The Best Accounting Notes

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ACCOUNTING FOR

ENTREPRENEURS

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Introduction

Meaning of Accounting

Definition

Bookkeeping

- Objectives of Book Keeping

- Difference between Book Keeping and Accounting

Objectives of Accounting

Branches of Accounting

Advantages of Accounting

Limitations of Accounting

Users of Accounting Information

- Internal Users

- External Users

Basic Accounting Terms

Accounting as a Science or an ArtRole of Accounting

MODEL QUESTIONS

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UNIT -


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Unit I Accounting AnInt roduct ion

ACCOUNTING AN INTRODUCTION

Introduction :

uman beings cant remember everything. They need a systematic

system to record the transactions. Accounting gives us a systematic

approach to record the transactions. Entrepreneurs keep their own

accounts in the beginning. As the size of business enlarges, the

entrepreneurs have to delegate the process of accounting. They have tohire professional accountants who keep systematic record of the accounts.

Thus accounting is required to execute the process of this record keeping.

It also helps the business in ascertaining its profitability and growth. .

H

In modern days, accounting is considered as the process ofkeeping of different accounts in various books. An account has differentdenotations from different points of view. From banking point of view, anaccount is an arrangement with a bank to keep money there, take someout etc.

In view of business records, an account means a written record ofmoney that is owed to a business and of money that has been paid by it inthe name of expense accounts, etc. These are the detailed records of allmoney received or paid by a business or a person.

From the viewpoint of a shop or store, we speak of credit account.It means an arrangement with a shop or store or business to pay or bepaid bills for goods or services at a later time.

In the age of computers and internets an account means anarrangement that somebody has with a company that allows them to usethe internet, send and receive messages by e-mail etc. This is called anInternet/E-mail Account.

On the whole, accounts mean the heads of accounts required tobe kept by business houses for recording these transactions andinterpreting the results periodically. More exactly speaking, accounting inthis book refers to Financial Accounting even though there are some otherbranches of accounting such as cost accounting and managementaccounting.

However, financial accounting is considered to be the father ofaccounting systems because this is based on double entry principleswhich is scientific in approach. This system is fathered by Luca Pacoli.

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Accounting An IntroductionUnit I

Meaning of Accounting:

Accounting is the process of identifying, measuring, recording andcommunicating the economic events (business transactions) of anorganization.

Definition :

Accounting has been defined by American Institute of CertifiedPublic Accountants (AICPA) as under "Accounting is the art of recording,classifying, and summarizing in a significant manner and in terms of

money, the transactions and events which are in part at least of a financialcharacter, and interpreting the results thereof."

The above definition can be analysed as under:

i. Accounting is the art of recording

ii. Accounting is the art of classifying

iii. Accounting is the art of summarising the business transactions

and events of financial characters in terms of money and non-

financial and non-monetary transactions are excluded.

iv. Interpreting the results, which may be calculation of profit or loss ofthe business for a period and determining the financial position for

the same period.

Book Keeping :

Recording commences when a business transaction occurs and ithas been quantified. Record of the transactions is made in order ofoccurrences. Recording is based on the following four fundamentalquestions:

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a) What to record

b) When to record

c) How to record

d) Value at which to record

In order to get answer to the above stated questions, it isimportant that one should master over the techniques and practice ofrecording business transactions which is known as Book-keeping.

In a nutshell, we can say that bookkeeping is an art of recordingfinancial data regarding business transactions in a significant and orderly

manner.According to J.R. Batliboi, Bookkeeping may be defined as the

science as well as an art of recording business transactions underappropriate accounts.

According to Northcott "Book-Keeping may be defined as an art ofrecording, books of accounts, the monetary aspects of commercial orfinancial transactions.

In case of a business, it is important to know how much thebusinessman was owes to outsiders and how much outsiders owe to him;

what are his expenses and what are his incomes; what amount of moneyhe has invested and how much he has received; whether he has increasedit or lost it?

All this require systematic record keeping of all that happens on aday-to-day basis in business and analysing this information to andbusiness decision making.

In simple words, "Accounting" in organisational context, merelymeans "reckoning" or "recounting" the performances / operations in asummerised form in monetary terms. Thus, the process of accountinginvolves recording, classifying and summarizing of past events andtransactions of financial nature, with a view of enabling the user ofaccounts to interpret the resulting summary.

From the above discussion, we came to understand that Accountinghas two important facts :

a) Record keeping, classification and summarisation (whichis called book-keeping)

b) Interpreting results

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Under Financial Accounting, all monetary events are recognised as"transactions" and classified into various account heads. The "account"heads are then summarised under related and significant groups so thatinterpretation becomes possible. For example, when a trader procures anitem, this event is recognised as a transaction. This transaction will berecorded under the account head 'purchases'. At the end of a specifiedperiod, all purchases and other costs associated with sales would besummarised into "cost of goods sold" figure. On comparing the cost ofgoods sold with sales, the difference can be interpreted as the profit orloss for the period.

The above discussion helps us to understand that Accounting isbroader, than bookkeeping and there is a difference between the twoterms. This will made more clear in the following lines.

Objectives of Book-keeping :

Following are the objectives of book-keeping:

1. To have a permanent record of each business transaction and to showits financial effect on the business.

2. To determine the combined effect of all the transactions on the

financial position.

Difference between Book Keeping and Accounting

Bookkeeping Accounting

Bookkeeping is a part of accounting

Accounting includes book-keeping

It is related to recordingbusiness transactions

It is related to recording,classifying, summarizingbusiness transactions and

interpreting the results.It is the basis of accounting. Itincludes journal, ledger, trialbalance.

It is the basis of businesslanguage.

It is the beginning part of anaccounting process and is calledthe root

Accounting starts where book-keeping ends and hence, it iscalled the fruit.

Book-keeping does not requireany special skill and knowledge.It can be done by machinesalso.

It requires special skills andknowledge.

It does not give completepicture of financial condition of

It gives complete informationabout financial condition of the

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the business business.

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Objectives of accounting :

The following are the various objectives of accounting.

1. Maintenance of records of business.

2. Finding out the results of business activities during a period bypreparing profit and loss account.

3. Knowing the financial position of the business as on a particulardate by preparing the balance sheet.

4. Maintaining control over the assets.

5. Supplying information to the government agencies and taxauthorities.

6. Deciding future plans in respect of cash by preparing cash budgets.

Branches of Accounting :

Accounting has the following branches:

1. Financial Accounting : This is the branch of accounting which isrelated to preparation of profit and loss account and balance sheet.

2. Cost Accounting : This is the branch of accounting which is relatedto finding out the cost of a product or job or service.

3. Management Accounting: This is the branch of accounting which isrelated to supply information to the management for the purpose ofplanning, control and decision making.

Advantages of Accounting :

1. Accounting replaces memory work because it provides completeand scientific record of business transactions.

2. It helps in determining the profitability position and financial positionof the business.

3. Accounting records are used as evidence in the court of law

4. Accounting helps in the evaluation of business to both the buyer andthe seller.

5. Accounting enables comparison of costs, profits, revenues, losses,expenses etc of the year with that of the previous years.

6. Accounting statements like profit and loss account and balancesheet are useful in getting loans from banks.

7. Accounting data help and guide the management in planning anddecision making.

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Limitations of Accounting :1. Non-monetary and non-financial events are ignored in financial

accounting.

2. Treatment of any one item may be made by more than oneprinciples which leads to lack of uniformity in accountingprocedures.

3. Personal judgment influence financial accounting which may lead tolack of uniformity and accuracy of accounts.

4. Financial accounting supplies information usually at the end of theyear . Such information may not be of any use to the management if

the management needs such information during the course of theyear.

5. Financial accounting shows financial position only but it does notdisclose the realisable value of the business.

Users of Accounting Information :

Accounting information is needed by two sets of people :

(i) Internal Users

(ii) External Users

i. Internal Users : People associated with management of thebusiness are internal users. Accounting information comes to themautomatically through reports and statements. They make analysisand interpretation of accounting data for drawing conclusions andmaking decisions.

ii. External User s : These are the people outside the business whomake use of accounting information for various reasons.

Such users are :

i. Investors

ii. Suppliers

iii. Lenders

iv. Share holders

v. Customers

vi. Govt. Agencies

vii. Employees

viii. Public

Basic Accounting Terms:

1. Assets : Assets are properties or resources owned by a businessunits which have money value and are useful for future operation of

the business.

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Example : Land, Building, Furniture, Stock, Cash Good-will,Patents, Trademark, Copy right etc.

2. Liability : Amount payable at present by the business to theoutsiders on account of past business activities is called a liability.

Example : Creditors, Bills payable, Loan, Outstanding expenses,etc.

3. Capital : It is the amount of money or money's worth invested in abusiness by its owner.

4. Drawings : The amount of money or value of goods withdrawn by

the proprietor for his personal use is called drawings.5. Transaction : It means exchange of goods or services for cash or

on credit.

6. Event : An even is a happening of consequence(s) to an entity. Itmay be an internal happening or external incident.

6. Entry :Record of a transaction in journal or ledger is called entry.

7. Entity : It refers to the business which is separatelyidentified/recognized from its owner.

8. Entrepreneur: He is a person who starts a business, bears all itsrisks and takes all its gains. He is also known as the owner orproprietor of the business.

9. Net-worth : Net-worth is the excess of assets over liabilities. It is theclaim of the owner against the assets of the firm. It is also known asowner's equity.

10. Business : Business is doing any trade or commerce by investingcapital with an object to make profit from sale of goods or services.

11. Revenues : Revenues are the amount which a business earns byselling its products or services to the customers.

12. Expenses : Expenses are the amount spent by a business in theprocess of obtaining revenues . It is an outflow of economic benefitsresulting in decrease in equity.

13. Loss : When expenses fail to produce any revenue, we call themlosses. The excess of expenses over revenue is also called loss.

14. Profit : It is the excess of revenue over the expenses during anaccounting year. It increases owner's equity.

15. Income : Income is the increase in the wealth of the firm during agiven period of time. It includes profit also. It is an inflow of

economic benefits resulting in increase in equity.

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16. Closing stock : It is the value of unsold goods on hand at the endof the accounting year.

17. Opening stock : The closing stock of the previous year which isavailable for sale at the beginning of the current year is calledopening stock.

18. Purchase : The total amount of goods procured by the business forcash or on credit for sale is called purchase.

19. Sale : The total amount of cash received and/or receivable fromcustomers by transferring ownership/handing over of goods orservices is called sale.

20. Debtors : The debtors are the persons from whom money isreceivable for goods/services sold to them on credit.

21. Creditors : They are the persons to whom money is payable onaccount of credit purchase of goods or services.

22. Books of Accounts : These are the Registers, Journal, Ledger orany other books maintained in a business house for keepingaccounts.

23. Accounting : It is a body of knowledge of recording, documenting,classifying, analyzing, summarizing and interpreting the businesstransactions.

24. Accountancy : The practice and art of the science of accounting istermed as accountancy .

25. Equity : All claims against the assets of a firm are called equity. It isthe total of outsiders equity (Liabilities) and owner's equity (Capital).It refers to the residual interest of owners in assets over liabilities.

26. Account : It is a statement in "T" form in which all transactionsrelating to a particular item are presented. It is a summarized record

of the relevant transactions at one place relating to a particularhead.

27. Debit : The left hand side of a "T" form account is called debit. It isshortly presented as "Dr" . This word is derived from the Latin word"Debeo" meaning "owed to me", the proprietor.

28. Credit : The right hand side of a "T' form account is called credit . It

is shortly presented as "Cr" . It is derived from the Latin word

"Credo" meaning "trust or believe".

29. Double entry : It is a system of book-keeping under which the two-

fold aspects of a transaction are recorded to get a complete picture.

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Two-fold aspects of a transaction means "When we receive

something, we also give something".

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Example : If goods are purchased for Rs. 5000/-

It has two aspects : i. Business receives goods of Rs. 5000/-

ii. Business pays cash of Rs. 5000/-

In order to record the transaction, we have to record the above

mentioned two aspects in the name of two accounts :

i. Purchase A/C, ii. Cash A/C.

One of the accounts will be debited and the other will be credited by

the same amount. Thus double entry means every transaction will

have a debit and a corresponding credit entry of equal amount.30. Depreciation : The value of fixed assets gradually reduces due to

wear and tear, passage of time, obsolescence, etc. The monetary

value of such reduction in the value of fixed assets is called

depreciation.

31. Outstanding expenses : These are the expenses which havebecome due for payment but is not paid during the accounting year.

Example : Outstanding rent, outstanding wages outstandingsalaries etc. This is a type of liability.

32. Prepaid expenses : These are the expenses which have been paid

in advance. The benefit of such expenses has not yet expired duringthe accounting year. These are also known as the unexpiredexpenses. Such accounts are treated as asset.

Example : Prepaid rent or rent paid in advance, prepaid wages, etc.

33. Accrued Income : Incomes earned but not received during theaccounting year is known as accrued income.

Example : Accrued interest, commission receivable, etc.

34. Income received in advance : This is the income which is not yetdue or earned but cash has been received against this incomebefore it becomes due. This is a type of liability.

Example : Commission received in advance, rent received inadvance, etc.

35. Invoice : At the time of credit sales or credit purchase of goods, astatement is sent along with it. It is called invoice. It contains detailsof the goods sold or purchased price, quantity, quality, terms ofpayment etc. Incase of seller, if is known as Outward Invoice. Incase of buyer, it is known as Inward Invoice.

36. Discount : It is an allowance off the bill value given by the seller tothe buyer. It is of two types Trade discount and Cash discount.

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37. Trade Discount : It is an allowance off the list price allowed by thewholesaler to the retailer. This is a margin left for the retailer toaccommodate his expenses and profit. Trade discount in notrecorded in the books of accounts because it is not considered as aloss. This discount is an incentive to the buyer to purchase in hugequantity.

38. Cash Discount : This is an allowance off the selling price allowedby the seller to the buyer. This discount is allowed to attract promptpayment from customers . This is a loss for the seller and hence it isshown in the books of accounts.

42. Primary Book : This is the book in which the transactions arerecorded primarily or originally.

43. Subsidiary Book : This is the book in which the transactions offrequent nature are recorded.

44. Principal Book : This is the book in which the transactions arerecorded in a classified manner showing the net effects. This is alsoknown as ledger.

Systems of Accounting : There are three systems of accounting.

i. Cash system

ii. Mercantile system

iii. Hybrid system

i. Cash system : This is a system of accounting in which onlycash transactions (received or paid) are recorded. No entryis made for the transactions in which payments or receiptsare merely due. Mostly small businesses utilise this systemof recording revenue and expenses.

ii. Mercantile System : In this system of accounting, the credittransactions will be recorded . It means the transactions inwhich receipts or payments are due are recorded.

iii. Mixed system : Under this system, both cash and mercantilesystems are followed. Some records are kept under cashsystem and some others are kept under mercantile system.This system is followed by larger business units.

Accounting is a science or an art :

Science is a body of knowledge. Accounting is a science becauseit contains accounting principles, concepts and some rules. Again scienceestablishes cause and effect relationship. But accounting does not alwaysestablish cause and effect relation-ship. So accounting is not a perfectscience like physics, chemistry etc. However, it can be considered as a

social science.

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An art is the practice and application of accepted theories,principles, rules etc.

Accounting is an art because it is practiced on the basis ofknowledge like accounting principles, concepts, conventions, assumptionsand accounting standards.

However, it can be concluded that accounting is both a scienceand an art.

Role of Accounting:

Accounting is a service activity and a support function in a business.

Accounting has many important roles in one's personal as well as

business life because accounting is not an end in itself, rather it is a means

to an end. The following roles of accounting may be noted:

a) It is an information system to many interested parties.

b) It gives varieties of services to different users and has a supportfunction in any business.

c) Accounting is the analyser, recorder and interpreter of financial

data and a good reporter of financial position and operating resultsin the form of statements.

d) It is called the language of the business and communicates theperformance and health of the enterprise.

e) Accounting is a tool in decision making.

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MODEL QUESTIONS

PART - A : SHORT QUESTIONS

1. Answer the following questions in two three sentences.

a) Who is considered as the Father of modern Accounting

System?

b) Why accounting is called the Language of Business?

c) What do you mean by Book-keeping?

d) Explain the meaning of Accounting?

e) Define Accounting.

f) Name the various branches of Accounting.

g) Name any two users of accounting information.

h) Is Accounting an information system? If yes, why?

i) Accounting is considered as a science, why?

j) Accounting is considered as an Art, why?

k) Name the various systems of accounting?

l) Write any two objectives of Accounting.

m) Write any two objectives of Book keeping.

n) Write any two functions of Accounting.

o) Which accounting system is considered to be the father of

other accounting systems?

p) Is Accounting superior to book keeping? How?

q) Write any two limitations of Accounting.r) Are accounting data helpful to management? How?

2. Give the meaning of the following terms : (Maximum 2 3 lines)

a) Assets b) Drawings

c)Entity d) Business

e) Liability f)Transaction g) Entrepreneurs

h) Expenses

i) Capital j)Entry k) Net worth l) Revenue

m) Loss n) Profit o) Income p) Books of Accounts

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q) Accounting r) Accountancy s) Double Entry t) Cash System ofAccounting

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3. Fill in the blanks.

a) Book keeping is a _____________ of accounting.

b) Book keeping is the __________ of recording transactions.

c) Accounting is a _________ science.

d) Luca Pacioli is regarded as _________ of accounting.

e) Under cash system of accounting, only _________

transactions are considered.

f) Financial Accounting is related to preparation of ______

and _______.

g) Cost Accounting is related to finding out _________.h) Supplying information to the management for decision

making is done under ___________ accounting.

4. State whether the following statements are True or False.

a) Accounting is a physical science.

b) Accounting and book-keeping are one and the same.

c) Accounting records only transactions, but not events.

d) Accounting records non-monetary aspects of transactions

and events.e) Accounting starts where book-keeping ends.

f) Accounting includes interpretation of results only.

g) Cost accounting is the oldest of all branches of

accounting.

h) The object of book-keeping is to make a permanent record

of each business transactions.

i) Accounting is related to only identifying economic events,

but not communicating their effects.

j) The function of book-keeping is to measure changes inassets, liabilities and capital.

PART - B: SHORT QUESTIONS - (Answer within 3 - 5 sentences)

1. Answer the following questions briefly within 3 5 sentences.

a) Give the functions of accounting.

b) Name the users of accounting information.

c) Give the various systems of accounting.

d) State any three limitations of accounting.e) Write any three objectives of Accounting.

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f) State any three distinctions between book-keeping andaccounting.

g) Mention the objectives of book-keeping.

h) Explain accounting as a science.

i) Explain accounting.

j) Why investors make use of accounting information

system?

k) Give the utility of accounting information to employees.

l) State how accounting data are useful to tenders, suppliers

and creditors.

m) How does accounting information serve customers?

n) Show how accounting information are useful to

governments.

PART - C : DESCRIPTIVE/SUBJECTIVE QUESTIONS

6. Explain the following questions.

a) Define Book-Keeping and Accounting . Distinguish

between these two.

b) What are the different systems of accounting. Clearly

explain the Double entry system.

c) Discuss the functions and objectives of Accounting in

detail.

d) Explain the various branches of accounting.

e) Explain the importance of Accounting to various parties.

f) Explain whether Accounting is a science or an art.

g) Bring out the meaning of the following terms

a) Assets b) Capital c) Liability

d) Business e) Proprietor f) Equity

g) Revenue h) Loss i) Net worth

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THEORY BASE OF ACCOUNTING

PRINCIPLES OF ACCOUNTING

CONCEPTS OF ACCOUNTING

1. Going concern concept

2. Business entity concept

3. Money measurement concept

4. Cost concept

5. Accounting period concept

6. Dual aspect concept

7. Accrual concept

8. Realisation concept9. Matching concept

10. Objectivity concept

CONVENTIONS

1. Full disclosure

convention

2. Consistency convention

3. Conservatism convention

4. Materiality convention

ACCOUNTING STANDARDS

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Theory Base of AccountingUnit II

THEORY BASE OF ACCOUNTING

A

ccounting is the language of business. Through this language, accountinginformation is communicated to various parties such as owner,government, creditors, workers etc. If accountants use different languages

in communicating quantitative information then it will not beunderstandable to all the parties in the same sense. Hence to understandthe same thing in the same sense by all the parties, accounting principles,concepts, and conventions are followed by accountants in preparingaccounting statements. This brings about uniformity in understandingaccounting which helps in the proper comparison of accounting databetween two different periods or two different firms. This leads to thedevelopment of accounting principles, concepts and conventions.

Principles of Accounting:

The set of rules and practices followed in recording transactions andpreparing financial statements are called accounting principles. These area set of guidelines to be followed by the accounting professionals forpreparing and reporting the financial information. Such principles are alsoknown as Generally Accepted Accounting Principles or "GAPP". FurtherGAAP can be categorised into concepts, conventions, principles andaccounting standards.

Concepts of Accounting :

The accounting concepts refer to the assumptions or ground rulesupon which accounting is based. The useful concepts are discussed as

under.

1. Going concern concept :

Under this concept it is assumed that the business will have anindefinite life and will continue for a long period of time. The business willcontinue till the period it becomes in solvent. As per this concept, thebusiness is not likely to be sold or liquidated in near future. So we are notinterested to know the sales value of the assets at the end of the year . Assuch balance sheet is prepared by taking into account the cost price lessdepreciation, but not the sales price.

Further, under this concept decision can be made about buying anasset or hiring an asset. For example, a contractor needs a building for his

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Unit II Theory Base ofAccounting

office at work site where the work will continue for six months. In this case,he will prefer hiring a building for a temporary period to construct abuilding of his own.

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2. Business entity concept :

A business is an artificial entity distinct from its proprietor(s) .

This concept is also known as separate entity concept which meansthat activities of the business are separated from its owner or otherentities. The transactions of the proprietor are treated separate from thebusiness. For example, when a person starts a business with cash,accounting considers that the business is receiving cash and that amountof money is payable by the business to the proprietor. Similarly, when theproprietor makes a drawing of cash from the business for his personaluse, accounting considers that the business has paid cash and theproprietor is liable to the business to the extent of that accounting principle.

Further, under this concept, the personal expenses or familyexpenses of the proprietor such as rent for his residential house, clothing,food, etc. must be separated from the business expenses. Thus, thepersonal expenses will not at all be recorded in the books of accounts. Ifthis distinction is not maintained, the personal and business incomes andexpenses will get mixed and it may create difficulty to know the true results(Profit or Loss) of the business.

3. Money measurement concept :

This concept of accounting records only those facts and events whichare expressible in monetary terms. The non-monetary transactions orfactors such as efficiency of general manager, quality of the staff, quarrelbetween the production manager and sales manager etc. are not recordedin the books of accounts because these can not be quantified in monetaryterms.

Further, this concept implies that the legal currency of a countryshould be used for such measurement.

4. Cost concept :

This concept maintains that the assets (Land and Building, Plant andMachinery etc.) and liabilities (Loans, Creditors etc.) should be shown attheir cost price or acquisition value.

For example, a business purchases a plot of land for Rs.50,000. The assetshould be recorded in the books at Rs,50,000 but not at its market valuewhich may be more than Rs.50,000/-. Thus, cost concept does not takeinto account the personal judgment or estimate. The accounts is kept freefrom bias.

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5. Accounting period concept :

It is assumed that business will continue for an indefinite period andit is reasonable to divide the life of the business into specific accountingperiods. The business can only accept the period of twelve months or oneyear as the accounting period. All the business transactions taking placeduring this period, the profit or loss and the financial position at the end ofthis period are determined. Accounting period may be a period of twelvemonths from 1st January to 31st December or 1st April to 31st March or1st October to 30th September or 1st July to 30th June. In case ofMarwari communities, the accounting year ranges from one Diwali to

another Diwali while some other business communities follow the Dusserato Dussera or Ganesh Puja to Ganesh Puja as their respective accountingyears.

6. Dual aspect concept :

This aspect is otherwise known as Accounting equivalence conceptbecause there will be equality of source of funds and uses of fundsalways.

This concept recognizes two aspects of accounting transactions . It is thereforenecessary to recognize at least two accounts in recording a transaction.

When a machinery is purchased, the two aspects involved in thistransaction are (i) Machinery(coming in) and (ii) Cash (going out) .

This dual aspect concept has developed double entry system of bookkeeping . This system states that for each and every debit, there must be acorresponding credit of equal amount in every transaction. In the aboveexample Machinery A/c is debited and Cash A/c is credited by the sameamount.

This concept expresses the relationship among assets, liabilities andcapital in the form of accounting equation which is given as under :

Assets = Liabilities + Capital

The above equation implies that a transaction must result in increaseor decrease in assets, liabilities or capital. However, at any point of time,after recording the resultant changes in assets, liabilities and capital, wefind that accounting equation still holds good.

7. Accrual concept :

It suggests that incomes and expenses should be recognized as andwhen they are earned and incurred irrespective of whether the money isreceived or paid in that connection. Sometimes at the end of the year,some expenses are incurred but remain unpaid. These are called

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outstanding or accrued expenses. Similarly some incomes are earned butis not yet received in cash by the end of the year. These are calledaccrued incomes. Accrual concept says that cash expenses and accruedexpenses, cash incomes and accrued incomes are taken into account tofind out the profit or loss during a period and also discloses the position inthe statement to interested parties on the close of the accounting year.

Example : Goods sold in cash Rs.1,000 and on credit Rs.500Rent paid Rs.900 and rent unpaid Rs.100

Total income = Sales income received + Accrued incomes

(Rs.1,000) (Rs.500)

= Rs. 1,500

Total expenses = Rent paid + Rent outstanding

(Rs.900) (Rs.100)

= Rs.1,000

As a result of the treatment made above, the Net Profit = TotalIncomes - Total Expenses = Rs.1,500 - Rs.1,000 = Rs.500.

8. Realisation concept :

This is also known as revenue recognition concept. Under this

concept, revenue is said to be realized or earned only when it is receivedin cash or a promise to pay for it is received.

Thus under realization concept, a sale or income with a very strongprobability or expectation can not be recorded in the books of accountsonly on the basis of such probability or expectation which may not getmaterialized in future.

In general, revenue is recognized at the time of sale or at theperformance of the service. The point / time at which the sale is made,depends upon the terms of the contracts between the buyer and the seller.But a sale is complete only when the goods are delivered by the seller and

accepted by the buyer. To recognize a revenue, there is no need to waituntil the cash is received. When revenue is recognized, it is included in theprofit and loss account.

As per realization concept, accountants refuse to record a sale unlessit is realized or received in cash or a customer becomes legally liable topay for it. Hence no profit or loss is said to have arisen on a sale which hasnot been realized.

Example : If goods costing Rs.15,000/- have a chance to be sold in the

market at Rs.20,000/- at higher than cost price, it will not be treated as an

income because of this chance only. It will be treated as an income onlywhen the goods are actually sold either in cash or on credit. Then only we

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can say that revenue is realized out of the sale and profit or loss on suchsale shall be taken into consideration.

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9. Matching concept :

Matching concept means comparison of revenue earned withexpenses incurred (made) to earn that revenue during a period. Thisconcept has developed the following equation which is vital to measurethe financial results of a business.

Net Income = Revenue - Expenses and losses

The timing of incurring expenses and earning revenue does notalways match. For Example, in case of a seasonal business, sales maytake place only in four months in a year whereas fixed expenses like

salaries, rent, etc. are incurred throughout the year.

10. Objectivity concept :

This concept is also known as verifiable objective evidence concept .This concept states that accounting date should be verifiable and free fromany personal bias. In simple, we can say that accounting transactions mustbe recorded on the basis of documentary evidence like in voices,vouchers, circulars, correspondences, receipts, minute books etc. Thishelps the auditors to check or verify the correctness of transactions in thebooks of accounts on the basis of such documents. This will help theauditor to give his report whether profit or loss account and balance sheetshow the true and fair picture of the business.

Conventions :

These are the traditions or customs or the rules or practices followedfor preparing the accounting statement. The different conventions arepresented in a simple manner as under :

1. Full disclosure convention :

It is a good accounting practice to disclose all significant informationor material fact fully and fairly while preparing accounting statements. The

information or accounting data should have narrative explanation forcorrect understanding. However unnecessary explanations in the name ofdisclosure should be avoided .

Disclosure convention requires to show the various assets along witha disclosure of their mode of valuation. Further it is required to show thevarious types of revenues and expenses separately for the purpose ofdisclosure. This will help to avoid confusion in accounting statements.

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2. Consistency convention :

This convention says that, the accounting practices should remainthe same from one year to another year. Accountant should follow thesame principles of recording and preparing the accounts for each andevery year so that the data of accounting statement of one year can becompared with the same of the other years.

Example : If straight line method of depreciation is followed in one year,

it should be continuously followed in the future also. This helps proper

comparison of accounting information in book value of assets.

When a new practice is found more suitable in a changingcircumstance, it can also be adopted but such a change and its effect mustbe stated separately in the form of an appendix. This will help the user ofaccounting information from being misled unnecessarily. He can be savedfrom drawing wrong conclusions on the basis of such statements withchanges in accounting practices.

3. Conservatism convention :

This convention is also known as convention of prudence. It states"anticipate no profits, but provide for all possible losses". This

convention implies that the profit should not be over stated but all expectedlosses should be recognized and recorded. The implication of thisconvention is that all anticipated losses should be recognized andrecorded but no unrealised gain should be recognized and recorded in thebooks of accounts. Thus, this convention gives due consideration toprospective losses but ignores all possible future profits. Efforts are to bemade by accountants to show assets and incomes at the lowest likelyvalues and losses and liabilities at the highest possible value.

Example :

i. Valuing closing stock at cost price or market price whichever is less.ii. Provision for doubtful debts (Anticipated loss)

iii. Showing assets in balance sheet after deducting due depreciation.

4. Materiality convention :

The terms materiality refers to the relative importance of an item. Thisconvention requires that only important or material items should befocused while recording and presenting the financial information. Theimmaterial items or events should be ignored. An item or event should beconsidered to be material if it is relevant to the user of the financial

statements. If the accountant records all material and immaterial facts inaccounting, the records will be lengthy and over burdened with un

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necessary details. So the accountant should make a distinction betweenthe material facts and immaterial facts and should record only the materialfacts. This will help in saving his time, reducing work load and making theaccounting records more understandable.

Materiality of items varies from industry to industry, firm to firm andcompany to company.

Example : Stationery items like pens, stapler, paper etc may be

shown as separate expenses by some firms where as some other firms

may club all these items under the head 'office stationery'.

Accounting Standards:Accounting bodies all over the world are striving to achieve a degree ofuniformity in the accounting policies by prescribing certain accountingstandards with respect to collection and presentation of accountinginformation. In India, recognizing the need to diversify the diverseaccounting policies and practices prevalent in India. The AccountingStandards Board of the Institute of Chartered Accountants of India haveframed and issued formally under the authority of Council of Chartered

Accountants. In case a company does not confirm to the mandatoryaccounting standards the auditor will have to qualify his report justifying

the reasons for deviations. The accounting standards presently issued are: Disclosure of accounting policies

Valuation of inventory

Changes in financial position

Contingencies and events occurring after the balance sheet date

Prior period and extraordinary items and changes in accountingpolicies

Depreciation accounting Accounting for construction contracts

Accounting for research and development

Revenue recognition

Accounting for foreign exchange transactions

Accounting for government grants

Accounting for investments

Accounting for amalgamations

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Accounting for retirement benefits

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MODEL QUESTIONS

PART A : VERY SHORT QUESTIONS

1. Answer the following questions in one or two sentences.

a) What do you mean by Accounting Principles?

b) What is GAAP?

c) What are the categories into which GAAP is classified?

d) What do you mean by Accounting Concepts?

e) What is Business Entity concept?

f) What is Going Concern concept?

g) What is Money Measurement concept?

h) Under which concept, the non-monetary events or factors

are ignored in accounting?

i) What does the cost concept imply?

j) Name the concept under which personal expenses and

business expenses are treated as different?

k) For which purpose, the world accounting bodies prescribe

Accounting Standards?l) How does Institute of Chartered Accountants of India

tackle the situation which diverse accounting policies that

are followed in India?

m) What do you mean by convention?

2. Put a tick ( ) against the correct alternative.

a) Recording of capital contributed by the owner as liabilityensures the adherence of principle of

i. Double entryii. Going concerniii. Separate entityiv. Materialityv. Consistency

b) The basic concepts related to balance sheet are

i. Cost conceptii. Business entity concept

iii. Accounting period conceptiv. Both (i) and (ii)

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v. All of the above

c) The basic concepts related to P & L account are

i. Realization conceptii. Matching conceptiii. Cost conceptiv. Both (i) and (ii)v. All of the above

d) As per the double entry concept

i. Assets + Liabilities = Capitalii. Capital = Assets Liabilitiesiii. Capital Liabilities = Assetsiv. Capital + Assets = Liabilitiesv. None of the above

e) Only the significant events which affect the business mustbe recorded as per principle of

i. Separate entityii. Accrualiii. Materialityiv. Going concernv. None of the above

f) P & L account is prepared for a period of one year byfollowing

i. Consistency conceptii. Conservatism conceptiii. Time period conceptiv. Cost conceptv. None of the above

g) If the going concern concept is no longer valid, which ofthe following is true?

i. All prepaid assets would be completed written offimmediately.

ii. Total contributed capital and retained earningswould remain unchanged.

iii. The allowance for uncollectable accounts would beeliminated.

iv. Intangible assets would continue to be carried at

net amortized historical cost.

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v. Land held as an investment would be valued at itsrealizable value.

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h) Under which of the following concepts are shareholderstreated as creditors for the amount they paid on theshares they subscribed to?

i. Cost conceptii. Duality conceptiii. Business entity conceptiv. Going concern conceptv. Since the shareholders own the business, they are not

treated as creditors

i) The underlying accounting principle(s) necessitatingamortization of intangible asset(s) is/are

i. Cost conceptii. Realization conceptiii. Matching conceptiv. Both (i) and (II)v. Both (iii) and (iv)

j) Which of the following practices is not in consonance withthe convention of conservatism?

i. Creating provision for bad debtsii. Creating provision for discount on creditorsiii. Creating provision for discount on debtorsiv. Creating provision for tax.v. None of the above

k) The accounting measurement that is not consistent withthe going concern concept is

i. Historical costii. Realization

iii. The transaction approachiv. Liquidation valuev. Continuity

l) Recording of fixed assets at cost ensures adherence of

i. Conservatism conceptii. Going concern conceptiii. Cost conceptiv. Both (i) and (ii)v. Both (iii) and (iv)

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m) Basic principles of accounting relate to how assets,liabilities, revenues and expenses are to be identified,measured, recorded and reported. An item that is not abasic principle of accounting is

i. Materialityii. Historical costiii. Revenue recognitioniv. Matchingv. Full disclosure

n) Which of the following statement(s) is/are true?i. The entity concept of accounting is not applicable to

sole trading concerns and partnership concerns.ii. Assets are to be shown in the balance sheet at the

values realizable on liquidation.iii. Money measurement concept takes into account

changes in the value of monetary unit.iv. What a creditor is paid, one asset is diminished and

another asset is increased..

(a) Both (i) and (iii) above(b) Both (i) and (ii) above(c) Both (iii) and (iv) above(d) Both (ii) and (iv) above(e) None of the above statements is true

o) Omission of paise and showing the round figures infinancial statements is based on

i. Conservatism conceptii. Consistency conceptiii. Materiality concept

iv. Realization conceptv. Cost concept

p) A company purchased goods for Rs.5 lakhs and sold 9/10th

of the value of goods for Rs.6 lakhs. Net expenses duringthe year were Rs.25,000/-. The company reported its netprofit as Rs.75,000/- Which of the following concepts isviolated by the company?

i. Realizationii. Conservation

iii. Matchingiv. Accrual

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v. Materiality

q) Accounting does not record non-financial transactionbecause of

i. Entity conceptii. Accrual conceptiii. Cost conceptiv. Measurement conceptv. Continuity concept

r) Mr.Raj Sekhar, owner of M/s Sekhar Industries Ltd. owns a

personal residence that cost Rs.6 lakhs, but has a marketvalue of Rs.9 lakhs. During preparation of the financialstatement for the business, the entire value of propertywas ignored and was not shown in the financialstatements. The principle that was followed was

i. The concept of the business entityii. The concept of the cost principleiii. The concept of going concern principleiv. The concept of duality principlev. The concept of realization principle

s) Provision for bad debt is made as per the

i. Entity conceptii. Conservatism conceptiii. Cost conceptiv. Going concern conceptv. Time period concept

t) Fixed assets and current assets are categorized as perconcept of

i. Separate entityii. Going concerniii. Contingencyiv. Consistencyv. Time period

u) Capital is shown under liabilities because of the

i. Conservatism conceptii. Accrual conceptiii. Entity conceptiv. Revenue recognition conceptv. Marketing concept

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3. Mention whether the following statements are true or false.

a) Accounting records only those facts and events which arecapable of being expressed in money.

b) Business entity concept is not applicable to sole tradingconcern.

c) Anticipate no profit and provide for all possible losses isthe theme of accrual concept.

d) All facts whether material or immaterial are recorded inaccounting.

e) Dual concept implies Capital + Liabilities = Assetsf) Withdrawals by proprietor would reduce both assets andowners equity.

g) Balance sheet is prepared on the basis of cost conceptand accounting period concept.

h) Excess of assets over liabilities represents capital.i) The aim of consistency convention is to facilitate

comparison.j) Interest received on investments decreases owners

equity.k) Revenue is said to be earned only when cash is received.

l) Every expense increases owners equity.m) Going concern concept is not applicable to joint venture

business.n) Assets must be equal to owners equity plus liabilities.o) Accounting year always starts from 1st January and ends

on 31st December of every year.p) An increase in assets is not necessarily due to profits.q) Principles which have substantial support are known as

generally accepted accounting principles.r) Personal transactions are distinguished from business

transactions in accordance with accounting entityconcept.s) Economic life of an enterprise is artificially dividend into

periodic intervals in accordance with going concernconcept.

t) Assets are classified into current and fixed categoryaccording to accounting period concept.

u) Revenues are matched with expenses according tomatching principle.

v) Relevance and reliability are two qualities that makeaccounting information useful.

w) Accrual means recognition of revenue as it is earned andof costs as they are paid.

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x) Cost concept creates anamolies in inflationary situation.y) Unrealized profits must be considered in accounting.

z) In accounting all transactions are recorded ashaving dual aspect.

4. Fill in the blanks:

a) Companies prepare financial statements at leastyearly due to __________ assumption.

b) Transaction of owner and business are separated dueto _______ concept.

c) __________ convention requires that the sameaccounting methods should be followed from year to year.

d) Under ________ concept, it is assumed that thebusiness will have an indefinite life.

e) As per _________ concept, a business is treated as anartificial entity distinct from its proprietor.

f) _________ concept recognizes two aspects of atransaction.

g) _________ concept states that assets and liabilitiesshould be recorded in the books at their cost price but notat realizable value.

h) ________ concept says that accounting data should beverifiable and free from bias.

PART B : SHORT QUESTIONS (Answer in 3 5 sentences)

1. Give short answers to the following questions in three to foursentences each.

a) What is accounting equation? How does loss effects suchan equation?

b) Explain the principles of matching cost with revenue indetermining business profit.

c) Explain the significance of accrual concept of accounting.d) Write a short note on information revealed by a proper

record of transactions of business.e) Discuss briefly any five of accounting concepts.f) Discuss any two accounting concepts and any two

accounting conventions.g) Explain any four accounting concepts.h) What is matching principle? What is its use to a business

concern?

i) What is accounting period concept? What is its use?j) Explain conservatism convention with example.

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k) Explain accrual concept with example.l) Explain realization concept with suitable example.m) What is full disclosure convention? Give its utility.n) Give the meaning and utility of consistency convention.o) When should revenue be recognized?p) Why is Going concern assumption necessary?

2. State on which concepts and conventions the followingstatements are based.

a) Assets are recorded at the price paid at the time of

purchaseb) Profit or loss is determined at the end of each year.

c) All expenses whether paid or not, all incomes whether

received or not are to be taken in to account to find the

profit and loss of given period.

d) Calibre and quality of management is not disclosed in

the Balance sheet directly.

e) Accounting transactions must be supported by a

documentary evidence.

PART - C : LONG TYPE QUESTIONS

1. Explain the terms 'Accounting Principles' 'Concepts' and

'conventions'.

2. What do you mean by Accounting concepts ? Briefly explain

the various concepts used by the accountants while preparing

accounting statements.

3. What is Accounting convention ? Explain clearly theconventions that are followed now-a-days.

4. Explain in detail the convention of Conservatism. Cite three

examples where this principle is followed.

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ACCOUNTING EQUATION AND

DOUBLE ENTRY BOOK-KEEPING

The Accounting Equation

Double Entry Book-keeping

Classification of Accounts

Traditional Classification & Rules of Debit & Credit

1. Personal Account

2. Impersonal Account

Real Accounts Nominal Accounts

Advantages of Double Entry System

Disadvantages of Double Entry System

Accounting Cycle

Accounting Procedure Journal

Types of Journal Entries

- Simple Entry- Compound Entry

Examples of some Typical Transactions

Advantages of Journal

Limitations of Journal

MODEL QUESTIONS

UNIT - III


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Accounting Equation & Double Entry Book-keepingUnit III

ACCOUNTING EQUATION ANDDOUBLE ENTRY BOOK-KEEPING

The Accounting Equation:

In order to express the relationship among the three elements -assets, liabilities and equity of the balance sheet we follow an equation

which is known as Fundamental Accounting Equation. The equation can bewritten as follows:

Assets (A) = Liabilities (L) + Equity (E) Eq. 1

The above equation has a unique feature in the sense that allbusiness transactions will affect the equation in such a way that either theequality will be maintained or a new equality achieved. This is possiblebecause of the operation of the double entry concept. Every businesstransaction can be explained in terms of its effect on the accountingequation.

The increase in owners equity (E) can normally occur in the followingsituations:

(a) there has been a fresh injection of funds by the owners (e.g. in termsof equity capital in case of a corporate entity).

(b) There has arisen a surplus (excess of income over expenses).

Infusion of funds by owners is an occasional feature and not a recurringphenomenon. Thus, if, for the sake of simplicity, we consider only situation(b) to be the cause for a change in owners equity, the equation (1) can bewritten as:

A = L + E0 + (Y X) Eq. 2Where, E0 is the equity at the beginning of an accounting period, Y is

the income recognized in the same accounting period and X is the expensesrecognized during that period.

The operation of the accounting equation and the continuing equalityof the two sides of the balance sheet can be explained with the help of thefollowing examples.

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Unit III Accounting Equation & DoubleEntry Book-keeping

Example 1 : The following is the position of assets and liabilities of M/s.Aditya Industries Ltd. As on 31st March, 1997.

Assets Amount(Rs. in Lakhs)

Land & building 120Plant & machinery 235Furniture & fixture 35Inventory 90

Debtors 40Cash & Bank balance 25545

LiabilitiesEquity 345Long term loan 140Short term loan 25Creditors 35

545

The following are some of the transactions entered into by M/s.Shiva Ltd.during 1997-98.

a) A land was purchased for Rs.5 lakhs in cashb) Rs.35 lakhs collected from debtors towards outstanding as on 31st

March 1997c) Rs.15 lakhs was paid towards repayment of an installment of long

term loand) Rs.20 lakhs paid to creditors

Show the effect of the above transactions upon the accounting equation.

Solution: The accounting equation (A=L+E) as on 31st

March, 1997 standsas below:

A = L + E or Rs.545 lakhs = Rs.200 lakhs + Rs.345 lakhs

The above equation is affected by every transaction entered into during1997-98. We shall show the effect of each transaction separately.

(a) A piece of land purchased for Rs.5 lakhs in cash :

Original position :A (Rs.545 lakhs) = L (Rs.200 lakhs) + E (Rs.345 lakhs)Revised position :A {Rs.545 lakhs + Rs.5 lakhs(land) Rs.5 lakhs (cash)}

= L (Rs.200 lakhs) + E (Rs.345 lakhs)

orA (Rs.545 lakhs) = L (Rs.200 lakhs) + E (Rs.345 lakhs)

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(b) Collected Rs.35 lakhs from debtors outstanding as on 31st

March1997:

A{(Rs.545 lakhs + Rs.35 lakhs(Cash) Rs.35 lakhs(Debtors)}

Or A(Rs.545 lakhs) = L (Rs.200 lakhs) + E (Rs.345 lakhs)

(c) Repaid an installment of long term loan Rs.15 lakhs:

A {(Rs.545 lakhs) Rs.15 lakhs (Cash)}= L{Rs.200 lakhs Rs.15 lakhs (long term loan)} + E (Rs.345 lakhs)

or A (Rs.530 lakhs) = L (Rs.185 lakhs) + E (Rs.345 lakhs)

(d) Paid Rs.20 lakhs to creditors:

A{Rs.530 lakhs Rs.20 lakhs(Cash)}= L{(Rs.185 lakhs Rs.20 lakhs (Creditors) + E (Rs.345 lakhs)or A (Rs.510 lakhs) = L (Rs.165 lakhs) + E (Rs.345 lakhs)

Example 2: The Cola Drinks Ltd. is an incorporated company to carry onthe business of selling soft drinks. Transactions of the above company forthe month of January were as follows:

Jan. 1 Issued equity shares of Rs.20 lakhs (cash received in full)

Jan. 5 Purchased land for Rs.5,75 lakhsJan. 8 Purchased a building for Rs.4.40 lakhs, paying Rs.1.40 lakhs

in cash and the balance payable in three monthly instalments.

Jan. 15 Purchased machinery worth Rs.2.20 lakhs

Jan. 20 Purchased raw materials for making soft drinks worth Rs.5.75lakhs, paying Rs.1.75 lakhs in cash and accepting a bill drawn

by the supplier for the balance.

Jan. 25 Purchased further machinery worth Rs.50,000/-

Jan. 31 Sold cold drinks worth Rs.50,000/-(consuming Rs.30,000/- ofsyrup

Show the effects of the above transactions upon the accounting equation.

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Accounting Equation & Double Entry Book-keeping Unit III

ASSETS LIABIL ITIES + EQUITY

Cash Inventory Land Building Machinery Creditors BillsPayable

Jan.1 (+) 20,00,000 = (+) 20,00,000

Jan.5 (-) 5,75,000 (+) 5,75,000 = 20,00,000

Balance 14,25,000 5,75,000 = 20,00,000

Jan. 8 (-) 1,40,000 (+) 4,40,000 = (+) 3,00,000

Balance 12,85,000 5,75,000 4,40,000 = 3,00,000 20,00,000

Jan. 15 (-) 2,20,000 (+) 2,20,000 =

Balance 10,65,000 5,75,000 4,40,000 2,20,000 = 3,00,000 20,00,000

Jan. 20 (-) 1,75,000 (+) 5,75,000 = (+) 4,00,000

Balance 8,90,000 5,75,000 5,75,000 4,40,000 2,20,000 = 3,00,000 4,00,000 20,00,000

Jan. 25 (-) 50,000 (+) 50,000 =

Balance 8,40,000 5,75,000 5,75,000 4,40,000 2,70,000 = 3,00,000 4,00,000 20,00,000

Jan. 31 (+) 50,000 ( -) 30,000 (+) 20,000

(50,000 -

30,000)

Balance 8,90,000 545,000 575,000 440,000 270,000 = 300,000 400,000 2,020,000

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Double Entry Book-keeping

Double entry is a system of book keeping which recognizes andrecords double aspects of every transaction. Accounting process startswith identifying the transactions to be recorded in the books of accounts.The recording of transactions and events follows a definite rule. Thetransactions are identified as two different accounts. They will berecorded with a debit and a corresponding credit of equal amounts. Thiswork is done on the basis of some rules of debit and credit. Thus, doubleentry implies that while recording the transaction, the accountant has tofollow the rule "to each and every debit there is a

corresponding credit of equal amount". This reminds us ofthe two notable characteristics of double entry systems. i.e. (i) eachtransaction is recorded in two accounts, and (ii) each account has twocolumns.

In double entry system, two entries are made for each transaction -one entry as a debit in one account and the other entry as a credit inanother account. The two entries keep the accounting equation in balanceso that Assets = Liabilities + Owner's equity

To illustrate, consider a repair shop with a transaction involving repairservice performed in July 14 for a cash payment of Rs.275/-. In a singleentry system of book-keeping, the transaction would be recorded asfollows:

Single Entry Example

Date Description Revenue (Rs.) Expenses(Rs.)

July 14 Performed repair service 275

In a double entry system, the transaction would be recorded as follows:

Double Entry Example

Date Description Revenue (Rs.) Expenses(Rs.)

July 14 Cash 275

Revenue 275

In this system, double entries take the form of debits and credits, with

debits in the left column and credits in the right. For each debit, there is an

equal and opposite credit and the sum of all debits must equal the sum of

all credits. This principle is useful for identifying errors in the transaction

recording process.

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Further, also the fundamental Accounting Equation as shown aboveis the basis of preparing Balance Sheet. This accounting equation model

has been in use since 18th century. It essentially status that a business

owes all of its assets to either creditors or owners. The assets of a

business are its resources and the creditors and owners are the sources of

those resources.

Let's take another example to understand double entry. When we

purchase machinery for cash, it has two aspects:

i. Machinery is received into the business.

ii. Cash is paid out of the business.

The above two aspects are recorded in the name of Machineryaccount and Cash account. One of these two accounts will be debitedand the other will be credited on the basis of some rules. The rules ofdebit and credit applicable for recording a transaction vary on the basis ofthe classification of accounts.

Classification of Accounts :

1. Modern classification/Accounting Equation based classification of

accounts.2. Traditional classification of accounts.

Types of Accounts on the basis of Accounting Equations andRules of Debit & Credit

On the basis of Accounting Equation, accounts are classified as :

(I) Assets (II) Liability (III) Capital (IV) Expenses and (V) Incomes

The rules of debit and credit are given as under

I. Assets : Increase in asset is debited

Decrease in asset is credited

II. Liability : Decrease in liability is debited

Increase in liability is credited

III. Capital : Decrease in capital is debited

Increase in capital is credited

IV. Expenses: Increase in expenses is credited

V. Incomes : Increase in income is credited

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Example :

Transaction- Pankaj Purchased machinery for Rs.20,000/-

Two aspects or two accounts involved in the transaction, viz.(a) Machineryand (b) Cash

Types of Accounts - Machinery account is an asset.Cash account is also another asset.

Example :1

Transaction- Pankaj Purchased machinery for Rs.20,000/-

Two aspects or two accounts involved in the transaction, viz.(a) Machineryand (b) Cash

Types of Accounts - Machinery account is an asset.

Cash account is also another asset.

Effects : Asset 'Machinery' increased in the business.

Asset 'Cash' decreased in the business.

Rule : Machinery account is debited.

Cash account is credited.

Example : 2

Transaction: Pankaj paid to creditors Rs.3,000/-

Two aspects : a. Creditor's accountsb. Cash account

Effects : Creditor is a liability which decreasesCash is an asset which also decreases

Rule: Creditor account is debited by Rs.3,000/-Cash account is credited by Rs.3,000/-

Example : 3

Transaction: Goti invested Rs.50,000/- in his business.Two Aspects : a. Cash account

b. Gotis capital account

Effects : Asset "Cash" increases in the businessGotis capital also increases

Rules : Cash account is debited by Rs.50,000/-Capital account is credited by Rs.50,000/-

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Example : 4

Transaction : Ajay paid wages Rs.500/-

Two aspects : a. Wages accountb. Cash account

Effects : Wages is an expense which increases in the businessCash is an asset which decreases in the business

Rules: Wages account is debited by Rs.500/-Cash account is credited by Rs.500/-

Example : 5

Transaction : Pankaj received interest on investment Rs.200/-

Two Assets : a. Cash accountb. Interest account

Effects : Cash is an asset in business which incasesInterest is an income for business which also increases

Rules : Cash account is debited by Rs.200/-Interest account is credited by Rs.200/-

Traditional classification of accounts and rules of Debit andCredit :

Accounts, in a traditional way, are classified as Personal andImpersonal Account. Impersonal Accounts are again classified as Realand Nominal.

1. Personal Accounts :

The Accounts recording transactions relating to persons or firms orcompanies or institutions are called Personal Account.

Examples :

Rama's account, XYZ & Co's account, Nalco's account, Bankaccount, BJB college's account, Capital account, Drawings account,Debtor's account, Creditor's account, etc.

2. Impersonal Accounts :

Accounts which are not personal such as machinery account, cashaccount, rent account, etc. are regarded as Impersonal Accounts.

As mentioned earlier, the impersonal accounts may be classified intotwo categories i.e. (a) Real accounts and (b) Nominal accounts.

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(a) Real accounts : These are the accounts recording transactionsrelating to real things or assets.

Examples :

Cash, Stock, Furniture, Plant and Machinery, Land and Building,Good- will, etc.

(b) Nominal accounts : These are the accounts which recordtransactions relating to the expenses or losses, and incomes or gains,

Examples: Rent, interest, salary, discount, wages, bad debts, etc.Rules of Debit and Credit:

1. Personal accounts : Debit the receiver

Credit the giver

2. Real Accounts : Debit what comes in

Credit what goes out

3. Nominal Accounts : Debit the expenses and losses

Credit the incomes and gains

Let us take the same examples as already given and apply the rulesof debit and credit on the basis of traditional classification of account.

Example - 1 :

Transaction : Dhaval purchased machinery worth Rs.20,000/-

Two Aspects : a. Machinery Accountb. Cash Account

Types of Accounts : a. Machinery - Real accountb. Cash - Real account

Effects : a. "Machinery" comes in to businessb. "Cash" goes out of business

Rules : a. Machinery account is debited by Rs.20,000/-b. Cash account is credited by Rs.20,000/-

Example - 2 :

Transactions : Dhaval paid to creditors Rs.3,000/-

Two Aspects : a. Creditors accountb. Cash account

Types of Accounts : a. Creditor's account - Personal account

b. Cash account - Real account

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Effects : a. "Creditors" receive cash Rs.3,000/-b. "Cash" goes out of the business Rs.3,000/-

Rules : a. Creditors account is debited by Rs.3,000/-b. Cash account is credited by Rs.3,000/-

Example - 3:

Transactions: Dhaval invested Rs. 50,000/- in his business.

Two Aspects : a. Cash accountb. Dhavalscapital account

Types of Account : a. Cash account - Real accountb. Dhaval's capital account - Personal account

Effects : a. "Cash" comes in to the business.b. "Dhaval" is the giver of the "Cash".

Rules : a. Cash account is Debited by Rs. 50,000/-b. Dhaval's capital account is credited by Rs.50,000/-

Example - 4:

Transaction : Dhaval paid wages Rs.500/-

Two Aspects : a. Wages accountb. Cash account

Types of account : a. Wages account - Nominal accountb. Cash account - Real account

Effects : a. "Wages" is an expense for the firmb. "Cash" goes out of the firm

Rules: a. Wages account is debited by Rs.500/-b. Cash account is credited by Rs.500/-

Example - 5 :

Transaction : Dhaval received interest on investment forRs.200/-

Two Aspects : a. Cash accountb. Interest account

Types of account : a. Cash account - Real Accountb. Interest account - Nominal Account

Effects : a. "Cash" comes in to the businessb. "Interest" is gained by the business

Rules: a. Cash account is debited by Rs.200/-b. Interest account is credited by Rs.200/-

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The above rules of Debit and Credit can be presented in the form ofanalysis table as under :

Let us take the same examples.

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Accounting Equation & Double Entry Book-keeping Unit III

Sl.No.

Transact ions Namesof

Accounts

involved

Traditionaltype of

classification P / R / N

Effects RuleDr./Cr.

On basisof

Accounting

Equation

Effect RuleDr./Cr.

1. PankajinvestedRs.50,000/-in hisbusiness

CashPankajsCapital

RealPersonal

Comesin Goesout

Dr.Cr.

AssetCapital

IncreasesIncreases

Dr.Cr.

2. PankajpurchasedMachineryforRs.20,000

MachineryCash

RealReal

ComesinGoesout

Dr.Cr.

AssetAsset

DecreasesDecreases

Dr.Cr.

3. Pankaj paidto CreditorsRs.3,000/-

CreditorsCash

PersonalReal

ComesinGoesout

Dr.Cr.

LiabilityAsset

DecreasesDecreases

Dr.Cr.

4. Pankaj paidwagesRs.200/-

Wages Nominal Expenses goesout

Dr.Cr.

ExpensesAsset

IncreasesDecreases

Dr.Cr.

5. Pankajreceivedinterest oninvestment

CashInterest

RealNominal

ComesinGain

Dr.Cr.

AssetIncome

IncreasesIncreases

Dr.Cr.

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Unit III Accounting Equation & Double Entry Book-keeping

Rs.200/-

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Advantages of Double Entry System

1. Scientific system - In comparison to single entry system and oldIndian system of accounting, double entry system is considered morescientific. It gives expected results.

2. Complete record- It is a complete system of recording the businesstransactions.

3. Test of accuracy :- Double entry system ensures the accuracy ofaccounts through the technique of trial balance. It helps in accuratecalculation of profit and loss in complex organisations.

4. Determination of profit of loss - This system aims at ascertainingresult of the business by preparing Profit & Loss Account andBalance Sheet. Various financial statements can be prepared fromthe accounts prepared under this system.

5. Helpful for control - Double entry system includes preparation ofvarious accounts. Such accounts supply useful/needful informationsto the management for the purpose of better control.

6. Comparison - Double entry records and financial statements of ayear can be compared with the same of the other years. If anychange is noticed, reason for such change may be taken forconsideration.

7. Decision making- Double entry system supplies various accountingdata to the management to help them for better decision making.

8. Easy detection of errors and frauds - This system removes theerrors and frauds. If any error takes place, it can be detected easilythrough trial balance and some other techniques.

Disadvantages of Double Entry System

1. Expensive - Under double entry system, a number of books ofaccounts are to be maintained. It involves both time and money. So itis a costlier method for small business.

2. Lack of accuracy - Agreement of trial balance is only test ofarithmetical accuracy, but not a conducive proof of accuracy.

3. Difficulty to understand - An ordinary businessman may not beable to understand the complicacies of double entry system. Hence,he may not be able to record and process his transactions correctlyunder this system.

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Accounting cycle

We understand that accounting function starts with the identifying andrecoding of transactions and events and ends with the presentation offinancial statements in a sequence. This sequence of activities in anaccounting process is called "Accounting Cycle of Accounting Trail".

Sequence of activities in accounting procedure can be presented inthe form of steps as given below:

Steps in Accounting Cycle:

Identify the Transaction :

Identify the event as a transaction and generate the source document

Analyse the Transaction

Determine the transaction amount, the accounts affected and the direction in

which they are affected

Make adjusting entries:

Adjusting entries are made for accrued and deferred items. The entries are

journalized and posted to T-accounts in the ledger

Prepare Adjusted Trial Balance

A new Trial Balance is prepared after making the adjusting entries.

Record in Primary books

The transaction is recorded in journals as a debit and a credit

Post to Secondary books or Post to Ledger:

The journal entries are transferred to appropriate T-accounts in the Ledger

Prepare Trial Balance:

A trial balance is calculated to verify that the sum of the debits is equal to the

sum of the credits

Prepare Financial Statements:

The Profit & Loss Account and Balance Sheet can be prepared on the basis of

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The balances on various accounts as shown in the Balance Sheet

are then transferred to new books of accounts for the next year tocomplete the cycle.

Accounting Procedure - Journal

Journal is the book of original entry. The transactions are recordedfor the first time in the book in a chronological order i.e, in order of datesand occurrences. Since the transactions are recorded for the first time inthis book, hence, it is called the book of original entry.

The process of recording transactions in the journal is calledJouralising. Each transaction is separately recorded on the basis of somesource documents. The source documents are briefly explained below:

When a business transaction occurs, a document known as thesource document captures the key data of the transaction. The sourcedocument describes the basic facts of the transaction such as its date,purpose, and amount.

Some examples of source documents:

- Cash receipts

- Cancelled cheque- Invoice sent or received- Credit memo for a customer refund- Employee time sheet

The source document is the initial input to the accounting processand serves as objective evidence of the transaction, serving as part of theaudit trail should the firm need to prove that a transaction occurred.

To facilitate referencing, each source document should have aunique identifier, usually a number or alphanumeric code. Pre-numbering

of commonly used forms help to enforce numbering, to classifytransactions and to identify and locate missing source documents. A well-designed source document form can minimize errors and improve theefficiency of transaction recording.

The source document may be created in either paper or electronicformat. For example, automated accounting systems may generate thesource document electronically or allow paper source documents to bescanned and converted into electronic images. Accounting software oftenprovides onscreen entry forms for different types of transactions to capturethe data and generate the source document.

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The source document is an early document in accounting cycle. Itprovides the information required to analyse and classify the transactionand to create the journal entries. The transactions and events are to berecorded in a proforma given below:

Proforma of Journal

Date Particulars L.F. Amount (Rs.)

Dr.

Amount (Rs.)

Cr.

In the above proforma, there are five columns which explains the steps inJournalising.

1. Date : The first column contains the date of transactions with monthand year in an orderly manner.

2. Particulars : The second column is the column which containsparticulars. The accounts to be debited and credited are written herealong with the narration in the first line, account debited is indicatedby the word "Dr" written to the right of the account. The account

credited is written in the next line with the work "To" pre-fixed to it.Then a brief explanatory note is given within a bracket to explain thenature of the transaction. This is called 'narration'.

3. L.F. : The third column stands for L.F or Ledger Folio. This indicates

the page number of the ledger book which contains the relevant

account against which the page number is given. This number is

used for reference.

4. "Dr" : The fourth column contains the amount to be debited.

5. "Cr": The fifth column contains the amount to be credited.

Example : Journalise the following transactions of Pankaj for the month ofMarch 2004.

2004 March Rs.

1st Pankaj started business with capital 1,00,000.00

3rd Pankaj purchased land for cash 35,000.00

12th He paid on completion of buildingconstructed 23,000.00

14th Purchased furniture on cash 4,000.00

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18th Purchased stock for cash 18,000.00

20th Purchased goods on credit 3,000.00

22th Sold goods 57,000.00

30th Paid salaries 2,000.00

31st Paid wages 15,000.00

31st Deposited into bank 40,000.00

Journals of Pankaj for the month ending on 31st March 2004

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Types of Journal Entries :There are two types of Journal Entries viz.

1. Simple Entry

2. Compound Entry

1. Simple Entry :

In this entry there are only two accounts involved in thetransaction. One account is debited and the other account is credited withthe same account.

Example :Transaction : Purchased goods for cash Rs. 5,000/- Journal Entry

- (simple)

Purchase Account Dr. Rs.5,000/-

To Cash Account Rs.5,000/-

(Being goods purchased)

2. Compound Entry :

When the transaction involves more than two accounts then therecord of such transaction is called compound entry. In a compound entry,

there may be two or more accounts to be debited and only one account tobe credited or vice-versa.

Example - 1:

Transaction (Compound)

Received Rs.485/- from Satish in full and final settlement of claim ofRs.500/- due from him.

Compound Journal Entry :

Cash Account Dr. Rs.485/-

Discount Account Dr. Rs.15/-To Satish Account Rs.500/-

Example - 2:

Transaction : Purchased goods worthRs.500/- on cash andRs.1,000/- on credit.

Journal Entry : Purchases Account Dr. 1500.00

To Cash Account 500.00

To Creditor's Account 1,000.00

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Examples of some typical transactions :

1. Bad Debts : When the debtor is unable to pay the dues in full due tohis insolvency, then unpaid portion is treated as bad debt. It is a lossfor the business. In such a case, the following journal entry is made:

Cash Account Dr.

Bad Debt Account Dr.

To Debtor's Account

2. Bad debt recovered : Sometimes the amount written off as bad debtin some past year may be received at present. The amount so

received is called "Bad debt recovered". It is a gain for the business.This transaction is recorded by the following journal entry :

Cash Account Dr.

To Bad Debts Recovered Account

3. Drawings : The amount of goods or cash on both with-drawn by theproprietor for his personal use is called "Drawings". For this thefollowing Journal entry is made:

Drawings Account Dr.

To Purchases Account

To Cash Account4. Loss by fire/theft :

Goods lost by fire/theft Account Dr.


5. Goods given as charity :

Charity Account Dr.


6. Goods distributed as free sample :

Advertisement Account Dr.

To Purchases Account7. Depreciation provided on Fixed Asset :

Journal Entry :

Depreciation Account Dr.

To Concerned Fixed Asset Account

8. Outstanding Expenses :

Journal Entry:

Concerned Expenses Account Dr.

To Outstanding Expense

Documents

The Best Accounting Notes