ii. iii. Cash book with discount and cash columns. Cash book with cash and bank columns. 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.

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Debit side Date

Double Column Cash Book of XXXX Particulars R. L. N F. Disc. Allow. Amount Rs. Date Particula V. L. rs N. F.

Credit side Disc. Rece. Amount Rs.

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 Date

Double Column Cash Book of XXXX Particulars R. L. N F. Cash Rs. Bank Rs. Date Particulars V. L. N. F.

Credit side Cash Rs. Bank Rs.

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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 Date Particulars R. L. N F. Triple Column Cash Book of XXXX Dis. Cash All. Rs. Bank Rs. Date Credit side Dis. Cash Rec Rs. Bank Rs.

Particulars V. L. N. F.

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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 DEBIT Rs CREDIT Rs

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.

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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. Salaries Sales Plant & Machinery Commission paid Stock on 1.4.2002 Repairs Sundry Expenses Returns Inward Discount Allowed Rent and Rates Solution: Trial Balance of Rahul as on 31st March, 2011 S. No. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19 20. Name of the Account Salaries Sales Plant and Machinery Commission Paid Stock on 1.4.2002 Repairs Sundry Expenses Returns Inward Discount Allowed Rent & Rates Purchases Sundry Debtors Travelling Expenses Carriage Inward Sundry creditors Capital 1.4.2002 Drawings Cash at Bank Returns Outward Investments TOTAL L. F. Dr. Rs. 36,320 34,300 1,880 11,100 1,670 460 1,000 1,150 3,220 1,44,670 1,430 2,630 240 3,500 1,090 6,000 2,50,660 Cr. Rs. 1,73,500 14,260 62,500 400 2,50,660
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Rs. 36,320 1,73,500 34,300 1,800 11,100 1,670 460 1,000 1,150 3,220

Purchases Sundry Debtors Travelling Expenses Carriage Inward Sundry Creditor Capital, 1.4.2002 Drawings Cash at Bank Returns Outward Investments

Rs. 1,44,670 1,430 2,630 240 14,260 62,500 3,500 1,090 400 6,000

Nature of Balance (Why Dr. or Cr.) Nominal A/c-expense Real A/c goods Real A/c asset Nominal A/c-expense Real A/c goods Nominal A/c-expense Nominal A/c-expense Real A/c goods Nominal A/c loss Nominal A/c-expense Real A/c goods Personal A/c - customers Nominal A/c-expense Nominal A/c-expense Personal A/c -Suppliers Personal A/c owner Personal A/c -owner Real A/c asset Real A/c goods Real A/c asset

Note: 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. Capital Cash in hand Building Stock Sundry creditors Commission paid Rent & Taxes Purchases Salaries Discount allowed Drawings Bad debts Rs. 4,70,200 6,000 3,20,000 33,000 26,000 750 6,300 1,65,000 70,600 650 5,000 1,350 Machinery Sundry Debtors Repairs Insurance premium Sales Telephone Charges Furniture Discount earned Loan from Mohammed Reserve fund Bills receivable Bills payable Rs. 1,58,800 48,000 5,400 3,300 2,90,000 6,450 11,000 1,100 51,000 5,900 8,600 6,000

3. Prepare Trial Balance as on 31.3.2010 from the books of Mrs.Chitra. Rs. Capital General expenses Machinery Wages Bad debts Sales Commission Bills payable Bank overdraft Discount 2,49,000 97,000 1,18,680 14,400 1,100 3,30,720 5,500 7,700 28,600 1,210 Drawings Building Stock Insurance Creditors Loam(Cr.) Purchases Reserve Fund Cash in hand Rs. 24000 78,000 1,32,400 2,610 5,000 75,000 2,10,800 15,000 25,320

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4. Prepare Trial Balance as on 31.12.2011 from the following balances ofMs. Fathima. Rs. Drawings Stock(1.1.2000) Capital Furniture Sundry creditors Printing charges Bank loan Freight Income tax Machinery 74,800 30,000 2,50,000 33,000 75,000 1,500 1,20,000 3,500 9,500 2,15,400 Purchases Discount received Discount allowed Sales Rent Sundry expenses Bills receivable Carriage outwards Insurance Bills payable Rs. 2,95,700 1,000 950 3,35,350 72,500 21,000 52,500 1,500 1,200 31,700

5. Prepare trial balance as on 31.3.2010 from the following balances of Mrs.Sujatha. Rs. Drawings Capital Sundry creditors Bills Payable Sundry Debtors Bills Receivable Loan from Shameem Furniture & Fittings Opening stock Cash at bank 43,000 2,12,000 61,500 22,000 55,000 72,600 2,50,000 12,250 2,23,500 86,250 Purchases Sales Salaries Sales return Purchases return Travelling expenses Commission paid Discount earned Cash in hand Rs. 2,98,000 3,64,000 44,950 500 2,550 12,300 250 2,000 65,450

6. Prepare Trial Balance from the following balances of Mrs.Dilshad as on 31.12.2010. Capital Building Machinery Furniture Car Opening stock Purchases Sales Sundry debtors Reserve for doubtful debts Rs. 4,20,000 1,15,000 60,000 11,000 68,000 86,000 94,000 1,96,000 16,200 7,300 Cash in hand Cash at bank Salaries Rent Commission Rates and Taxes Bad debts Insurance General Expenses Sundry Creditors Rs. 25,000 84,700 94,000 48,000 1,400 2,600 3,200 2,400 800 68,000

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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 Profit and Loss Account

Balance Sheet

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.
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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. II. III. IV. V. Interest received on investment Interest received on fixed deposits. Discount earned. Commission earned. 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 owners 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 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: xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx Rs. Rs

xxxx Add: Fixed Assets: Goodwill Plant and Machinery Furniture Investment xxxx

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Total Fixed Assets Capital Employed (Both owners and outsiders) Less: Long Term Liabilities Debentures Loans Total Long Term Liabilities Net Assets Represented by: Owners 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 This order is exactly the reverse of the above. Assets and liabilities are recorded in the order of their life in the business concern.
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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. Basis Distinction Trial balance Balance sheet

1.

Objective

To know the arithmetical accuracy To know the true and fair of the accounting work. financial position of a business.

2.

Format

The columns are debit balances and credit balances.

The two sides are assets and liabilities

3.

Content

It is a summary of all the ledger It is a statement showing balances personal, real and closing balances of personal & nominal accounts. real accounts.

4.

Stage

It is the middle stage in the preparation of accounts.

It is the last stage in the preparation of accounts.

5.

Period

It can be prepared periodically, It is generally prepared at the say at the end of the month, end of the accounting period. quarterly or half yearly, etc.

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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 Balances shown in the balance are not in order. sheet must be in order.

9.

Evidence

It cannot be produced as It can be produced documentary evidence in the court. documentary evidence.

as

10.

Compulsion

Preparation of trial balance is not Preparation of the balance sheet compulsory. 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 VI has not prescribed any form for Profit and Loss Account. But, it must be remembered that the

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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? 16. What is XBRL? How is it useful?

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Problem: Identification of Accounts. Identify the account(s) to be debited and credited for the following transactions:

Transaction (a) Paid creditors on account (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

Debit Cash

Credit Creditors

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. 2. 3. 4. 5. 6. 7. 8. 9. Shekar invested cash Rs 6,500 in Shekar Arts Limited in exchange for 650 shares. Bought office supplies for cash, Rs 430 Bought office equipment on credit, Rs 3,200 Received fees for services provided, Rs 6,700 Billed customers for services provided, Rs 2,100 Paid creditors in (c), Rs 3,200 Paid assistants' salaries Rs 800 Paid office rent for the month, Rs 500 Declared and paid dividends, Rs 600

Prepare journal entries to record the transactions.

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True or False Type Questions 1. 2. 3. Depreciation is an amortized expenditure. Pre-operative expenses are revenue expenses. 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. 6. When we buy furniture on cash we debit cash account. Capital + Long-term liabilities = Fixed assets + Current assets + Cash Current liabilities. 7. 8. 9. 10. 11. 12. 13. Net profit is reflected in higher cash balance and net loss is reflected in lower net worth. Profit and Loss Account shows the financial position of the concern. Expenses incurred to keep the machine in working condition are a capital expenditure. Providing depreciation ensures sufficient cash for asset replacement. Fixed costs remain relatively unaffected in a defined period of time. An expenditure intended to benefit the current period is revenue expenditure. A withdrawal of cash from the business by the proprietor should be charged to Profit and Loss Account as expense. 14. 15. 16. 17. 18. 19. 20. 21. The Trial Balance ensures the arithmetical accuracy of the books. The allowance made for prompt payment is called trade discount. Finished goods are normally valued at cash or market price whichever is higher. Accrual concept implies accounting on cash basis. Depreciation cannot be provided in case of loss, in a financial year. Wages paid to workers to produce a tool to be captively consumed is capital expenditure. Amounts written off from the cost of fixed assets is capital expenditure. Deferred Revenue Expenditure is current years revenue expenditure to be paid in later years. 22. 23. 24. Rectification of errors will not necessarily balance a Trial Balance. Profit and Loss Account shows the financial position of the concern. Providing depreciation in the accounts reduces the amount of profit available for dividend.
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25. 26.

Fixed assets are stated in the balance sheet at their market value. 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. 30. 31. 32. 33. 34. 35.

Finished goods are normally valued at cost or market price whichever is higher. Trial balance is prepared after preparing the Profit and Loss Account. Sale of Office Furniture should be credited to Sales Account. Wages paid of erection of machinery are debited to Profit and Loss Account. Amount paid for acquiring Goodwill is deferred revenue expenditure. Receipts and Payments Account is a summary of all capital receipts and payments. The Provision for discount on Debtors is calculated before deducting the provision for doubtful debts from debtors.

36. 37. 38. 39. 40. 41.

Patent Rights is in the nature of Nominal Account. A bill given to a creditor is called bills payable. The trial balance checks the honesty of the book-keeper. The balance in the Cash Book show net income. Goodwill is not a fictitious asset. 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. 44. 45. 46. 47. 48. 49.

Purchases Book records all purchases of goods. The debts written off as bad, if recovered subsequently, are credited to debtors account. Discount Account should be balanced in the Cash Book. An expenditure intended to benefit the current period is revenue expenditure. The Trial Balance ensures the arithmetical accuracy of the books. Depreciation cannot be provided in case of loss, in financial year. Profit and Loss Account shows the financial position of the concern.
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50. 51. 52. 53.

Sale of Office furniture should be credited to Sales Account. Receipts and Payments Account is a summary of all capital receipts and payments. Goodwill is current asset. A tallied Trial balance will not reveal compensating errors and errors on account of wrong balancing.

54. 55. 56. 57. 58. 59. 60. 61.

Goodwill is in the nature of Personal Account. Nominal accounts are balance at the end of the accounting year. Higher depreciation will not affect cash profit of the business. Companies can keep their accounts under cash basis. Heavy advertising to introduce a new product is capital expenditure. Receipts and Payments Account highlights total income and expenditure. Legal fees paid to acquire a property are capital expenditure. Expenditure on renovation of a theatre which has increased the seating capacity by 10% is deferred revenue expenditure.

62. 63. 64.

Outstanding expenditure is a nominal account. Provision for Bad Debits is debited to Sundry Debtors Account. There is no difference between the written down value method and diminishing balance method of depreciation.

65. 66. 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. 77.

The debit balance in the Profit and Loss Account is surplus. Partners can share profits or losses in their capital ratio, when there is no agreement. Goodwill is fictitious asset. Land is also a depreciable asset. Capital is all assets less fictitious assets. Finished goods are normally valued at cost of market price, whichever is lower. Patent Right is in the nature of Real Account. A bill given to a creditor is called Bills Receivable. Purchase Book records all credit purchases of goods. Legal fees paid to acquire a building are a capital expenditure. Debit balance of profit and loss account is real asset. Depreciation is cash expenditure like other normal expenses. The Sales Book is kept to record both cash and credit sales.
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Classify the following accounts according to their types: asset, liability, or equity: a) b) c) d) e) f) g) h) i) j) k) l) m) Interest Expense Commission Income Prepaid Rent Office Supplies Proprietors Drawings Fines and Penalties Paid to Government Advances to Suppliers Unearned Insurance Premium Income Tax Expense Income Tax Payable Dividend Paid Dividend Received Advances from Customers

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