Accounts Thoery - Unit 1

 

SEMESTER :  I                                                                                    HOURS/WEEK   : 4

CODE            :  P24CA104                                                                            CREDITS    : 4

                                                                                                                

 ACCOUNTING AND FINANCIAL MANAGEMENT

         

1.                 Introduction

 “Accounting is as old as money itself”. Since in early ages commercial activities were based on barter system, record keeping was not a necessity. The Industrial Revolution of 19th century along with rapid rise in population, paved way for the development of commercial activities, mass production and credit terms. Thus recording of business transaction has become an important feature. In recent years with the change of technologies and marketing along with stiff competition, accounting system has undergone remarkable changes.

1.1 Need and Importance of Accounting

When a person starts a business, whether large or small, his main aim is to earn profit. He receives money from certain sources like sale of goods, interest on bank deposits etc. He has to spend money on certain items like purchase of goods, salary, rent, etc. These activities take place during the normal course of his business. He would naturally be anxious at the year end, to know the progress of his business. Business transactions are numerous, that it is not possible to recall his memory as to how the money had been earned and spent. At the same time, if he had noted down his incomes and expenditures, he can readily get the required information. Hence, the details of the business transactions have to be recorded in a clear and systematic manner to get answers easily and accurately for the following questions at any time he likes.

i.                    What has happened to his investment?

ii.                  What is the result of the business transactions?

iii.                What are the earnings and expenses?

iv.                How much amount is receivable from customers to whom goods have been sold on credit?

v.                  How much amount is payable to suppliers on account of credit purchases?

vi.                What are the nature and value of assets possessed by the business concern?

vii.              What are the nature and value of liabilities of the business concern?

These and several other questions are answered with the help of accounting. The need for recording business transactions in a clear and systematic manner is the basis which gives rise to Book-keeping.

1.2. Book-keeping

Book-keeping is that branch of knowledge which tells us how to keep a record of business transactions. It is often routine and clerical in nature. It is important to note that only those transactions related to business which can be expressed in terms of money are recorded. The activities of book-keeping include recording in the journal, posting to the ledger and balancing of accounts.

1.3 Accounting

Book-keeping does not present a clear financial picture of the state of affairs of a business. When one has to make a judgment regarding the financial position of the firm, the information contained in these books of accounts has to be analysed and interpreted. It is with the purpose of giving such information that accounting came into being.

Accounting is considered as a system which collects and processes financial information of a business. These information are reported to the users to enable them to make appropriate decisions.

 

1.3.1 Definition

American Accounting Association defines accounting as “the process of identifying, measuring and communicating economic information to permit informed judgments and decision by users of the information”.

1.3.2 Objectives

The main objectives of accounting are

i.                    To maintain accounting records.

ii.                  To calculate the result of operations.

iii.                To ascertain the financial position.

iv.                 To communicate the information to users.

1.3.3 Process

The process of accounting as per the above definition is given below:

The process of accounting as per the above definition is given below in order to accomplish its main objective of communicating information to the users, accounting embraces the following functions.

i.             Identifying: Identifying the business transactions from the source documents.

ii.            Recording: The next function of accounting is to keep a systematic record of all business transactions, which are identified in an orderly manner, soon after their occurrence in the journal or subsidiary books.

iii.          Classifying: This is concerned with the classification of the recorded business transactions so as to group the transactions of similar type at one place. i.e., in ledger accounts. In order to verify the arithmetical accuracy of the accounts, trial balance is prepared.

iv.          Summarising : The classified information available from the trial balance are used to prepare profit and loss account and balance sheet in a manner useful to the users of accounting information.

v.            Analysing: It establishes the relationship between the items of the profit and loss account and the balance sheet. The purpose of analysing is to identify the financial strength and weakness of the business. It provides the basis for interpretation.

vi.          Interpreting: It is concerned with explaining the meaning and significance of the relationship so established by the analysis. Interpretation should be useful to the users, so as to enable them to take correct decisions.

vii.         Communicating: The results obtained from the summarised, analysed and interpreted information are communicated to the interested parties.

1.3.4 Meaning of Accounting Cycle

An accounting cycle is a complete sequence of accounting process that begins with the recording of business transactions and ends with the preparation of final accounts.

When a businessman starts his business activities, he records the day-today transactions in the Journal. From the journal the transactions move further to the ledger where accounts are written up. Here, the combined effect of debit and credit pertaining to each account is arrived at in the form of balances.

To prove the accuracy of the work done, these balances are transferred to a statement called trial balance. Preparation of trading and profit and loss account is the next step. The balancing of profit and loss account gives the net result of the business transactions. To know the financial position of the business concern balance sheet is prepared at the end.

These transactions which have completed the current accounting year, once again come to the starting point – the journal – and they move with new transactions of the next year. Thus, this cyclic movement of the transactions through the books of accounts (accounting cycle) is a continuous process.

1.4 Accountancy, Accounting and Book-keeping

Accountancy refers to a systematic knowledge of accounting. It explains “why to do” and “how to do” of various aspects of accounting. It tells us why and how to prepare the books of accounts and how to summarize the accounting information and communicate it to the interested parties.

Accounting refers to the actual process of preparing and presenting the accounts. In other words, it is the art of putting the academic knowledge of accountancy into practice.

Book-keeping is a part of accounting and is concerned with record keeping or maintenance of books of accounts. It is often routine and clerical in nature.

 1.5 Users of Accounting Information

The basic objective of accounting is to provide information which is useful for persons and groups inside and outside the organisation.

I.             Internal users: Internal users are those individuals or groups who are within the organisation like owners, management, employees and trade unions.

II.            External users: External users are those individuals or groups who are outside the organisation like creditors, investors, banks and other lending institutions, present and potential investors, Government, tax authorities, regulatory agencies and researchers.

1.6 Branches of Accounting

Increased scale of business operations has made the management function more complex. This has given raise to specialised branches in accounting. The main branches of accounting are Financial Accounting, Cost Accounting and Management Accounting.

1.6.1        Financial Accounting: It is concerned with recording of business transactions in the books of accounts in such a way that operating result of a particular period and financial position on a particular date can be known.

1.6.2        Cost Accounting: It relates to collection, classification and ascertainment of the cost of production or job undertaken by the firm.

1.6.3        Management Accounting: It relates to the use of accounting data collected with the help of financial accounting and cost accounting for the purpose of policy formulation, planning, control and decision making by the management.

1.7 Basic Accounting Terms

The understanding of the subject becomes easy when one has the knowledge of a few important terms of accounting. Some of them are explained below.

1.7.1 Transactions

Transactions are those activities of a business, which involve transfer of money or goods or services between two persons or two accounts. For example, purchase of goods, sale of goods, borrowing from bank, lending of money, salaries paid, rent paid, commission received and dividend received. Transactions are of two types, namely, cash and credit transactions.

Cash Transaction is one where cash receipt or payment is involved in the transaction. For example, When Ram buys goods from Kannan paying the price of goods by cash immediately, it is a cash transaction.

Credit Transaction is one where cash is not involved immediately but will be paid or received later. In the above example, if Ram, does not pay cash immediately but promises to pay later, it is credit transaction.

1.7.2 Proprietor

A person who owns a business is called its proprietor. He contributes capital to the business with the intention of earning profit.

1.7.3 Capital

It is the amount invested by the proprietor/s in the business. This amount is increased by the amount of profits earned and the amount of additional capital introduced. It is decreased by the amount of losses incurred and the amounts withdrawn. For example, if Mr.Anand starts business with Rs.5,00,000, his capital would be Rs.5,00,000.

1.7.4 Assets

Assets are the properties of every description belonging to the business. Cash in hand, plant and machinery, furniture and fittings, bank balance, debtors, bills receivable, stock of goods, investments, Goodwill are examples for assets. Assets can be classified into tangible and intangible.

Tangible Assets: These assets are those having physical existence. It can be seen and touched. For example, plant & machinery, cash, etc.

Intangible Assets: Intangible assets are those assets having no physical existence but their possession gives rise to some rights and benefits to the owner. It cannot be seen and touched. Goodwill, patents, trademarks are some of the examples.

1.7.5 Liabilities

Liabilities refer to the financial obligations of a business. These denote the amounts which a business owes to others, e.g., loans from banks or other persons, creditors for goods supplied, bills payable, outstanding expenses, bank overdraft etc.

1.7.6 Drawings

It is the amount of cash or value of goods withdrawn from the business by the proprietor for his personal use. It is deducted from the capital.

 

1.7.7 Debtors

A person (individual or firm) who receives a benefit without giving money or money’s worth immediately, but liable to pay in future or in due course of time is a debtor. The debtors are shown as an asset in the balance sheet. For example, Mr.Arul bought goods on credit from Mr.Babu for Rs.10,000. Mr.Arul is a debtor to Mr.Babu till he pays the value of the goods.

1.7.8 Creditors

A person who gives a benefit without receiving money or money’s worth immediately but to claim in future, is a creditor. The creditors are shown as a liability in the balance sheet. In the above example Mr.Babu is a creditor to Mr.Arul till he receive the value of the goods.

1.7.9 Purchases

Purchases refers to the amount of goods bought by a business for resale or for use in the production. Goods purchased for cash are called cash purchases. If it is purchased on credit, it is called as credit purchases. Total purchases include both cash and credit purchases.

1.7.10 Purchases Return or Returns Outward

When goods are returned to the suppliers due to defective quality or not as per the terms of purchase, it is called as purchases return. To find net purchases, purchases return is deducted from the total purchases.

1.7.11 Sales

Sales refers to the amount of goods sold that are already bought or manufactured by the business. When goods are sold for cash, they are cash sales but if goods are sold and payment is not received at the time of sale, it is credit sales. Total sales includes both cash and credit sales.

 

1.7.12 Sales Return or Returns Inward

When goods are returned from the customers due to defective quality or not as per the terms of sale, it is called sales return or returns inward. To find out net sales, sales return is deducted from total sales.

1.7.13 Stock

Stock includes goods unsold on a particular date. Stock may be opening and closing stock. The term opening stock means goods unsold in the beginning of the accounting period. Whereas the term closing stock includes goods unsold at the end of the accounting perid. For example, if 4,000 units purchased @ Rs. 20 per unit remain unsold, the closing stock is Rs.80,000. This will be opening stock of the subsequent year.

1.7.14 Revenue

Revenue means the amount receivable or realised from sale of goods and earnings from interest, dividend, commission, etc.

1.7.15 Expense

It is the amount spent in order to produce and sell the goods and services. For example, purchase of raw materials, payment of salaries, wages, etc.

1.7.16 Income

Income is the difference between revenue and expense.

1.7.17 Voucher

It is a written document in support of a transaction. It is a proof that a particular transaction has taken place for the value stated in the voucher. It may be in the form of cash receipt, invoice, cash memo, bank pay-in-slip etc. Voucher is necessary to audit the accounts.

 

1.7.18 Invoice

Invoice is a business document which is prepared when one sell goods to another. The statement is prepared by the seller of goods. It contains the information relating to name and address of the seller and the buyer, the date of sale and the clear description of goods with quantity and price.

1.7.19 Receipt

Receipt is an acknowledgement for cash received. It is issued to the party paying cash. Receipts form the basis for entries in cash book.

1.7.20 Account

Account is a summary of relevant business transactions at one place relating to a person, asset, expense or revenue named in the heading. An account is a brief history of financial transactions of a particular person or item. An account has two sides called debit side and credit side.

2.                 Accounting Concepts

In order to maintain uniformity and consistency in preparing and maintaining books of accounts, certain rules or principles have been evolved. These rules/principles are classified as concepts and conventions. These are foundations of preparing and maintaining accounting records.

Let us take an example. In India there is a basic rule to be followed by everyone that one should walk or drive on his/her left hand side of the road. It helps in the smooth flow of traffic. Similarly, there are certain rules that an accountant should follow while recording business transactions and preparing accounts. These may be termed as accounting concept. Thus, this can be said that: “Accounting concept refers to the basic assumptions and rules and principles which work as the basis of recording of business transactions and preparing accounts”.

The main objective is to maintain uniformity and consistency in accounting records. These concepts constitute the very basis of accounting. All the concepts have been developed over the years from experience and thus they are universally accepted rules. Following are the various accounting concepts that have been discussed in the following sections:

1.                  Business entity concept

2.                  Money measurement concept

3.                  On Going concern concept

4.                  Accounting period concept

5.                  Accounting cost concept

6.                  Duality aspect concept

7.                  Realisation concept

2.1 BUSINESS ENTITY CONCEPT

This concept assumes that, for accounting purposes, the business enterprise and its owners are two separate independent entities. Thus, the business and personal transactions of its owner are separate. For example, when the owner invests money in the business, it is recorded as liability of the business to the owner. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not treated as business expense. Thus, the accounting records are made in the books of accounts from the point of view of the business unit and not the person owning the business. This concept is the very basis of accounting.

Let us take an example. Suppose Mr. Sahoo started business investing Rs.100000. He purchased goods for Rs.40000, Furniture for Rs.20000 and plant and machinery of Rs.30000. Rs.10000 remains in hand. These are the assets of the business and not of the owner. According to the business entity concept Rs.100000 will be treated by business as capital i.e. a liability of business towards the owner of the business.

Now suppose, he takes away Rs.5000 cash or goods worth Rs.5000 for his domestic purposes. This withdrawal of cash/goods by the owner from the business is his private expense and not an expense of the business. It is termed as Drawings. Thus, the business entity concept states that business and the owner are two separate/distinct persons. Accordingly, any expenses incurred by owner for himself or his family from business will be considered as expenses and it will be shown as drawings.

2.2 MONEY MEASUREMENT CONCEPT

This concept assumes that all business transactions must be in terms of money that is in the currency of a country. In our country such transactions are in terms of rupees. Thus, as per the money measurement concept, transactions which can be expressed in terms of money are recorded in the books of accounts. For example, sale of goods worth Rs.200000, purchase of raw materials Rs.100000, Rent Paid Rs.10000 etc. are expressed in terms of money, and so they are recorded in the books of accounts. But the transactions which cannot be expressed in monetary terms are not recorded in the books of accounts. For example, sincerity, loyalty, honesty of employees are not recorded in books of accounts because these cannot be measured in terms of money although they do affect the profits and losses of the business concern.

Another aspect of this concept is that the records of the transactions are to be kept not in the physical units but in the monetary unit. For example, at the end of the year 2006, an organisation may have a factory on a piece of land measuring 10 acres, office building containing 50 rooms, 50 personal computers, 50 office chairs and tables, 100 kg of raw materials etc. These are expressed in different units. But for accounting purposes they are to be recorded in money terms i.e. in rupees. In this case, the cost of factory land may be say Rs.12 crore, office building of Rs.10 crore, computers Rs.10 lakhs, office chairs and tables Rs.2 lakhs, raw material Rs.30 lakhs. Thus, the total assets of the organisation are valued at Rs.22 crore and Rs.42 lakhs. Therefore, the transactions which can be expressed in terms of money is recorded in the accounts books, that too in terms of money and not in terms of the quantity.

2.3 ON GOING CONCERN CONCEPT

This concept states that a business firm will continue to carry on its activities for an indefinite period of time. Simply stated, it means that every business entity has continuity of life. Thus, it will not be dissolved in the near future. This is an important assumption of accounting, as it provides a basis for showing the value of assets in the balance sheet; For example, a company purchases a plant and machinery of Rs.100000 and its life span is 10 years.

According to this concept every year some amount will be shown as expenses and the balance amount as an asset. Thus, if an amount is spent on an item which will be used in business for many years, it will not be proper to charge the amount from the revenues of the year in which the item is acquired. Only a part of the value is shown as expense in the year of purchase and the remaining balance is shown as an asset.

2.4 ACCOUNTING PERIOD CONCEPT

All the transactions are recorded in the books of accounts on the assumption that profits on these transactions are to be ascertained for a specified period. This is known as accounting period concept. Thus, this concept requires that a balance sheet and profit and loss account should be prepared at regular intervals. This is necessary for different purposes like, calculation of profit, ascertaining financial position, tax computation etc.

Further, this concept assumes that, indefinite life of business is divided into parts. These parts are known as Accounting Period. It may be of one year, six months, three months, one month, etc. But usually one year is taken as one accounting period which may be a calendar year or a financial year.

Year that begins from 1st of January and ends on 31st of December, is known as Calendar Year. The year that begins from 1st of April and ends on 31st of March of the following year, is known as financial year.

As per accounting period concept, all the transactions are recorded in the books of accounts for a specified period of time. Hence, goods purchased and sold during the period, rent, salaries etc. paid for the period are accounted for and against that period only.

2.5 ACCOUNTING COST CONCEPT

Accounting cost concept states that all assets are recorded in the books of accounts at their purchase price, which includes cost of acquisition, transportation and installation and not at its market price. It means that fixed assets like building, plant and machinery, furniture, etc are recorded in the books of accounts at a price paid for them. For example, a machine was purchased by XYZ Limited for Rs.500000, for manufacturing shoes. An amount of Rs.1,000 were spent on transporting the machine to the factory site. In addition, Rs.2000 were spent on its installation. The total amount at which the machine will be recorded in the books of accounts would be the sum of all these items i.e. Rs.503000. This cost is also known as historical cost. Suppose the market price of the same is now Rs 90000 it will not be shown at this value. Further, it may be clarified that cost means original or acquisition cost only for new assets and for the used ones, cost means original cost less depreciation. The cost concept is also known as historical cost concept. The effect of cost concept is that if the business entity does not pay anything for acquiring an asset this item would not appear in the books of accounts. Thus, goodwill appears in the accounts only if the entity has purchased this intangible asset for a price.

2.6 DUAL ASPECT CONCEPT

Dual aspect is the foundation or basic principle of accounting. It provides the very basis of recording business transactions in the books of accounts. This concept assumes that every transaction has a dual effect, i.e. it affects two accounts in their respective opposite sides. Therefore, the transaction should be recorded at two places. It means, both the aspects of the transaction must be recorded in the books of accounts. For example, goods purchased for cash has two aspects which are (i) Giving of cash (ii) Receiving of goods. These two aspects are to be recorded. Thus, the duality concept is commonly expressed in terms of fundamental accounting equation:

Assets = Liabilities + Capital

The above accounting equation states that the assets of a business are always equal to the claims of owner/owners and the outsiders. This claim is also termed as capital or owners equity and that of outsiders, as liabilities or creditors’ equity. The knowledge of dual aspect helps in identifying the two aspects of a transaction which helps in applying the rules of recording the transactions in books of accounts. The implication of dual aspect concept is that every transaction has an equal impact on assets and liabilities in such a way that total assets are always equal to total liabilities.

 

 

Let us analyse some more business transactions in terms of their dual aspect:

1. Capital brought in by the owner of the business

The two aspects in this transaction are:

(i) Receipt of cash

(ii) Increase in Capital (owner’s equity)

2. Purchase of machinery by cheque

The two aspects in the transaction are

(i) Reduction in Bank Balance

(ii) Owning of Machinery

3. Goods sold for cash

The two aspects are

(i) Receipt of cash

(ii) Delivery of goods to the customer

4. Rent paid in cash to the landlord

The two aspects are

(i) Payment of cash

(ii) Rent (Expenses incurred).

Once the two aspects of a transaction are known, it becomes easy to apply the rules of accounting and maintain the records in the books of accounts properly. The interpretation of the Dual aspect concept is that every transaction has an equal effect on assets and liabilities in such a way that total assets are always equal to total liabilities of the business.

2.7 REALISATION CONCEPT

This concept states that revenue from any business transaction should be included in the accounting records only when it is realised. The term realisation means creation of legal right to receive money. Selling goods is realisation, receiving order is not. In other words, it can be said that: ‘Revenue is said to have been realised when cash has been received or right to receive cash on the sale of goods or services or both has been created’.

 Let us study the following examples:

(i) N.P. Jeweller received an order to supply gold ornaments worth Rs.500000. They supplied ornaments worth Rs.200000 up to the year ending 31st December 2005 and rest of the ornaments were supplied in January 2006.

(ii) Ramkumar sold goods for Rs.1,00,000 for cash in 2006 and the goods have been delivered during the same year.

(iii) Akshay sold goods on credit for Rs.50,000 during the year ending 31^st December 2005.

The goods have been delivered in 2005 but the payment was received in March 2006. Now, let us analyse the above examples to ascertain the correct amount of revenue realised for the year ending 31st December 2005.

(i) The revenue for the year 2005 for N.P. Jeweller is Rs.200000. Mere getting an order is not considered as revenue until the goods have been delivered.

(ii) The revenue for Ramkumar for year 2005 is Rs.1,00,000 as the goods have been delivered in the year 2005. Cash has also been received in the same year.

(iii) Akshay’s revenue for the year 2005 is Rs.50,000, because the goods have been delivered to the customer in the year 2005. Revenue became due in the year 2005 itself.

In the above examples, revenue is realized when the goods are delivered to the customers. The concept of realisation states that revenue is realized at the time when goods or services are actually delivered. In short, the realisation occurs when the goods and services have been sold either for cash or on credit. It also refers to inflow of assets in the form of receivables.

3.                 Accounting Conventions

An accounting convention refers to common practices which are universally followed in recording and presenting accounting information of the business entity. They are followed like customs, tradition, etc. in a society. Accounting conventions are evolved through the regular and consistent practice over the years to facilitate uniform recording in the books of accounts. Accounting Conventions help in comparing accounting data of different business units or of the same unit for different periods. These have been developed over the years. The most important conventions which have been used for a long period are:

1.                  Convention of consistency.

2.                  Convention of full disclosure.

3.                  Convention of materiality.

4.                  Convention of conservatism.

3.1 Convention of consistency

The convention of consistency means that same accounting principles should be used for preparing financial statements year after year. A meaningful conclusion can be drawn from financial statements of the same enterprise when there is comparison between them over a period of time. But this can be possible only when accounting policies and practices followed by the enterprise are uniform and consistent over a period of time. If different accounting procedures and practices are used for preparing financial statements of different years, then the result will not be comparable. Generally a businessman follows the undermentioned general practices or methods year after year.

While charging depreciation on fixed assets or valuing unsold stock, once a particular method is used it should be followed year after year so that the financial statements can be analysed and compared provided the depreciation on fixed assets is charged or unsold stock is valued by using particular method year after year. This can be further clarified as: in case of charging depreciation on fixed assets accountant can decide to adopt any one of the methods of depreciation such as diminishing value method or straight line method. Similarly, in case of valuation of closing stock it can be valued at actual cost price or market price or whichever is less. However precious metals like gold, diamond, minerals are generally valued at market price only.

 

 

3.2 Convention of Full Disclosure

Convention of full disclosure requires that all material and relevant facts concerning financial statements should be fully disclosed. Full disclosure means that there should be full, fair and adequate disclosure of accounting information. Adequate means sufficient set of information to be disclosed. Fair indicates an equitable treatment of users. Full refers to complete and detailed presentation of information. Thus, the convention of full disclosure suggests that every financial statement should fully disclose all relevant information. Let us relate it to the business. The business provides financial information to all interested parties like investors, lenders, creditors, shareholders etc. The shareholder would like to know profitability of the firm while the creditor would like to know the solvency of the business. In the same way, other parties would be interested in the financial information according to their requirements. This is possible if financial statement discloses all relevant information in full, fair and adequate manner.

Let us take an example. As per accounts, net sales are Rs.1,50,000, it is important for the interested parties to know the amount of gross sales which may be Rs.2,00,000 and the sales return Rs.50,000. The disclosure of 25% sales returns may help them to find out the actual sales position. Therefore, whatever details are available, that must be honestly provided. Additional information should also be given in the financial statement. For example, in a balance sheet the basis of valuation of assets, such as investments, inventories, land and building etc. should be clearly stated. Similarly, any change in the method of depreciation or in making provision for bad debts or creating any reserve must also be shown clearly in the Balance Sheet.

Therefore, in order to achieve the purpose of accounting, all the transactions of a business and any change in accounting policies, methods and procedures are fully recorded and presented in accounting.

3.3 Convention of Materiality

The convention of materiality states that, to make financial statements meaningful, only material fact i.e. important and relevant information should be supplied to the users of accounting information. The question that arises here is “what is a material fact”. The materiality of a fact depends on its nature and the amount involved. Material fact means the information of which will influence the decision of its user.

For example, a businessman is dealing in electronic goods. He purchases T.V., Refrigerator, Washing Machine, Computer etc. for his business. In buying these items he uses larger part of his capital. These items are significant items; thus should be recorded in books of accounts in detail. At the same time to maintain day to day office work he purchases pen, pencil, match box, scented stick, etc. For this he will use very small amount of his capital. But to maintain the details of every pen, pencil, match box or other small items is not considered of much significance. These items are insignificant items and hence they should be recorded separately. Thus, the items that are significantly important in recording the details are termed as material facts or significant items. The items that are of less significance are immaterial facts or insignificant items.

Thus according to this convention important and significant items should be recorded in their respective heads and all immaterial or insignificant transactions should be clubbed under a different accounting head.

3.4 Convention of Conservatism

This convention is based on the principle that “Anticipate no profit, but provide for all possible losses”. It provides guidance for recording transactions in the books of accounts. It is based on the policy of playing safe in regard to showing profit. The main objective of this convention is to show minimum profit. Profit should not be overstated. If profit shows more than actual, it may lead to distribution of dividend out of capital. This is not a fair policy and it will lead to the reduction in the capital of the enterprise.

Thus, this convention clearly states that profit should not be recorded until it is realised. But if the business anticipates any loss in the near future, provision should be made in the books of accounts for the same. For example, valuing closing stock at cost or market price whichever is lower, creating provision for doubtful debts, discount on debtors, writing off intangible assets like goodwill, patent, etc. The convention of conservatism is a very useful tool in situation of uncertainty and doubts.

4.                 System of Book Keeping

Book-keeping is that branch of knowledge which tells us how to keep a record of business transactions. It is often routine and clerical in nature. It is important to note that only those transactions related to business which can be expressed in terms of money are recorded. The activities of book-keeping include recording in the journal, posting to the ledger and balancing of accounts.

4.1 Definition

R.N. Carter says, “Book-keeping is the science and art of correctly recording in the books of account all those business transactions that result in the transfer of money or money’s worth”.

4.2 Objectives

The objectives of book-keeping are

                    i.                        To have permanent record of all the business transactions.

                  ii.                        To keep records of income and expenses in such a way that the net profit or net loss may be calculated.

                iii.                        To keep records of assets and liabilities in such a way that the financial position of the business may be ascertained.

                iv.                        To keep control on expenses with a view to minimize the same in order to maximize profit.

                  v.                        To know the names of the customers and the amount due from them.

                vi.                        To know the names of suppliers and the amount due to them.

              vii.                        To have important information for legal and tax purposes.

 

Recording of business transactions has been in vogue in all countries of the world. In India, maintenance of accounts was practised not in such a developed form as today. Kautilya’s famous Arthasastra not only relates to Politics and Economics, but also explains the art of account keeping in a separate chapter. Written in 4th century BC, the book gives details about account keeping, methods of supervising and checking of accounts and also about the distinction between capital and revenue, income and expenses etc.

Double entry system was introduced to the business world by an Italian merchant named Lucas Pacioli in 1494 A.D. Though the system of recording business transactions in a systematic manner has originated in Italy, it was perfected in England and other European countries during the 18th century only i.e., after the Industrial Revolution. Many countries have adopted this system today.

4.3 Double Entry System

There are numerous transactions in a business concern. Each transaction, when closely analysed, reveals two aspects. One aspect will be “receiving aspect” or “incoming aspect” or “expenses/loss aspect”. This is termed as the “Debit aspect”. The other aspect will be “giving aspect” or “outgoing aspect” or “income/gain aspect”. This is termed as the “Credit aspect”. These two aspects namely “Debit aspect” and “Credit aspect” form the basis of Double Entry System. The double entry system is so named since it records both the aspects of a transaction.

In short, the basic principle of this system is, for every debit, there must be a corresponding credit of equal amount and for every credit, there must be a corresponding debit of equal amount.

4.3.1 Definition

According to J.R.Batliboi “Every business transaction has a two-fold effect and that it affects two accounts in opposite directions and if a complete record were to be made of each such transaction, it would be necessary to debit one account and credit another account. It is this recording of the two fold effect of every transaction that has given rise to the term Double Entry System”.

4.3.2 Features

i. Every business transaction affects two accounts.

ii. Each transaction has two aspects, i.e., debit and credit.

iii. It is based upon accounting assumptions concepts and principles.

iv. Helps in preparing trial balance which is a test of arithmetical accuracy in accounting.

v. Preparation of final accounts with the help of trial balance.

4.3.3 Approaches of Recording

There are two approaches for recording a transaction.

I. Accounting Equation Approach

II. Traditional Approach

I. Accounting Equation Approach

This approach is also called as the American Approach. Under this method transactions are recorded based on the accounting equation, i.e.,

Assets = Liabilities + Capital

II. Traditional Approach

This approach is also called as the British Approach. Recording of business transactions under this method are formed on the basis of the existence of two aspects (debit and credit) in each of the transactions. All the business transactions are recorded in the books of accounts under the ‘Double Entry System’.

4.3.4 Advantages

The advantages of this system are as follows:

i. Scientific system: This is the only scientific system of recording business transactions. It helps to attain the objectives of accounting.

ii. Complete record of transactions: This system maintains a complete record of all business transactions.

iii. A check on the accuracy of accounts: By the use of this system the accuracy of the accounting work can be established by the preparation of trial balance.

iv. Ascertainment of profit or loss: The profit earned or loss occurred during a period can be ascertained by the preparation of profit and loss account.

v. Knowledge of the financial position : The financial position of the concern can be ascertained at the end of each period through the preparation of balance sheet.

vi. Full details for control: This system permits accounts to be kept in a very detailed form, and thereby provides sufficient informations for the purpose of control.

vii. Comparative study: The results of one year may be compared with those of previous years and the reasons for change may be ascertained.

viii. Helps in decision making: The mangement may be able to obtain sufficient information for its work, especially for making decisions. Weaknesses can be detected and remedial measures may be applied.

ix. Detection of fraud: The systematic and scientific recording of business transactions on the basis of this system minimises the chances of fraud.

4.4 Account

Every transaction has two aspects and each aspect has an account. It is stated that ‘an account is a summary of relevant transactions at one place relating to a particular head’.

4.4.1 Classification of Accounts

Transactions can be divided into three categories.

i. Transactions relating to individuals and firms

ii. Transactions relating to properties, goods or cash

iii. Transactions relating to expenses or losses and incomes or gains.

Therefore, accounts can also be classified into Personal, Real and Nominal.

I. Personal Accounts : The accounts which relate to persons. Personal accounts include the following.

i. Natural Persons : Accounts which relate to individuals. For example, Mohan’s A/c, Shyam’s A/c etc.

ii. Artificial persons : Accounts which relate to a group of persons or firms or institutions. For example, HMT Ltd., Indian Overseas Bank, Life Insurance Corporation of India, Cosmopolitan club etc.

iii. Representative Persons: Accounts which represent a particular person or group of persons. For example, outstanding salary account, prepaid insurance account, etc.

The business concern may keep business relations with all the above personal accounts, because of buying goods from them or selling goods to them or borrowing from them or lending to them. Thus they become either Debtors or Creditors.

The proprietor being an individual his capital account and his drawings account are also personal accounts.

II . Impersonal Accounts: All those accounts which are not personal accounts. This is further divided into two types Real and Nominal accounts.

i. Real Accounts: Accounts relating to properties and assets which are owned by the business concern. Real accounts include tangible and intangible accounts. For example, Land, Building, Goodwill, Purchases, etc.

ii. Nominal Accounts: These accounts do not have any existence, form or shape. They relate to incomes and expenses and gains and losses of a business concern. For example, Salary Account, Dividend Account, etc.

 

Classify the following items into Personal, Real and Nominal Accounts.

1. Capital

2. Sales

3. Drawings

4. Outstanding salary

5. Cash

6. Rent

7. Interest paid

8. Indian Bank

9. Discount received

10. Building

11. Bank

12. Chandrasekar

13. Murugan Lending Library

14. Advertisement

15. Purchases

Solution:

1. Personal account

2. Real account

3. Personal account

4. Personal (Representative) account

5. Real account

6. Nominal account

7. Nominal account

8. Personal (Legal Body) account

9. Nominal account

10. Real account

11. Personal account

12. Personal account

13. Personal account

14. Nominal account

15. Real account

 

4.4.2 Golden Rules of Accounting

All the business transactions are recorded on the basis of the following rules.

S.No.	Name of Account	Debit Aspect	Credit Aspect
1.	Personal Account	The receiver	The giver
2.	Real Account	What comes in	What goes out
3.	Nominal Account	All expenses and losses	All incomes and gains.

 

5.     Journal

Accounting process starts with identifying the transactions to be recorded in the books of accounts. Accounting identifies only those transactions and events which involve money. They should be of financial character. Accountant does so by sorting out various cash memos, invoices, bills, receipts and vouchers.

In the accounting process, the first step is the recording of transactions in the books of accounts. The origin of a transaction is derived from the source document. Source documents are the evidences of business transactions which provide information about the nature of the transaction, the date, the amount and the parties involved in it. Transactions are recorded in the books of accounts when they actually take place and are duly supported by source documents. According to the verifiable objective principle of Accounting, each transaction recorded in the books of accounts should have adequate proof to support it. These supporting documents are the written and authentic proof of the correctness of the recorded transactions. These documents are required for audit and tax assessment. They also serve as the legal evidence in case of a dispute.

5.1 Journal

Journal is a date-wise record of all the transactions with details of the accounts debited and credited and the amount of each transaction.

5.2  Format

Date	Particulars	L.F.	Debit Amount Rs.	Credit Amount Rs.

Explanation:

1. Date : In the first column, the date of the transaction is entered. The year and the month is written only once, till they change. The sequence of the dates and months should be strictly maintained.

2. Particulars : Each transaction affects two accounts, out of which one account is debited and the other account is credited. The name of the account to be debited is written first, very near to the line of particulars column and the word Dr. is also written at the end of the particulars column. In the second line, the name of the account to be credited is written, starts with the word ‘To’, a few space away from the margin in the particulars column to the make it distinct from the debit account.

3. Narration : After each entry, a brief explanation of the transaction together with necessary details is given in the particulars column with in brackets called narration. The words ‘For’ or ‘Being’ are used before starting to write down narration. Now, it is not necessary to use the word ‘For’ or ‘Being’.

4. Ledger Folio (L.F): All entries from the journal are later posted into the ledger accounts. The page number or folio number of the Ledger, where the posting has been made from the Journal is recorded in the L.F column of the Journal. Till such time, this column remains blank.

5. Debit Amount : In this column, the amount of the account being debited is written.

6. Credit Amount : In this column, the amount of the account being credited is written.

5.3 Steps in Journalising

The process of analysing the business transactions under the heads of debit and credit and recording them in the Journal is called Journalising. An entry made in the journal is called a ‘Journal Entry’.

Step 1 → Determine the two accounts which are involved in the transaction.

Step 2 → Classify the above two accounts under Personal, Real or Nominal.

Step 3 → Find out the rules of debit and credit for the above two accounts.

Step 4 → Identify which account is to be debited and which account is to be credited.

Step 5 → Record the date of transaction in the date column. The year and month is written once, till they change. The sequence of the dates and months should be strictly maintained.

Step 6 → Enter the name of the account to be debited in the particulars column very close to the left hand side of the particulars column followed by the abbreviation Dr. in the same line. Against this, the amount to be debited is written in the debit amount column in the same line.

Step 7 → Write the name of the account to be credited in the second line starts with the word ‘To’ a few space away from the margin in the particulars column. Against this, the amount to be credited is written in the credit amount column in the same line.

Step 8 → Write the narration within brackets in the next line in the particulars column.

Step 9 → Draw a line across the entire particulars column to separate one journal entry from the other.

5.3.1 Capital and Drawings

It is important to note that business is treated as a separate entity from the business man. All transactions of the business have to be analysed from the business point of view and not from the proprietor’s point of view. The amount with which a trader starts the business is known as Capital. The proprietor may withdraw certain amounts from the business to meet personal expenses or goods for personal use. It is called Drawings.

5.3.2 Bank Transactions

Bank transactions that occur often in the business concerns are cash paid into bank, cheques and bills received from customers paid into bank for collection, payment of cheques for expenses and cheques issued to suppliers or creditors. When a cheque is received treat it as cash.

5.3.3 Compound Journal Entry

When two or more transactions of similar nature take place on the same date, such transactions can be entered in the journal by means of a combined journal entry is called Compound Journal Entry. The only precaution is that the total debits should be equal to total credits.

5.3.4. Opening Entry

Opening Entry is an entry which is passed in the beginning of each current year to record the closing balance of assets and liabilities of the previous year. In this entry asset accounts are debited and liabilities and capital account are credited. If capital is not given in the question, it will be found out by deducting total of liabilities from total of assets.

5.3.5 Advantages

The main advantages of the Journal are:

1. It reduces the possibility of errors.

2. It provides an explanation of the transaction.

3. It provides a chronological record of all transactions.

5.3.6 Limitations

The limitations of the Journal are:

1. It will be too long if all transactions are recorded here.

2. It is difficult to ascertain the balance of each account.

 

6.     Ledger

In the Journal, each transaction is dealt with separately. Therefore, it is not possible to know at a glance, the net result of many transactions. So, in order to ascertain the net effect of all the transactions relating to a particular account are collected at one place in the Ledger.

A Ledger is a book which contains all the accounts whether personal, real or nominal, which are first entered in journal or special purpose subsidiary books.

According to L.C. Cropper, ‘the book which contains a classified and permanent record of all the transactions of a business is called the Ledger’.

The ledger that is normally used in a majority of business concern is a bound note book. This can be preserved for a long time. Its pages are consequently numbered. Each account in the ledger is opened preferably on a separate page. If one page is completed, the account will be continued in the next or some other page. But in bigger concerns, it is not practical to keep the ledger as a bound note book, Loose-leaf ledger now takes the place of a bound note book. In a loose-leaf ledger, appropriate ruled sheets of thick paper are introduced and fixed up with the help of a binder. Whenever necessary additional pages may be inserted, completed accounts can be removed and the accounts may be arranged and rearranged in the desired order. Therefore, this type of ledger is known as Loose-leaf Ledger.

Ledger is a principal or main book which contains all the accounts in which the transactions recorded in the books of original entry are transferred. Ledger is also called the ‘Book of Final Entry’ or ‘Book of Secondary Entry’, because the transactions are finally incorporated in the Ledger. The following are the advantages of ledger.

i. Complete information at a glance:

All the transactions pertaining to an account are collected at one place in the ledger. By looking at the balance of that account, one can understand the collective effect of all such transactions at a glance.

ii. Arithmetical Accuracy

With the help of ledger balances, Trial balance can be prepared to know the arithmetical accuracy of accounts.

iii. Result of Business Operations

It facilitates the preparation of final accounts for ascertaining the operating result and the financial position of the business concern.

iv. Accounting information

The data supplied by various ledger accounts are summarised, analysed and interpreted for obtaining various accounting information.

6.1 Format

 

Explanation:

i.                    Each ledger account is divided into two parts. The left hand side is known as the debit side and the right hand side is known as the credit side. The words ‘Dr.’ and ‘Cr.’ are used to denote Debit and Credit.

ii.                  The name of the account is mentioned in the top (middle) of the account.

iii.                The date of the transaction is recorded in the date column.

iv.    The word ‘To’ is used before the accounts which appear on the debit side of an account in the particulars column. Similarly, the word ‘By’ is used before the accounts which appear on the credit side of an account in the particulars column.

v.      The name of the other account which is affected by the transaction is written either in the debit side or credit side in the particulars column.

vi.    vi. The page number of the Journal or Subsidiary Book from where that particular entry is transferred, is entered in the Journal Folio (J.F) column.

vii.  The amount pertaining to this account is entered in the amount column.

6.2 Posting

The process of transferring the entries recorded in the journal or subsidiary books to the respective accounts opened in the ledger is called Posting. In other words, posting means grouping of all the transactions relating to a particular account at one place. It is necessary to post all the journal entries into various accounts in the ledger because posting helps us to know the net effect of various transactions during a given period on a particular account.

6.3 Procedure of Posting

The procedure of posting is given as follows:

I. Procedure of posting for an Account which has been debited in the journal entry.

·         Step 1 → Locate in the ledger, the account to be debited and enter the date of the transaction in the date column on the debit side.

·         Step 2 → Record the name of the account credited in the Journal in the particulars column on the debit side as “To..... (name of the account credited)”.

·         Step 3 → Record the page number of the Journal in the J.F column on the debit side and in the Journal, write the page number of the ledger on which a particular account appears in the L.F. column.

·         Step 4 → Enter the relevant amount in the amount column on the debit side.

II . Procedure of posting for an Account which has been credited in the journal entry.

·         Step 1 → Locate in the ledger the account to be credited and enter the date of the transaction in the date column on the credit side.

·         Step 2 → Record the name of the account debited in the Journal in the particulars column on the credit side as “By...... (name of the account debited)”

·         Step 3 → Record the page number of the Journal in the J.F column on the credit side and in the Journal, write the page number of the ledger on which a particular account appears in the L.F. column.

·         Step 4 → Enter the relevant amount in the amount column on the credit side.

6.4 Posting of Compound Journal Entries

Compound or Combined Journal Entry is one where more than one transactions are recorded by passing only one journal entry instead of passing several journal entries. Since every debit must have the corresponding equal amount of credit, special care must be taken in posting the compound journal entry, where there may be only one debit aspect but many corresponding credit aspects of equal value or vice versa.

6.5 Posting the Opening Entry

The opening entry is passed to open the books of accounts for the new financial year. The debit or credit balance of an account what is get at the end of the accounting period is known as closing balance of that account. This closing balance becomes the opening balance in the next accounting year.

The procedure of posting an opening entry is same as in the case of an ordinary journal entry. An account which has a debit balance, the words ‘To balance b/d’ are recorded on the debit side in the particulars column. An account which has a credit balance, the words “By balance b/d” are recorded in the particulars column on the credit side. In fact opening entry is not actually posted but the accounts are merely incorporated in the ledger, if the ledger is a new one or old.

6.6. Balancing an Account

Balance is the difference between the total debits and the total credits of an account. When posting is done, many accounts may have entries on their debit side as well as credit side. The net result of such debits and credits in an account is the balance.

Balancing means the writing of the difference between the amount columns of the two sides in the lighter (smaller total) side, so that the grand totals of the two sides become equal.

6.6.1 Significance of balancing

There are three possibilities while balancing an account during a given period. It may be a debit balance or a credit balance or a nil balance depending upon the debit total and the credit total.

i.                    Debit Balance : The excess of debit total over the credit total is called the debit balance. When there is only debit entries in an account, the amount itself is the balance of that account, i.e., the debit balance. It is first recorded on the credit side, above the total. Then it is entered on the debit side, below the total, as the first item for the next period.

ii.                  Credit Balance : The excess of credit total over the debit total is called the credit balance. When there is only credit entries in an account, the amount itself is the balance of that account i.e., the credit balance. It is first written in the debit side, as the last item, above the total. Then it is recorded on the credit side, below the total, as the first item for the next period.

iii.                Nil Balance : When the total of debits and credits are equal, it is closed by merely writing the total on both the sides. It indicates the equality of benefits received and given by that account.

6.6.2 Balancing of different accounts

Balancing is done periodically, i.e., weekly, monthly, quarterly, half yearly or yearly, depending on the requirements of the business.

i. Personal Accounts : These accounts are generally balanced regularly to know the amounts due to the persons (creditors) or due from the persons (debtors).

ii. Real Accounts : These accounts are generally balanced at the end of the financial year, when final accounts are being prepared. However, cash account is frequently balanced to know the cash on hand. A debit balance in an asset account indicated the value of the asset owned by the business. Assets accounts always show debit balances.

iii. Nominal Accounts : These accounts are in fact, not to be balanced as they are to be closed by transfer to final accounts. A debit balance in a nominal account indicates that it is an expense or loss. A credit balance in a nominal account indicates that it is an income or gain.

All such balances in personal and real accounts are shown in the Balance Sheet and the balances in nominal accounts are taken to the Profit and Loss Account.

6.6.3 Procedure for Balancing

While balancing an account, the following steps are involved:

·         Step 1 → Total the amount column of the debit side and the credit side separately and then ascertain the difference of both the columns.

·         Step 2 → If the debit side total exceeds the credit side total, put such difference on the amount column of the credit side, write the date on which balancing is being done in the date column and the words “By Balance c/d” (c/d means carried down) in the particulars column. (OR) If the credit side total exceeds the debit side total, put such difference on the amount column of the debit side, write the date on which balancing is being done in the date column and the words “To Balance c/d” in the particulars column.

·         Step 3 → Total again both the amount columns, put the total on both the sides and draw a line above and a line below the totals.

·         Step 4 → Enter the date of the beginning of the next period in the date column and bring down the debit balance on the debit side along with the words “To Balance b/d” (b/d means brought down) in the particulars column and the credit balance on the credit side along with the words “By balance b/d” in the particulars column.

Note: In the place of c/d and b/d, the words c/f or c/o (carried forward or carried over) and b/f or b/o (brought forward or brought over) may also be used. When the balance is carried down in the same page, the words c/d and b/d are used, while balance is carried over to the next page, the term c/o and b/o are used. When balance is carried forward to some other page either in same book or some other book, the abbreviations c/f (carried forward) and b/f (brought forward) are used.

7.     Trial Balance

In the previous chapters, how to record and classify the transactions in the various accounts along with balancing thereof have been learned. The next step in the accounting process is to prepare a statement to check the arithmetical accuracy of the transactions recorded so for. This statement is called ‘Trial Balance’.

Trial balance is a statement which shows debit balances and credit balances of all accounts in the ledger. Since, every debit should have a corresponding credit as per the rules of double entry system, the total of the debit balances and credit balances should tally (agree). In case, there is a difference, one has to check the correctness of the balances brought forward from the respective accounts. Trial balance can be prepared in any date provided accounts are balanced.

7.1 Definition

“Trial balance is a statement, prepared with the debit and credit balances of ledger accounts to test the arithmetical accuracy of the books” – J.R. Batliboi.

7.2 Objectives

The objectives of preparing a trial balance are:

i. To check the arithmetical accuracy of the ledger accounts.

ii. To locate the errors.

iii. To facilitate the preparation of final accounts.

7.3 Advantages

The advantages of the trial balance are

·         It helps to ascertain the arithmetical accuracy of the book-keeping work done during the period.

·         It supplies in one place ready reference of all the balances of the ledger accounts.

·         If any error is found out by preparing a trial balance, the same can be rectified before preparing final accounts.

·         It is the basis on which final accounts are prepared.

7.4 Methods

A trial balance can be prepared in the following methods.

i. The Total Method : According to this method, the total amount of  the debit side of the ledger accounts and the total amount of the credit side of the ledger accounts are recorded.

ii. The Balance Method : In this method, only the balances of an account either debit or credit, as the case may be, are recorded against their respective accounts.

The balance method is more widely used, as it supplies ready figures for preparing the final accounts.

 

 

7.5  Format

Points to be noted :

i. Date on which trial balance is prepared should be mentioned at the top.

ii. Name of Account column contains the list of all ledger accounts.

iii. Ledger folio of the respective account is entered in the next column.

iv. In the debit column, debit balance of the respective account is entered.

v. Credit balance of the respective account is written in the credit column.

vi. The last two columns are totalled at the end.

The following accounts always appear with debit balance in Trial Balance.

·         Asset Accounts:

·         Land Account

·         Building Account

·         Machinery Account

·         Furniture Account

·         Debtors Account

·         Stock Account

·         Bills Receivable Etc.

·    Accounts Relating To Expenses And Losses:

·         Salaries Account

·         Wages Account

·         Rent Account

·         Carriage Account

·         Discount Account

·         Bad Debts Account

·         Depreciation Account

·         Purchases Account

·         Return Inward Account (Sales Return Account) Etc.

The following accounts always appear with credit balances in Trial Balance:

·         Liabilities Accounts:

·         Creditors Account

·         Loan Account

·         Mortgage Account

·         Bills Payable Account

·         Bank Overdraft Account

·         All Types Of Reserves And Funds Accounts.

·         Income And Gain Accounts:

·         Interest Realized Account,

·         Rent Collected Account,

·         Discount Received Account,

·         Sales Account,

·         Return Outward Account (Purchase Return Account) Etc.

7.6 Sundry Debtors and Sundry Creditors

In the ledger there are many personal accounts, some of them may show debit balances, some others may show credit balances. If all the names are to be written in the trial balance it will be unduly long. Therefore, a list of names with the debit balances is prepared. This list is known as ‘Sundry Debtors’ (Sundry means ‘many’). Similarly, a list of names with the credit balances is prepared. This list is known as ‘Sundry Creditors’.

Note: The last column given in the solution does not appear in practice. It is included here to illustrate the following generalised rules, that

i) a debit balance is either an asset or loss or expense; and

ii) a credit balance is either a liability or income or gain.

7.7 Limitations

Though the trial balance helps to ensure the arithmetical accuracy of the books of accounts, it is possible only when the accountant has not committed any error. As all the errors made are not disclosed by the trial balance, it would not be regarded as a conclusive proof of correctness of the books of accounts maintained.

8.     Final Accounts

Trial 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.

8.1 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.

8.2 Trading Account

Trading means buying and selling. The trading account shows the result of buying and selling of goods.

8.2.1 Need

At the end of each year, it is necessary to ascertain the net profit or net loss. For this purpose, it is first necessary to know the gross profit or gross loss. The trading account is prepared to ascertain this. The difference between the selling price and the cost price of the goods is the gross earning of the business concern. Such gross earning is called as gross profit. However, when the selling price is less than the cost of goods purchased, the result is gross loss.

 

 

8.2.2 Format

Items appearing in the debit side

1. Opening stock: Stock on hand at the beginning of the year is termed as opening stock. The closing stock of the previous accounting year is brought forward as opening stock of the current accounting year. In the case 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 expenses.

Items appearing in the credit side

i. Sales: 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).

8.2.3 Balancing

The difference between the two sides of the Trading Account, indicates either Gross Profit or Gross Loss. If the credit side total is more, the difference represents Gross Profit. On the other hand, if the total of the debit side is more, the difference represents Gross Loss. The Gross Profit or Gross Loss is transferred to Profit & Loss Account.

8.2.4 Closing Entries

Like ledger accounts, trading account will be closed by transferring the gross profit or gross loss to the profit and loss account.

 

8.3 Profit and Loss Account

After calculating the gross profit or gross loss the next step is to prepare the profit and loss account. To earn net profit a trader has to incur many expenses apart from those spent for purchases and manufacturing of goods. If such expenses are less than gross profit, the result will be net profit. When total of all these expenses are more than gross profit the result will be net loss

8.3.1 Need:

The aim of profit and loss account is to ascertain the net profit earned or net loss suffered during a particular period.

8.3.2 Format

Items appearing in the debit side

Those expenses which are chargeable to the normal activities of the business are recorded in the debit side of profit and loss account. They are termed as indirect expenses.

i. Office and Administrative Expenses : Expenses incurred for the functioning of an office are office and administrative expenses – office salaries, office rent, office lighting, printing and stationery, postages, telephone charges etc.

ii. Repairs and Maintenance Expenses : These expenses relates to the maintenance of assets - repairs and renewals, depreciation etc.

iii. Financial Expenses : Expenses incurred on borrowings – Interest paid on loan.

iv. Selling and Distribution Expenses : All expenses relating to sales and distribution of goods - advertising, travelling expenses, salesmen salary, commission paid to salesmen, discount allowed, repacking charges etc.

 

 

Items appearing in the credit side

Besides the gross profit, other gains and incomes of the business are shown on the credit side. The following are some of the incomes and gains.

i. Interest received on investment

ii. Interest received on fixed deposits.

iii. Discount earned.

iv. Commission earned.

v. Rent Received

 

Note:

i. If trial balance shows both trading expenses as well as office expenses, the trading expenses should be shown in the trading account and office expenses should be shown in profit & loss account. On the other hand, if the trial balance shows only trading expenses, it should be shown in the profit & loss account.

ii. If in the trial balance, wages are clubbed with salaries and shown as ‘wages and salaries’. This item is shown in trading account. On the other hand, if it appears as ‘salaries and wages’, this item is recorded in the profit & loss account.

iii. Income tax paid by a proprietor is considered as personal expenses. So it should be deducted from the capital.

8.3.3 Balancing

The difference between the two sides of profit and loss account indicates either net profit or net loss. If the total on the credit side is more the difference is called net profit. On the other hand if the total of debit side is more the difference represents net loss. The net profit or net loss is transferred to capital account.

 

 

8.3.4 Closing Entries

Profit and loss account should be closed by transferring the net profit or net loss to capital account.

8.4 Balance Sheet:

This forms the second part of the final accounts. It is a statement showing the financial position of a business. Balance sheet is prepared by taking up all personal accounts and real accounts (assets and properties) together with the net result obtained from profit and loss account. On the left hand side of the statement, the liabilities and capital are shown. On the right hand side, all the assets are shown. Balance sheet is not an account but it is a statement prepared from the ledger balances. So, the accounts should not prefixed with the words ‘To’ and ‘By’.

Balance sheet is defined as ‘a statement which sets out the assets and liabilities of a business firm and which serves to ascertain the financial position of the same on any particular date’.

8.4.1 Need :

The need for preparing a Balance sheet is as follows:

i. To know the nature and value of assets of the business

ii. To ascertain the total liabilities of the business.

iii. To know the position of owner’s equity.

 

 

8.4.2 Format

The Balance sheet of a business concern can be presented in the following two forms

i. Horizontal form or the Account form

ii. Vertical form or Report form

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 sheet

In this, Balance is presented in a statement form.

8.4.3 Classification of Assets and Liabilities Assets

 

 

ASSETS

Assets 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:

 

a) Tangible Assets:

Assets which have some physical existence are known as tangible assets. They can be seen, touched and felt, e.g. Plant and Machinery

Tangible assets are classified into

i. Fixed assets :

Assets which are permanent in nature having long period of life and cannot be converted into cash in a short period are termed as fixed assets.

ii. Current assets :

Assets which can be converted into cash in the ordinary course of business and are held for a short period 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 Assets

The assets which have no physical existence and cannot be seen or felt. They help to generate revenue in future, e.g. goodwill, patents, trademarks etc.

c) Fictitious Assets

These assets are nothing but the unwritten off losses or non-recoupable expenses. They are really not assets but are worthless items. For example, Preliminary expenses.

 

 

LIABILITIES

The amount which a business owes to others is liabilities. Credit balance of personal and real accounts together with the capital account are liabilities.

a) Long Term Liabilities

Liabilities which are repayable after a long period of time are known as Long Term Liabilities. For example, capital, long term loans etc.

b) Current Liabilities

Current liabilities are those which are repayable within a year. For example, creditors for goods purchased, short term loans etc.

c) Contingent liabilities

It is an anticipated liability which may or may not arise in future. For example, liability arising for bills discounted. Contingent liabilities will not appear in the balance sheet. But shown as foot note.

8.4.4 Marshalling of Assets and Liabilities

The term ‘Marshalling’ refers to the order in which the various assets and liabilities are shown in the balance sheet. The assets and liabilities can be shown either in the order of liquidity or in the order of permanence.

a) In order of liquidity

Liquidity means convertibility into cash. Assets will be said to be liquid if it can be converted into cash easily, they are placed at the top of the balance sheet. Liabilities are arranged in the order of their urgency of payment. The most urgent payment to be made is listed at the top of the balance sheet.

b) In order of permanence

This order is exactly the reverse of the above. Assets and liabilities are recorded in the order of their life in the business concern.

 

 

8.4.5 Balance Sheet Equation

An important thing to note about the Balance Sheet is that, the total value of the assets is always equal to the total value of the liabilities. This is because the liability to the owner - capital, is always made up of the difference between assets and liabilities. Thus,

Assets = Liabilities + Capital

                   or

Capital = Assets - Liabilities

While preparing the trial balance in case it does not tally the difference is transferred to an imaginary account called as suspense account. In case the suspense account is not closed before the preparation of the final accounts then it has to be placed in the balance sheet, so that it can be rectified later. If suspense account has a debit balance it will appear as the last item in the asset side. In case it shows a credit balance it will appear as the last item in the liability side.

 

8.5 Difference between Trial Balance and Balance Sheet

 

S.No.	Basis Distinction	Trial balance	Balance sheet
1	Objective	To know the arithmetical accuracy of the accounting work.	To know the true and fair financial position of a business.
2	Format	The columns are debit balances and credit balances.	The two sides are assets and liabilities.
3.	Content	It is a summary of all the ledger balances – personal, real and nominal accounts.	It is a statement showing closing balances of personal & real accounts.
4	Stage	It is the middle stage in the preparation of accounts.	It is the last stage in the preparation of accounts.
5	Period	It can be prepared periodically, say at the end of the month, quarterly or half yearly, etc.	It is generally prepared at the end of the accounting period.
6	Preparation	It is prepared before the preparation of trading, profit and loss account.	It is prepared after the preparation of trading, profit and loss account.
7	Stock	It shows opening stock only.	It shows closing stock only.
8	Order	Balances shown in the trial balance are not in order.	Balances shown in the balance sheet must be in order.
9	Evidence	It cannot be produced as a documentary evidence in the court.	It can be produced as a documentary evidence.
10	Compulsion	Preparation of trial balance is not compulsory.	Preparation of the balance sheet is a must.