Unit 1: Theoretical Framework

Chapter 1:

Introduction to Accounting

MEANING OF ACCOUNTING

“Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events, which are in part at least, of a financial character, and interpreting the results thereof.”

Accounting is the process of recording financial transactions pertaining to a business. The accounting process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators, and tax collection entities. The financial statements used in accounting are a concise summary of financial transactions over an accounting period, summarizing a company's operations, financial position, and cash flows.

NEED FOR ACCOUNTING

• In all activities and organizations (business or non-business) which require money and other economic resources, accounting is required to account for these resources.

• In other words, wherever money is involved, accounting is required to account for it.

• Accounting is often called the language of business. The basic function of any language is to serve as a means of communication. Accounting also serves this function.

CHAPTER -2

THE THEORY BASE OF ACCOUNTING

Generally Accepted Accounting Principles (GAAP)

In order to maintain uniformity and consistency in accounting records, certain rules or principles have been developed which are generally accepted by the accounting profession. These rules are called by different names such as principles, concepts, conventions, postulates, assumptions and modifying principles. The term ‘principle’ has been defined by AICPA as ‘A general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice’.

The word ‘generally’ means ‘in a general manner’, i.e. pertaining to many persons or cases or occasions. Thus, Generally Accepted Accounting Principles (GAAP) refers to the rules or guidelines adopted for recording and reporting of business transactions, in order to bring uniformity in the preparation and the presentation of financial statements. For example, one of the important rule is to record all transactions on the basis of historical cost, which is verifiable from the documents such as cash receipt for the money paid. This brings in objectivity in the process of recording and makes the accounting statements more acceptable to various users. The Generally Accepted Accounting Principles have evolved over a long period of time on the basis of past experiences, usages or customs, statements by individuals and professional bodies and regulations by government agencies and have general acceptability among most accounting professionals.

However, the principles of accounting are not static in nature. These are constantly influenced by changes in the legal, social and economic environment as well as the needs of the users. These principles are also referred as concepts and conventions. The term concept refers to the necessary assumptions and ideas which are fundamental to accounting practice, and the term convention connotes customs or traditions as a guide to the preparation of accounting statements. In practice, the same rules or guidelines have been described by one author as a concept, by another as a postulate and still by another as convention. This at times becomes confusing to the learners. Instead of going into the semantics of these terms, it is important to concentrate on the practicability of their usage. From the practicability view point, it is observed that the various terms such as principles, postulates, conventions, modifying principles, assumptions, etc. have been used inter- changeably and are referred to as Basic Accounting Concepts in the present chapter.

Basic Accounting Concepts

Accounting Principles

Principles of Accounting are the general law or rule adopted or proposed as a guide to action, a settled ground or basis of conduct or practice. Accounting principles are man-made. Unlike the principles of physics, chemistry, and the other natural sciences, accounting principles were not deducted from basic axioms, nor is their validity verifiable by observation and experiment. Instead, they have evolved. This evolutionary process is going on constantly; accounting principles are not “eternal truths”.

Business Entity Concept

This concept considers a business unit as a separate entity. Business and businessman are two separate entities and all the business transactions are recorded in the books of accounts from business point of view.

Dual Aspect Concept

This Concept also known as equivalence concept signifies that every business transaction has two fold effects or every transaction affects at least two accounts. This concept is, in fact, the base on  which Double Entry System of Book-Keeping is based. According to this principle, every debit has a corresponding credit.

Accounting Period Concept

According to this concept the long life of business is divided into justifiable accounting periods so as to help businessman to know the results of his investment during each such period. This period is known as accounting period and the length of this period depends on the nature of business. Accounting period may be either a calendar year (From January 1 to December 31) or the fiscal year of the Govt. (April 1 to March 31)

Going Concern Concept

This concept assumes that every business has a long and indefinite life. Since financial statements are prepared on the basis of this concept, all fixed assets are shown in the books at their cost ignoring their market value.

Cost Concept

According to this concept all fixed assets are recorded in the books at cost i.e. the price paid to acquire them. Any subsequent increase or decrease in their value will not be shown in the records except the depreciation of these assets. In subsequent years, therefore fixed assets are shown at cost less depreciation provided on them up to date. Continuous charging of depreciation on the asset will ultimately eliminate the asset from the books.

Money Measurement Concept

According to this concept only those transactions are recorded in the books of accounts which can be expressed in monetary terms. The non-financial or non-monetary transactions do not find any place in the accounting records. Money is the common denominator to denote the value of the various assets of diverse nature to give a meaningful total of these assets.

Matching Concept

This concept states that it is necessary to charge all the expenses incurred to earn revenue during the accounting period against that revenue in order to ascertain the net income or trading results of the business. The matching concept which is so closely related to accrual concept and accounting period concept helps a businessman in realizing his objective i.e. in ascertaining the trading results or profit or loss from the business. For ascertaining the net income.

 Accounting Equivalence Concept

According to this concept assets owned by the business must be equal to the funds contributed by the businessman in the form of capital. These days when business is to be carried on a large scale, funds may be borrowed from third parties to supplement the funds contributed by the proprietor.

Realization Concept

According to this concept income is treated as being earned on the date on which it is realized i.e. the date on which goods or services are transferred to the customers. Since this exchange of goods or services may be for cash or on credit, it is not important whether cash has actually been received or not.

Objective Evidence Concept or Verifiable Objective Concept

This concept justifies the significance of verifiable documents supporting various transactions. According to it, each transaction should be supported by objective evidences like vouchers. Objective evidence, here, means evidence free from bias of the accountant.

Materiality

This principle emphasizes that only those transactions should be recorded which are material or relevant for the determination of income from the business. All immaterial facts should be ignored.

Full Disclosure

This concept implies that financial statements should disclose all material information which is required by the proprietor and other users to assess the final accounts of the business unit

Consistency

This principle requires that accounting practices, methods and techniques used by a business unit should be consistent. A business unit can adopt any accounting practice, but once a particular practice is chosen, it must be used for a number or years.

Conservatism or Prudence

This principle is nothing but a formal expression of the maxim “Anticipate no profits and provide for all possible losses.” In other words, it considers all possible losses but ignores all possible profits.

Timeliness of Information

Accounting information to the management should be supplied in time and frequently so that some rational decisions may be taken. If information is not supplied in time, it will obstruct the quick decision-making process of the undertaking.

CHAPTER -3

RECORDING OF TRANSACTIONS

 

BUSINESS TRANSACTION AND SOURCE DOCUMENTS

Meaning of Source document:

Business transactions are recorded in the books of accounts on the basis of some written evidence called source document.

Types of sources of documents:

1. Cash memo-when the trader sells and purchase goods for cash he gives and received cash memo.

2. Invoice and bill- when a trader sells goods on credit he prepares a sale invoice which contain of all detail of transaction.

3. Debit note-when a business return goods to supplier business prepare a debit not and send to the supplier with the return goods.

4. Credit note- when goods are received back from a customer a credit not send to him that the customer account has been credited in our books.

5. Pay in slip-this is a form available from a bank and it used to deposit money in the bank.

 Meaning of Voucher

Documentary evidence in support of the transaction is known as voucher.

Type of voucher:

1. Cash voucher- Cash voucher is prepared for cash transaction i.e., cash receipt and cash payments. These are two type ;

(i) debit voucher-its prepared for cash payment

(ii) Credit voucher- its prepared for cash receipts.

2. Non –cash voucher-these vouchers are prepared for credit transactions like credit sale and purchase, depreciation, bad debts.

FORMATE OF CREDIT VOUCHER

ACCOUNTING AS ASOURCE OF INFORMATION

Accounting is a definite process of interlinked activities that begins with the identification of transactions and ends with the preparation of financial statements.

Every step in the process of accounting generates information.

Generation of information is not an end in itself. It is a means to facilitate the dissemination of information among different user groups.

Such information enables the interested parties to take appropriate decisions. Therefore, dissemination of information is an essential function of accounting.

To be useful, the accounting information should ensure to:

• provide information for making economic decisions.

• serve the users who rely on financial statements as their principal source of information.

• provide information useful for predicting and evaluating the amount, timing and uncertainty of potential cash-flows.

• provide information for judging management’s ability to utilize resources effectively in meeting goals.

• provide factual and interpretative information by disclosing underlying assumptions on matters subject to interpretation, evaluation, prediction, or estimation.

• provide information on activities affecting the society.

OBJECTIVES OF ACCOUNTING

• Objective of accounting may differ from business to business depending upon their
• specific requirements. However, the following are the general objectives of accounting.
• Keeping systematic record.
• Ascertain the results of the operation.
• Ascertain the financial position of the business.
• Portray the liquidity position.
• To provide information to various parties.
• To facilitate rational decision – making.
• To satisfy the requirements of law

ACCOUNTING

• The object of accounting is to record, classify, summarize, analyze, and interpret the business transactions and ascertain financial results and to communicate to various parties.
• It has a wider scope.
• It is concerned with all levels of Management.

ADVANTAGES OF ACCOUNTING

• Replacement of memory
• Evidence court
• Assessment of taxation liability
• Comparative study
• Sale of business
• Assistance to the insolvent person
• Assistance to various parties
• Facilities in raising loans
• Information regarding financial position.

LIMITATIONS OF ACCOUNTING

• Records only monetary transactions.
• Unsuitable for forecasting.
• No realistic information
• Personal bias of the accountant affects the accounting statements .
• Incomplete information.
• Profit no real test of managerial performance .
• Historical in nature.
• Window dressing in balance sheet.

ROLE OF ACCOUNTING

For centuries, the role of accounting has been changing with the changes in economic development and increasing societal demands.

It describes and analyses a mass of data of an enterprise through measurement, classification and summarization, and reduces those date into reports and statements, which show the financial condition and results of operations of that enterprise. Hence, it is regarded as a language of business.

It also performs the service activity by providing quantitative financial information that helps the users in various ways.

Accounting as an information system collects and communicates economic information about an enterprise to a wide variety of interested parties. However, accounting information relates to the past transactions and is quantitative and financial in nature, it does not provide qualitative and non-financial information. These limitations of accounting must be kept in view while making use of the accounting information.

USERS OF ACCOUNTING INFORMATION

Owners:

The owners provide funds or capital for the organization. They possess curiosity in knowing whether the business is being conducted on sound lines or not, and whether the capital is being employed properly or not. Owners, being businessmen, always keep an eye on the returns from the investment. Comparing the accounts of various years helps in getting good pieces of information.

Management:

The management of the business is greatly interested in knowing the position of the firm. The accounts are the basis, the management can study the merits and demerits of the business activity. Thus, the management is interested in financial accounting to find whether the business carried on is profitable or not. The financial accounting is the “eyes and ears of management and facilitates in drawing future course of action, further expansion etc.”

Creditors:

Creditors are the persons who supply goods on credit, or bankers or lenders of money. It is usual that these groups are interested to know the financial soundness before granting credit. The progress and prosperity of the firm, two which credits are extended, are largely watched by creditors from the point of view of security and further credit. Profit and Loss Account and Balance Sheet are nerve centers to know the soundness of the firm.

Employees:

Payment of bonus depends upon the size of profit earned by the firm. The more important point is that the workers expect regular income for the bread. The demand for wage rise, bonus, better working conditions etc. depend upon the profitability of the firm and in turn depends upon financial position. For these reasons, this group is interested in accounting.

Investors:

The prospective investors, who want to invest their money in a firm, of course wish to see the progress and prosperity of the firm, before investing their amount, by going through the financial statements of the firm. This is to safeguard the investment. For this, this group is eager to go through the accounting which enables them to know the safety of investment.

Government:

Government keeps a close watch on the firms which yield good amount of profits. The state and central Governments are interested in the financial statements to know the earnings for the purpose of taxation. To compile national accounting is essential.

Consumers:

These groups are interested in getting the goods at reduced price. Therefore, they wish to know the establishment of a proper accounting control, which in turn will reduce to cost of production, in turn less price to be paid by the consumers.

Researchers are also interested in accounting for interpretation.

Research Scholars:

Accounting information, being a mirror of the financial performance of a business organization, is of immense value to the research scholar who wants to make a study into the financial operations of a particular firm as such study needs detailed accounting information relating to purchases, sales, expenses, cost of materials used, current assets, current liabilities, fixed assets, long-term liabilities and share-holders funds.

• The accounting system concerned only with the financial state of affairs and financial results of operations.
• It is the original form of accounting. It is mainly concerned with the preparation of financial statements for the use of outsiders like creditors, debenture holders, investors and financial institutions.

MEANING AND DEFINITION OF BOOKKEEPING

Definition: “The art keeping permanent record of business transactions is book keeping.”
J. R. Batliboi: “book-keeping is an art of recording business dealings in a set of books”.
R. N. Carter: “Book-keeping is the science and art of correctly recording in the books of accounts, all those business transactions that results in transfer of money’s worth”.

FEATURES OF BOOK-KEEPING

• It is the process of recording business transactions.
• Monetary transactions are only recorded.
• Recording is made in given set of books of accounts.
• Record is prepared for a specific period but presented for future references.
• It is an art of recording business transactions scientifically.

DIFFERENCE B/W BOOK-KEEPING AND ACCOUNTING

BOOK-KEEPING

• The object of book-keeping is to prepare originalbooks of accounts, trial balance and to maintain systematic record of financial results.
• It has a limited scope.
• Level of work is restricted to clerical work

BASIC TERMS USED IN ACCOUNTING

Entity

• An entity means an economic unit which performs economic activities e.g., Bajaj Auto, Maruti, TISCO.

Account

• It is a summarized record of

• Relevant transactions at one place

• relating to a particular head. It records not only the amount of transactions.

• But also reflect the direction of the account.

Entry

• A transaction and event when recorded in the books of accounts is known as an Entry.

Transaction

• It is a financial happening entered into by two or more willing parties.

• It effects a change in the asset, liability, or net worth account.

• It is recorded first in journal and then posted into the ledger Examples of a transaction are sale of goods, purchases of goods, receipt from debtors, payment made to creditors, purchase or sale of fixed assets, payment of dividend, etc.

Proprietor

• is the person who makes the investment and bears all the risks and rewards of the business.

Debtor

• A person or firm or company who owes amount to the enterprise on account of credit sale of goods or services.

• The amount due from him is a debt.

• The amount due from a person as per the books of the account is called a book debt.

Drawings

• It is the amount of money or the value of goods which the proprietor or a partner takes for his domestic or personal use.

• Drawing reduces the investment (or capital) of the owners.

• It appears only in the accounts of sole proprietorship firms and partnership firms.

Purchases

• The term purchases are used only for purchases of goods.

• Goods are those items which are purchased for resale or

• for manufacture of products which are also to be sold.

• It includes both cash and credit purchases

Depreciation

• It is a fall in the value of an asset

• Because of usage

• With passage of time

• Obsolescence

• Accident

Purchases Return:

• Goods purchased may be returned due to any reason, say, they are not as per specifications or are defective.

• Goods returned are termed as Purchases Return or Returns Outward.

Sale

• This term is used for the sale of goods dealt by the enterprise.

• The term ‘Sales’ includes both Cash and Credit Sales.

• When goods are sold for cash, they are cash sales

• When goods are sold and payment is to be received at a later date, they are credit sales.

Sales Return or Returns Inwards

• It means Goods sold returned by the purchaser.

Discount

• A reduction in the price of goods is Discount.

Trade Discount

• It is a discount allowed to a customer on the basis of quantity of goods purchased.

Cash Discount

• It is a discount allowed to a customer for making prompt or timely payment.

Capital

• It means the amount (in terms of money or assets having money value)

• Which the proprietor has invested in the business

• can claim from it.

• It is a liability of the business towards the owner.

• It is so because of Business Entity Concept.

• Capital = Assets – Liabilities

Gain

• It is a profit that arises from transactions which are incidental to business such as

• sale of investments or fixed assets

• at more than their book values.

• Gain may be operating gain or non-operating gain.

Cost

• It is the amount of expenditure

• incurred on or

• Attributable to

• A specified article, product or activity.

Creditor

• A person or firm or company to whom the enterprise owes amount on account of Credit purchase of goods or services.

Assets:

• Assets are property or legal rights

• owned by an individual or business

• to which money value can be attached.

• In other words, anything which will enable the firm to get cash or a benefit in the future,

Bad Debt

• It is the amount that has become irrecoverable

• It is a business loss, and

• Thus, is debited to Profit and Loss Account.

Insolvent

• Insolvent is a person or an enterprise which is not in a position to pay its debts.

Liabilities

• Liabilities means the amount

• Which the business owes to outsiders,

• Excepting the proprietors.

• Liabilities can be classified in

(i) Long-Term Liabilities

(ii) Current Liabilities,

• This can be expressed as: Liabilities = Assets – Capital

Goods

• They refer to items forming part of the stock-in-trade of an enterprise,

• Which are purchased or manufactured with a purpose of selling.

• In other words, they refer to the products in which an enterprise is dealing.

Stock or Inventory

• Stock is the tangible property held by an enterprise

• For the purpose of sale in the ordinary course of business or

• For the purpose of using it in the production of goods

• meant for sale or services to be rendered.

• Stock may be opening stock or closing stock.

Profit

• Profit is the surplus of revenues of a business over its costs.

Profit is categorized into:

 (i) Gross Profit: Gross Profit is the difference between sales revenue or the proceeds of goods sold and/or services rendered over its direct cost.

 (ii) Net Profit: Net Profit is the profit made after allowing for all expenses. In case expenses are more than the revenue; it is Net Loss.

Loss

• Loss is excess of expenses over its related revenues which may arise from normal business activities.

• It decreases the owner’s equity.

• It also refers to money or money’s worth lost (or cost incurred) against which the enterprise receives no benefit, e.g., cash or goods lost in theft.

• It also arises from events of non-recurring nature, e.g., loss on sale of fixed assets.

Expense

• An expense is the amount spent in order to produce and sell the goods and services which produce the revenue.

• Expense is the cost of the use of things or services for the purpose of generating revenue.

• Expense is that part of the expenditure which has been consumed during the current accounting period.

• Examples of expense are payment of salaries, wages, rent, etc.

Expenditure:

• Expenditure is the amount spent or liability incurred for the value received

• Expenditure may be categorized into: (i) Capital Expenditure (ii) Revenue Expenditure

• Expenditure is a payment (or a money sacrifice) for a benefit received.

Capital Expenditure

• It is the amount spent in purchasing assets which will give benefit over more than one accounting period.

• It means expenditure incurred to acquire fixed assets or its improvement.

• Capital expenditure is debited to particular asset account.

• They appear at the assets side of the Balance Sheet.

Revenue Expenditure

• It is the amount spent to purchase goods and services that are consumed during the accounting period.

• It is shown in the debit side of the Profit and Loss Account.

Revenue

• It is the gross inflow of cash, receivables or other consideration.

• arising in the ordinary course of business activities.

• From the sale of goods, rendering of services.

• Use by others of enterprise resources yielding interest, royalties and dividends.

Income:

• Income is the profit earned during an accounting period.

• In other words, the difference between revenue and expense is called income.

• Income = Revenue – Expense

System accounting

The systems of recording transactions in the book of accounts are generally classified into two types, viz. Double entry system and Single entry system. Double entry system is based on the principle of “Dual Aspect” which states that every transaction has two effects, viz. receiving of a benefit and giving of a benefit. Each transaction, therefore, involves two or more accounts and is recorded at different places in the ledger. The basic principle followed is that every debit must have a corresponding credit. Thus, one account is debited and the other is credited. Double entry system is a complete system as both the aspects of a transaction are recorded in the book of accounts. The system is accurate and more reliable as the possibilities of frauds and mis-appropriations are minimised. The arithmetic inaccuracies in records can mostly be checked by preparing the trial balance.

The system of double entry can be implemented by big as well as small organisations. Single entry system is not a complete system of maintaining records of financial transactions. It does not record two-fold effect of each and every transaction. Instead of maintaining all the accounts, only personal accounts and cash book are maintained under this system. In fact, this is not a system but a lack of system as no uniformity is maintained in the recording of transactions. For some transactions, only one aspect is recorded, for others, both the aspects are recorded. The accounts maintained under this system are incomplete and unsystematic and therefore, not reliable. The system is, however, followed by small business firms as it is very simple and flexible (you will study about them in detail later in this book).

Business Transactions

An exchange of goods or services for cash or on credit by the business with outsiders is called a transaction. In the words of L. C. Copper, “A person’s dealings in money or money’s worth are termed as transactions.”

Entity: - Business entity means a specific identifiable business enterprise like Tata, Reliance, Amul, Sony etc.

Transactions: - Exchange of goods and services for consideration.

Assets: - These are properties or economic resources of an enterprises which can be expressed in monetary terms it can be divided in two parts

(a) Non-Current Assets: Fixed assets: Tangible & Intangible (more than 1 year period)

• Tangible Assets
• Land and Building
• Plant and Machinery
• Furniture
• Office Equipments
• Intangible Assets
• Goodwill
• Patents
• Trademarks
• Copyright
• Computer software

(b) Current assets (less than 1 year period)

• Debtors
• Bills Receivable
• Cash in hand
• Cash at bank
• Cheque in hand
• Drafts in hand
• Stock
• Prepaid Expenses

Definition of Assets

“Assets are future economic benefits, the rights, which are owned or controlled by an organization or individual.” -- Finney and Miller “Assets are property or legal right owned by an individual or a company to which money value can be attached.” -- R. Brockington According to Institute of Certified Public Accountants, U.S.A; “Current Assets include cash and other assets or resources commonly identified as those which are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.”

Liabilities:

These are certain obligations or dues which firm has to pay. Liabilities can be divided into two categories i.e.,Non-Current Liabilities and Current Liabilities.

Non-Current Liabilities

• Bank Loan
• Mortgage
• Loan from other financial institutions
• Other long-term liabilities

Current Liabilities

• Creditors
• Bills Payable
• Outstanding Expenses
• Bank overdraft

Trade Receivables: Debtors + Bills Receivables

Debtors: - There are persons who owe to an enterprise an amount for buying goods and services on credit.

Bills Receivables: Amount to be received againt B/R (from debtors).

Trade Payable: Creditors + Bills Payable.

Creditors: - These are persons who have to be paid by an enterprise an amount for providing the enterprise goods and services on credit.

Bills Payable:  Amount payable against the bills (to the creditors).

Capital: It is an essential investment for commencement of every business.

Sales: It can be credit or cash, in which goods are delivered to customers: (a) Cash Sales (b) Credit Sales.

Revenues: -It is the amount which is earned by selling of products.

Expense: -It is known as cost of assets consumed or services which used.

Expenditure: -It means spending money for some benefit.

Profit: - Excess of revenues over expenses is called profit.

Gain: - It generates from incidental transaction such as sales of fixed asset, winning of court case.

Loss: - Excess of expenses over income is termed as loss.

Discount: -It is defined as concession or deduction in price of goods sold.

Voucher: -It is known as evidence in support of a transaction.

Goods: - It refers all the tangible goods (Raw material, work in progress, finished goods.)

Drawings: - Amount of goods or cash which is withdrawn from business for personal use.

Purchases: - It means of procurement of goods on credit or cash.

Stock: - It is a part of unsold goods. It can be divided into two categories.

1. Opening stock

2. Closing stock.

Balance Sheet: Balance Sheet is prepared at the end of each accounting period to ascertain the financial position of the business.

Format of Balance Sheet

Capital expenditure:

“Outlay resulting in the increase or acquisition of an asset or increase in the earning capacity of the business is capital expenses”. William pickles

Benefit of this expenditure we [business] enjoy for a long time. Capital expenditure is incurred for the purpose of enjoying long term advantage for the business.

This expenditure is mostly incurred for buying assets [tangible or intangible] which can later to be sold and converted into cash.

This expenditure is incurred to increase the earning capacity of the business.

Some examples of capital expenditure:

• Expenditure which are only for acquisition of fixed Assets
• Expenditure which are used for the extension or improvement in fixed Assets
• Legal charges incurred
• purchase of land, building,
• Purchase of furniture,
• Or any fixed asset for permanent use in the business.

Revenue expenditure: Mostly benefit of this expenditure we [business] enjoy only within the current year. Expenses of administration, manufacturing, selling expense, Office expense and all day to day expenses of the current year, are example of revenue expenditure.

According to Kohlar, it is “an expenditure charged against operation: a term used to contrast with capital expenditure.”

Basis of Accounting:

Cash Basis of Accounting: Under this method only cash transactions are recorded in the books of accounts. Entries are made only if cash is received or paid.

Accrual Basis of Accounting: Under this method all transactions are recorded in the books of accounts (Cash and Non-Cash). Entries are made on the Accrual basis, it means cash and Non-cash both transactions are recorded in the books of accounts.

Source of Documents

All financial transactions are recorded in the books of accounts on the basis of source document or on the basis of some evidence. Source documents are helpful to prove that a transaction is actually made or not.

Cash Memo: Cash Memo is A bill of sale, it is a written document by a 'seller' to a purchaser, reporting that on a specific date, a particular sum of money or other "value received",

Invoice or Bill: When goods are sold on credit, An invoice or bill is issued on the name of the buyer, indicating the products, quantities, and agreed prices for products or services, the seller has provided the buyer.

Receipt: A receipt is a written acknowledgment that a specified a sum of money has been received from the customer as an exchange for goods or services. The receipt is evidence of purchase of the goods or service.

Pay-in-Slip: Pay in slip is a form that is filled when the money is deposited by a customer in to his bank account.

Cheque: A cheque is a document (usually a piece of paper) that orders a payment of money. The person writing the cheque, the drawer, usually has a account where the money is deposited.

Debit Note: When we return goods back to the supplier, a debit not is made on the name of supplier, it means his account his debited. Debit Note proves that a debit entry has been made to a debtor's or creditor's account.

Credit Note: When we receive goods back from our customer, then a credit not is made on the name of the customer, it means customer’s account is credited.

Meaning of Voucher: Voucher is the documentary proof or evidence in support of a transaction. For example when we purchase goods for cash, we get cash memo, and when we purchase goods on credit, we get an invoice, when we make payment we get Receipt.

Types of Vouchers

There are two types of vouchers a) Cash Voucher b) Non Cash Voucher

Cash Vouchers: Cash vouchers are prepared for cash transactions only, when cash is received or paid. There are two types of cash vouchers: a) Debit Vouchers b) Credit Vouchers

Debit Vouchers: Debit vouchers are prepared only for cash payments.

Credit Vouchers : Credit vouchers are the opposite side of debit vouchers, Credit vouchers are prepared when we receive cash

Preparation of accounting vouchers: All business transactions recorded in the books of accounts can be compared with the source documents. Accounts are debited or credited on the basis of these source documents. After deciding, that what to be debited or credited, the next step is the preparation of the vouchers.

Meaning of Accounting Equation

The Accounting Equation' is based on the double-entry book keeping system. For every debit there must be a credit. The accounting equation states that the sum of the Total assets must be equal to the sum of the liabilities.

Assets = Liabilities + Capital

                  Or

 Capital = Assets - Liabilities

                 Or

 Liabilities = Assets - Capital

                 Or

 Assets = Total Liabilities or Total Equity

               Or

 Total Assets = Internal Liabilities + External Liabilities

Accounting Standards

History and Development of Accounting Standards

The International Accounting Standards Committee (IASC) came into existence on 29th June 1973. The main objectives of IASC are to develop the accounting standards. In India the Institute of Charted Accountants of India (ICAI) had constituted the ‘Accounting Standards Board’ in April 1977 for developing the Accounting Standards

Meaning of Accounting Standards:

Accounting standards are the rules in written form that ensure the uniformity of accounting Standards, and provide guidance for the preparation, presentation and reporting of accounting information.

Features/Characteristics/Nature of Accounting Standards:

a) Provide Guidance to the Accountants.

b) Brings Uniformity.

c) Accounting Standards are flexible.

d) Provide information.

Advantages of Accounting Standards

a) Helpful in bringing the uniformity.

b) Helpful in improving the reliability of financial statements.

c) Helpful in resolving the conflicts among the users of financial information.

Accounting Standards issued by the ICAI:

Amendment is made recently in the section 211 of companies act 1956. According to this amendment, the financial statements (Profit and Loss Account and Balance Sheet) of a company should comply with the Accounting Standards. The Council of the Institute of Charted Accountants of India has so far issued the following 32 Accounting Standards (AS).

Process of Accounting:

• Collecting and identifying financial transactions
• Recording
• Classifying
• Summarizing
• Deals with financial transactions
• Analysis and Interpretation
• Communicates

Accounting Equation:

The accounting equation is the basic element of the balance sheet and the primary principle of accounting. It helps the company to prepare a balance sheet and see if the entire enterprise’s asset is equal to its liabilities and stockholder equity. It is the base of the double-entry accounting system.

Double-entry accounting is a system that ensures that accounting and transaction equation should be equal as it affects both sides. Any change in the asset account, there should be a change in related liability and stockholder’s equity account. While performing journal entries accounting equation should be kept in mind.

Total Assets =Total Liabilities

          OR

Total Assets = Internal Liabilities + External Liabilities

         OR

Total Assets = Capital + Liabilities

Examples of accounting equation

1) Ram started business with cash rs.10000

Assets (cash+) = liabilities (capital+) +10000 = +10000

Its mean assets increase and liabilities also increase same amount so result will be same

2) mohan purchase good with cash rs.1000

Assets (stock+) asset (cash-) =liabilities +1000 -1000

3) Goods sold to shyam on credit for rs.5000

Assets (stock-) assets (debtors+) = lia. (No change)

4) Furniture purchase for cash rs.25000

Assets (furniture+) assets (cash) = lia. (No change)

5) Paid rent rs.500

Assets (cash-) = liabilities (capital-)

6) Received commission rs.400

Assets (cash+) = lia. (Capital+)

Multiple effect entries

Goods sold on credit (cost price rs.30000) for Rs. 40000

Assets (stock-) assets (debtors+) = lia. (capital+)

-30000 + 40000 = + 10000

Classification of Transactions Following are the nine basic transactions:

1. Increase in assets with corresponding increase in capital.

2. Increase in assets with corresponding increase in liabilities.

3. Decrease in assets with corresponding decrease in capital.

4. Decrease in assets with corresponding decrease in liabilities.

5. Increase and decrease in assets.

6. Increase and decrease in liabilities

7. Increase and decrease in capital

8. Increase in liabilities and decrease in capital

9. Increase in capital and decrease in liabilities.

Example :

Show the effect of the following business transactions on assets, liabilities and capital through accounting equations:

1. Commenced business with cash 20,000

2. Goods purchased on credit 7,000

3. Furniture purchased 3,000

4. paid to creditors 2,000

5. Amount withdrawn by the proprietor 4,000

6. Creditors accepted a bill for payment 1,500

7. Interest on capital 1,000

8. Transfer from capital to loan 5,000

9. Allotted shares to creditors 1,000

Solution:

 Important note

Assets = Liabilities +Capital

Assets are equal to the sum total of Liabilities and Capital

Question for Practice:

Prepare Accounting equation on the basis of following information:

(1) Sohan started business with cash =80,000

Machinery =10,000

And stock =10,000

(2) Interest on the above capital was allowed @10%

(3) Money withdrew from the business for his personal use10, 000

(4) Interest on drawings 500

(5) Depreciation charged on machinery 2,000

USING DEBIT AND CREDIT

Rules of Debit and Credit

Traditional or English Approach: This approach is based on the main principle of double entry system i.e., every debit has a credit and every credit has a debit. According to this system we should record both the aspects of a transaction whereas one aspect of a transaction will be debited and other aspect of a transaction will be credited.

(1) Personal Account: The accounts which related to an individual, firms, company, or an institution.

Personal account classified three categories:

(i) Natural person accounts -Mohan, Seeta, bank, capital, and drawing. Debtors, creditors account

(ii) Artificial personal accounts-company, firms and institutions.

(iii) Representative personal accounts- outstanding expenses, prepaid expenses, accord income and received in advance.

RULE

Debit - the receiver

Credit - the giver

(2) Real Account: The account all of those things whose value can be measure term of money like cash, goods, furniture, goodwill etc.

RULE

Debit what comes in

Credit what goes out.

(3) Nominal Account: these accounts include the account of all expenses and incomes. Like rent, salary, interest, commission, discount received/allowed etc.

RULE

Debit all expenses & losses

Credit all incomes and gains.

(2) Debit and Credit rules (Modern or American Approach)

This approach is based on the accounting equation or balance sheet. In this approach accounts are debited or credited according to the nature of an account. In a summarized way the five rules of modern approach is as follows:

1. Increase in asset will be debited and decrease will be credited.

2. Increase in the liabilities will be credited and decrease will be debited.

3. Increase in the capital will be credited and decrease will be debited.

4. Increase in the revenue or income will be credited and decrease will be debited.

5. Increase in expenses and losses will be debited and decrease will be credited.

IMPORTANT NOTE:

1. Increase in Assets/ Expenses and Losses will be debited and decrease will be credited

2. Increase in Liabilities/ capital/ Revenue or Gain will be credited and decrease will be debited

Books of Original Entry

When a businessman starts their company, one of the primary things they do is keep a track of their everyday transactions. These transactions are recorded on a timely basis (depending on the nature of their business) in a book before they are transferred to ledger accounts. Books of original entry are nothing but an accounting book or journal where all transactions are initially recorded. All business transactions, their details and descriptions are first recorded in the book of original entry.

Entering transactions on a regular basis in Book of original entry that carries details and evidence of business transactions before they are posted or transferred into proper ledger because, without the book of original entry being filled with evidence of business transactions, the writing of a ledger cannot be initiated.

Types of Books of Original Entry:

• General Journal - To record the transactions not recorded in special journals
• Special Journals - Special journals include further sub-journals; as given below:
• Sales journal - To record sales invoices issued by the firm when selling goods on credit
• Purchases journal - To record purchases invoices received by the business from suppliers, when buying goods on credit
• Return inwards journal - To record sales returns from customers
• Return outwards journal - To record purchases returns to suppliers
• Cash book - To record receipts or payments

Entries in the books of original entry normally consist of:

• Date of transaction
• Details relating to transactions, i.e., the second aspect of transactions, e.g., name of trade receivable in the sales journal
• Monetary amount of the transactions
• References to the relevant ledger account (often called folio)
• References to original source documents, e.g., invoice number

Journal

This is the basic book of original entry. In this book, transactions are recorded in the chronological order, as and when they take place. Afterwards, transactions from this book are posted to the respective accounts. Each transaction is separately recorded after determining the particular account to be debited or credited.

Journal

The first column in a journal is Date on which the transaction took place. In the Particulars column, the account title to be debited is written on the first line beginning from the left hand corner and the word ‘Dr.’ is written at the end of the column. The account title to be credited is written on the second line leaving sufficient margin on the left side with a prefix ‘To’. Below the account titles, a brief description of the transaction is given which is called Narration. Having written the Narration a line is drawn in the Particulars column, which indicates the end of recording the specific journal entry. The column relating to Ledger Folio records the page number of the ledger book on which relevant account is appears. This column is filled up at the time of posting and not at the time of making journal entry.

The Debit amount column records the amount against the account to be debited and similarly the Credit Amount column records the amount against the account to be credited. It may be noted that, the number of transactions is very large and these are recorded in number of pages in the journal book. Hence, at the end of each page of the journal book, the amount columns are totaled and carried forward (c/f) to the next page where such amounts are recorded as brought forward (b/f) balances. The journal entry is the basic record of a business transaction. It may be simple or compound. When only two accounts are involved to record a transaction, it is called a simple journal entry.

For Example, Goods Purchased on credit for Rs.30,000 from M/s Govind Traders on December 24, 2017, involves only two accounts: (a) Purchases A/c (Goods), (b)

Govind Traders A/c (Creditors). This transaction is recorded in the journal as follows:

It will be noticed that although the transaction results in an increase in stock of goods, the account debited is purchases, not goods. In fact, the goods account is divided into five accounts, viz. purchases account, sales account, purchases returns account, sales returns account, and stock account. When the number of accounts to be debited or credited is more than one, entry made for recording the transaction is called compound journal entry. That means compound journal entry involves multiple accounts.

For example, Office furniture is purchased from Modern Furniture’s on July 4, 2017 for ` 25,000 and ` 5,000 is paid by cash immediately and balance of ` 20,000 is still payable. It increases furniture (assets) by ` 25,000, decreases cash (assets) by ` 5,000 and increases liability by ` 20,000.

The entry made in the journal on July 4, 2017 is:

Books of Rohit Journal

The Ledger

The ledger is the principal book of accounting system. It contains different accounts where transactions relating to that account are recorded. A ledger is the collection of all the accounts, debited or credited, in the journal proper and various special journal (about which you will learn in chapter 4). A ledger may be in the form of bound register, or cards, or separate sheets may be maintained in a loose leaf binder. In the ledger, each account is opened preferably on separate page or card.

A ledger is very useful and is of utmost importance in the organisation. The net result of all transactions in respect of a particular account on a given date can be ascertained only from the ledger. For example, the management on a particular date wants to know the amount due from a certain customer or the amount the firm has to pay to a particular supplier, such information can be found only in the ledger. Such information is very difficult to ascertain from the journal because the transactions are recorded in the chronological order and defies classification. For easy posting and location, accounts are opened in the ledger in some definite order. For example, they may be opened in the same order as they appear in the profit and loss account and in balance sheet. In the beginning, an index is also provided. For easy identification, in big organisations, each account is also allotted a code number.

According to this format the columns will contain the information as given below: An account is debited or credited according to the rules of debit and credit already explained in respect of each category of account. Title of the account : The Name of the item is written at the top of the format as the title of the account. The title of the account ends with suffix ‘Account’. Dr./Cr. : Dr. means Debit side of the account that is left side and Cr. Means Credit side of the account, i.e. right side. Date : Year, Month and Date of transactions are posted in chronological order in this column.

Particulars : Name of the item with reference to the original book of entry is written on debit/credit side of the account.

Journal Folio : It records the page number of the original book of entry on which relevant transaction is recorded. This column is filled up at the time of posting.

Amount : This column records the amount in numerical figure, corresponding to what has been entered in the amount column of the original book of entry.

Distinction between Journal and Ledger

The Journal and the Ledger are the most important books of the double entry mechanism of accounting and are indispensable for an accounting system.

Following points of comparison are worth noting :

1. The Journal is the book of first entry (original entry); the ledger is the book of second entry.

2. The Journal is the book for chronological record; the ledger is the book for analytical record.

3. The Journal, as a book of source entry, gets greater importance as legal evidence than the ledger.

4. Transaction is the basis of classification of data within the Journal; Account is the basis of classification of data within the ledger.

5. Process of recording in the Journal is called Journalising; the process of recording in the ledger is known as Posting.

Classification of Ledger Accounts

We have seen earlier that all ledger accounts are put into five categories namely, assets, liabilities, capital, revenues/gains and expense losses. All these accounts may further be put into two groups, i.e. permanent accounts and temporary accounts. All permanent accounts are balanced and carried forward to the next accounting period. The temporary accounts are closed at the end of the accounting period by transferring them to the trading and profit and loss account.

All permanent accounts appear in the balance sheet. Thus, all assets, liabilities and capital accounts are permanent accounts and all revenue and expense accounts are temporary accounts. This classification is also relevant for preparing the financial statements.

Posting from Journal

Posting is the process of transferring the entries from the books of original entry (journal) to the ledger. In other words, posting means grouping of all the transactions in respect to a particular account at one place for meaningful conclusion and to further the accounting process. Posting from the journal is done periodically, may be, weekly or fortnightly or monthly as per the requirements and convenience of the business.

The complete process of posting from journal to ledger has been discussed below:

Step 1 : Locate in the ledger, the account to be debited as entered in the journal.

Step 2 : Enter the date of transaction in the date column on the debit side.

Step 3: In the ‘Particulars’ column write the name of the account through which it has been debited in the journal. For example, furniture sold for cash ` 34,000. Now, in cash account on the debit side in the particulars column ‘Furniture’ will be entered signifying that cash is received from the sale of furniture. In Furniture account, in the ledger on the credit side is the particulars column, the word, cash will be recorded. The same procedure is followed in respect of all the entries recorded in the journal.

Step 4 : Enter the page number of the journal in the folio column and in the journal write the page number of the ledger on which a particular account appears.

Step 5 : Enter the relevant amount in the amount column on the debit side. It may be noted that the same procedure is followed for making the entry on the credit side of that account to be credited. An account is opened only once in the ledger and all entries relating to a particular account is posted on the debit or credit side, as the case may be.

We will now see how the transactions listed to different accounts from the journal.