Basic Concepts of Financial Accounting

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TOPICS
Forms of Business Organizations Accounting Terminologies Types of Accounting Methods Dual Entry System Types of Accounts with examples Debit & Credit Rules for different Accounts Accounting Cycle Journal Ledger Trial Balance Income Statement Balance Sheet
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OBJECTIVES
To get an overview of basics of Financial Accounting To understand basic terminologies of Accounting To understand the two types of Accounting To understand different types of Accounts and their corresponding rules for Debit & Credit To Understand each components of the Accounting Cycle (i.e. Journal, Ledger, Trial Balance, Income Statement & Balance Sheet)

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Forms of Business Organization

Proprietorship Partnership Corporation

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Accounting
is the Accounting
art of Recording

Classifying

the results to help users make better decisions. the financial aspect and
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Summarizing

Presenting Interpreting

Accounting
Recording means entering the financial transactions in journals. Classifying means posting the transactions from journals to ledger Summarizing means to prepare the Trial Balance. Presentation means setting out the financial data in a systematic manner in the form of Statements ( i.e. Profit & Loss and Balance Sheet). Interpretation means to understand the financial statements for the user to make appropriate decisions.
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Foundation of Accounting Systems

Indian Accounting Standards encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time. Institute of Chartered Accountants of India (ICAI) is primarily responsible for evaluating, setting, or modifying IAS in India.

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Users of Accounting Information

External Users
Internal Users

Lenders

Consumer Groups

Managers Officers

Sales Staff Budget Officers

Shareholders External Auditors Governments Customers

Internal Auditors Controllers

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Users of Accounting Information

Lenders: Whether the firm (borrower) can repay the money? Shareholders: Whether to buy, hold, or sell stocks? Governments: Whether the firm pay all due tax? Customers: Whether the firm can exist to provide post-sale services? External Auditors: Whether the financial statements are prepared according to IAS? Accounting provides the relevant information for internal decision makers.

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Accounting Terminologies
Assets: Assets are the properties or resources which are owned by the business entity. Ex: Land, building, machinery, cash etc. owned by the business. Liabilities: Liabilities are the debts owed by the business to the outsiders. Ex: Amount due to suppliers, Loan from bank. Capital: Capital represents owners claim or share in the assets of the business. In common sense, Capital is the amount invested by the proprietor in his business. Drawings: Drawing means the amount of cash or any asset withdrawn by the owner of the business for his personal or domestic use.

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Accounting Terminologies
Expense: Expenses are the amounts spent on purchasing, manufacturing and selling of goods and services. Ex: Salary, Rent, Wages, Telephone bills paid etc. Revenue: Revenue represents the cash generated by sale of goods or by rendering services. Ex: Sale proceeds of goods, Rent earned, Consulting fees etc. Accounting Year: Accounting year is generally a period of 12 months during which the accounts are maintained. An accounting year may be a calendar year (i.e. from 1st January to 31st December) or any financial year (i.e. from 1st April to 31st March) or any other period of year. The Profit or Loss of a business are ascertained after the close of every accounting year.
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Accounting Methods
CASH BASIS The Cash Method of accounting records revenue when cash is received, and records expenses when cash is paid. Ex: Magazine Subscription ACCRUAL BASIS The accrual method records revenue when they are earned and records expenses when they are actually incurred.

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Dual Entry System

The term Double-entry system means the method of recording of two-fold aspects of a transaction.

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Accounting Cycle
Financial Transactions

Entering Into Journals Accounting Process

Posting to Ledger Accounts

Taking out Trial Balance

Preparing P & L and Balance Sheet Statement Confidential

Accounting Terminologies
Journal: Journal is a book of original entry where transactions are entered in sequence of their occurrence date wise. Ledger: Ledger is a book of final entry containing all the accounts of the business. The accounts are the classified records of all the transactions prepared on the basis of journals. Posting: Posting is the process of transferring the entries of the transactions from journals to the ledger accounts.

Trial Balance: Trial Balance is the list of all debit and credit balances of accounts taken out from the ledger at any given date.

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Accounting Terminologies
P & L Account: It is a summarized revenue account which shows net profit or loss made by a business during the year. Balance Sheet: Balance sheet is the statement of assets and liabilities prepared with a view to ascertain the financial position of the business as on a specified date.

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Accounting Terminologies
Goods: It includes all commodities, articles or products which are purchased for the purpose of resale. Purchases: The term Purchases means goods purchased for resale. Any goods purchased for office use is not regarded as purchases. It may be treated as an Asset or office expense depending upon the use of such goods Ex: If a furniture dealer buys tables, chairs etc. for trading purpose, it will be treated as Purchases. But if they are purchased for use in the office, it will be treated as an Asset. It should be noted that Purchases are treated as expenses for accounting purpose.
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Accounting Terminologies
Sales: The term Sales means goods sold for cash or on credit. Note: Sales doesnt include sale of any asset. It may be treated as an Asset or Revenue depending upon the use of such goods. Ex: If a furniture dealer sells tables, chairs etc. for trading purpose, it will be treated as Sales. But if he sells the office furniture's in use, then it will be treated as an Asset. It should be noted that Sales are treated as Revenue for accounting purpose.

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Accounting Terminologies
Purchases Returns (or Returns Outwards): It means the goods which were purchased being returned to the suppliers. Goods may be returned for reasons such as poor quality, damage by bad packing etc. The amount of goods returned reduces the purchases. Sales Returns (or Returns Inwards): It means the goods which were sold to customers are now returned for the same reasons stated above. The amount of such returns reduces the sales.

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Accounting Terminologies
Debtor: Debtor is a person who owes any amount to another person. Ex: If we sell goods to Mr. X on credit, he becomes our debtor. Creditor: Creditor is a person to whom any amount is owed by other person. Ex: If we purchase goods from Mr. Y on credit, he becomes our creditor.

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Accounting Terminologies
Accounts Payable: Accounts payable is money owed by a business to its suppliers shown as a liability. Ex: If we purchase goods on credit, then we make use of Accounts Payables instead of Cash account.

Accounts Receivables: Accounts receivables is money yet to be received by a business from its customers shown as a asset. Ex: If we sell goods on credit, then we make use of Accounts Receivables instead of Cash account.

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Accounting Terminologies
Account: Account means the record of transactions in a summarized form pertaining to a particular person or a particular asset or a particular expense or income.

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Every Account has:

An Increase Side, and A Decrease Side But, Some Accounts Increase on the Debit Side(Left Side) And, Some Accounts Increase on the Credit Side(Right Side)
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5 Rules of Debits and Credits

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Rule #1
ASSET ACCOUNTS

Increase on Debit Side

Dr.

Cr.

Decrease on Credit Side

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Rule #2
LIABILITY ACCOUNTS

Decrease on Debit Side

Dr.

Cr.

Increase on Credit Side

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Rule #3
CAPITAL ACCOUNTS

Decrease on Debit Side

Dr.

Cr.

Increase on Credit Side

+
JUST LIKE LIABILITY ACCOUNTS
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Rule #4
REVENUE ACCOUNTS

Decrease on Debit Side

Dr.

Cr.

Increase on Credit Side

+
JUST LIKE LIABILITY & CAPITAL ACCOUNTS
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Rule #5
EXPENSE ACCOUNTS

Increase on Debit Side

Dr.

Cr.

Decrease on Credit Side

+
JUST LIKE ASSET ACCOUNTS
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Rule #1
ASSET ACCOUNTS

Increase on Debit Side

Dr.

Cr.

Decrease on Credit Side

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Example
PURCHASED OFFICE SUPPLIES FOR $800 CASH

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Step #1
Name the accounts affected:

CASH

OFFICE SUPPLIES

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Step #2
Determine Classification of Accounts

CASH

OFFICE SUPPLIES

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Step #3
Now that we know the classification, we can identify increase and decrease sides.

CASH
DR. CR.

OFFICE SUPPLIES
DR. CR.

+
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PURCHASED OFFICE SUPPLIES FOR $800 CASH

Did Office Supplies Increase or Decrease in this transaction?

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INCREASED

OFFICE SUPPLIES + $800

DR. CR.

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PURCHASED OFFICE SUPPLIES FOR $800 CASH

What about Cash? Increase or Decrease in this transaction?

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DECREASED

CASH
DR. CR.

$800

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DEBITS = CREDITS
OFFICE SUPPLIES DR. CR.
$800

CASH DR. CR.

+
$800

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Rule #2
LIABILITY ACCOUNTS

Decrease on Debit Side

Dr.

Cr.

Increase on Credit Side

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Example
PURCHASED EQUIPMENT ON ACCOUNT FOR $3,000.

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Step #1
Name the accounts affected:

EQUIPMENT

ACCOUNTS

PAYABLE

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Step #2
Determine Classification of Accounts

ACCOUNTS

PAYABLE EQUIPMENT

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Step #3
Now that we know the classification, we can identify increase and decrease sides.

EQUIPMENT
DR. CR.

ACCOUNTS PAYABLE
DR. CR.

+
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PURCHASED EQUIPMENT ON ACCOUNT FOR $3,000.

Did Equipment Increase or Decrease in this transaction?

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INCREASED

EQUIPMENT
DR. CR.

+
$3000

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PURCHASED EQUIPMENT ON ACCOUNT FOR $3,000.

ACCOUNTS PAYABLE? Increase or Decrease in this transaction?

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INCREASED

ACCOUNTS PAYABLE
DR. CR.

$3000

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DEBITS = CREDITS
EQUIPMENT DR. CR.
$3000

ACCOUNTS PAYABLE DR. CR.

+
$3000

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Rule #3
CAPITAL ACCOUNTS

Decrease on Debit Side

Dr.

Cr.

Increase on Credit Side

+
JUST LIKE LIABILITY ACCOUNTS
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Example
MARY ADAMS, THE OWNER, INVESTED $25,000 IN THE BUSINESS

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Step #1
Name the accounts affected:

CAPITAL

CASH

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Step #2
Determine Classification of Accounts

CASH
CAPITAL

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Step #3
Now that we know the classification, we can identify increase and decrease sides.

CAPITAL
DR. CR. DR.

CASH
CR.

+
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MARY ADAMS, THE OWNER, INVESTED $25,000 IN THE BUSINESS

Did Capital Increase or Decrease in this transaction?

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INCREASED

M. ADAMS, CAPITAL
DR. CR.

$25,000

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MARY ADAMS, THE OWNER, INVESTED $25,000 IN THE BUSINESS

CASH? Increase or Decrease in this transaction?

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INCREASED

CASH
DR. CR.

+
$25,000

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DEBITS = CREDITS
CASH DR. CR. M. ADAMS, CAPITAL DR. CR. $25,000

+
$25,000

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Rule #4
REVENUE ACCOUNTS

Decrease on Debit Side

Dr.

Cr.

Increase on Credit Side

+
JUST LIKE LIABILITY & CAPITAL ACCOUNTS
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Example
MARY PERFORMED SERVICES AND RECEIVED $4,500 IN CASH

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Step #1
Name the accounts affected:

CONSULTING FEES

CASH

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Step #2
Determine Classification of Accounts

CASH
CONSULTING FEES

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Step #3
Now that we know the classification, we can identify increase and decrease sides.

CONSULTING FEES
DR. CR.

CASH
DR. CR.

+
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MARY PERFORMED SERVICES AND RECEIVED $4,500 IN CASH

Did Consulting Fees Increase or Decrease in this transaction?

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INCREASED

CONSULTING FEES
DR. CR.

$4,500

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MARY PERFORMED SERVICES AND RECEIVED $4,500 IN CASH

CASH? Increase or Decrease in this transaction?

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INCREASED

CASH
DR. CR.

+
$4,500

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DEBITS = CREDITS
CASH DR. CR. CONSULTING FEES DR. CR. $4,500

+
$4,500

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Rule #5
EXPENSE ACCOUNTS

Increase on Debit Side

Dr.

Cr.

Decrease on Credit Side

+
JUST LIKE ASSET ACCOUNTS
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Example
MARY ADAMS PAID HER ASSISTANT $750 IN WAGES

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Step #1
Name the accounts affected:

WAGES EXPENSE

CASH

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Step #2
Determine Classification of Accounts

CASH WAGES EXPENSE

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Step #3
Now that we know the classification, we can identify increase and decrease sides.

WAGES EXPENSE
DR. CR. DR.

CASH
CR.

+
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MARY ADAMS PAID HER ASSISTANT $750 IN WAGES

Did Wages Expense Increase or Decrease in this transaction?

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INCREASED

OFFICE SUPPLIES
DR. CR.

+
$750

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MARY ADAMS PAID HER ASSISTANT $750 IN WAGES

What about Cash? Increase or Decrease in this transaction?

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DECREASED

CASH
DR. CR.

$750

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DEBITS = CREDITS
WAGES EXPENSE DR. CR.
$750

CASH DR. CR.

+
$750

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How to apply the Rules????

Firstly, find out which are the two accounts affected in the transaction Secondly, find out to which class the above two accounts belong. Thirdly, find out whether the account value increases or decreases. Lastly, write the particular account to be debited and the account to be credited.

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Extra Examples:
Gagan commenced business with Rs. 100,000.
Cash Account Capital Account Capital Account Increases Credit Capital Account

Asset Account
Increases

Debit Cash Account

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Extra Examples: (Contd..)

Purchased goods from Mr. Abhishek Rs. 10,000 for cash.
Purchases Account Expense Account Increases Debit Purchases Account Cash Account

Asset Account
Decreases

Credit Cash Account

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Extra Examples: (Contd..)

Purchased goods from Mr. Ankit Rs. 20,000 on Credit.
Purchases Account Expense Account Increases Debit Purchases Account Ankits Account

Liability Account
Increases

Credit Ankits Account

NOTE: Accounts Payables is an account which indicates the liability that needs to be paid off in the near future.
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Extra Examples: (Contd..)

Paid Cash Rs. 8000 to Mr. Ankit on account.
Ankits Account Liability Account Decreases Debit Ankits Account Cash Account

Asset Account
Decreases

Credit Cash Account

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Extra Examples: (Contd..)

Returned goods worth Rs. 1000 to Mr. Ankit.
Ankits Account Purchases Returns Account Expense Account Decreases Credit Purchases Returns Account

Liability Account
Decreases

Debit Ankits Account

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Extra Examples: (Contd..)

Purchased furnitures from Mr. Anil Rs. 3000 on Credit.
Furnitures Account Asset Account Increases Debit Furnitures Account Anils Account

Liability Account
Increases

Credit Anils Account

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Extra Examples: (Contd..)

Purchased machinery for cash Rs. 5000.
Machinery Account Asset Account Increases Debit Furniture Account Cash Account

Asset Account
Decreases

Credit Cash Account

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Extra Examples: (Contd..)

Returned machinery due to a serious defect in the design.
Cash Account Asset Account Increases Debit Cash Account Machinery Account Asset Account

Decreases
Credit Furniture Account

NOTE: Here, we assume that the Supplier returns the amount immediately. If the supplier doesnt returns the amount immediately, then the offset account will be Accounts Receivables.
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Extra Examples: (Contd..)

Sold goods to Mr. Jitender Rs. 15,000 for cash
Cash Account Sales Account Revenue Account Increases Credit Sales Account

Asset Account
Increases

Debit Cash Account

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Extra Examples: (Contd..)

Sold goods to Mr. Akhtar Rs. 9000 for credit
Akhtars Account Sales Account Revenue Account Increases Credit Sales Account

Asset Account
Increases

Debit Akhtars Account

NOTE: Accounts receivables is an account which has future economic benefit, that is why it is regarded as asset account.
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Extra Examples: (Contd..)

Received cash Rs. 4000 from Mr. Akhtar on account.
Cash Account Asset Account Increases Debit Cash Account Akhtars Account

Asset Account
Decreases

Credit Akhtars Account

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Extra Examples: (Contd..)

Mr. Akhtar returned goods worth Rs. 500.
Sales Returns Account Revenue Account Decreases Debit Sales Returns Account Akhtars Account

Asset Account
Decreases

Credit Akhtars Account

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Extra Examples: (Contd..)

Mr. Jitender returned defective goods worth Rs. 1000.
Sales Returns Account Revenue Account Decreases Debit Sales Account Cash Account

Asset Account
Decreases

Credit Cash Account

NOTE: Here, we assume that the amount is returned immediately. If the company doesnt returns the amount immediately, then the offset account will be Accounts Payables.
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Extra Examples: (Contd..)

Paid Salary Rs. 7000 to Accountant.
Salary Account Expense Account Increase Debit Salary Account Cash Account

Asset Account
Decreases

Credit Cash Account

NOTE: Here, we assume that the salary is paid as on date. If the company doesnt pays the amount as on date, then the offset account will be Salary Payables which will be a Liability Account.
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Extra Examples: (Contd..)

Paid Landlord, office rent Rs. 5000
Rent Account Expense Account Increase Debit Rent Account Cash Account

Asset Account
Decreases

Credit Cash Account

NOTE: Here, we assume that the rent is paid as on date. If the company doesnt pays the rent amount as on date, then the offset account will be Rent Payables which will be a Liability Account. Confidential

Extra Examples: (Contd..)

Paid wages Rs. 1500
Wages Account Expense Account Increase Debit Wages Account Cash Account

Asset Account
Decreases

Credit Cash Account

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Extra Examples: (Contd..)

Received interest on bank deposit Rs. 1200
Cash Account Interest Account Revenue/Income Account Increases Credit Wages Account

Asset Account
Increases

Debit Cash Account

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Extra Examples: (Contd..)

Withdrawn cash Rs. 1000 for personal expenses.
Drawings Account Cash Account Asset Account Decreases Credit Cash Account

Capital Account
Decreases

Debit Drawings Account

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Extra Examples: (Contd..)

Borrowed Bank Loan of Rs. 10,000
Cash Account Asset Account Increases Debit Cash Account Bank Loan Account

Liability Account
Increases

Credit Bank Loan Account

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Banking Transactions
Business concerns generally deposit their excess cash into bank. It is for the sake of safety and also the bank provides some facilities to the depositors. Whenever cash is required it can be withdrawn from bank and even the payments can be made to others through cheques.

The other parties may also make payments to us by means of cheques drawn on their banks.
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Extra Examples: (Contd..)

Deposited cash into bank Rs. 5,000.
Bank Account Cash Account Asset Account Decreases Credit Cash Account

Asset Account
Increases

Debit Bank Account

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Extra Examples: (Contd..)

Withdrawn from bank for office use Rs. 1,000.
Cash Account Asset Account Increases Debit Cash Account Bank Account

Asset Account
Decreases

Credit Bank Account

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Extra Examples: (Contd..)

Paid Mr. Ankit on account by cheque Rs. 2,000
Ankits Account Liability Account Decreases Debit Ankits Account Bank Account

Asset Account
Decreases

Credit Bank Account

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Extra Examples: (Contd..)

Received Cheque from Mr. Akhtar on Account Rs. 3,000
Cash Account Asset Account Increases Debit Cash Account Akhtars Account

Asset Account
Decreases

Credit Akhtars Account

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Extra Examples: (Contd..)

Deposited the above cash into bank.
Bank Account Asset Account Increases Debit Bank Account Cash Account

Asset Account
Decreases

Credit Cash Account

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Journal Format
Date Particulars L.F. Dr. Cr.

NOTE: L.F means Ledger folio or page number of ledger. (Similarly, in ledger, page number of journal is mentioned for cross reference.
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Journal Entries
Jan 1, 2013: Borrowed from Mr. B cash Rs. 10,000 Jan 3, 2013: Paid Rs. 6,000 to Mr. B on Account. Journal Entries
Date Jan 1, 2013 Jan 3, 2013 Particulars Cash Account To Mr. Bs Account Mr. Bs Account To Cash Account L.F. Dr. 10,000 10,000 6,000 Cr.

6,000

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Ledger Format
Name of the Account
Debit Date Particulars J.F. Amount Date Credit Particulars J.F. Amount

NOTE: J.F means Journal folio or page number of Journal.

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Posting
Journal Entries
Date
Jan 1, 2013 Jan 3, 2013

Particulars
Cash Account To Mr. Bs Account Mr. Bs Account To Cash Account

L.F.

Dr.
10,000

Cr.
10,000

6,000 6,000 Particulars By Mr. Bs A/c J.F Amount 6,000

Cash Accounts
Date Particulars J.F Amount 10,000 Date Jan 3, 2013 Jan 1, To Mr. Bs 2013 Account

Mr. Bs Accounts
Date Particulars J.F Amount 6,000 Date Jan 1, 2013
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Particulars By Cash A/c

J.F

Amount 10,000

Jan 3, To Cash 2013 Account

T Accounts
ACCOUNT NAME

CASH
Dr. Cr. SHAPED LIKE a T

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BALANCING T ACCOUNTS
CASH
10,000 1
1

6,000

BALANCE

4,000

Balance is written on side with larger total

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Accounting Terminologies
Debit Balance: If the total amount of debit side of an account is higher than that of the credit side, the difference amount is called the Debit Balance. Credit Balance: If the total amount of credit side of an account is higher than that of the debit side, the difference amount is called the Credit Balance.

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Format of Trial Balance

GlobalMinds Advisory Services Pvt. Ltd. Trial Balance April 30, 20-Sl. No Account Title Debit Balance Credit Balance

HEADING should include: Name of the Company Title of Document Trial Balance Date of the Trial Balance
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It Balances!!! Debits = Credits

Format of Profit & Loss Account

Profit and Loss Account for the year ending .
Expenses/ Loss Amount Revenue/Profit Amount

Total

XXXX

Total

XXXX

NOTE: The result of P& L Account may be either: Net Profit or Net Loss. The Net Profit is shown on the debit side and the Net Loss on the credit side.
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Format of Balance Sheet

Balance Sheet as on ..
Liabilities Amount Assets Amount

Total

XXXX

Total

XXXX

NOTE: The Balance Sheet, when totaled up, should tally. It means, the total of both the sides must be equal.
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Example

NOTE: Please refer the word document for complete flow of transactions from the Journal to Balance Sheet.

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QUESTIONS

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118

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