basics of book-keeping and accounting

8/7/2019 Basics of book-keeping and accounting

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ACCOUNTING A 1

Study Note - 1Basics of Book-Keeping and Accounting

This Study Note includes

Introduction

Definitions

Objectives of Accounting

Basic business terminologie s

Accounting Concepts and Conventions

Accounting Standards The Accounting Process

The Concepts of Account, Debit & Credit

Types of Accounts

The Golden Rules of Accounting

1.0 Introduction

Business is an economic activity und ertaken w ith the m otive of earning p rofits and to maximize

the w ealth for the ow ners. Business cannot be run in isolation. Largely, the business activity is

carried out by peop le coming together w ith a pu rpose to serve a comm on cause. This team is

often referred to as an organization, which could be in different forms such as Sole

prop rietorship, partnership , bodies corporate etc. The ru les of business are based on general

principles of trade, social values, and statu tory framew ork encompa ssing national or

international boundaries. While these variables could be different for different businesses,

different countries etc., the basic purpose is to add value to a product or service to satisfy

customer demand.

The business activities require resources (wh ich are limited & have mu ltiple u ses) prim arily in

terms of material, labour, machineries, factories and other services. The success of business

dep ends on how efficiently and effectively these resources are m anaged . There is, therefore,

need to ensure the bu sinessman tracks the use of these resources. The resources are not free

and thu s one mu st be careful to keep an eye on cost of acquiring them as well.

For the basic purpose of business is to make profit, one must keep an ongoing track of the

activities un dertaken in course of business. Two basic questions wou ld have to be answered:

(a) What is the result of business operations? This will be answered by find ing out w hether

it has made p rofit or loss.

(b) What is the position of the resources acquired and used for business pu rpose? How are

these resources financed? Where the fun ds come from?


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Basics of Book-keeping and Accounting

The answers to these questions are to be foun d continuously and the best way to find them is

to record all the business activities. Record ing of business activities has to be done in a scientificmanner so that they reveal correct outcome. The science of book-keeping and accounting

provides an effective solution. It is a branch of social science. This stud y material aims at giving

a platform to the studen ts to un derstan d basic principles and concepts, which can be app lied to

accurately measure performance of business. After studying the various chapters included

herein, the student should be able to apply the p rinciples, rules, conventions and practices to

different bu siness situations like trad ing, manufacturing or service.

Over years, the art and science of accoun ting has evolved together w ith progress of trade and

commerce at national and global levels. Professional accounting bodies have been doing

intensive research to come up with accoun ting rules that w ill be app licable. Modern business

is certainly m ore complex and continuou s up dating of these rules is required. Every stakeholderof the business is interested in a p articular facet of information about the bu siness. The art and

science of accounting helps to pu t together these requirements of information as per universally

accepted principles and also to interp ret the resu lts. It is interesting to note that each one of us

has an accountant hidden in us. We do see our parents keep track of monthly expenses. We

make a distinction between p ayment d one for m onthly grocery and that for buying a hou se or

a car. We understand that w hile grocery is a month ly expense and buying a h ouse is like creating

a resource that has indefinite future u se. The most common accoun ting record that each one of

us know s is our ban k passbook or a bank statemen t, which the bank maintains for us. It tracks

each ru pee that we d eposit or withdraw from ou r account. When we go to sup ermarket to buy

something, the cashier at the counter will record things we buy and give us a bill or cash

mem o. These are source docum ents prepared for the dealing between the superm arket and u s.

While these are simple examples, there could be more complex business activities. A good

working know ledge of keeping records is therefore necessary. Professional accoun ting bod ies

all over the w orld have been developed with th e objective of providing this body of know ledge.

These institutions are engaged in imparting training in the field of accounting. You will

appreciate the importance and utility of this subject as you will go along this course. Let us

start with some basic definitions, concepts, conventions and p ractices used in d evelopmen t of

this art as well as science. Please follow this material sequentially to derive maximu m ad vantage.

Complete grasping of the basics is a must for your understanding. This study pack provides

you with sufficient questions on th eory and practice. The stud ents will be imm ensely benefited

if they practice more problems on their own.

1.1 Definitions

In order to u nd erstand the subject ma tter with clarity, let us see some of the definitions wh ich

dep ict the scope, content and pu rpose of Accoun ting. The field of accounting is generally sub-

divided into:

(a) Book-keeping

(b) Financial Accounting

(c) Cost Accounting and

(d) Management Accounting


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Let us understand each of these concepts.

Book-keeping

The most com mon d efinition of book-keeping as given by J. R. Batliboi is Book-keeping is an

art of recording bu siness transactions in a set of books.

As can be seen, it is basically a record keeping function. One must understand that not all

dealings are, however, recorded . Only transactions expressed in terms of money will find p lace

in books of accounts. These are the transactions which will ultimately result in transfer of

economic value from one p erson to the other. Book-keeping is a continuous activity, the records

being maintained as transactions are entered into. This being a rou tine and repetitive work, in

todays world, it is taken over by the computer systems. Many packages and systems areavailable to su it different bu siness organizations.

It is also referred to as a set of primary records. These records form the basis for accounting. It

is an art because, the record is to be kept in such a manner that it will facilitate further processing

and reporting of financial information which will be useful to all stakeholders of the business.

This is explained fur ther in details.

Financial Accounting

It is comm only connoted as Accoun ting. The American Institute of Certified Pu blic Accountan ts

defines Accounting as an art of recoding, classifying and sum mar izing in significant m annerand in terms of money, transactions and events wh ich are of financial character, and interpreting

the r esults thereof.

The first step in the cycle of accounting is to identify transactions that will find place in books

of accounts. Transactions having financial imp act only are to be r ecorded. E.g. if a businessman

negotiates with the customer regarding supply of products, this will not be recorded. The

negotiation is a deal w hich will potentially create a tran saction w hich will have exchange of

money or moneys wor th. But un less this transaction is finally entered into, it will not be recorded

in the books of accounts.

Secondly, the recording of the business transactions is done based on the golden rules of

accoun ting (which are explained later) in a systematic mann er. Transaction of similar natu re

are grou ped together an d recorded accordingly. E.g. Sales transactions, Purchase transactions,

cash transactions etc. One has to interp ret the transaction and then ap ply the relevant golden

rule to m ake a correct entry th ereof.

Thirdly, as the transactions grow in number, it will be difficult to understand the combined

effect of the sam e by referring to ind ividua l records. Hence, the art of accounting also involves

the step of summarizing them. With the aid of computers, this task is simplified in todays

accoun ting though. The summarization will help users of the business information to understand

and interpret business results.


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Lastly, the accounting process provides the users with statements which will describe what

has happened to the business. Remember the two basic questions we talked about, one toknow whether business has mad e profit or loss and the other to know the position of resources

that are used by the bu siness.

It can be noted that a lthough accoun ting is often referred to as an art, it is a science also. This is

because it is based on u niversally ap plicable set of rules. How ever, it is not a pu re science as

there is a possibility of different interp retation.

Cost Accounting

According to the Chartered Institute of Managemen t Accountants (CIMA), Cost Accountancy

is defined as app lication of costing and cost accoun ting pr inciples, methods an d techniques tothe science, art and practice of cost control and the ascertainment of profitability as well as the

presentation of information for the pu rpose of managerial decision-mak ing.

It is a branch of account ing dealing with the classification, recording , allocation, sum marization

and reporting of current and prospective costs and an alyzing their behaviours. Cost accoun ting

is frequently used to facilitate internal decision making and provides tools with which

managem ent can app raise performance and control costs of doing bu siness. It pr imarily involves

relating the costs to the different products produced and sold or services rendered by the

business. While financial accoun ting d eals with business transactions at a broader level, cost

accoun ting aims at furth er breaking it up to the last possible level to inden tify costs with produ cts

and services. It uses the same financial accounting documents and records. Modern

compu terized accounting p ackages like ERP systems p rovide for p rocessing financial as well

as cost accounting records simultaneously. We will study this at length later in this study

material.

This branch of accounting deals with th e process of ascertainm ent of costs. The concept of cost

is always ap plied w ith reference to a context. Know ledge of cost concepts an d their application

provide a very sound platform for d ecision supp ort systems. Cost Accounting aims at equipp ing

man agemen t with information tha t can be used for control on bu siness activities. We will cover

these concepts in dep th later in this stud y material.

Management Accounting

Managem ent accoun ting is concerned w ith the u se of financial and cost accoun ting information

to managers within organizations, to provide them with the basis in making informed business

decisions that would allow them to be better equipped in their management and control

functions. Unlike financial accounting information (which, for public companies, is public

information), management accounting information is used within an organization (typically

for decision-making) and is usua lly confidential and its access available only to a select few.

According to the Chartered Institute of Management Accountants (CIMA), Management

Accounting is the process of iden tification, measuremen t, accumu lation, analysis, preparation,


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interpretation and communication of information used by management to plan, evaluate

and control within an entity and to assure appropriate use of and accountability for itsresources. Management accounting also comprises the preparation of financial reports for

non management groups such as shareholders, creditors, regulatory agencies and tax

authorities

Basically, management accounting aims at helping management in formulating strategies,

plann ing and constructing business activities, mak ing d ecisions, optimal use of resources, and

safeguard ing assets of business.

These branches of accoun ting have evolved over years of research and are basically synchronized

with th e requiremen ts of business organizations and all entities associated w ith them . We will

now see what are they and how accoun ting satisfies various needs of different stakeholders.

1.2 Objectives of Accounting

The main objective of Accounting is to provide financial information to various interested

par ties. This financial informat ion is normally given via financial statemen ts, which are prepared

on the basis of Generally Accepted Accoun ting Principles (GAAP). There are various accounting

standards developed by professional accoun ting bodies all over the world. In Ind ia, these are

governed by The Institute of Char tered Accoun tants of Ind ia, (ICAI). In the US, the Am erican

Institute of Certified Public Accountants (AICPA) is responsible to lay down the standards.

The Financial Accoun ting Standards Board (FASB) is the body that sets up the International

Accoun ting Stand ards. These standards basically deal with accoun ting treatment of business

transactions and disclosing the same in financial statements.

The following objectives of accounting will explain the width of the application of this

knowledge stream:

(a) To ascertain the amoun t of profit or loss made by the business i.e. to comp are the income

earned versus the expenses incurred an d the net result thereof.

(b) To know the financial position of the business i.e. to assess what the business owns and

wh at it owes.

(c) To provide a record for comp liance with statutes and laws ap plicable.

(d) To enable the readers to assess progress mad e by the business over a period of time.

(e) To disclose information needed by d ifferent stakeholders

Let us now see which are different stakeholders of the business and wh at do th ey seek from the

accoun ting information. This is shown in the following table.


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1.3 Basic business terminologies

In order to understand the subject matter clearly, one must grasp the following common

expressions always used in business accounting. The aim here is to enable the student with

these often used concepts before we embark on accounting procedures and rules. You maynote that th ese terms can be app lied to an y business activity with th e same connotation. Please

study them carefully.

(1) Transaction: It means a bu siness activity which involves exchan ge of money or m oneys

worth between parties. E.g. purchase of goods would involve receiving material and

making payment or creating an obligation to pay to the supplier at a future date.

Transaction could be a cash tran saction or credit transaction. When the par ties settle

the tran saction immed iately by effecting p ayment in cash or by cheque, it is called a

cash transaction. In credit transaction, the payment is settled at a future date as per

agreement between the parties.

Stakeholder Interest in business Accounting Information

Owners / Investors existingand potential

Profits or losses Financial statements, Costingrecords, management

accounting reports

Lenders Assessment of capability of

the business to pay interest

and principal of money lent.

Basically, they monitor the

solvency of business.

Financial statement and

analysis thereof, reports

forming part of accounts,

valuation of assets given as

security.

Customers and supp liers Stability and growth of the

business

Financial and Cash flow

statements to assess ability of

the business to offer better

business terms and ability to

supply the products and

services

Government Whether the business is

complying with various legal

requirements

Accounting d ocuments such

as vouchers, extracts of books,

information of purchase,

sales, employee obligations

etc. and Financial statements

Employees and trade unions Growth and profitability Financial statements for

negotiating pay packages

Competitors Performance and possible tie-

ups in the era of mergers and

acquisitions

Accounting information to

find out possible synergies


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(2) Goods: These are things of article or commodity in which a business deals. These

articles or comm odities are either bough t and sold or prod uced and sold. E.g. Agrocer will buy an d sell grocery items or a pharm aceutical comp any w ill man ufacture

a d rug and sell it. At times, wh at m ay be classified as goods to one business firm m ay

not be goods to the other firm. E.g. for a machine manufacturing company, the

machines are goods as they are frequently mad e and sold. But for the bu ying firm, it

is not good s as the inten tion is to use it as resource and not sell it. This subtle d ifference

must be carefully understood.

(3) Profit: The excess of Income over expenditure is called profit. It could be calculated

for each transaction or for business as a whole.

(4) Loss: The excess of expenditure over income is called Loss. It could be calculated for

each transaction or for business as a wh ole.

(5) Asset: Asset is a resource owned by the business with the purpose of using it for

generating future profits. It could be tangible resource like land, building, factory,

machinery & equipment, comp uters an d vehicles. It could be intangible asset like brand

value, copy right, patents & tradem arks and goodwill. These assets are held for relatively

longer period and are called as Fixed Assets. The intention of holding such assets is not

to sell them but to m ake best possible use to earn p rofits du ring the w orking life of the

assets. While there are other assets held by the business for relatively shorter period,

which are called as Current Assets. E.g. stock of goods is held with the purpose of

selling, cash is held for making payments for services or goods. Understanding the

concepts of Fixed and Current Assets is important as you will notice a separate

accoun ting treatmen t is required for them.

(6) Liability: It is an obligation of financial nature to be settled at a futu re d ate. It represents

amou nt of money that the bu siness owes to the other p arties. E.g. when goods are bou ght

on credit, the firm will create an obligation to pay to the su pp lier the p rice of goods on

an agreed future date or when a loan is taken from ban k, an obligation to pay interest

and principal amou nt is created. Depend ing upon the period of holding, these obligations

could be further classified into Long Term liabilities and Short Term or current liabilities.

A credit purchase of goods on 60 day credit will be a short term liability or the salary

payable to the staff is a short term liability. A seven year term loan would be a long

term liability. The d ifference between th e two is imp ortant from the d isclosure point of

view.

(7) Contingent Liability: It represents a potential obligation that could be created d epend ing

on th e outcom e of an event. E.g. if sup plier of the bu siness files a legal su it, it will not betreated as a liability because no obligation is created immediately. If the verd ict of the

case is given in favour of the sup plier then only the obligation is created. Till that it is

treated as a contingent liability. Please note th at contingent liability is not recorded in

books of account, but d isclosed by w ay of a note to the financial statements.

(8) Capital: It is amou nt invested in the business by its owners. It may be in the form of

cash, goods, or any other asset wh ich the p roprietor or partners of business invest in the

business activity. From business point of view capital of owners is a liability w hich is to

be settled on ly in the event of closure or transfer of the business. Hence, it is not classified

as a norm al liability. For corporate bod ies capital is normally represented as share capital.


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(9) Drawings: It represents an amount of cash, goods or any other assets which the

owner withdraws from business for his or her personal use. E.g. if the life insurancepremium of proprietor or a partner of business is paid from the business cash, it is

called d raw ings. Drawings w ill result in reduction in the ow ners capital. The concept

of draw ing is not app licable to the corporate bod ies like limited compan ies.

(10)Net worth: It represents excess of total Assets over total liabilities of the business.

Technically, this amount is available to be distributed to ow ners in the even t of closure

of the business after satisfying all liabilities. That is why it is also termed as Owners

equity. A profit making bu siness will result in increase in the owners equity whereas

losses will red uce it.

(11)Debtor: A debtor is a person w ho ow es money or m oneys worth to the business. The

money receivable from customers against supply of goods is called trade debtors or

trad e receivables. The m oney recoverable for transaction oth er than for sale of goods iscalled Amount receivable. E.g. a travel advance given to the employee that is

recoverable will be classified as Other Receivable or Amount Receivable. Receivables

are generally classified as current asset.

(12)Creditor: A creditor is a person to wh om the business owes money or mon eys worth .

e.g. money payable to sup plier of goods or p rovider of service. Creditors are generally

classified as Curren t liabilities.

(13)Capital Expenditure: This represents expend iture incurred for the purpose of acquiring

a fixed asset which is intend ed to be used over long term for earning p rofits there from.

E. g. amount paid to buy a computer for office use is a capital expenditure. At times

expenditure may be incurred for enhancing the production capacity of the machine.

This also will be capital expenditure. Capital expenditure forms part of the Balance

Sheet.

(14)Revenue expenditure: This represents expenditure incurred to earn revenue of the

current period. The benefits of revenue expenses get exhausted in the year of the

incurrence. E.g. repairs, insu rance, salary & wages to employees, travel etc. The reven ue

expend iture results in redu ction in revenu e. It forms part of the Income statement.

(15)Deferred Revenue Expenditure: When benefits of a revenue expense extend beyond

an accounting year, it is called deferred r evenue expend iture. E.g. if a company incurs

expend iture of Rs 10 lacs on advertising campaign for a new p rodu ct. This camp aign is

expected to benefit the marketing of this new product for 3 to 4 years. This will be

charged against the income for those 3 or 4 years. Accord ingly, in the cur rent year only

one-third or one-fourth of Rs 10 lacs will be charged aga inst the curren t year revenues.

The deferred p ortion of this expend iture is reflected in the balance sheet.

(16)Balance Sheet: It is the statement of financial position of the business entity as of a

par ticular date. It lists all assets, liabilities and capital in a par ticular way as explained

later. It is important to note tha t this statement exhibits the state of affairs of the business

as on a particular da te only. It describes what the bu siness own s and w hat the bu siness

owes to outsiders (this denotes liabilities) and to the own ers (this denotes capital). It is

prep ared after incorporating the results of Income statement.

(17)Profi t and Loss Account or Income Statement: This account show s the revenu e earned


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by the business and the expenses incurred by the business to earn that revenue. This

is prepared usually for a particular accounting period, which could be a quarter, ahalf year or a year. The net result of the Profit and Loss Account will show profit

earned or loss made by the business entity.

(18)Trade Discount: It is the discount usually allowed by the wholesaler to the retailer

comp uted on th e list price or invoice price. E.g. the list price a TV set could be Rs 15000.

The wholesaler may allow 20% discoun t thereof to the retailer. This means the retailer

will get it for Rs 12000/ - and is expected to sale it to final customer at the list price. Thu s

the trad e discount enables the retailer to m ake profit by selling at the list price. Trade

discount is never entered in the books of accounts. The tran sactions are recorded at net

values only. In above example, the transaction will be recorded at Rs 12000/ - only.

(19)Cash Discount: This is allowed to encourage p romp t paym ent by the debtor. This has

to be entered in the books of accounts. This is calculated after deducting the tradediscount. E.g. if list price is Rs 15000/ - on wh ich a trad e discoun t of 20% and cash

discount of 2% apply, then first trade discoun t of Rs 3000/ - (20% of Rs 15000/ -) will be

deducted and the cash d iscount of 2% will be calculated on Rs 12000/ - (Rs15000 Rs

3000). Hence the cash d iscount will be Rs 240/ - (2% of Rs 12000/ -)

You will find repetitive use of these terminologies all along and hence must grasp them

thoroughly. Let us see if we can apply these in the following examp les.

Illustration 1

Fill in the blanks:

(1) The cash discount is allowed by to the .

(2) Profit means excess of over .

(3) Debtor is a person who to others.

(4) In a credit transaction, the buyer is given a facility.

(5) The fixed asset is generally held for .

(6) The current liabilities are obligations to be settled in period.

(7) The withdrawal of money by the owner of business is called

(8) The amount invested by owners into business is called .

(9) Transaction means exchange of money or moneys worth for .

(10) The net result of an income statement is or .(11) The shows financial position of the business as on a pa rticular d ate.

(12) The discount is never entered in the books of accoun ts.

(13) Vehicles represent expend iture wh ile repairs to vehicle wou ld mean

expend iture.

(14) Expenditu re is called expend iture if the benefits from it extend to m ore

than one year.

(15) Net w orth is excess of over .


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Answers:

(1) Creditor, debtor

(2) Income, expenditure

(3) Ow es

(4) Cred it

(5) Longer period

(6) Short

(7) Draw ings

(8) Cap ital

(9) Value

(10) Profit or loss

(11) Balance sheet

(12) Trade

(13) Capital, revenue

(14) Deferred revenue

(15) Total assets, total liabilities

Illustration 2

Give one word or a term used to describe the following

(a) An exchange of benefit for value(b) A transaction w ithout immed iate cash settlement.

(c) Commod ities in w hich a business deals.

(d) Excess of expend iture over income.

(e) Things of value owned by business to earn future p rofits.

(f) Amount owed by business to others.

(g) An obligation w hich m ay or may not m aterialise.

(h) An allowance by a creditor to debtor for promp t payment.

(i) Assets like brand value, copy rights, goodwill

Answers(a) Transaction, (b) cred it tran saction, (c) good s, (d) loss, (e) Assets, (f) liability, (g)

contingent liability, (h) cash discount, (i) intangible assets

1.4 Accounting concepts and convention

As seen earlier, the accoun ting information is published in the form of financial statemen ts.

The three basic financial statements are

I. The profit & loss account th at shows net business result i.e. profit or loss for a

certain p eriod


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II. The Balance Sheet that exhibits the financial strength of the business as on a particular

dateIII. The Cash Flow Statemen t that d escribes the movemen t of cash from one date to

the other

As these statements are meant to be used by different stakeholders, it is necessary that the

information contained therein is based on definite principles, concrete concepts and well

accepted convention.

Accounting principles are basic guidelines that provide standards for scientific accounting

practices and p rocedu res. They guide as to how the transactions are to be recorded and reported.

They assure u niformity and und erstand ability.Accounting concepts lay down th e found ation

for accoun ting p rinciples. They a re ideas essentially at m ental level and are self-evident. These

concepts ensure recording of financial facts on sound bases and logical considerations.Accounting conventions are method s or procedu res that are widely accepted. When transactions

are recorded or interpreted, they follow the conventions. Many times, however, the terms

principles, concepts and conven tions are used interchangeably.

Professional Accounting Bodies have p ublished statements of these concepts. Over years, m any

of these concepts are being challenged as outlived. Yet, no major deviations have been m ade as

yet. Path breaking ideas have emerged and the accounting stand ards of modern d ays do require

compan ies to record and report transactions w hich may not be necessarily based on concepts

that ar e in vogue for long. It is essential for a fresh stu den t desirous of stud ying accoun ting

from the basic levels to und erstand these concepts in entirety.

1.4.1 Business Entity Concept

As per this concept, the business is treated as distinct (and separate) from the ind ividuals who

own or man age it. When recording bu siness transactions, the important qu estion is how w ill it

affect the business entity? How they affect the persons who own it or run it or otherwise

associated w ith it is irrelevant. App lication of this concept enables recording of transactions of

the business entity with its owners or managers or other stakeholders. For example, if the

own er pays h is personal expenses from bu siness cash, this transaction can be recorded in the

books of business entity. This transaction w ill take the cash ou t of business and also redu ce the

obligation of the business toward s the owner.

At times it is difficult to separate owners from the business. Consider a couple who runs asmall retail outlet. In th e eyes of law , there is no d istinction mad e between financial affairs of

the ou tlet with that of the couple. The creditors of the retail outlet can sue the coup le and collect

his claim from p ersonal resources of the coup le. How ever, in accounting, the records are kep t

as d istinct for the retail outlet and the coup le respectively. For certain forms of business entities

such as limited comp anies this distinction is easier. The limited compan ies are separate legal

persons in th e eyes of law as w ell.

The entity concept requ ires that all the transactions are to be viewed , interp reted an d r ecorded

from business entity point of view. An accoun tant steps into th e shoes of the bu siness entity


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and decides to account for the transactions. The owners capital is the obligation of business

and it has to be paid back to the own er in the event of business closure. Also, the p rofit earnedby the bu siness will belong to the ow ner and h ence is treated as ow ners equity.

1.4.2 Money Measurement Concept

A bu siness transaction w ill always be recoded if it can be expressed in term s of money. The

advantage of this concept is that different types of transactions could be recorded as hom ogenous

entries with m oney as common d enomina tor. A business may ow n Rs 3 Lacs cash, 1500 kg of

raw material, 10 vehicles, 3 comp uters etc. Unless each of these is expressed in term s of mon ey,

we cannot find ou t the assets own ed by the business. When expressed in the common m easure

of money, transactions could be added or subtracted to find out the combined effect. In the

above example, we could add values of different assets to find th e total assets owned.

The application of this concept has a limitation. When transactions are recorded in terms of

money, we only consider the absolute value of the money. The real value of the money may

fluctuate from time to time d ue to inflation, exchange rate changes etc. This fact is not considered

when recording the transaction.

1.4.3 Historical Cost concept

Business transactions are always recorded at the actual cost at which they are actually

undertaken. The basic advantage is that it avoids an arbitrary value being attached to the

transactions. Whenever an asset is bought in it is recorded at its actual cost and the same is

used as the basis for all subsequ ent accoun ting pu rposes such as charging dep reciation on the

use of asset. E.g. if a production equip ment is bought for Rs 1.50 crores, the asset w ill be show n

at the same va lue in all future periods w hen d isclosing th e original cost. It w ill obviously be

redu ced by the am oun t of depreciation, wh ich w ill be calculated w ith reference to the actual

cost paid for. The actual value of the equipm ent m ay rise or fall subsequ ent to the p urchase,

but th at is considered irrelevant for accoun ting pu rpose as per th e cost concept.

The limitation of this concept is that the balance sheet does not show the market value of the

assets owned by the bu siness and accordingly the ow ners equity w ill not reflect the real value.

However, on an ongoing basis, the assets are shown at their historical costs as reduced by

depreciation.

1.4.4 Going Concern Concept

The basic rationale of this concept is that business is assumed to exist for an indefinite period

and is not established with the objective of closing it d own . So un less there is good evid ence to

the contrary, the accoun tant a ssumes th at a bu siness entity is a going concern - that it w ill

continue to operate as usual for a longer period of time. It will keep getting money from its

customers, pay its creditors, buy and sell goods, use assets to earn profits in future. If this

assumption is not considered, one will have to constantly value the worth of the assets and

resource. This is not practicable. This concept enables the accoun tant to carry forw ard the valu es

of assets and liabilities from one accoun ting period to the other w ithout asking th e question


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ACCOUNTING A 13

about usefulness and worth of the assets and recoverability of the receivables.

The going concern concept forms a sound basis for preparation of a balance sheet.

1.4.5 Due l Aspect Concept

The assets represent economic resources of the business, whereas the claims of various p arties

on bu siness are called obligations. The obligations could be toward s own ers (called as owners

equity) and towards p arties other than the ow ners (called as liabilities).

When a business transaction happens, it will involve use of one or the other resource of the

business to create or settle one or more obligations. E.g. consider Mr. Suresh starts a shop with

the investment of Rs 25 lacs. Here, the business has got a resource of cash worth Rs 25 lacs

(which is its asset), but at th e same time it has created an obligation of business toward s Mr.

Suresh that in the event of business closure, the money w ill be paid back to him. This could be

shown as:

Assets = Liabilities + Capital

In other words,

Cash brought in by Mr. Suresh (Rs 25 lacs) = Liability of business towards Mr. Suresh (Rs 25

lacs)

We know that liability of the business could be tow ards owners and par ties other than ow ners,

this equation could be re-written as:Assets = Liabilities + Owners equity

Cash Rs 2500000 = Liabilities Rs nil + Mr. Sureshs equity Rs 2500000

This is the fundamental accounting equation shown as formal expression of the dual aspect

concept. This powerful concept recognizes that every bu siness transaction hasdual impact on

the accoun ting records. Accounting systems are set up to simultaneou sly record both of these

aspects of every transaction; that is wh y it is called asDouble-entry syst em of account ing. In its

present form the d ouble entry system of accounting ow es its existence to an Italian expert Mr.

Luca Pacioli in th e year 1495.

Continuing with our example of Mr. Suresh, consider he borrow s Rs 15 lacs from bank. The

du el aspect of this transaction will be while on one hand the bu siness cash will increase by Rs

15 lacs and a liability toward s the ban k will be created for Rs 15 lacs.

Assets = Liabili ties + Owners equity

Cash Rs 4000000 = Liabili ties Rs 1500000 + Mr. Sureshs equityRs2500000


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ACCOUNTINGA 14


The student must note that the dual aspect concept entails recognition of the two effects of

each transaction. These effects are of equal amount and reverse in nature. How to decidethese two aspects? The golden rules of accounting are used to arrive at this decision. After

recording both aspects of the transaction, the basic accounting equation will always tally.

The above five concepts find the application in preparation of the balance sheet which is the state-

ment of assets and liabilities as on a particular date. We will now see some more concepts that are

important for preparation of Profit and Loss account or Income Statement.

1.4.6 The Accounting Period Concept

We have seen that as per the going-concern concept the business entity is assumed to have

an indefinite life. Now if we were to assess whether the business has made profit or loss,

should we wait un til this indefinite period is over? Would it m ean that w e will not be able toassess the business performance on an ongoing basis? Does it deprive all stakeholders the

right to the accounting information? Would it mean that the business will not pay income

tax as no income will be computed?

To circumven t this problem, the business entity is supp osed to be pau sed after a certain time

interval. This time interval is called an accounting period. This period is usually one year, wh ich

could be a calend ar year i.e. 1st Janu ary to 31st December or it could be a fiscal year in Ind ia as 1st

April to 31st march. The business organizations have the freedom to choose their ow n accounting

year. For certain organizations, reporting of financial information in public domain are

compu lsory. In Ind ia, listed comp anies must report their quarterly unau dited financial results

and yearly audited financial statements. For internal control purpose, many organizations

prepare monthly financial statements. The modern computerized accounting systems enable

the comp anies to prepare r eal-time online financials at the click of button!

Businesses are living, continuou s organisms. The splitting of the continu ous stream of business

events into time p eriods is thus somewh at arbitrary. There is no significant change just because

one accoun ting period ends and a new one begins. This results into the m ost difficult p roblem

of accounting of how to measu re the net income for an accounting period. One has to be careful

in recognizing revenu e and expenses for a particular accoun ting period . Subsequent section on

accoun ting procedu res will explain how one goes about it in practice.

1.4.7 The Conservatism Concept

Accoun tants w ho p repare financial statements of the business, like other hu man being, would

like to give a favourable report on how well the business has performed d ur ing an accoun ting

period . How ever, pru den t reporting based on skepticism builds confidence in the results and,

in the long run best serves all the divergent interests of users of financial statements. This

ph ilosophy of pru dence leads to the conservatism concept.

The concept un derlines the pru dence of und er-stating than over-stating the net income of an

entity for a period an d th e net assets as on a particular d ate. This is because business is done in

situations of uncertainty. For years, this concept w as mean t to anticipate no profits but recognize


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ACCOUNTING A 15

all losses. This can be stated as

(a) Delay in recognizing income unless one is reasonably sure

(b) Immediately recognize expenses when reasonably sure

This, of course, does not mean to overdo and create wind ow d ressing in rep orting. E.g. if the

business has sold Rs 20 Lacs worth goods on the last day of accounting period and also

received a cheque for the same, one cannot argue that the revenue should not be recognized

as it is not certain whether the cheque will be cleared by the bank. One cannot stretch the

conservatism concept too much. But at the same time, if the business has to receive Rs 5 lacs

from a customer to whom goods were sold quite some time ago and no payments are

forthcoming, then while determining the net income period, the accountant must judge the

likelihood of the recoverability of this money and the p rud ence will prevail to make a provision

for this amoun t as d oubtful debtors.

Let us take an other examp le. A business had procured goods for Rs 10 lacs before the end of

an accounting p eriod. If sold at th e usual selling p rice, the goods w ould fetch the price of Rs

12.50 lacs. Due to innovative produ ct introdu ced by th e competition, the good s are likely to

be sold for Rs 9 lacs only. At what value should the goods be shown in the balance sheet?

Would it be at Rs 10 lacs being the actual cost of buying? Or would it be at Rs 9 lacs? Here,

the conservatism p rinciple w ill come in p lay. The stock of goods w ill be valued at Rs 9 lacs

and Rs 1 lacs will be taken as a charge to the net income of the period.

1.4.8 The Realisation Concept

While the conservatism concept tells wh ether or not revenue should be recognized, the concept

of realisation talks about what revenue should be recognized. It says amount should be

recognized only to the tun e of wh ich it is certainly realizable. Thus mere getting an order from

the custom er wont make it eligible to recognize as revenue. The reasonable certainty of realizing

the money w ill come only when the goods ordered are actually supp lied to the customer and

he is billed. This concept ensu res that income unearned or un realized will not be considered as

revenue and the firms will not inflate profits.

Consider that a store sales goods for Rs 25 lacs du ring a m onth on credit. The experience and

past d ata show s that generally 2% of the amou nt is not realized. The revenu e to be recognized

will be Rs 24.50 lacs. Although conceptually the revenue to be recognized at this value, inpractice the doubtful amou nt of Rs 50 thousan d (2 % of Rs 25 lacs) is often considered as expense.

1.4.9 The Matching Concept

As we have seen the sale of goods has tw o effects: (1) a revenu e effect, which resu lts in increase

in owners equity by the sales value of the tr ansaction and (2) an expense effect, which redu ces

own ers equity by the cost of goods sold, as the good s go ou t of the bu siness. The net effect of

these two effects will reflect either profit or loss. In order to correctly arrive at the net result,

both these aspects must be recognized du ring the same accounting p eriod. One cannot recognize

only the revenu e effect thereby inflating the p rofit or only the expense effect wh ich w ill deflate


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ACCOUNTINGA 16


the profit. Both the effects must be recognized in the same accounting period. This is the

principle of matching concept.

To generalize, when a given even t has two effects one on revenu e and the other on expense,

both mu st be recognized in the same accoun ting period.

1.4.10 The Accrual Concept

The accrua l concept is based on recognition of both cash an d credit transactions. In case of a

cash transaction, owners equity is instantly affected as cash either is received or paid. In a

credit transaction, however, a mere obligation towards or by the business is created. When

credit transactions exist (which is generally the case), revenues are not the sam e as cash receipts

and expenses are not same as cash paid d uring the period.

When good s are sold on credit as per norm ally accepted trad e practices, the business gets the

legal right to claim the money from th e custom er. Acquiring such right to claim the consideration

for sale of goods or services is called accrual of revenue. The actual collection of money from

customer could be at a later date.

Similarly, when the business procures goods or services with the agreem ent that the paym ent

will be made at a futu re date, it does not mean tha t the expense effect should n ot be recognized.

Because an obligation to p ay for goods or services is created up on the procurem ent thereof, the

expense effect also m ust be recognized.

Todays accounting system s based on accrual concept are called as Accrual system or mercantile

system of accoun ting.

1.4.11 The Concept of Consistency

This concept ad vocates that once an organization decides to adop t a particular method of revenue

or expense recognition in line with th e other concepts, the same should be consistently app lied

year after year, un less there is a valid reason for change in the meth od. Lack of consistency

would result in the financial information becoming non-comparable between the different

accoun ting period s. The insistence of this concept would result in avoidance of window d ressing

the results by choosing the accoun ting meth od by convenience and thereby either inflating or

und erstating net income.

Consider an example. An asset of Rs 10 lacs is pu rchased by bu siness. It is estimated to haveuseful life of 5 years. It w ill follow that the asset w ill be depreciated over a p eriod of 5 years at

the ra te of Rs 2 lacs every year. The estimate of u seful life and the ra te of dep reciation cannot be

changed from one period to the other without a valid reason. Suppose the firm applies the

same d epreciation rate for the first three years and du e to change in technology the asset becomes

useless, the whole of the remaining amou nt could be expensed ou t in the fourth year.

However, it may be d ifficult to be consistent if the bu siness entities have tw o factories in different

countries which have different statutory requ irement for accounting treatm ent.


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ACCOUNTING A 17

1.4.12 The concept of Materiality

This is more of a convention than a concept. It proposes that while accounting for various

transactions, only those w hich may have m aterial effect on p rofitability or financial status of

the business should have special consideration for reporting. This does not mean that the

accoun tant should exclud e some transactions from recording. E.g. even Rs 20 worth conveyance

paid must be recorded as expense. What this convention claims is to attach importance to

material details and insignificant d etails should be ignored w hile deciding certain accoun ting

treatmen t. The concept of materiality is subjective and an accountan t w ill have to d ecide on

merit of each case. Generally, the effect is said to be material, if the knowledge of an event

wou ld influence the decision of an informed stakeholder.

The materiality could be related to information, amount, procedure and nature. Error in

description of an asset or wrong classification between capital and revenue would lead to

materiality of information. If postal stamps of Rs 500 remain unused at the end of accounting

period, the sam e may n ot be considered for recognizing as inventory on accoun t of materiality

of amount. Certain accounting treatments depend up on p rocedures laid d own by accounting

standard s. Some tran sactions are by nature material irrespective of the amou nt involved . E.g.

aud it fees, loan to d irectors.

1.4.13 Conclusion

The above paragraphs bring out essentially broad concepts and conventions that lay down

principles to be followed for accounting of business transaction. While going through the

different topics, stud ents are advised to keep track of concepts app licable for various account ingtreatment. One wou ld have by now understood the importance of these concepts in p reparation

of basic financial statements. More clarity will emerge as one explores the ocean of different

business transactions arising out of complex business situations. The legal and professional

requirements also have their say in deciding the accounting treatment. In the context of the

requirement that the CFO has to certify the statement of accounts, the significance of basic

accounting concepts, conventions and principles need not be over emphasized. Let us see if

you can app ly these concepts in th e following illustrations.

Illustration 3

Recognise the accounting concept in th e following:

(1) The business will run for an indefinite period.

(2) The business is distinct and separate from its owners.

(3) The transactions are recorded at their original cost.

(4) The transactions recorded are those that can be expressed in money terms.

(5) Revenues will be recognized on ly if there is reasonable certainty that it w ill be paid for.

(6) Accounting treatment once decided should be followed period after p eriod.


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ACCOUNTINGA 18


(7) Every transaction has two effects to be recorded in books of accoun ts.

(8) Transactions are recorded even if an obligation is created and actual cash is not in-volved.

(9) Stock of goods is valued at lower of its cost and realizable value.

(10)Effects of an event mu st be recognized in the sam e accoun ting period.

1.5 Accounting standards

The accounting records are maintained as per the guidelines developed by the professional

accoun ting bodies. These bodies develop an d issue statements of accoun ting treatment in respect

of variou s business transactions. In Ind ia, the Institute of Char tered Accoun tants of India (ICAI)

is the statutory body responsible to govern the accounting profession in India. Since its formationby the Parliament Act in 1949, the ICAI has published about 29 accoun ting stand ard s prescribing

methods of accoun ting for d ifferent business transactions. Following is the list of accoun ting

stand ards issued till date:

AS 1: Disclosure of accoun ting policies

AS 2: Valuation of inventories

AS 3: Cash flow statements

AS 4: Contingencies and events occurr ing after balance sheet date

AS 5: Net profit or loss for the p eriod, prior period items and changes in accoun ting policies

AS 6: Depreciation accounting

AS 7: Construction contracts

AS 8: Accounting for research and developm ent

AS 9: Revenu e recognition

AS10: Account ing for fixed assets

AS 11: The effects of change in foreign exchange ra tes

AS 12: Accoun ting for governm ent gran ts

As 13: Accounting for investments

AS 14: Accounting for amalgamations

AS 15: Employee ben efits

AS 16: Borrowing costsAS 17: Segmental reporting

As 18: Related party disclosures

AS 19: Accounting for leases

As 20: Earnings per share

AS 21: Consolidated financial statement

As 22: Account ing for taxes on incom e

AS 23: Accounting for investments in associates in consolidated financial statements

AS 24: Discontinuing operations


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ACCOUNTING A 19

AS 25: Interim financial reporting

As 26: Intangible assets

AS 27: Financial reporting of interests in joint venture

AS 28: Impairment of assets

AS 29: Provisions, contingent liabilities and contingent assets

While these standards are quite detailed and comprehensive, the professional knowledge of

the same may be gathered at a later stage in the course. Stud ents interested in getting a han g

of them could visit the site www.icai.org to get further details.

Similar standards have been developed by the International Accounting standards commit-

tee which was constituted in 1973 (since 2001 it is replaced by the International Accounting

Standards Board)to develop international accounting standards. The committee since then

has published 39 accounting standards that are internationally recognized.

1.6 The Accounting Process

Under double entry system, the accounting of a business transaction involves the following

steps:

(a) Consider w hether an event qualifies to be entered in books of accounts in m oney terms

(b) If the answer to the above is yes, then assess the two aspects of the tran saction

(c) Determine w hat typ e of accoun t is affected by each of the aspects

(d) App ly the golden rule of Debit and credit

(e) Prepare the basic docum ent such as invoice, voucher, debit note or credit note(f) Record th e transaction in the primary books or subsidiary books

(g) Carry out the posting into the ledger

(h) Prepare the list of all ledger balances and ensure it tallies

(i) Rectify the errors, if any

(j) Pass adjustment entries

(k) Prepare ad justed Trial Balance

(l) Prepare the financial statements the income statement and balance sheet

Although it looks to be a lengthy process on pap er, in p ractice it does not take time. With the

aid of comp uter systems, in fact one has to prepare basic docum ents and en ter them into pre-program med screens. The comp uter p rogram autom atically carries out the rest of the processes

to give us real time on line financial statemen ts. To get a hang of this, studen ts are ad vised to

lay their hand s on simple comp uterized accoun ting packages like Tally after learning basics

given in this material.

We w ill be d iscussing each of the above steps at length in the following pages. But before that ,

let us see the Gold en Rules of Accounting.

1.7 The Concepts of Account, Debit and Credit


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ACCOUNTINGA 20


One must get conversant with these terms before embarking to learn actual record-keeping

based on the rules.

An Account is defined as a su mm arised record of transactions related to a person or a th ing.

E.g. when the business deals with customers and suppliers, each of the customers and sup plier

will be a separate account. You know that each one of us is iden tified as a separate accoun t by

the bank when we open an account with them. The account is also related to things both

tangible and intan gible. E.g. land, building, equipm ent, brand value, tradem arks etc. are some

of the things. When a bu siness transaction hap pens, one has to identify the accoun t that w ill

be affected by it and then ap ply the ru les to decide accoun ting treatmen t.

Typically, an accoun t is expressed as a statemen t in form of English letter T. It has tw o sides.

The left han d side is called as Debit side and the right hand side is called as Cred it side. The

debit is connoted as Dr and the credit by Cr. The convention is to write the Dr and Cr labels

on both sides as shown below. Please see the following example:

Dr. Cash Account Cr.

Debit site Credit site

Each side of the account w ill show similar effects, so that one can easily take totals of both sides

and find out the d ifference between the two. Such difference in the two sides of an account is called

balance. If the total of debit side is more than the credit side, the balance is called as debit

balance and if the total of credit side is more th an th e debit side, the balance is called as credit

balance. If the debit and cred it side are equal, the account w ill show nil balance. Please grasp

this very well as this will enable you to interp ret these balances, which is imp ortant.

The balances are to be comp uted at the end of an accoun ting period . These balances are then

considered for preparation of income statement and balance sheet. Let us see the example,

Dr Cash account Cr

Cash brought into business 100000 Paid for goods purchased 50000

Received for goods sold 25000 Paid for rent 15000Balance at the end 60000

Total 125000 Total 125000

It can be seen from the above examp le that the d ebit side of cash accoun t show s the receipt of

cash into the business and the credit side reflects the cash tha t has gone out of the bu siness.

What is the m eaning of the balance at the end? Well, it shows that cash balance available in the

business.

1.8 Types of Accounts


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ACCOUNTING A 21

We have seen that an account m ay be related to a p erson or a thing tangible or intangible.

While doing business transactions (that may be large in num ber and complex in natu re), onemay come across nu merou s accounts that are affected. How does one decide about accounting

treatmen t for each of them? If comm on ru les are to be app lied to similar type of accoun ts, there

mu st be a w ay to classify the accoun t on the basis of their common characteristics.

Please take look at the following chart.

Let us see wh at each type of accoun t mean s.

(1) Personal Accounts: As the nam e suggests these are accounts related to persons.

(a) These persons could be n atural persons like Sureshs a/ c, Anils a/ c, Ranis a/ c etc.

(b) The persons could also be artificial persons like compan ies, bodies corporate or

association of persons or partnerships etc. Accordingly we could have Videocon

Indu stries a/ c, Infosys Technologies a/ c, charitable trust a/ c, Ali and Sons trading

a/ c.

(c) There could be representative personal accounts as w ell. Although the ind ividu al

identity of persons related to these is known , the convention is to reflect them as

collective accoun ts. E.g. when salary is payable to employees, we know how mu ch

is payable to each of them , but collectively the accoun t is called as Salary Payable

a/ c. Similar examples are rent payable, Insu rance prep aid, comm ission pre-receivedetc. The students should be careful to have clarity on this type and the chances of error are

more here.

(2) Real accounts: These are accounts related to things or properties or possessions.

Depending on their physical existence or otherw ise, they are further classified as follows.

(a) Tangible real accounts Accounts that have ph ysical existence and can be seen, and

touched. E.g. machinery a/ c, stock a/ c, cash a/ c, vehicle a/ c

(b) Intangible real accounts These represent possession of prop erties that have no

physical existence but can be measured in term s of mon ey and have value attached

Accounts

Personal

Accounts

Impersonal

Accounts NominalAccounts

Real Accounts (tangibleand intangible)

Natural Persons

Active Persons

Representative

Persons


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ACCOUNTINGA 22


to them. E.g. Goodw ill a/ c, trade mark a/ c, patents & copy rights a/ c

(3) Nominal Accounts These accoun ts are related to expenses or losses and incomes or

gains e.g. salary and w ages a/ c, comm unication a/ c, travel a/ c, comm ission received

a/ c, loss by fire a/ c etc.

Let us see if we can classify the following accoun ts into th e above typ es.

Illustration 4

Identify the type of the account for the following:

Answer: Personal accounts: 2, 3, 6, 12, 13, 20, 26, 27.

Real accounts: 1, 5, 10, 11, 18, 21, 23.

Nominal accounts: 4, 7, 8, 9, 14, 15, 16, 17, 19, 22, 24, 25.

Please practice this w ith other examples to get conversant w ith account classification.

All these types of accoun ts can be fitted into the five basic accoun ting elements a s given below:

1. Assets It will be seen that asset accoun ts are basically all real accoun ts

2. Liability These are mostly personal accounts

3. Incomes or gains These are nominal accounts

4. Expenses or losses These are nominal accounts

5. Own ers capital or equity These are personal accounts

If this relationship is w ell un derstood , one will find it very easy to grasp an d interpret financial

statements also.

(1) Cash a/ c

(2) Bank overd raft a/ c

(3) Bank of India a/ c

(4) Salary a/ c

(5) Furniture a/ c

(6) Mr. Su nils d raw in g a/ c

(7) Discou nt received a/ c

(8) In terest on ban k d ep osit a/ c

(9) Printing and station ery a/ c

(10) Investm ent a/ c

(11) Lan d an d bu ild ing a/ c

(12) Guruku l educa tion trust a/ c

(13) Cr icket club of India a / c

(14) Bad debts a/ c

(15) Repair s and main tenance a/ c

(16) Carriage inw ard a/ c

(17) Rent paid a/ c

(18) Trad em arks a/ c

(19) Stock destroyed a/ c(20) Maru ti Ud yog ltd a/ c

(21) Stores an d sp ares a/ c

(22) Com m ission p aid a/ c

(23) Personal computers and Laptops a/ c

(24) Software expenses a / c

(25) Taxes p aid a/ c

(26) Salary p ayable a/ c

(27) Sh areh old ers a/ c


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ACCOUNTING A 23

1.9 The Golden rules of Accounting:

When on e identifies the account that is getting affected by a transaction an d type of that account,

the next step is to apply the rules to decide whether the accounting treatment is to debit or

credit the account. The golden rules will tell us whether the account is to be debited or

credited.

There is one rule for each basic type of account i.e. personal, real and nominal. These ru les are

shown in the following chart.

Please stud y these ru les carefully. We w ill see the following examp le to und erstand app lication

of these ru les. Consider th e following transactions:

(1) Mr. Vikas and Mrs. Vaibhavi who are hu sband and wife start consulting bu siness by

bring ing in their per sonal cash of Rs 500000 and Rs 250000 respectively.

From bu siness point of view th e two effects of this transaction are: One, the cash of Rs

750000 has come into business and Two, there is an obligation of the bu siness toward s

Mr. Vikas and Mrs. Vaibhavi.

Now, we know that Cash is real accoun t, so rule for real accoun t will app ly. Cash has

come into the business thereby increasing the asset.Hence, Cash Account should be debited.

We also know that Vikass a/ c and Vaibhavis a/ c are personal accounts, so rule for

personal accoun t will apply. As both Vikas and Vaibhavi are givers of cash, their respective

accounts will be credited.

The answer will be Debit cash Rs 750000

Cred it Vikass Cap ital Rs 500000

Debit the receiver or who ow es to business

Credit the giver or to whom business owes

Debit wha t comes into business

Credit what goes out of business

Debit the expenses or losses

Credit the incomes or gainsNominal Account

Real Account

Personal Accoun t


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ACCOUNTINGA 24


Credit Vaibhavis capital Rs 250000

Please note that the total debits and total credit match. Remember the dual aspect

concept?

(2) They buy office furn iture of Rs 25000 for cash.

Here, the tw o effects are: One, Furniture (which is an asset) has come into the business

in exchange for cash (which is also an asset) that has gone ou t of business.

Since, both th e accoun ts viz. Furniture and Cash are real accoun ts, rule for real accoun t

will app ly. Furn iture has come in (asset increase), it will be debited an d cash has gone

out (asset decrease), it will be credited.

The answer will be Debit Furniture Rs 25000

Credit Cash Rs 25000

(3) They open a current account w ith Citi bank by d epositing Rs 100000

Here, the tw o effects are: One, cash has gone out (asset decrease) and two, the business

cash at bank has increased (asset increase). Cash is a real accoun t and Bank is a personal

account.

The answer will be Debit Citi Bank Rs 100000Credit Cash Rs 100000

(4) They pay office rent of Rs 15000 for the m onth by cheque d raw n on their Citi Bank to

M/ s Realtors Properties.

Here, the tw o effects are: One, since the paym ent is mad e by cheque, bank balance will

redu ce (asset decrease), and two, rent being an item of expense w ill increase.

Citi Bank a/ c being a personal a/ c, rule for personalaccount will app ly. Citi bank a/ c

will be credited.

Rent a/ c being a n ominal account, rule for nominal accoun t will app ly. Since, rent ispaid , it is an expense. Hence, rent a/ c will be debited.

The answer will be Debit Rent Rs 15000

Credit Citi Bank Rs 15000

In case of a cash transaction, the party w ith wh om the transaction is mad e does not get

entered, but the cash or bank accoun t is recorded.

(5) They buy a motor car worth Rs 450000 from Millennium Motors by making a dow n

paym ent of Rs 50000 by cheque drawn on Citi Bank an d the balance by taking a loan

from H DFC Bank.


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ACCOUNTING A 25

Here the effects will be: One, Motor Car (which is an asset) has come into th e business(increase in asset). Second ly, Bank balance (wh ich is an asset) has redu ced (decrease in

asset). Thirdly, there is an obligation created tow ards HDFC Bank from whom loan of

Rs 400000 is taken (increase in liability).

Motor Car is a real account and Citi Bank is personal account, so ru le for real account

will app ly. Motor Car has come in, so Motor Car a/ c will be debited an d Citi Bank

balance has gone out, so Citi Bank a/ c will be credited.

HDFC Bank is provider of loan to whom money is payable by the business in future.

HDFC Bank account being a personal accoun t, rule for personal a/ c will app ly. HDFC

Bank being the giver, it will be credited. (Note: have you understood why have we consideredCiti Bank a/c as real and HDFC a/c as personal? Remember, the balance at Citi Bank a/c belongs

to the business, so its an asset; whereas, theres no business cash at HDFC Bank who has paid

Millennium Motors on behalf of the business)

The answer will be Debit Motor Car Rs 450000

Credit Citi Bank Rs 50000

Cred it Loan from H DFC Bank Rs 400000

Will you now answer as to why no accounting treatment is considered for Millennium M otors?

(6) Vikas and Vaibhavi carried out a consulting assignmen t for Avon Pharm aceuticals andraise a bill for Rs 1000000 as consultancy fees. Avon Pharmaceuticals have imm ediately

settled Rs 250000 by way of cheque and the balance will be paid after 30 days. The

cheque received is deposited into Citi Bank.

Here the effects will be: One, the w ork done by Vikas and Vaibhavi has resulted in th e

revenu e for the business. What shou ld be the am oun t of revenue considered? Is it Rs 10

lac for w hich work is don e or only Rs 2.50 lacs which is received? The revenue of entire

Rs 10 lac will be considered as by d oing the w ork the business has acquired legal claim

against Avon Pharmaceutical. Second effect will be cash that is received by way of

chequ e (asset increase). The third effect will be the am ount of Rs 7.50 lacs, which Avon

Pharm aceuticals owes to the business.

Consultancy fees received (revenue earned) being income, rule for nominal account

will apply and this account will be credited. Cheque received and deposited into Citi

bank will increase the balance at the bank. Citi Bank being a personal accountwill be

debited. The amount receivable from Avon is an asset, but its due from Avon at a

future date. To be able to recover it from them , their personal accoun t will have to be

created in books of accounts. Avon Pharm aceuticals is a personal account and they are

receiver of consultancy, it will be debited.


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The answer will be Debit Citi Bank Rs. 250000

Debit Avon Ph arm aceu ticals Rs. 750000

Credit Consultancy Fees Rs. 1000000

(7) They have employed a receptionist on a salary of Rs 5000 per m onth and one officer at

a salary Rs 10000 per month. The salary for the current month is payable to them.

Is this a transaction to be recorded in the books? Remember accrual concept? Accordingly

the expense of salary for the current m onth m ust be recognized as the expense for the

current month even if its not paid for. In fact, the business owes the salary to its

emp loyees and this obligation (which is a liability) must be shown in the books.

The effects will be: One, salary being an item of expense, is a nomina l accoun t and rule

for nominal account w ill be app lied. So Salary a/ c will be debited. Second ly, the

obligation to pay salary is towards both employees, the convention is not to create

separate employee accounts, but to use a representative personal account named as

Salary Payable account. Since, this is personal account rule of personal account will

apply. Employees being givers of service, it will be credited.

The answer will be Debit Salary Rs 15000

Credit Salary payable Rs 15000

Please look at the way we have approached each transaction and decided about accounting

treatment. If you follow these logical steps, you will certainly be able to grasp the basics thoroughly.

Now can w e relate effects of each of the above transaction on th e basic accounting equ ation?

Remember th e basic accoun ting equa tion is:

Assets = Liabilities + Owners equity

While trying to do this correlation, please note that incomes or gains will increase owners


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ACCOUNTING A 27

equity and expenses or losses will reduce it. In our example, although we have con-

sidered two own ers, for simplicity, we w ill show them as combined. Please carefullystud y the following tabu lation of the above seven tran sactions d escribing their effect

on the basic accounting equation.

Please note after the first transaction th e equation stood at

Assets 750000 = Liabilities Nil + Owners equity 750000

After considering the effect of the remaining tran sactions, the equation now stan ds as

Assets 2135000 = Liabilities 415000 + Owners Equity 1720000

Please note th at ow ners equity has gone up from Rs 750000 to Rs 1720000. This would

mean that th e business has earned a net income of Rs 970000 during this period .

1.10 Conclusion

In this opening chapter, you w ere introduced to some of very preliminary aspects of accoun tingprocess. Please make sure to th orough ly digest these basic concepts, wh ich w ill enable you to

und erstand the depth of this subject. Stud ents are therefore advised to attemp t as man y problems

Sr.

No.

Assets = Liabilities + Ow ners Equity

1 Cash 750000 = - + Cap ital 750000

2 Cash 725000 +

Furn iture 25000

= - + Cap ital 750000

3 Cash 625000 + Citi

Bank 100000 +

Furn iture 25000

= - + Cap ital 750000


Bank 85000 +

Furn iture 25000

= - + Cap ital 750000 ren t

paid 15000


bank 35000 +

Furn iture 25000 +

Motor Car 450000

= Loan from HDFC Bank

400000

+ Cap ital 750000 ren t

paid 15000


Bank 285000 +

Furn iture 25000 +

Motor Car 450000 +

Receivables 750000


400000


paid 15000 + revenue

earned 1000000


Bank 285000 +

Furn iture 25000 +Motor Car 450000 +

Receivables 750000


400000 + salary p ayable

15000


pa id 15000 + revenu e

earned 1000000 salary p ayable 15000

basics of book-keeping and accounting

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