ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

INTRODUCTION

Let us imagine a situation where you are a proprietor and you take copies of your books of account to five different accountants. You ask them to prepare the financial statements on the basis of the above records and to calculate the profits of the business for the year. After few days, they are ready with the financial statements and all the five accountants have calculated five different amounts of profits and that too with very wide variations among them. Guess in such a situation what impact would it leave on you about accounting profession. To avoid this, a generally accepted set of rules have been developed. This generally accepted set of rules provides unity of understanding and unity of approach in the practice of accounting and also in better preparation and presentation of the financial statements.

Accounting is a language of the business. Financial statements prepared by the accountant communicate financial information to the various stakeholders for decision-making purpose. Therefore, it is important that financial statements prepared by different organizations should be prepared on uniform basis. Also there should be consistency over a period of time in the preparation of these financial statements. If every accountant starts following his own norms and notions for accounting of different items then there will be an utter confusion.

To avoid confusion and to achieve uniformity, accounting process is applied within the conceptual framework of ‘Generally Accepted Accounting Principles’ (GAAPs). The term GAAPs is used to describe rules developed for the preparation of the financial statements and are called concepts, conventions, postulates, principles etc. These GAAPs are the backbone of the accounting information system, without which the whole system cannot even stand erectly. These principles are the ground rules, which define the parameters and constraints within which accounting reports are generated. Accounting principles are basic norms and assumptions on which the whole accounting system has been developed and established. Accountant also adheres to various accounting standards issued by the regulatory authority for the standardization of accounting policies to be followed under specific circumstances. These conceptual frameworks, GAAPs and accounting standards are considered as the theory base of accounting.

Accounting conceptsAccounting concepts define the assumptions on the basis of which financial statements of a business entity are prepared. Certain concepts are perceived, assumed and accepted in accounting to provide a unifying structure and internal logic to accounting process. The word concept means idea or notion, which has universal application. Financial transactions are interpreted in the light of the concepts, which govern accounting methods. Concepts are those basic assumptions and conditions, which form the basis upon which the accountancy has been laid. Unlike physical science, accounting concepts are only result of broad consensus. These accounting concepts lay the foundation on the basis of which the accounting principles are formulated.

Accounting principles“Accounting principles 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 exits.”

Accounting principles must satisfy the following conditions: 1. They should be based on real assumptions;

2. They must be simple, understandable and explanatory; 3. They must be followed consistently;4. They should be able to reflect future predictions; 5. They should be informational for the users.Accounting conventionsAccounting conventions emerge out of accounting practices, commonly known as accounting principles, adopted by various organizations over a period of time. These conventions are derived by usage and practice. The accountancy bodies of the world may change any of the convention to improve the quality of accounting information. Accounting conventions need not have universal application.In the study material, the terms ‘accounting concepts’, ‘accounting principles’ and ‘accounting conventions’ have been used interchangeably to mean those basic points of agreement on which financial accounting theory and practice are founded.

CONCEPTS, PRINCIPLES & CONVENTION

Now we shall study in detail the various accounting concepts on which accounting is based. The following are the widely accepted accounting concepts:(a) Entity concept : Entity concept states that business enterprise is a separate identity apart from its owner. Accountants should treat a business as distinct from its owner. Business transactions are recorded in the business books of accounts and owner’s transactions in his personal books of accounts. The practice of distinguishing the affairs of the business from the personal affairs of the owners originated only in the early days of the double-entry book-keeping. This concept helps in keeping business affairs free from the influence of the personal affairs of the owner. This basic concept is applied to all the organizations whether sole proprietorship or partnership or corporate entities.Entity concept means that the enterprise is liable to the owner for capital investment made by the owner. Since the owner invested capital, which is also called risk capital he has claim on the profit of the enterprise. A portion of profit which is apportioned to the owner and is immediately payable becomes current liability in the case of corporate entities.

Example: Mr. X started business investing ` 7,00,000 with which he purchased machinery for` 5,00,000 and maintained the balance in hand. The financial position of the business (which is shown by Balance Sheet) will be as follows:

Balance Sheet

This means that the enterprise owes to Mr. X ` 7,00,000. Now if Mr. X spends ` 5,000 to meet his family expenses from the business fund, then it should not be taken as business expenses and would be charged to his capital account (i.e., his investment would be reduced by ` 5,000). Following the entity concept the revised financial position would be

LIABILITIES AMT ASSETS AMT

CAPITAL 7,00,000 MACHINERY 5,00,000 CASH 2,00,000

7,00,000 7,00,000

Balance Sheet (Rs in ‘000)Liability

CapitalLess : Drawings

7005

`

695

695

Assets

MachineryCash

` 500 195,

695

(b) Money measurement concept : As per this concept, only those transactions, which can be measured in terms of money are recorded. Since money is the medium of exchange and the standard of economic value, this concept requires that those transactions alone that are capable of being measured in terms of money be only to be recorded in the books of accounts. Transactions, even if, they affect the results of the business materially, are not recorded if they are not convertible in monetary terms. Transactions and events that cannot be expressed in terms of money are not recorded in the business books. For example; employees of the organization are, no doubt, the assets of the organizations but their measurement in monetary terms is not possible therefore, not included in the books of account of the organization. Measuring unit for money is taken as the currency of the ruling country i.e., the ruling currency of a country provides a common denomination for the value of material objects. The monetary unit though an inelastic yardstick,remains indispensable tool of accounting.

It may be mentioned that when transactions occur across the boundary of a country, one may see many currencies. Suppose an Indian businessman sells goods worth ` 50 lakhs at home and he also sells goods worth of 1 lakh Euro in the United States. What is his total sales? ` 50 lakhs plus 1 lakh Euro.These are not amenable to even arithmetic treatment. So transactions are to be recorded at uniform monetary unit i.e. in one currency. Suppose EURO 1 = ` 55.Total Sales = ` 50 lakhs plus 55 lakhs = ` 105 lakhs. Money Measurement Concept imparts the essential flexibility for measurement and interpretation of accounting data.This concept ignores that money is an inelastic yardstick for measurement as it is based on the implicit assumption that purchasing power of the money is not of sufficient importance as to require adjustment. Also, many material transactions and events are not recorded in the books of accounts just because it cannot be measured in monetary terms. Therefore it is recognized by all the accountants that this concept has its own limitations and inadequacies. Yet it is used for accounting purposes because it is not possible to adopt a better measurement scale.Entity and money measurement are viewed as the basic concepts on which other procedural concepts hinge.(c) Periodicity concept : This is also called the concept of definite accounting period. As per ‘going concern’ concept an indefinite life of the entity is assumed. For a business entity it causes inconvenience to measure performance achieved by the entity in the ordinary course of business.If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as financial position only at the end of its life.So a small but workable fraction of time is chosen out of infinite life cycle of the business entity for measuring performance and looking at the financial position. Generally one year period is taken up for performance measurement and appraisal of financial position. However, it may also be 6 months or 9 months or 15 months.According to this concept accounts should be prepared after every period & not at the end of the life of the entity. Usually this period is one calendar year. In India we follow from 1st April of a year to 31st March of the immediately following year.Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an

unduly long time-frame. This concept makes the accounting system workable and the term ‘accrual’ meaningful. If one thinks of indefinite time-frame, nothing will accrue. There cannot be unpaid expenses and non-receipt of revenue. Accrued expenses or accrued revenue is only with reference to a finite time-frame which is called accounting period.

Thus, the periodicity concept facilitates in :(i) Comparing of financial statements of different periods(ii) Uniform and consistent accounting treatment for ascertaining the profit and assets of the business(iii) Matching periodic revenues with expenses for getting correct results of the business operations(d) Accrual concept : Under accrual concept, the effects of transactions and other events are recognised on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past events involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future.To understand accrual assumption knowledge of revenues and expenses is required. Revenue is the gross inflow of cash, receivables and other consideration arising in the course of the ordinary activities of an enterprise from sale of goods, from rendering services and from the use by others of enterprise’s resources yeilding interest, royalties and dividends. For example, (1) Mr. X started a cloth merchandising. He invested ` 50,000, bought merchandise worth ` 50,000. He sold such merchandise for ` 60,000. Customers paid him ` 50,000 cash and assure him to pay ` 10,000 shortly. His revenue is ` 60,000. It arose in the ordinary course of cloth business; Mr. X received ` 50,000 in cash and ` 10,000 by way of receivables.Take another example; (2) an electricity supply undertaking supplies electricity spending` 16,00,000 for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of electricity charges. This is also revenue which arose from rendering services.Lastly, (3) Mr. A invested ` 1,00,000 in a business. He purchased a machine paying` 1,00,000. He hired it out for ` 20,000 annually to Mr. B. ` 20,000 is the revenue of Mr. A; it arose from the use by others of the enterprise’s resources.Expense is a cost relating to the operations of an accounting period or to the revenue earned during the period or the benefits of which do not extend beyond that period.In the first example, Mr. X spent ` 50,000 to buy the merchandise; it is the expense of generating revenue of ` 60,000. In the second instance ` 16,00,000 are the expenses. Also whenever any asset is used it has a finite life to generate benefit. Suppose, the machine purchased by Mr. A in the third example will last for 10 years only. Then ` 10,000 is the expense he met. For the time being, ignore the idea of accounting period.Accrual means recognition of revenue and costs as they are earned or incurred and not as money is received or paid. The accrual concept relates to measurement of income, identifying assets and liabilities.Example: Mr. J D buys clothing of ` 50,000 paying cash ` 20,000 and sells at ` 60,000 of which customers paid only ` 50,000.His revenue is ` 60,000, not ` 50,000 cash received. Expense (i.e., cost incurred for the revenue) is ` 50,000, not ` 20,000 cash paid. So the accrual concept based profit is ` 10,000 (Revenue – Expenses).As per Accrual Concept : Revenue – Expenses = ProfitAccrual Concept provides the foundation on which the structure of present day accounting has been developed.

Alternative as per Cash basis

Cash received in ordinary course of business – Cash paid in ordinary course of business = profit.

Revenue may not be realised in cash. Cash may be received simultaneously or (i) before revenue is created (A. 1)(ii) after revenue is created (A. 2)Expenses may not be paid in cash. Cash may be paid simultaneously or (i) before expense is made (B. 1) (ii) after expense is made (B. 2)A. 1 creates a liability when cash is received in advance. A. 2 creates an asset called Trade receivables. B. 1 creates an asset called Trade Advance when cash is paid in advance while B. 2 creates a liability called payables or Trade payables or outstanding liabilities. If the expenses remain unpaid in respect of goods, it is called Trade payables, if it remains unpaid for other expenses, it is called Expense payables.(e) Matching concept : In this concept, all expenses matched with the revenue of that period should only be taken into consideration. In the financial statements of the organization if any revenue is recognized then expenses related to earn that revenue should also be recognized.This concept is based on accrual concept as it considers the occurrence of expenses and income and do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain items like prepaid and outstanding expenses, unearned or accrued incomes.It is not necessary that every expense identify every income. Some expenses are directly related to the revenue and some are time bound. For example:- selling expenses are directly related to sales but rent, salaries etc are recorded on accrual basis for a particular accounting period. In other words periodicity concept has also been followed while applying matching concept.Mr. P K started cloth business. He purchased 10,000 pcs. garments @ ` 100 per piece and sold 8,000 pcs. @ ` 150 per piece during the accounting period of 12 months 1st January to 31st December, 2011. He paid shop rent @ ` 3,000 per month for 11 months and paid ` 8,00,000 to the suppliers of garments and received ` 10,00,000 from the customers.Let us see how the accrual and periodicity concepts operate.Periodicity Concept fixes up the time-frame for which the performance is to be measured and financial position is to be appraised. Here, it is January 2011-December, 2011. So revenues and expenses are to be measured for the year 2011 and assets and liabilities are to be ascertained as on 31st December, 2011.Accrual Concept operates to measure revenue of ` 12,00,000 (arising out of sale of garments 8,000 Pcs × ` 150) which accrued during 2011, not the cash received ` 10,00,000 and also the expenses correctly. Shop rent for 12 months is an expense item amounting to ` 36,000, not ` 33,000 the cash paid.Should the accountant treat ` 10,00,000 as expenses for purchase of merchandise ? And should he treat ` 1,64,000 as profit? (Revenue ` 12,00,000-Merchandise ` 10,00,000. Shop Rent ` 36,000). Obviously the answer is No. Matching links revenue with expenses.Revenue – Expenses = ProfitBut this unqualified equation may create misconception. It should be defined as : Periodic Profit = Periodic Revenue – Matched ExpensesFrom the revenue of an accounting period such expenses are deducted which are expended to generate the revenue to determine profit of that period.In the given example revenue relates to only sale of 8,000 pcs. of garments. So the cost of 8,000 pcs of garments should be treated as expenses.

Thus, Profit Assets = RevenueLess :

E

xpens

es: MerchandiseShop Rent 8,00,000

`36,000

` 12,00,000

` 8,36,000` 3,64,000

` 2,00,000

Liabilities :

Inventory (2,000 pcs × 100) Trade receivablesCash (Cash Receipts ` 10,00,000 – cash payments ` 8,33,000)

Trade Payables Expense PayablesCapital (for Profit)

` 2,00,000

1,67,000 ` 5,67,000

`2,00,000 ` 3,000

` 3,64,000` 5,67,000

Thus, accrual, matching and periodicity concepts work together for income measurement and recognition of assets and liabilities.

(f) Going Concern concept : The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.The valuation of assets of a business entity is dependent on this assumption. Traditionally, accountants follow historical cost in majority of the cases.Suppose Mr. X purchased a machine for his business paying ` 5,00,000 out of ` 7,00,000 invested by him. He also paid transportation expenses and installation charges amounting to ` 70,000. If he is still willing to continue the business, his financial position will be as follows:

Balance Sheet (Rs in ‘000)LiabilityCapital

` 7,00

7,00

Assets MachineryCash

` 5,70 1,307,00

Now if he decides to back out and desires to sell the machine, it may fetch more than or less than` 5,70,000. So his financial position should be different. If going concern concept is taken, increase/

decrease in the value of assets in the short-run is ignored. The concept indicates that assets arekept for generating benefit in future, not for immediate sale; current change in the asset value is not realisable and so it should not be counted

(g) Cost concept : By this concept, the value of an asset is to be determined on the basis of historical cost, in other words, acquisition cost. Although there are various measurement bases, accountants traditionally prefer this concept in the interests of objectivity. When a machine is acquired by paying ` 5,00,000, following cost concept the value of the machine is taken as `

5,00,000. It is highly objective and free from all bias. Other measurement bases are not so objective. Current cost of an asset is not easily determinable. If the asset is purchased on 1.1.1995 and such model is not available in the market, it becomes difficult to determine which model is the appropriate equivalent to the existing one. Similarly, unless the machine is actually sold, realisable value will give only a hypothetical figure. Lastly, present value base is highly subjective because to know the value of the asset one has to chase the uncertain future.

However, the cost concept creates a lot of distortion too as outlined below :(a) In an inflationary situation when prices of all commodities go up on an average, acquisition cost loses its relevance. For example, a piece of land purchased on 1.1.1995 for ` 2,000 may cost ` 1,00,000 as on 1.1.2011. So if the accountant makes valuation of asset at historical cost, the accounts will not reflect the true position.(b) Historical cost-based accounts may lose comparability. Mr. X invested ` 1,00,000 in a machine on 1.1.1995 which produces ` 50,000 cash inflow during the year 2011, while Mr. Y invested` 5,00,000 in a machine on 1.1.2005 which produced ` 50,000 cash inflows during the year. Mr. X earned at the rate 20% while Mr. Y earned at the rate 10%. Who is more-efficient ?Since the assets are recorded at the historical cost, the results are not comparable. Obviously it is a corollary to (a).(c) Many assets do not have acquisition costs. Human assets of an enterprise are an example. The cost concept fails to recognise such asset although it is a very important asset of any organization.Many other controversial issues have arisen in financial accounting that revolves around the cost concept which will be discussed at the advanced stage. However, later on we shall see that in many circumstances, the cost convention is not followed. See conservatism concept for an example, which will be discussed later on in this unit.(h) Realisation concept : It closely follows the cost concept. Any change in value of an asset is to be recorded only when the business realises it. When an asset is recorded at its historical cost of ` 5,00,000 and even if its current cost is ` 15,00,000 such change is not counted unless there is certainty that such change will materialise.However, accountants follow a more conservative path. They try to cover all probable losses but do not count any probable gain. That is to say, if accountants anticipate decrease in value they count it, but if there is increase in value they ignore it until it is realised. Economists are highly critical about the realisation concept. According to them, this concept creates value distortion and makes accounting meaningless.Example : Mr. X purchased a piece of land on 1.1.1995 paying ` 2,000. Its current market value is` 1,02,000 on 31.12.2011. Should the accountant show the land at ` 2000 following cost concept and ignoring ` 1,00,000 value increase since it is not realised? If he does so, the financial positionwould be

Balance SheetLiability ` Asset `Capital 2,000

2,000Land 2,000

2,000

Is it not proper to show it in the following manner?

Balance SheetLiabilities ` Asset `

Capital Unrealised Gain

2,000 1,00,000 1,02,000

Land 1,02,000

1,02,000

Now-a-days the revaluation of assets has become a widely accepted practice when the change in value is of permanent nature. Accountants adjust such value change through creation of revaluation (capital) reserve.

Thus the going concern, cost concept and realization concept gives the valuation criteria.

(i) Dual aspect concept : This concept is the core of double entry book-keeping. Every transaction or event has two aspects:

(1) It increases one Asset and decreases other Asset;(2) It increases an Asset and simultaneously increases Liability; (3) It decreases one Asset, increases another Asset; (4) It decreases one Asset, decreases a LiabilityAlternatively(5) It increases one Liability, decreases other Liability; (6) It increases a Liability, increases an Asset;(7) It decreases Liability, increases other Liability; (8) It decreases Liability, decreases an Asset.

So every transaction and event has two aspects. This gives basic accounting equation :Equity (E) + Liabilities (L) = Assets (A) orEquity (E)= Assets (A) – Liabilities(L)Or, Equity + Long Term Liabilities + Current Liabilities = Fixed Assets + Current Assets Or, Equity + Long Term Liabilities = Fixed Assets + (Current Assets – Current Liabilities) Or, Equity = Fixed Assets + Working Capital – Long Term LiabilitiesWhatever is received as funds is either expended (Expenses) – Debited to Profit & Loss Account

Or Lost – Losses are transferred to Capital AccountOr saved – Shown on the Assets side of the Balance SheetTherefore, Capital + Income/Profits + Liabilities = Expenses + Net Loss + Assets Or, Capital + Income – Expenses + Net Profits = Assets – LiabilitiesSince the net profit / loss is transferred to equity, the net effect is Equity + Liabilities = Assets

(j) Conservatism : Conservatism states that the accountant should not anticipate income and should provide for all possible losses. When there are many alternative values of an asset, an accountant should choose the method which leads to the lesser value. Later on we shall see that the golden rule of current assets valuation - ‘cost or market price’ whichever is lower originated from this concept.

The Realisation Concept also states that no change should be counted unless it has materialised. The Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain but it is desirable to guard against all possible losses.For this concept there should be atleast three qualitative characteristics of financial statements, namely,(i) Prudence, i.e., judgement about the possible future losses which are to be guarded, as well as gains which are uncertain.(ii) Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as well as to exclude uncertain gains,

(iii) Faithful representation of alternative values.Many accounting authors, however, are of the view that conservatism essentially leads to understatement of income and wealth and it should not be the basis for the preparation of financial statements.(k) Consistency : In order to achieve comparability of the financial statements of an enterprise through time, the accounting policies are followed consistently from one period to another; a change in an accounting policy is made only in certain exceptional circumstances.The concept of consistency is applied particularly when alternative methods of accounting are equally acceptable. For example a company may adopt any of several methods of depreciation such as written-down-value method, straight-line method, etc. Likewise there are many methods for valuation of inventories. But following the principle of consistency it is advisable that the company should follow consistently over years the same method of depreciation or the same method of valuation of Inventories which is chosen. However in some cases though there is no inconsistency, they may seem to be inconsistent apparently. In case of valuation of Inventories if the company applies the principle ‘at cost or market price whichever is lower’ and if this principle accordingly results in the valuation of Inventories in one year at cost price and the market price in the other year, there is no inconsistency here. It is only an application of the principle.But the concept of consistency does not imply non-flexibility as not to allow the introduction of improved method of accounting.

An enterprise should change its accounting policy in any of the following circumstances only: a. To bring the books of accounts in accordance with the issued Accounting Standards.b. To compliance with the provision of law.

c. When under changed circumstances it is felt that new method will reflect more true and fair picture in the financial statement.

(l) Materiality: Materiality principle permits other concepts to be ignored, if the effect is not considered material. This principle is an exception of full disclosure principle. According to materiality principle, all the items having significant economic effect on the business of the enterprise should be disclosed in the financial statements and any insignificant item which will only increase the work of the accountant but will not be relevant to the users’ need should not be disclosed in the financial statements

The term materiality is the subjective term. It is on the judgement, common sense and discretion of the accountant that which item is material and which is not. For example stationary purchased by the organization though not used fully in the accounting year purchased still shown as an expense of that year because of the materiality concept. Similarly depreciation on small items like books, calculators etc. is taken as 100% in the year of purchase though used by the company for more than a year. This is because the amount of books or calculator is very small to be shown in the balance sheet though it is the asset of the company

The materiality depends not only upon the amount of the item but also upon the size of the business, nature and level of information, level of the person making the decision etc. Moreover an item material to one person may be immaterial to another person. What is important is that omission of any information should not impair the decision-making of various usersFundamental Accounting AssumptionsThere are three fundamental accounting assumptions :(i) Going Concern (ii) Consistency(iii) AccrualAll the above three fundamental accounting assumptions have already been explained in this unit.If nothing has been written about the fundamental accounting assumption in the financial statements then it is assumed that they have already been followed in their preparation of financial statements. However, if any of the above mentioned fundamental accounting assumption is not followed then this fact should be specifically disclosed

Financial StatementsThe aim of accounting is to keep systematic records to ascertain financial performance and financial position of an entity and to communicate the relevant financial information to the interested user groups. The financial statements are basic means through which the management of an entity makes public communication of the financial information along with selected quantitative details. They are structured financial representations of the financial position and the performance of an enterprise. To have a record of all business transactions and also to determine whether all these transactions resulted in either ‘profit or loss’ for the period, all the entities will prepare financial statements viz., balance sheet, profit and loss account, cash flow statement etc. by following various accounting concepts, principles, and conventions which have been already discussed.

ACCOUNTING PROCESS

By this time, you must have understood that accounting is the process of identifying, measuring, recording, classifying, summarising, analysing, interpreting and communicating the financial transactions and events. Accounting helps in keeping systematic records to ascertain

financial performance and financial position of an entity and to communicate the relevant financial information to the interested user groups. Transactions and events recorded by suitable account headings are analysed in term of debit and credit; and thus assets become equal to equity and liabilities. Accounts are classified as personal, real and nominal types. Transactions and events are first journalised, then posted to suitable ledgers accounts and all accounts are balanced at the end of year. Generally balances of the nominal accounts are transferred to profit and loss account for determination of profit or loss and balance of personal and real accounts are carried to balance sheet.

The process of accounting, depicting how information flows from the source documents up to the stage where final accounts are prepared, can be shown as:

Source Documents

Book of Original Entry

Ledger Accounts

Trial Balance

Final Accounts

Represents all documents in business which contains financial records and act as evidence of the transactions which have taken place.

These are books which are used in recording the transactions for the first time. The books are maintained for memorandum purpose only and will not form part of the double entry system. Examples include; Purchase day book, Cash book, Sales day book and purchases return day book

These form part of double entry system and used to record the transactions for the period. These are accounts where information relating to a particular asset, liability, capital, income and expenses are recorded.

Contains the totals from various ledger accounts and act as a preliminary check on accounts before producing final accounts.

Financial Statements are produced to show the financial performance and financial position of a business entity.

Double entry system:Double entry system of book-keeping has emerged in the process of evolution of various accounting techniques. It is the only scientific system of accounting. According to it, every transaction has two-fold aspects–debit and credit and both the aspects are to be recorded in the books of accounts. For example, if a business acquires something then either it must have been given by someone or it must have been acquired by giving up something. On purchase of furniture either the cash balance will be reduced or a liability to the supplier will arise. This has been made clear already, the Double Entry System is so named since it records both the aspects. We may define the Double Entry System as the system which recognises and records both the aspects of transactions. This system has proved to be systematic and has been found of great use for recording the financial affairs for all institutions requiring use of money.

ACCOUNTS:We have seen how the accounting equation becomes true in all cases. A person starts his business with say, Rs. 10,000; capital and cash are both Rs. 10,000. Transactions entered into by the firm will alter the cash balance in two ways, one will increase the cash balance and other

will reduce it. Payment for goods purchased, for salaries and rent, etc., will reduce it; sales of goods for cash and collection from customers will increase it.We can change the cash balance with every transaction but this will be cumbersome. Instead it would be better if all the transactions that lead to an increase are recorded in one column and those that reduce the cash balance in another column; then the net result can be ascertained. If we add all increases to the opening balance of cash and then deduct the total of all decreases we shall know the closing balance. In this manner, significant information will be available relating to cashThe two columns which we reffered above are put usually in the form of an account, called the 'T' form. This is illustrated below by taking imaginary figures:

What we have done is to put the increase of cash on the left hand side and the decrease on the right hand side; the closing balance has been ascertained by deducting the total of payments, Rs. 2,000 from the total of the left - hand side. Such a treatment of receipts and payment of cash is very convenient.

The proper form of an account is as follows:ACCOUNTDr. Cr.

Date Particulars Ref. Amount Date Particulars Ref. AmountRs. Rs.

The columns are self-explanatory except that the column for reference (Ref.) is meant to indicate the sources where information about the entry is availableDEBIT & CREDIT:

We have seen that by deducting the total of liabilities from the total of assets the amount of capital is ascertained, as is indicated by the accounting equation.Assets = Liabilities + Capital orAssets – Liabilities = Capital

We have also seen that if there is any change on one side of the equation, there is bound to be similar change on the other side of the equation or amongst items covered by it. This is again illustrated below:

As has been seen previously, what has been given above is suitable only if the number of transactions is small. But if the number is large, a different procedure of putting increases and decreases in different columns will be useful and this will also yield significant information. The transactions given above are being shown below according to this method.

Total Assets = Liabilities + Owner's CapitalIncreaseRs.

DecreaseRs.

DecreaseRs.

IncreaseRs.

DecreaseRs.

IncreaseRs.

(1) 10,000 10,000(2) 5,000 5,000(3) 2,000 2,000(4) 1,000 1,000Total 15,000 3,000 1,000 5,000 2,000 10,000Balance 1 2 , 0 0 0 = 4 , 0 0 0 + 8,00 0

It is a tradition that:(i) increases in assets are recorded on the left-hand side and decreases in them on the right-hand side; and(ii) in the case of liabilities and capital, increases are recorded on the right-hand side and decreases on the left-hand side.When two sides are put together in T form, the left-hand side is called the 'debit side' and the right hand side is 'credit side'. When in an account a record is made on the debit or left-hand side, one says that one has debited that account; similary to record an amount on the right-hand side is to credit it.

From the above, the following rules can be obtained:When there is an increase in the amount of an asset, its account is debited; the account will be credited if there is a reduction in the amount of the asset concerned : Suppose a firm purchases furniture for Rs. 800, the furniture account will be debited by Rs. 800 since the asset has increased by this amount. Suppose later the firm sells furniture to the extent of Rs. 300, the reduction will be recorded by crediting the furniture account by Rs. 300.(ii) If the amount of a liability increases, the increase will be entered on the credit side of the liability account, i.e. the account will be credited : similarly, a liability account will be debited if there is a reduction in the amount of the liability. Suppose a firm borrows Rs. 500 from Mohan; Mohan's account will be credited since Rs. 500 is now owing to him. If, later, the loan is repaid, Mohan's account will be debited since the liability no longer exists.(iii) An increase in the owner's capital is recorded by crediting the capital account : Suppose the proprietor introduces additional capital, the capital account will be credited. If the owner withdraws some money, i.e., makes a drawing, the capital account will be debited.

(iv) Profit leads to an increase in the capital and a loss to reduction : According to the rule mentioned in (iii) above, profit may be directly credited to the capital account and losses may be similarly debited.However, it is more useful to record all incomes, gains, expenses and losses separately. By doing so, very useful information will be available regarding the factors which have contributed to the year's profits and losses. Later the net result of all these is ascertained and adjusted in the capital account.(v) Expenses are debited and Incomes are credited : Since incomes and gains increase capital, the rule is to credit all gains and incomes in the accounts concerned and since expenses and losses decrease capital, the rule is to debit all expenses and losses. Of course, if there is a reduction in any income or gain, the account concerned will be debited; similarly, for any reduction in an expenses or loss the concerned account will be credited.

The rules given above are summarised below:(i) Increases in assets are debits; decreases are credits; (ii) Increases in liabilities are credits; decreases are debits;(iii) Increases in owner's capital are credits; decreases are debits; (iv) Increases in expenses are debits; decreases are credits; and(v) Increases in revenue or incomes are credits; decreases are debits.The terms debit and credit should not be taken to mean, respectively, favourable and unfavourable things. They merely describe the two sides of accounts.

TRANSACTIONS:In the system of book-keeping, students can notice that transactions are recorded in the books of accounts. A transaction is a type of event, which is generally external in nature and can be determined in terms of money. In an accounting period, every business has huge number of transactions which are analysed in financial terms and then recorded individually, followed by classification and summarisation process, to know their impact on the financial statements. A transaction is a two way process in which value is transferred from one party to another. In it either a party receives a value in terms of goods etc. and passes the value in terms of money or vice versa. Therefore, one can easily make out that in a transaction, a party receives as well as passes the value to other party. For recording transaction it is very important that they are supported by a substantial document like purchasing invoices, bills, pay-slips, cash-memos, passbook etc.Transactions analysed in terms of money and supported by proper documents are recorded in the books of accounts under double entry system. To analyse the dual aspect of each transaction, two approaches can be followed:(1) Accounting Equation Approach. (2) Traditional Approach.Accounting Equation Approach.The relationship of assets with that of liabilities and owners' equity in the equation form is known as 'Accounting Equation'. Basic accounting equation comes into picture when sum total of capital and liabilities equalises assets, where assets are what the business owns and capital and liabilities are what the business owes. Under double entry system, every business transaction has two-fold effect on the business enterprise where each transaction affects changes in assets, liabilities or capital in such a way that an accounting equation is completed and equated. This accounting equation holds good at all points of time and for any number of transactions and events except when there are errors in accounting process.Let us suppose that an individual started business by contributing Rs. 5,00,000 and taking loan of Rs.1,00,000 from a bank to be repayable, after 5 years. He purchased furniture costing Rs. 1,00,000, and merchandise worth Rs. 5,00,000. For purchasing the merchandise he paid Rs.

4,00,000 to the suppliers and agreed to pay balance after 3 months. Assume that all these transactions and events occurred at to, base point of time.The contribution by the owner is termed as capital; the borrowings are termed as loans or liabilities. Whenever the loan is repayable in the short-run, say within one year, it is called short-term loan or liability. On the other hand, if the loan is repayable within 4 or 5 years or more, it would be termed as long term loan or liability.Some other short-term liabilities relating to credit purchase of merchandise are popularly called as trade creditors, and for other purchases and services received on credit as expense creditors. These short-term liabilities are also termed as current liabilities.On the other hand, money raised has been invested in two types of assets–fixed assets and current assets. Furniture is a fixed asset, if it lasts long, say more than one year, and has utility to the business, while inventory and cash balance will not remain fixed for long as soon as the business starts to roll-these are current assets.Often the owner's claim or fund in the business is called equity. Owner's claim implies capital invested plus any profit earned minus any loss sustained.

Now at to we have an equation: Equity + Liabilities = Assetsor, Equity + Long-Term Liabilities = Fixed Assets + Current Assets - Current LiabilitiesCheck : L.H.S.

Equity Rs. 5,00,000Long – Term Liabilities Rs. 1,00,000Current Liabilities R s . 1 ,00, 0 0 0

R s . 7 ,00, 0 0 0 R.H.S.

Fixed Assets:Furniture Rs. 1,00,000Current Assets:Inventory Rs. 5,00,000Cash R s . 1 ,00, 0 0 0

R s . 7 ,00, 0 0 0 Cash = Capital + Loan - Furniture - Payment to Creditors= Rs. 5,00,000 + Rs. 1,00,000 - Rs. 1,00,000 - Rs. 4,00,000 = Rs. 1,00,000EQUITY = ASSETS - LIABILITIES

Traditional A p proach

Under traditional approach of recording transactions one should first understand the term debit and credit and their rules. The term debit and credit have already been explained .Transactions in the journal are recorded on the basis of the rules of debit and credit only. For the purpose of recording, these transactions are classified in three groups:

(i) Personal transactions.(ii) Transactions related to assets and properties.

(iii) Transactions related to expenses, losses, income and gains.

CLASSIFICATION OF ACCOUNTS(i) Personal Accounts: Personal accounts relate to persons, debtors or creditors. Example would be; the account of Ram & Co., a credit customer or the account of Jhaveri & Co., a supplier of goods. The capital account is the account of the proprietor and, therefore, it is

Accounts

Personal Accounts Impersonal Accounts

Real Nominal Natural Artificial

(legal) Representative

also personal but adjustment on account of profits and losses are made in it. This account is further classified into three categories:

(a) Natural personal accounts: It relates to transactions of human beings like Ram, Rita, etc.(b) Artificial (legal) personal account: For business purpose, business entities are treated to have separate entity. They are recognised as persons in the eye of law for dealing with other persons. For example: Government, Companies (private or limited), Clubs, Co-operative societies etc.(c) Representative personal accounts: These are not in the name of any person or organisation but are represented as personal accounts. For example: outstanding liability account or prepaid account, capital account, drawings account.(ii) Impersonal Accounts: Accounts which are not personal such as machinery account, cash account, rent account etc. These can be further sub-divided as follows:

(a) Real Accounts: Accounts which relate to assets of the firm but not debt. For example, accounts regarding land, building, investment, fixed deposits etc., are real accounts. Cash in hand and Cash at the bank accounts are also real.(b) Nominal Accounts: Accounts which relate to expenses, losses, gains, revenue, etc. like salary account, interest paid account, commission received account. The net result of all the nominal accounts is reflected as profit or loss which is transferred to the capital account. Nominal accounts are, therefore, temporary.

GOLDEN RULES OF ACCOUNTINGAll the above classified accounts have two rules each, one related to Debit and one related to Credit for recording the transactions which are termed as golden rules of accounting, as transactions are recorded on the basis of double entry system.

1. Personal account is governed by the following two rules: Debit the receiverCredit the giver2. Real account is governed by the following two rules: Debit what comes in

Credit what goes out3. Nominal account is governed by the following two rules: Debit all expenses and lossesCredit all incomes and gainsJOURNAL:Transactions are first entered in this book to show which accounts should be debited and which credited. Journal is also called subsidiary book. Recording of transactions in journal is termed as journalizing the entries.

JOURNALISING PROCESSAll transactions are first recorded in the journal as and when they occur; the record is chronological; otherwise it would be difficult to maintain the records in an orderly manner. The form of the journal is given below :

JOURNAL

Date Particulars

(1) (2)

Dr. Cr. L.F. Amount Amount . Rs. Rs.(3) (4) (5)

The columns have been numbered only to make clear the following but otherwise they are not numbered. The following points should be noted

(i) In the first column the date of the transaction is entered-the year is written at the top, then the month and in the narrow part of the column the particular date is entered.(ii) In the second column, the names of the accounts involved are written; first the account to be debited, with the word "Dr" written towards the end of the column. In the next line, after leaving a little space, the name of the account to be credited is written preceded by the word "To" (the modern practice shows inclination towards omitting "Dr." and "To"). Then in the next line the explanation for the entry together with necessary details is given-this is called narration.(iii) In the third column the number of the page in the ledger on which the account is written up is entered.(iv) In the fourth column the amounts to be debited to the various accounts concerned are entered.

In the fifth column, the amount to be credited to various accounts is entered POINTS TO BE TAKEN INTO CARE WHILE RECORDING A TRANSACTION IN THE JOURNAL1. Journal entries can be single entry (i.e. one debit and one credit) or compound entry (i.e. one debit and two or more credits or two or more debits and one credit or two or more debits and credits). In such cases, it is important to check that the total of both debits and credits are equal.2. If journal entries are recorded in several pages then both the amount column of each page should be totalled and the balance should be written at the end of that page and also that the same total should be carried forward at the beginning of the next page.An entry in the journal may appear as follows: Rs. Rs. May 5 Cash Account Dr. 450

To Mohan 450(Being the amount received from Mohan in payment of the amount due from him)We will now consider some individual transactions.(i) Mohan commences business with Rs. 5,000. This means that the firm has Rs. 5,000 cash. According to the rules given above, the increase in an asset has to be debited to it. The firm also now owes Rs. 5,000 to the proprietor, Mohan as capital. The rule given above also shows that the increase in capital should be credited to it. Therefore, the journal entry will be:

Cash Account Dr. Rs. 5,000To Capital Account Rs. 5,000(Being capital introduced by Shri Mohan)

(ii) Out of the above, Rs. 500 is deposited in the bank. By this transaction the cash balance is reduced by Rs. 500 and another asset, bank account, comes into existence. Since increase in assets is debited and decrease is credited, the journal entry will be:

Bank Account Dr. Rs. 500To Cash Account Rs. 500(Being cash deposited in Bank)

(iii) Furniture is purchased for cash Rs. 200. Applying the same reasoning as above the entry will be:

Furniture Account Dr. Rs. 200To Cash Account Rs. 200(Being Furniture purchased vide CM No....)

(iv) Purchased goods for cash Rs. 400. The student can see that the required entry is:Purchases Account Dr. Rs. 400To Cash Account Rs. 400(Being goods purchased vide CM No....)

(v) Purchased goods for Rs. 1,000 credit from M/s.Ram Narain Bros. Purchase of merchandise is an expense item so it is to be debited. Rs. 1,000 is now owing to the supplier; his account should therefore be credited, since the amount of liabilities has increased. The entry will be:

(vi) Sold goods to M/S Ram & Co. for cash Rs. 600. The amount of cash increases and

Purchases Account Dr. Rs. 1,000To M/s Ram Narain Bros. Rs.

1,000(Being goods purchased vide Bill No.....)

therefore, the cash amount should be debited; sale of merchandise is revenue item so it is to be credited. The entry will be:

Cash Account Dr. Rs. 600To Sales Account Rs. 600(Being goods sold vide CM No....)

(vii) Sold goods to Ramesh on credit for Rs. 300. The stock of goods has decreased and therefore, the goods account has to be credited. Ramesh now owes Rs. 300; that is an asset and therefore, Ramesh should be debited. The entry is:

Ramesh Dr. Rs. 300To Sales Account Rs. 300(Being goods sold vide Bill No....)

(viii)Received cash from Ramesh Rs. 300. The amount of cash increased therefore the cash account has to be debited. Ramesh no longer owes any amount to the firm, i.e., this particular form of assets has disappeared; therefore, the account of Ramesh should be credited. The entry is:

Cash Account Dr. Rs. 300To Ramesh Rs. 300(Being cash received against Bill No....)

(ix) Paid to M/s Ram Narain Bros. Rs. 1,000. The liability to M/S Ram Narain Bros. has been discharged; therefore this account should be debited. The cash balance has decreased and, therefore, the cash account has to be credited. The entry is:

M/S Ram Narain Bros. Dr. Rs. 1,000To Cash Account Rs. 1,000(Being cash paid against Bill No....)

(x) Paid rent Rs. 100. The cash balance has decreased and therefore, the cash account should be credited. No asset has come into existence because of the payment; the payment is for services enjoyed and is an expense. Expenses are debited. Therefore, the entry should be:

Rent Account Dr. Rs. 100To Cash Account Rs. 100(Being rent paid for the month of .......)

(xi) Paid Rs. 200 to the clerk as salary. Applying the reasons given in (x) above, the required entry is:

Salary Account Dr. Rs. 200To Cash Account Rs. 200(Being salary paid to Mr..... for the month of ...........)

(xii) Received Rs. 20 interest. The cash account should be debited since there is an increase in the

cash balance. There is no increase in any liability; since the amount is not returnable to any one, the amount is an income, incomes are credited. The entry is :

Cash Account Dr. Rs. 20To Interest Account Rs. 20(Being interest received from........ for the period ............)

When transactions of similar nature take place on the same date, they may be combined while they are journalised. For example, entries (x) and (xi) may be combined as follows:

Rent Account Dr. Rs. 100Salary Account Dr. Rs. 200To Cash Account(Being expenses done as per detail attached)

Rs. 300

When journal entry for two or more transactions are combined, it is called composite journal entry. Usually, the transactions in a firm are so numerous that to record the transactions for a month will require many pages in the journal. At the bottom of one page the totals of the two columns are written together with the words "Carried forward" in the particulars column. The next page is started with the respective totals in the two columns with the words "Brought forward" in the particulars column.

Analyse transactions of M/S Sahil & Co. for the month of March, 2014 on the basis of double entry system by adopting the following approaches:

(A) Accounting Equation Approach. (B) Traditional Approach.Transactions for the month of March, 2014 were as follows: 1. Sahil introduced cash Rs. 40,000. 2. Cash deposited in the City Bank Rs. 20,000. 3. Cash loan of Rs. 5,000 taken from Mr. Y.4. Salaries paid for the month of March, 2006, Rs. 3,000 and Rs. 1,000 is still payable for the month of March, 2014.

5. Furniture purchased Rs. 5,000.What conclusions one can draw from the above analysis? Solution

(A) Analysis of Business Transaction: Accounting Equation Approach

Transaction Analysis Account Affected and Nature of Account

Rule Entry

Introduction of Rs. 40,000 cash by the Proprietor

Cash received Investmentby owner

Cash – Asset

Capital – Capital

Debit increase in asset

Credit increase in capital

Debit Cash

Credit Capital

Cash deposited

in bank Rs. 20,000

Bank balance increases

Cash balance decrease

Bank – Asset

Cash – Asset

Debit increase in asset

Credit decrease in asset

Debit Bank

Credit Cash

Loan from Y Rs. 5,000

Cash balance increasesCreates an obligation to repay Y

Cash – Asset

Y's Loan Liability

Debit increase in assetsCredit increase in liabilities

Debit Cash

Credit Y's Loan

Salaries paid Rs. 3,000 and outstanding Rs. 1,000

Salaries for services received Rs. 4,000paid Rs. 3,000 Obligation to pay Rs. 1,000

Salary Temporary capital (Expense) Cash–Asset

Salaries outstanding Liability

Debit increase in expenses

Credit decrease in assetCredit increase in liabilities

Debit Salary (Rs. 4,000)

Credit Cash (Rs. 3,000) Credit Salaries outstanding (Rs. 1,000)

Furniture purchased Rs. 5,000

Increases furniture owned Cash decreases

Furniture–Asset

Cash–Asset

Debit increase in assetCredit decrease in asset

Debit Furniture

Credit Cash

(B) Analysis of Business Transactions: Traditional Approach

Transaction Analysis Account Affected and Nature of Account

Rule Entry

Introduction of Rs. 40,000 cash by the proprietor

Cash is received by business Owner has given cash

Cash–Real

Capital–Personal

Debit what comes inCredit the giver

Debit Cash

Credit Capital

Cash deposited in bankRs. 20,000

Bank receives cashCash goes out of business

Bank–Personal

Cash–Real

Debit the receiver

Credit what goes out

Debit Bank

Credit CashLoan from Y Rs. 5,000

Business gets cash Y pays cash

Cash–RealY's Loan–Personal

Debit what comes inCredit the giver

Debit Cash

Credit Y's Loan

Salary paid Rs. 3,000 and still payable Rs. 1,000

Cost of services used Rs. 4,000 Cash goes out Rs. 3,000Still payable or outstanding for services received Rs. 1,000

Salary Nominal

Cash–Real

Salary Outstanding Personal

Debit all expenses

Credit what goes out

Credit the giver

Debit Salary (Rs. 4,000) Credit Cash(Rs. 3,000)Credit Salary outstanding (Rs. 1,000)

Furniture purchased Rs. 5,000

Furniture is purchased Cash is paid

Furniture Real

Cash–Real

Debit what comes in Credit what goes out

Debit Furniture

Credit CashConclusion:It is evident from above analysis that procedure for analysis of transactions, classification of accounts and rules for recording business transactions under accounting equation approach and traditional approach are different. But the accounts affected and entries in affected accounts remain same under both approaches. Thus, the recording of transactions in affected accounts on the basis of double entry system is independent of the method of analysis followed by a business enterprise. In other words, accounts to be debited and credited to record the dual aspect remain same under both the approaches.

Ledgers

INTRODUCTIONAfter recording the transactions in the journal, recorded entries are classified and grouped into by preparation of accounts and the book, which contains all set of accounts (viz. personal, real and nominal accounts), is known as Ledger. It is known as principal books of account in which account-wise balance of each account is determinedledger account SpecimenA ledger account has two sides-debit (left part of the account) and credit (right part of the account). Each of the debit and credit side has four columns. (i) Date (ii) Particulars (iii) Journal folio i.e. page from where the entries are taken for posting and (iv) Amount.

Dr. Account Cr.

Date Particulars J.F. Amount (Rs). Date Particulars J.F. Amount (Rs.)

POSTING:The process of transferring the debit and credit items from journal to classified accounts in the ledger is known as posting.

RULES REGARDING POSTING OF ENTRIES IN THE LEDGER1. Separate account is opened in ledger book for each account and entries from ledger posted to respective account accordingly.2. It is a practice to use words 'To' and 'By' while posting transactions in the ledger. The word 'To' is used in the particular column with the accounts written on the debit side while 'By' is

used with the accounts written in the particular column of the credit side. These 'To' and 'By' do not have any meanings but are used to represent the account debited and credited.3. The concerned account debited in the journal should also be debited in the ledger but reference should be of the respective credit account. For example: Rent paid by cash Rs. 500. The journal entry for this transaction would be.

BALANCING AN ACCOUNT:At the end of the each month or year or any particular day it may be necessary to ascertain the balance in an account. This is not a too difficult thing to do; suppose a person has bought goods worth Rs. 1,000 and has paid only Rs. 850; he owes Rs. 150 and that is balance in his account. To ascertain the balance in any account, what is done is to total the sides and ascertain the difference; the difference is the balance. If the credit side is bigger than the debit side, it is a credit balance. In the other case it is a debit balance. The credit balance is written on the debit side as, "To Balance c/d"; c/d means "carried down". By doing this, two sides will be equal. The totals are written on the two sides opposite one another.Then the credit balance is written on the credit side as "By balance b/d (i.e., brought down)". This is the opening balance for the new period. The debit balance similarly is written on the credit side as "By Balance c/d", the totals then are written on the two sides as shown above as then the debit balance written on the debit side as, "To Balance b/d", as the opening balance of the new period.It should be noted that nominal accounts are not balanced; the balance in the end are transferred to the profit and loss account. Only personal and real accounts ultimately show balances. In the illustration given above, one will have noticed that the capital account, the purchases account, sales account, the discount account, the rent account and the salary account have not been balanced. The capital account will have to be adjusted for profit or loss and that is why it has not been balanced yet.

Trial Balance

INTRODUCTIONPreparation of trial balance is the third phase in the accounting process. After posting the accounts in the ledger, a statement is prepared to show separately the debit and credit balances. Such a statement is known as the trial balance. It may also be prepared by listing each and every account and entering in separate columns the totals of the debit and credit sides. Whichever way it is prepared, the totals of the two columns should agree. An agreement indicates reasonable accuracy of the accounting work; if the two sides do not agree, then there is simply an arithmetic error(s).This follows from the fact that under the Double Entry System, the amount written on the debit sides of various accounts is always equal to the amounts entered on the credit sides of other accounts and vice versa. Hence the totals of the debit sides must be equal to the totals of the credit sides. Also total of the debit balances will be equal to the total of the credit balances. Once this agreement is established, there is reasonable confidence that the accounting work is free from clerical errors, though is not proof of cent per cent accuracy, because some errors of principle and compensating errors may still remain. Generally, to check the arithmetic accuracy of accounts, trial balance is prepared at monthly intervals. But because double entry system is followed, one can prepare a trial balance any time. Though a trial balance can be prepared any time but it is preferable to prepare it at the end of the accounting year to ensure the arithmetic accuracy of all the accounts before the preparation of the financial statements. It may be noted that trial balance is a statement and not an account.

Objectives of TBThe preparation of trial balance has the following objectives:(i) Trial balance enables one to establish whether the posting and other accounting processes have been carried out without committing arithmetical errors. In other words, the trial balance helps to establish arithmetical accuracy of the books.

(ii) Financial statements are normally prepared on the basic of agreed trial balance; otherwise the work may be cumbersome. Preparation of financial statements, therefore, is the second objective.The trial balance serves as a summary of what is contained in the ledger; the ledger may have to be seen only when details are required in respect of an account.The under mentioned points may be noted:(i) A trial balance is prepared as on a particular date which should be mentioned at the top (ii) In the second column the name of the account is written.(iii) In the fourth column the total of the debit side of the account concerned or the debit balance, if any is entered.

(iv) In the next column, the total of the credit side or the credit balance is written. (v) The two columns are totalled at the end.The first and third column needs no explanation.METHODS OF PREPARING TB1. TOTAL METHODUnder this method, every ledger account is totaled and that total amount (both of debit side and credit side) is transferred to trial balance. In this method, trial balance can be prepared as soon as ledger account is totaled. Time taken to balance the ledger accounts is saved under this method as balance can be found out in the trial balance itself. The difference of totals of each ledger account is the balance of that particular account. This method is not commonly used as it cannot help in the preparation of the financial statements.2. BALANCE METHODUnder this method, every ledger account is balanced and those balances only are carry forward to the trial balance. This method is used commonly by the accountants and helps in the preparation of the financial statements. Financial statements are prepared on the basis of the balances of the ledger accounts.3.TOTAL AND BALANCE METHODUnder this method, the above two explained methods are combined. Under this method statement of trial balance contains seven columns instead of five columns

TRIAL BALANCEThe form of the trial balance is simple as shown below:

T B as at.......................S. No Ledger Accounts L.F. Dr. Amount (Total or Balance) Rs.

Cr. Amount (Total or Balance)Rs.

FINAL ACCOUNTSTrial balance proves the arithmetical accuracy of the business transactions, but it is not the end. The businessman is interested in knowing whether the business has resulted in profit or loss and what the financial position of the business is at a given period. In short, he wants to know the profitability and the financial soundness of the business. The trader can ascertain these by preparing the final accounts. The

final accounts are prepared at the end of the year from the trial balance. Hence the trial balance is said to be the connecting link between the ledger accounts and the final accounts

Parts of Final Accounts The final accounts of business concern generally includes 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 AccountTrading means buying and selling. The trading account shows the result of buying and selling of goodsAt 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.Items appearing in the debit side1. Opening stock: Stock on hand at the begining 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 of 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 expensesItems appearing in the credit sideSales: This includes both cash and credit sale made during the year. Net sales 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).BalancingThe 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 thetotal of the debit side is more, the difference represents Gross Loss. The Gross Profit or Gross Loss is transferred to Profit & Loss Account.

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 andmanufacturing 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.BalancingThe 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 andproperties) 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 financialposition 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 businessii. To ascertain the total liabilities of the business.iii. To know the position of owner’s equity. FormatThe Balance sheet of a business concern can be presented in thefollowing two formsi. Horizontal form or the Account formii. Vertical form or Report form

i) Horizontal form of Balance Sheet:The right hand side of the balance sheet is asset side and the left hand side is liabilities side. All accounts having debit balance will appear in the asset side and all those having credit balance will appear in the liability side.ii) Vertical form of Balance SheetIn this, Balance Sheet is presented in a statement form.

Classification of Assets and LiabilitiesAssetsAssets represents everything which a business owns and has money value. In other words, asset includes possessions and properties of the business. Asset are classified as follows:Tangible Intangible FictitiousFixed Currenta) 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 intoi. 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 is known as current assets.This is also termed as floating assets. For example, cash in hand, cash at bank, sundry debtors etc.b) Intangible AssetsThe 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 AssetsThese 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.LiabilitiesThe amount which a business owes to others is liabilities. Credit balance of personal and real accounts together with the capital account are liabilities.Long TermCurrent Contigenta) Long Term LiabilitiesLiabilities which are repayable after a long period of time are known as Long Term Liabilities. For example, capital, long term loans etc.b) Current LiabilitiesCurrent liabilities are those which are repayable within a year. For example, creditors for goods purchased, short term loans etc.c) Contingent liabilitiesIt is an anticipated liability which may or may not arise in future. For example, liability arising for bills discounted. Contigent liabilities will not appear in the balance sheet. But shown as foot note

Marshalling of Assets and LiabilitiesThe 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 liquidityLiquidity means convertability 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 permanenceThis order is exactly the reverse of the above. Assets and liabilities are recorded in the order of their life in the business concern. Balance Sheet EquationAn 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 + CapitalorCapital = Assets - LiabilitiesWhile 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 the asset side. In case itshows a credit balance it will appear as the last item in the liability side.

Adjustments

Some important and common items, which need to be adjustedat the time of preparing the final accounts are discussed below.1. Closing stock2. Outstanding expenses3. Prepaid Expenses4. Accrued incomes5. Incomes received in advance6. Interest on capital 7. Interest on drawings8. Interest on loan9. Interest on investment10. Depreciation11. Bad Debts12. Provision for bad and doubtful debts13. Provision for discount on debtors14. Provision for discount on creditors.Note : All adjustments are given outside the trial balance.

Banking Financial StatementMeaning of BankingBanks are vital to business and may be likened to the heart in a human being, circulating money through the economy.

Banks in India and their activities are regulated by the Banking Regulation Act, 1949. Banking :

Under Section 5(b) of the said Act “Banking” means,

Accepting deposits of money from public for the purpose of lending

These deposits are repayable on demand and can be withdrawn by cheque, draft or otherwise

Banking Company: Any bank which transacts this business as stated in section 5 (b) of the act in India is called a banking company. However merely accepting public deposits by a company for financing its own business shall not make it a bank. It may be mentioned that the Banking Regulation Act, 1949 is not applicable to a primary agricultural society, a co-operative land mortgage bank and any other co-operative society.Accounts

Sections 29 to 34A of the Banking Regulation Act deal with accounts and audit. At the end of each financial year every banking company incorporated in India in respect of business transacted by it shall prepare with reference to that year or period, a Balance Sheet (Form A) and Profit and Loss Account (Form B) as on the last working day of that year or the period in the forms set out in the Third Schedule of Banking Regulation Act.

Similarly, every banking company incorporated outside India is required to prepare Balance Sheet and Profit and Loss Account in respect of all business transacted through its branches in India..

The statement of accounts must be signed by the manager or principal officer and by at least three directors or all directors if there are not more than three directors in case of a banking company incorporated in India. In case of a banking company incorporated outside India, the statement of accounts must be signed by the manager or agent of the principal office of the company in India.

Under Section 30 of the Banking Regulation Act, the Balance Sheet and Profit and Loss Account prepared in accordance with Section 29 shall be audited by a person duly qualified under any law for the time being in force to be an auditor of companies. Every banking company is required to take previous approval of the Reserve Bank of India before appointing, re-appointing or removing any auditor or auditors. In addition, the Reserve Bank can order special audit of the banking companies accounts if it thinks fit in the public interest of the banking company or its depositors. Main Characteristics of a Bank’s Book-Keeping SystemThe book-keeping system of a banking company is substantially different from that of a trading or manufacturing enterprise. A bank maintains a large number of accounts of various types for its customers. As a safeguard against any payment being made in the account of a customer in excess of the amount standing to his credit or a cheque of a customer being dishonoured due to a mistake in the balance in his account, it is necessary that customers’ accounts should be kept up-to-date and checked regularly. In many other mercantile enterprises, books of primary entry (i.e., day books) are generally kept up-to- date while their ledgers including the general ledger and subsidiary ledgers for debtors, creditors etc. are written afterwards. However a bank cannot afford to ignore its ledgers, particularly those concerning the accounts of its customers and has to enter into the ledgers every transactions as soon as it takes place.

In bank accounting, relatively less emphasis is placed on day books. These are merely treated as a means to an end-the end being to keep up-to-date detailed ledgers and to balance the trial balance everyday and to keep all control accounts in agreement with the detailed ledgers.

Presently most if not all of the Banks' accounting is done on Core Banking Solutions (CBS) wherein all accounts are maintained on huge servers with posting being effected instantly through vouchers, debit cards, internet banking etc.

The main characteristics of a bank’s system of book-keeping are as follows:

(a) Voucher posting – Vouchers are nothing but loose leaves of journals or cash books on which transactions are recorded as they occur. Entries in the personal ledger are made directly from vouchers instead of being posted from the books of prime entry.(b) Voucher summary sheets - The vouchers entered into different personal ledgers each day are summarised on summary sheets, totals of which are posted to the control accounts in the general ledger. (c) Daily trial balance - The general ledger trial balance is extracted and agreed every- day.(d) Continuous checks - All entries in the detailed personal ledgers and summary sheets are checked by persons other than those who have made the entries. A considerable force of such check is employed, with the general result that most clerical mistakes are detected before another day begins.(e) Control Accounts - A trial balance of the detailed personal ledgers is prepared periodically, usually every two weeks, agreed with general ledger control accounts.

(f) Double voucher system - Two vouchers are prepared for every transaction not involving cash - one debit voucher and another credit voucher.Forms of Balance Sheet and Profit and Loss AccountThe Committee under the Chairmanship of Shri A. Ghosh, Deputy Governor, RBI, after due deliberation suggested suitable changes/amendments in the forms of balance sheet and profit and loss account of banks, having regard to :

1. need for better disclosure

2. expansion of banking operations both area-wise and sector-wise over the period

3. need for improving the presentation of accounts etc.

The formats are given below as specified in Banking Regulation Act in Form A of Balance Sheet, Form B of Profit and Loss Account and eighteen other schedules of which the last two relates to Notes and Accounting Policies.

Third Schedule (See Section 29) Form ‘A’

Schedule As on 31.3__(current year)

As on 31.3__(previous year)

Capital & LiabilitiesCapital 1Reserves & Surplus 2Deposits 3Borrowings 4Other liabilities and provisions 5            TotalAssetsCash and Balances with Reserve Bank of India

6

Balances with banks and money at call and short notice

7

Investments 8Advances 9Fixed Assets 10Other Assets 11            TotalContingent Liabilities Bills for Collection

12

Form of Profit & Loss Account for the year ended 31st March

I. Income Interest earnedOther income TotalII. Expenditure Interest expended Operating expensesProvisions and contingencies TotalIII. Profit/LossNet profit/loss (—) for the year Profit/Loss (—) brought forward TotalIV. AppropriationsTransfer to statutory reservesTransfer to other reserves

Schedule

13 14

1516

Year ended As on 31.3....(Current year)

(’000 omitted) Year ended As

on 31.3....(Previous year)

Liabilities Side of Balance Sheet of a Bank 

Schedule 1 : Capital of a Bank

We have to show paid up capital of bank. If bank is incorporated outside India, then its start up capital will be shown under this schedule in balance sheet's liabilities side.

Schedule 2 : Reserves and Surplus

a) Statutory  reserveb) Capital reservec) Share premiumd) Revenue and other reservee) balance of profit and loss account

Schedule 3 : Deposits 

Deposits of customers in bank will be the liability of bank. This liability will be classified in saving banks deposit, term deposits, demand deposits.

Schedule 4 : Borrowing 

Sometime bank takes loan from RBI or other banks. All these borrowings are the liabilities of bank.

Schedule 5 : Other Liabilities and Provisions 

In these liabilities, we can include bill payable, outstanding interest and provision for taxes.

Assets Side of Balance Sheet of a Bank

Schedule 6 : Cash and Balance with RBI

RBI has made rule of depositing some money with him. So, cash and balance with RBI will be the asset of a bank.

Schedule 7 : Balance with Banks and Money at Call and Short Notice

Above schedule 3 is deposit liability. But some of these deposit bank keeps in his pocket in cash form or money at call or short notice. So, this is the asset of bank.

Schedule 8 : Investment 

Bank is not doing social activities. It is doing business. Most of his deposit is invested in good and profitable schemes. All investment of bank will be the asset of bank. It will be shown under schedule 8. In investment of bank, we can include investment in govt. securities, investment in shares, bonds, debentures and investment in subsidiaries.

Schedule 9 : Advances 

Bank gives advance to other banks in the form of cash credit, bank overdraft and loan payable on demand. All these advances are the assets of a bank and will be shown under schedule 9 in the asset side of balance sheet of a bank.

Schedule 10 :  Fixed Assets

Banks all branch offices building and land will be part of its fixed asset, if these are own of bank. Bank may have other fixed assets like furniture, fixtures, equipment, computers and ATM Machines. All addition in it will add in the opening balance of fixed asset. All deduction will deduct from the balance of fixed asset. We deduct depreciation of each fixed asset except land.

Schedule 11 : Other Assets

In other assets, we can show stock of stationery and stamps, tax paid in advance, interest receivables, and bills for collections.

PROFIT & LOSS ACCOUNT-BANK

Interest earned13 I. Interest/discount on

advances/bills

II. Income on Investments

III. Interest on balances with Reserve Bank of India and other

Interbank fundsIV. Others

Includes interest and discount on all types of loans and advances like cash credit, demand loans, overdraft, export loans, term loans, domestic and foreign bills purchased and discounted (including those rediscounted), overdue, interest and also interest subsidy, if any, relating to such advances/bills.Includes all income derived from the investment portfolio by way of interest and dividendIncludes interest on balances with Reserve Bank and other banks, call loans, money market placements, etc.

Includes any other interest/discount income not included in above heads.

Other Income 14 I. Commission, exchange and brokerage

II. Profit on sale of investments Less Loss on sale of investments

III. Profit on revaluation of investments Less: Loss on

revaluation of

Includes all remuneration on services such as commission on collections, commission/exchange on remittances and transfers, commission on letter of credit and guarantees, commission on Government business commission on other permitted agency business including consultancy and other services, broke-rage, etc. on securities. It does not include foreign exchange income.Includes profit/loss on sale of securities, furniture land and buildings, motor of vehicle, gold, silver etc.. Only the net position should be shown. If the net position is a loss, the amount should be shown as deduction.The net profit/loss on revaluation of assets may also be shown under this item.

IV. Profit on sale of land, building and other assets Less : Loss on sale of land, buildings and other assetsV. Profit on exchange transactions Less : Loss on exchange transactionsVI. Income earned by way of dividends

etc. from subsidiaries, companies and/or joint ventures abroad/in IndiaVII. Miscellaneous income

Includes profit/loss on dealing in foreign exchange all income earned by way of foreign exchange commission and charges on foreign exchange, transactions excluding interest which will be shown under interest. Only the net position should be shown. If the net position is a loss, it is to be shown as a deduction.

Includes recoveries from constituents for the godown rents, income from bank’s properties, security charges, insurance etc. and any other miscellaneous income. In case any item under this head exceeds one percentage of the total income, particulars may be given in the notes.

Interest Expended 15 I. Interest on deposits

II. Interest on Reserve Bank ofIndia/inter-bank borrowings

III. Others

Includes interest paid on all types of deposits including deposits from banks and others institutions.Includes discount/interest on all borrowings and refinance from Reserve Bank of India and other banks.Includes discount / interest on all borrowings/refinance from financial institutions. All otherpayments like interest on participation certificates, penal interest paid, etc. may also be included here.

Operating expenses 16 I. Payments to and Provisions for employees

II. Rent, taxes and lighting

Includes staff salaries / wages, allowances, bonus, other staff benefits like provident fund, pension, gratuity liveries to staff, leave fare concessions, staff welfare, medical allowance to staff etc.Includes rent paid by the banks on building and other municipal and other taxes paid (excluding income tax and interest tax) electricity and other similar charges and levies. House rent allowance and othersimilar payments to staff should appear

III. Printing and Stationery

IV. Advertisement and publicity

V. Depreciation on Bank’s property

VI. Directors’ fees, allowances and expenses

VII. Auditors’ fees and expenses (including branch auditors’ fees and expenses)

VIII. Law charges

IX. Postage, telegrams, telephones, etc.X. Repairs andmaintenance

under the head ‘Payments to and provisions for employees’.Includes books and forms and stationery used by the bank and other printing charges which are not incurred by way of publicity expenditure.Includes expenditure incurred by the bank for advertisement and publicity purposes including printing charges of publicity matter.Includes depreciation on bank’s own property: motor cars and other vehicles, furniture, electric fittings,

vaults, lifts, leasehold properties, non banking assets, etc.Includes sitting fees and all other items of expenditure incurred on behalf of directors. The daily allowances, hotel charges, conveyance charges, etc. which though in the nature of reimbursement of expenses incurred may be included under this head. Similar expenses of local Committee members may also be included under this head.Includes fees paid to the statutory auditors and branch auditors for professional services rendered and all expenses for performing their duties, even though they may be in the nature of reimbursement of expenses. If external auditors have been appointed by banks themselves for internal inspections and audits and other services the expenses incurred in that context including fees may not be included under this head but shown under ‘other expenditure’.All legal expenses and reimbursement of expenses incurred in connection with legal services are to be included here.Includes all postal charges like stamps, tele-gram, telephones, teleprinter, etc.Includes repairs to banks’ property, their maintenance charges, etc..

Provisions and contingencies

Treatment of accumulated losses

XI. Insurance

XII. Other expenditure

Includes insurance charges on bank’s property, insurance premium paid to DepositInsurance & Credit Guarantee Corporation, etc. to the extent they are not recovered from the concerned parties.All expenses other than those not included in any of the other heads like, licence fees, donations, subscriptions to papers, periodicals, entertainment expenses, travel expenses, etc. may be included under this head. In case any particular item under this head exceeds one percentage of the total income particulars may be given in the notes.Includes all provisions made for bad and doubtful debts, provisions for taxation, provisions for diminution in the value of investments, transfers to contingencies and other similar items.While preparing the Balance Sheet and Profit and Loss Account accumulated losses should be brought forward under Item III or Form “B” before appropriation of the balance profit made.