Unit I Basics of Accounting

Unit I – Basics of Accounting

Introductory Terms

• Business: Activity involving exchange of goods/services to earn income and profit.
• Business Transactions: Any transaction, dealing, or event involving the transfer of money or money’s worth between two parties.
• Expenditure: Spending money or incurring an obligation to pay later.
  • Capital Expenditure: Leads to the acquisition of an asset.
  • Revenue Expenditure: Benefit from it will soon be exhausted.
• Expense: Expenditure whose benefit is enjoyed and finished immediately or almost immediately.
• Cash Transaction: Payment for business activity made immediately.
• Non-Cash Transaction: Business transaction with no immediate or future cash payment or receipt. Examples: Depreciation, Bad Debts etc.
• Proprietor: The owner of the business, who invests capital to earn profit.
• Capital: Amount invested by the proprietor in the business; always equal to assets minus liabilities (also called owners’ equity). Capital = Assets - Liabilities
• Drawings: Value of cash or goods withdrawn from the business by the owner for personal use.
• Debtors: A person who owes money to the business.
• Creditors: A person to whom the business owes money.
• Assets: Properties or things owned by a business, including amounts due from others. Examples: Buildings, Machinery, Stock, Cash and Bank balances, Investments etc.
• Liabilities: Debts or amounts due from a business to others for borrowed money, goods/assets purchased on credit or services received without immediate payment. Examples: Bank loan or overdraft, trade creditors, outstanding expenses etc.
• Debt: The amount due from a debtor.
• Brought Down (b/d): Written in the ledger to show the opening balance in any account, brought down from the previous period.
• Carried Down (c/d): Written in the ledger account when closing the account.

Definitions of Accounting

• Smith and Ashburn: Accounting is the science of recording and classifying business transactions and events, primarily of financial character, and the art of making significant summaries, analysis and interpretations of those transactions and events, and communicating the results to persons who must make decisions or form judgements.
• American Institute of Certified Public Accountants: Accounting is the art of recording, classifying and summarising in significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results there of.

Objectives of Accounting

• Keeping Systematic Records: Maintain a systematic record of financial transactions.
• Protecting and Controlling Business Properties: Ensure no unauthorized use or disposal of assets; maintain proper records; track money due from and to various parties; ensure timely recovery of amounts due and avoid unnecessary payments.
• Ascertaining the operational profit or loss: Show the results of activities in a given period (usually a year), i.e. to show how much profit has been earned or how much loss has been incurred, by keeping a proper record of revenues and expenses of a particular period.
• Ascertaining the financial position of the business: Determine the financial position of the firm at the end of a particular period by preparing a balance sheet showing the value of firms possessions and the amount the firm is owing to others.
• Facilitating rational decision making: Collection, analysis, and reporting of information at the required time to facilitate rational decision making.

Users of Accounting Information

• Proprietors: Owners need information related to their business.
• Managers: Management is concerned with accounting information as they are answerable to the owners.
• Prospective investors: People contemplating investing in a business want to know about its profitability and financial position.
• Creditors, Bankers and other lending institutions: Want assurance of timely payment, assess financial statements for loan acceptability.
• Government: Interested in financial statements for taxation, labor, and corporate laws.
• Employees: Wages and bonus depend on profits earned.
• Regulatory agencies: Government departments and agencies use accounting reports for tax assessment and evaluating business operations under regulatory legislation.
• Researchers: Accounting data used in research on accounting theory, business affairs, and practices.

Systems of Accounting

• Cash System of Accounting: Entries made only when cash is received or paid; no entry made when payment or receipt is merely due. Example: Government system of accounting is mostly on the cash system.
• Accrual System of Accounting: (Mercantile system) Accounting entries made based on amounts having become due for payment or receipt, attempts to record the financial effects of the transactions, events, and circumstances of an enterprise in the period in which they occur rather than recording them in period(S) in which cash is received or paid by the enterprise. The purpose of accrual basis accounting is to relate the revenue in terms of cost so that reported net income measures an enterprise’s performance during a period instead of merely listing its cash receipts and payments

Accounting Principles, Concepts and Conventions

Accounting principles are defined as “the body of doctrines commonly associated with the theory and procedure of accounting, serving as an explanation of current practices and as a guide for the selection of conventions or procedures where alternatives exist”.

• Accounting concepts
• Accounting conventions

Accounting Concepts

• Business Entity Concept: The enterprise is separate from its owners, with a distinct accounting entity controlling resources and being accountable. Accounts are kept for a business entity as distinguished from the persons associated with it. They will record transactions between the owner and the firm.
• Money Measurement Concept: Only transactions and events that can be interpreted in terms of money are recorded. Events or transactions which cannot be expressed in money do not find place in the books of account though they may be very useful for the business.
• Cost Concept: Transactions are recorded at the amount actually involved; personal views are not considered.
• Going Concern Concept: Assumes the business will continue for a fairly long time; transactions recorded considering future benefits and consequences. It is on this basis that a clear distinction must be made between assets and expenses.
• Dual Aspect Concept: Every transaction has two aspects with double effect.
• Realisation Concept: Revenue is recognized when a sale is made i.e. when money has been realised, i.e. either cash has been received or a legal obligation to pay has been assumed by the customer no sale can be said to have taken place and no profit can be said to have arisen.
• Accrual Concept: Consequences of a transaction or event must follow; assets and liabilities affected even if cash settlement is later. Failure to record means wrong assets, liabilities, and capital.

Accounting Conventions

Customs or traditions used as a guide in preparing accounting reports and statements.

• Consistency: Accounting practices should remain unchanged from one period to another. It requires that working rules once chosen should not be changed arbitrarily and without notice of the effects of change to those who use the accounts.
• Disclosure: Significant information should be disclosed in financial statements, possibly through footnotes.
• Conservatism: Financial statements are usually drawn up on a conservative basis. Anticipated profits are ignored but anticipated losses are taken into account while drawing the statements.
• Materiality: Focus on material details and ignore insignificant details (to avoid overburdening accounting with minute details).

Book-keeping and Accounting

• Book-keeping: Concerned with recording financial data relating to business operations in an orderly manner. It is mechanical and repetitive. This work is usually entrusted to junior employees f accounts section of a business house.
• Accounting: Broader and more analytical, including the design of accounting systems, preparation of financial statements, audits, cost studies, income-tax work, and analysis/interpretation of accounting data. This work requires more skill, experience and imagination. It can be said that accounting begins where book-keeping ends.

Double Entry System

Recognizes that every transaction has two aspects and records both aspects of each and every transaction. Under this system in every transaction an account is debited and some other account is credited.

Merits of Double Entry System

• Keeps a complete record of business transactions.
• Provides a check on the arithmetical accuracy of the both of accounts, since every debit has corresponding credit to it and vice-versa.
• The detailed profit and loss account can be prepared to show profits earned or loss suffered during any given period.
• The system makes possible the comparison of purchases as well as sales, expenditure, income etc. of a current year with those of the previous years, thus enabling a businessman to control his business activities.
• The balance sheet can be prepared at any specified point of time or any date showing the actual amount of assets, liabilities and capital.
• The system being a scientific one, it prevents commission of fraud and if a fraud is committed it can be easily detected.
• The accurate details with regard to any account can be easily obtained.

Accounts

An individual record of a person, firm, or thing, an item of income or an expense.

Classification of Accounts

Broadly classified into two classes: (i) Personal Accounts and (ii) Impersonal Accounts.
The latter are further sub-divided into a) Real Accounts and b) Nominal Accounts. Thus all accounts can be classified into Personal, Real and Nominal Accounts.

• Personal Accounts: Relating to persons with whom the business deals. Can include
  • Natural person’s accounts: e.g. Mohan’s Account, Sheena’s Account, Raj’s Account etc.
  • Artificial person’s or body of person’s account: e.g. Bank Account, Firm Account, Company Account, Club Account etc.
  • Representative personal accounts: e.g. Outstanding Wages Account, Prepaid Rent Account, Unexpired Insurance Account etc.
• Real Accounts:
  • Tangible Real Accounts: Land Account, Furniture Account, Stock Account, and CashAccount etc.
  • Intangible Real Accounts: Goodwill Account, Trade Mark Account, Patent Account etc.
• Nominal Account: Accounts of incomes, expenses, gains and losses. Interest received, wages, salaries, rent, postage, profit and loss are such items, and a separate account is opened for each of these items.

Basic Accounting Rules

• Personal Accounts:
  • Debit: The Receiver
  • Credit: The Giver
• Real Accounts:
  • Debit: What comes in
  • Credit: What goes out
• Nominal Accounts:
  • Debit: Expenses and Losses
  • Credit: Incomes and Gains

Illustration 1

From the following transactions , state the nature of account and also state which account will be debited and which account will be credited:

a) X started business with cash
b) Paid wages
c) Purchased goods for cash
d) Purchased goods from Amar on credit
e) Purchased machinery for cash
f) Interest paid
g) Dividend received
h) Machinery sold
i) Outstanding for salaries

Journal

The journal is the book of prime entry in which every transaction is recorded before being posted into the ledger. It is that book of account in which transactions are recorded in a chronological ( day to day ) order.
A Specimen ruling of a journal is as under:

• (i) Date : The date on which the transaction took place is entered in this column. The year is written on the top, then the date column is divided in two parts, the first part is used for writing the month and second part is used for writing the date.
• (ii) Particulars : In the first line, the name of the account to be debited is written . The word ‘Dr.’ is written at the end of the first line. In the second line some space is left and the word ‘To’ is written before the name of the account to be credited. Then the name of the account to be credited is written. A brief explanation, usually beginning with the word ‘Being’ is written called ‘narration’. The narration explains the reason for debiting and crediting the particular accounts and helps one to understand the nature and purpose of the journal entry At a future date. To separate one entry from another, a line is drawn below every entry to cover particular column only.
  The line does not extend to other columns.
• (iii)L.F : Stands for Ledger Folio’. In this column the page numbers on which the various accounts appear in the ledger are entered.
• (iv) Debit Amount: In this column , the amount to be debited against the debit account is written.
• (v) Credit Amount : In this column, the amount to be credited against the credit account is written.

Illustration 2

Journalise the following transactions:

2007
April, 1 Rajesh stars business with cash 20,000
April,2 He buys goods for cash 15,000
April,4 He buys goods from Malhotra on credit 6,000
April,5 Furniture is purchased for cash 1,000
April,9 Cash sales made 1,500
April,11 Goods sold on credit to Satya Dev 4,000
April,16 Payment made to Malhotra 6,000
April,19 Cash sales 4,300
April,21 Purchases of stationery for cash 20
April,25 Sales on credit to Yusuf 1,770
April,30 Rent for the month paid in cash 500

Journal Entries

Illustration 3

Give journal entries for the following.

1. Raju commenced business with Rs. 1,00,000
2. Purchased furniture for cash Rs. 50,000
3. Purchased machinery from Mahesh on credit Rs. 40,000
4. Received cash from Goyal Rs. 80,000 on account.
5. Paid rent to landlord Rs. 5,000

Journal Entries in the books of Raju

| April,21 | To cash a/c | | | 20 |
| | ( being stationery purchased for cash) | | | |
| | _ | | | | | April,25 | Yousuf …Dr. | | 1,770 | | | | To sales a/c | | | 1,770 | | | ( being sales made to Yusuf on credit) | | | | | | _ | | | |
| April,30 | Rent a/c …Dr. | | 500 | |
| | To cash a/c | | | 500 |
| | ( being rent paid in cash ) | | | |

Illustration 4

Journalise the following transactions.

2007

Jan 1. Pankaj commenced business with a capital of Rs. 5, 00,000
Jan 2. Deposited in bank Rs. 4, 00,000
Jan 5. Purchased goods from Krishna on credit Rs. 1, 00,000
Jan 7. Sold goods to Rama on credit Rs. 80,000
Jan 9. Purchased goods from Manish for cash Rs. 50,000
Jan 12. Sold goods for cash to Sailesh Rs. 8,500
Jan 15. Purchased machinery from Ajay Engg. Co. Payment made by cheque Rs. 20,000
Jan 18. Issued cheque to Krishna Rs. 75,000
Jan 20. Received interest from Ashok Rs. 500
Jan 22. Cash withdrawn from bank for office use 20,000
Jan 24. Amount withdrawn from bank for personal use 8,000
Jan 27. Took loan from Rajiv Varma 1,50,00
Jan 29. Cash withdrawn from office for personal use 10,000
Jan 30. Goods withdrawn for personal use 20,000
Jan 31. Paid rent to landlord by cheque 6,000

JOURNAL

RECORDING OF TRANSACTIONS

Accounting Process

Following are the successive steps which are in practice, taken to record transactions:

a) Entering transactions in Subsidiary Books, i.e. Journalising.
b) Preparation of ledger accounts on the basis of records in subsidiary books, i.e. Posting.
c) Balancing of ledger accounts.
d) Preparation of Trial Balance.
e) Preparation of Final Accounts ; Trading Accounting, Profit and Loss Account, in the case of trading concerns and Manufacturing Account, Trading Account and Profit and Loss Account in the case of manufacturing concerns.
f) Preparation of Balance Sheet.

Ledger

The ledger is the principal book of accounts where similar transactions relating to a particular person or thing are recorded. In other words, it is a set of accounts. It contains all accounts of the business enterprise whether real, nominal or personal. The main function of a ledger is to classify or sort out all the items appearing in the journal or other subsidiary books under their appropriate accounts so that at the end of the accounting period each account will contain the entire information of all the transactions relating to it in a summarised or condensed form.

The following is the specimen ruling of the standard form of ledger account.

The following are the important features of the ledger account:

• The ledger account is divided into two sides – the left hand side is known as debit side while the right hand side is known as credit side. The abbreviations ‘Dr.’ And ‘ Cr.’ Are placed at the top left and right hand corners respectively. This is more by custom than under any law.
• The name of account is written in the middle of the account.
• J.F. denotes folio or page number on which its journal entry may be found

Ledger Posting

The term ‘posting ‘ means transferring the debit and credit items from the journal to their respective accounts in the ledger.

i. Separate accounts should be opened in the ledger for posting transactions relating to different accounts recorded in the journal.
ii. The concerned account which has been debited in the journal should also be devited in the ledger i.e. the debit of the journal entry is posted to the debit side. However, a reference should be made of the other account which has been debited in the journal.
iii. The concerned account which has been credited in the journal, should also be credited in the ledger i.e. the credit of the journal entry is posted to the credit side, but a reference should be given of the other account which has been debited in the journal.
iv. It is customary to use the words ‘To’ AND ‘ By’ while making posting in the ledger. The words ‘To’ is used with the accounts shown on the debit side of the ledger account while the word ‘By’ is used with accounts which appear on the credit side of the ledger account.
v. In the folio column, the page number of the journal from where the entry is transferred to ledger account is written.
vi. The date of the transaction is written on the date column.

Balancing Ledger Accounts

Balancing of an account means the process of equalising the two sides of an account by putting the difference on the side where the amount is short. If the debit side > credit side, the account has a debit balance. If the credit side exceeds the debit side, the account has a credit balance.

The following steps are followed for balancing the account:

i. Total the amounts of debit and credit entries in the account.
ii. If the debit and credit sides are equal then there is no balance. The account stands automatically balanced or closed.
iii. If the debit side total is more, put the difference on the credit side amount column, by writing the words in particulars column “ By Balance c/d “. If the credit side total is more, put the difference on the debit side amount column by writing the words in the particular column “ To Balance c/d “.
iv. After putting the difference in the appropriate side of the account, add both sides of the account and draw a thin line above and below the total.
v. Bring down the debit balance on the debit side by writing the words in particular column “To Balance b/d “. Similarly bring down the credit balance on the credit side by writing the words in the particulars column “ By Balance b/d”.

The debit balance of an account may represent either an asset or an expense . If such balance related to a Personal Account it reflects debtors; if it relates to Real Account, it is a property, if it relates to Nominal Account it is an expense or loss.

Similarly credit balance of an account represents either a liability or a gain. If such balance relates to Personal Account, it is a creditor, if it relates to Nominal Account, it is a gain or income. Real Accounts usually shows debit balance. In case there is a credit balance in a Real Account, it reflects loss on sale of the asset. It may be noted that when Nominal Accounts are balanced on the last day of an accounting year their balance are not carried down but are transferred to Trading and Profit and Loss Account.

Illustration 5

Record the following transactions in the Journal and post them into Ledger of Mr. Aditya Raj:

2008

March 1 Purchase of goods from Ramautar 3,20,000
March 10 Paid rent for the month 2,000
March 11 Purchase of Plant 1,00,000
March 12 Paid salaries 12,000
March 15 Paid Ramautar 1,00,000
March 20 Sold goods to Shyam 20,000
March 25 Received from Shyam 30,000
March 31 Received cash from cash sales 2,50,000
March 31 Wages paid 5,000

Journal Entries in the books of Aditya Raj