Basics of accounting

MODULE -1

Introduction to accounting,

journal, ledger, trial balance

Definitions

1. Recording, classifying, summarising business

transactions and interpreting the results thereof.

2. It is an information system whose purpose is to identify ,

collect, measure and communicate information about

economic units to those with an interest in the units

financial affairs. To permit judgment and decisions by

users of the information.

Systematic record of business transactions.

Protecting the property of the business.

Communicating results to the interested parties.

Compliance with legal requirements.

Evidence in court.

Settlement of taxation liability.

Comparative study.

Sale of business.

Assistance to various parties.

Records only monetary transactions.

Effect of price level changes not considered.

Historical in nature.

Personal bias of Accountant affects the

accounting statements.

Generally Accepted Accounting Principles

In order to make the accounting work uniform and

comparable, a set of Guidelines called as the “GAAP” have

been developed by professional bodies.

ICWAI:- Institute of cost & work Accountants of

India.

ICAI:- Institute of Charted Accountants of India.

AICPA:- American Institute of Certified Public

Accountants.

Capital:-

It means the amount (in terms of money or

assets having money value) which the proprietor has

invested in the firm or can claim from the firm.

For the firm Capital is a liability towards the

owner. It is so because the owner is treated to be

separate from the business.

Liabilities:-

If an amount is due to be paid to any other person or institution other than the owner it is called as a liability.

Liabilities can be classified into following:

i) Long-term liabilities: These are those liabilities which are payable after a long term, (generally more than one year).

Example; Long-term loans, debentures etc.

ii) Current liabilities: These are those liabilities which are payable in near future ,(generally within one year).

Example; creditors, bank overdrafts, bills payable, short-term loans, etc.

Assets:-

Any physical thing or right owned that has a money value is an asset. In other words, an asset is that expenditure which results in acquiring of some property or benefit of a lasting nature.

Assets can be classified as:

i) Fixed Assets: Fixed assets are those assets which are purchased for the purpose of operating the business and not for resale. E.g. land, building, machinery, furniture, etc.

ii) Current Asset: Current assets are those assets of the business which are kept for short term for converting into cash. E.g. debtors, bills receivables, bank balance, etc.

Debtors:-

A person who owes money to the firm, generally

on account of credit sale of goods is called a debtor.

For e.g. When goods are sold to a person on credit

that person pays the price in future. He is called a debtor

because he owes the amount to the firm.

Receivables:-

The term receivables is used for the amount

that is receivable by the firm, other than the amount due

from the debtors.

Creditors:-

A person to whom the firm owes money is

called a creditor. For e.g. Mr. M is creditor of the firm when

goods are purchased on credit from him.

Payables:-

The term payables is used for the amount payable by the firm, other than the amount due to creditors.

Drawings:-

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

Revenue:-

It means the amount which, as a result of operations, is added to the capital. “Revenue is an inflow of assets which results in an increase in owner’s equity. E.g. sale of goods, rent income.

Expense:-

It is the amount spent in order to produce and sell

the goods and services which produce the revenue.

“Expenses is the cost of the use of things or services for the

purpose of generating revenue”. E.g. payment of salary,

wages, rent, etc.

Income:-

It is the profit earned during a period of time. In

other words, the difference between revenue and expense is

called income.

Gross Profit:- Gross profit is the difference between sales

revenue or the proceeds of goods sold and services rendered over its direct cost.

Net Profit:-

Net Profit is the profit made after allowing for all expenses. In case, expenses are more than revenue, it is Net Loss.

Cost of goods sold:-

It is the direct cost of the goods or services sold.

Expenditure:-

Expenditure is the amount spent or liability

incurred for the value received. Expenditure may be

classified into:

i) Revenue Expenditure: It is the amount that is incurred in

current activities to purchase goods and services which are

consumed during the period.

ii) Capital Expenditure: It is the amount that is incurred in

purchasing assets which will give benefit extending over a

number of accounting periods.

Discount:-

When customers are allowed any type of

reduction in the prices of goods by the businessman, that is

called discount.

Gain:-

It is a term used to describe profit of an irregular

nature, e.g. capital gains.

Cash Transaction:-

Transactions involving immediate

receipt or payment of cash.

Credit Transaction:-

Transactions in which the

receipt/payment of cash is postponed to a future date is

called as a credit transaction.

Net worth:-

It means assets minus outside liabilities.

Profits of a business increase net worth where as losses reduce the net worth of a business.

Turn over:-It means total trading income from cash sales

and credit sales.

Voucher:-

Any written document in support of a business transaction is called a voucher. It is an objective evidence in support of a transaction.

Basis of Accounting

a) Cash Basis

b) Accrual / Mercantile Basis

Cash Basis:-

Under this basis, actual cash

receipts & actual cash payments are recorded.

Credit transactions are not recorded until the

cash is actually received or paid.

Limitation: Does not show actual profits nor does

it show the financial position of a firm.

Mercantile or Accrual Basis:-

In the accrual basis of accounting, the income,

whether received or not, but has been earned or accrued

during the period forms part of the total income of that

period.

Similarly, if the firm has taken benefit of a particular

service, but has not paid within that period, the expenses will

relate to the period in which the service has been utilised.

Accounting concepts

1. Entity

2. Money measurement

6. Accruals

4. Cost

3. Going-concern

5. Réalisation

7. Matching

8. Periodicity

9. Consistency

10. Conservatisme

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

The affairs of the business are distinct from the personal affairs of its owner. The business is an independent ENTITY.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

Records are kept in monetary terms, and only matters capable of being expressed in monetary terms are reflected in the books.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

The business is assumed to have a continuing and indefinite life. The business IS NOT on the verge of extinction.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

Accountants compute the value of an asset by reference to its acquisition cost, AND NOT by reference to its expected future benefits.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. réalisation

7. Matching

8. Periodicity

9. Consistency

10. conservatism

Any change in the value of an asset may only be recognized at the moment the firm REALIZES it, or disposes of that asset.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

The recognition of an expense (or revenue) and the related liability (or asset) results from an accounting EVENT, and is not necessarily signaled by a cash transaction.

SFAC #1: Accrual accounting attempts to record the financial effects on an enterprise of transactions and other events and circumstances that have cash consequences for the enterprise in the periods in which these transactions, etc… occur rather than only in the periods when cash is received or paid.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

Expenses should be recognized in the same accounting period during which the firm has recognized the associated revenues.

Revenues and expenses resulting from the same transactions (or events, circumstances, etc…) should be recognized simultaneously.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

Accounting reports must be prepared for fixed, and relatively short, periods of time.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. conservatism

Like transactions should be treated the same way in consecutive periods.

• Accounting concepts

1. Entity

2. money measurement

6. Accruals

4. Cost

3. Going-concern

5. realization

7. Matching

8. Periodicity

9. Consistency

10. Conservatisme

(1) The accountant should not anticipate profit, and should provide for all possible losses;(2) Faced with several methods of valuing an asset, the accountant should choose that which leads to the lesser value.

Business Transactions:-

Any event which involves

exchange of money or money’s worth between the firm and

any other person is known as a Business Transaction.

In other words any event which affects the

business and involves money is a Business Transaction.

ILLUSTRATIONS:-

a) Capital introduced into the business by the proprietor [BT]

b) Sending of price list [NBT]

c) Purchase of goods for cash [BT]

d) Receiving of a price list [NBT]

e) Purchase of goods on credit [BT]

f) Placing of an order [NBT]

g) Sale of goods on credit [BT]

h) Receipt of an order [NBT]

Accounting Equation

The equation is based on the principle that accounting deals

with property & rights to property & the sum of the

properties owned is equal to the sum of the rights to the

properties. The properties owned by a business are called

assets & the rights to properties are known as liabilities or

equities of the business.

Assets = Liabilities + Capital

The Double-Entry System

The double-entry book-keeping system is based on the

principle that for every business transaction that takes place

two entries must be made in the accounts: a debit entry,

showing goods or value coming into the business, & a

corresponding credit entry, showing goods or value going

out of the business.

Rules of the Double Entry System

1) Personal Account:-

These accounts record a business dealings with

persons or firm.

The person receiving something is given debit

and the person giving something is given credit.

2) Real Account:-

These are the accounts of assets. Assets

entering the business is given debit and assets leaving the

business is given credit.

3) Nominal Account:-

These accounts deal with expenses, incomes,

profits and losses. Accounts of expenses and losses are

debited and accounts of incomes and gains are credited.

Debit Receiver

Personal Account

Credit Giver

Debit What comes in

Real Account

Credit What goes out

Debit Expenses & Losses

Nominal Account Credit Incomes & Gains

Advantages of Double Entry System

a) Complete record of the financial transactions is maintained.

b) It gives accurate information of amount due to & due by the

business unit at any time.

c) It is helpful in preventing frauds & errors.

d) Arithmetical accuracy of the account books can be tested.

e) It is helpful in preparing profit & loss account and Balance

sheet of a firm.

Accounting Cycle

a) Recording:-

First, all transactions should be recorded in

the Journal or Books of original entry known as subsidiary

books.

b) Classifying:-

All entries in the Journal should be posted to

the appropriate ledger accounts to find out at a glance the

total effect of all such transactions in a particular account.

c) Summarising:-

Last stage is to prepare the trial balance

and final accounts with a view to ascertaining the profit or

loss made during a trading period and the financial position

of the business on a particular date.

Journal

Journal means a daily record of business transactions.

Journal is a book of original entry because transaction is first

written in the Journal from which it is posted to the ledger.

Date Particular LF Debit

Rs [Dr]

Credit

Rs [Cr]

Year

Month

Date

Name of account to be debited.

To, Name of account to be credited.

[Narration]

The ruling of the journal is as follows:-

Journal

L.F:-

It stands for Ledger Folio which means page of the

ledger. This column is used to record the page numbers on

which the various accounts appear in the ledger.

Trade Discount:-

It is a deduction allowed by the

manufacturer to the wholesaler or retailer on the gross value

or list price of goods to enable the buyer to sell the goods

further (at list price) and yet make a profit for himself.

Trade discount is not recorded in any

account as it is deducted in the invoice itself from the gross

value of goods.

Cash Discount:-

It is allowed by the creditor to the debtor as

an incentive to the latter to make an early payment.

Cash discount is calculated on net value of

goods, after deducting trade discount.

Cash discount being a nominal account, it

is debited with the loss on discount allowed and credited

with the gain on discount received.

Example – 1

Sale of food & drink as meals in a restaurant

amounted to Rs. 1,500 cash.

In this case the sales account would be credited

with the value of the food & drink leaving the restaurant as

meals, and the cash account would be debited with Rs. 1,500

cash coming into the business from the sale.

Example – 2

A hotelier sent a cheque for Rs. 20,000 as

payment of her electricity bill.

In this case the bank account would be credited

with Rs. 20,000 going out of the business and electricity

account would be debited with Rs. 20,000 being the cost of

the electricity used in the business.

Debit1.Increase in asset accounts

2.Increase in expense accounts 

3.Decrease in liability accounts

4.Decrease in equity accounts

5.Decrease in revenue accounts

Credit1.Decrease in asset accounts

2.Decrease in expense accounts 

3.Increase in liability accounts

4.Increase in equity accounts

5.Increase in revenue accounts

LEDGER

A ledger account may be defined as a summary statement of

all the transactions relating to a person, asset, expense or

income which have taken place during a given period of

time and shows their net effect.

Date Particular F Amount

Date Particular F Amount

To, Name of credit A/c

Rs By, Name of debit A/c

Rs

Ledger Format

Each account in the ledger is divided into two

equal parts by a vertical line. The left hand side of the

account is known as debit side and the right hand side is

called credit side.

‘F’ stands for folio (page number) of the

journal or subsidiary book.

Ledger Posting of Journal

Every transaction is first recorded in the

journal in the form of a journal entry.

From the journal it is transferred to the

concerned accounts in the ledger. This process of

transferring the transaction from the journal to the ledger is

known as Posting.

Balancing of Accounts

Various accounts in the ledger are balanced

with a view to preparing the final accounts.

1) Take the totals of the two sides of the account concerned.

2) Ascertain the difference between the totals of two sides.

3) Enter the difference in the amount column of the side

showing less total writing against the difference in the

particular column “To, balance c / d” [ c/d means carried

down] on the debit side of the account and “By, Balance

c/d” on the credit side of the account. In this way, the totals

of two sides will agree.

4) The balance is brought forward at the beginning of the next

period. If “To, Balance C/d” is written on the debit side

before balancing, it is brought forward on the credit side and

“By, Balance b/d” [b/d means brought down] is written

against the balance in the particulars column and vice versa.

An account is said to have a debit balance if the

total of its debit side is more than the total of its credit side.

On the other hand, an account is considered to

have a credit balance if the total of its credit side is more

than the total of its debit side.

1] Journalise the following transactions & post them to ledger.

2008 Jan 1. Started business with cash Rs. 1,00,000

2. Cash paid into bank Rs. 40,000

3. Purchased goods Rs. 6,000

7. Cash sales Rs. 10,000

9. Goods sold to Mr. Raj Rs. 15,000

12. Purchased goods from Mr. Nanda Rs. 20,000

19. Returned goods to Mr. Nanda Rs. 2,500

25. Received from Mr. Raj Rs. 15,000

27. Paid Mr. Nanda Rs. 17,500 by cheque.

Trial Balance

Trial Balance is a list of balances

extracted from the ledger accounts at the end of an

accounting period. Since the balances in ledger accounts are

effects of double entries, the total of debit balances should

be equal to total of credit balances.

Uses of Trial Balances

1) It is the basis of preparation of Final Accounts.

2) It helps in verifying the arithmetical accuracy of ledger

accounts.

The two sides of the trial balance will not tally if a mistakes

has taken place in the following.

a) Posting

b) Totaling

c) Balancing.

Nature of Balances:

In the normal circumstances,

i) All assets accounts & also dues from persons will show

debit balances.

ii) All liabilities accounts will show credit balances.

iii) All expenses account will show debit balances.

iv) All income accounts will show credit balances.

Sl No Particulars LF Debit Balance

Rs

Credit Balance

Rs

Errors Revealed by the Trial Balance:-

1) Incorrect balances of the cash book.

2) Incorrect totals in purchases, purchase returns, allowances

or sales day books.

3) Entries posted to the wrong side of an account.

4) Omission of a debit or a credit in posting from the journals

to the ledger.

5) Incorrect figures posted from a journal to the ledger

account.

6) Discounts transferred incorrectly.

Procedures for locating Errors in the Trial Balance

a) Check the cash balance in the cash book against the actual

cash in hand.

b) Check and reconcile the bank balance in the cash book

against the balance in the bank statement.

c) Prove the purchases and purchases returns figures against

the purchases control account.

Errors not revealed by the Trial Balance:-

1) Errors of omission:

This type of errors occurs when an

accounting document, e.g. an invoice or a credit note, is lost

or mislaid, the result being that there is no debit or credit

entry in either the book of first entry or the ledger account.

2) Errors of original entry:

This type of error occurs when an

amount on an invoice, e.g. Rs. 600, is entered wrongly in the

book of first entry, e.g. Rs. 666, and then is posted wrongly

to the ledger account, as Rs. 666.

As there has been a debit entry and a

credit entry for the same amount, the totals of the trial

balance will still be in agreement.

3) Errors of principle:

This type of error occurs when a

transaction has a debit entry and a credit entry but the item is

posted in principle to the wrong classification of account.

E.g. Motor expenses of Rs. 300 has been debited to motor

vehicles account.

4) Errors of commission:

When a wrong amount is entered

either in the subsidiary books or in the ledger accounts or

when amount is posted on the wrong side, it is a case of

errors of commission.

For example, if fuel costs are incorrectly debited to the

postage account (both expense accounts). This will not

affect the totals.

5) Compensating errors:

An example of this type of errors is

where the wages account has been over-added by Rs. 5,000

& by coincidence the sales account has been over added by

Rs. 5,000. So an error on debit side is compensated by an

error on the credit side.

6) Errors of duplication:

An example of this type of error is

when the same invoice is entered into the purchases day

book twice and posted from there to the ledger account

twice.

The Suspense Account:-

When trial balance does not tally , the

difference is put into a newly opened account named

suspense account and the trial balance is thus made to tally.

In case , the debit side exceeds the credit

side the difference is put on the credit side of suspense

account . Likewise , if the credit side of the trial balance

exceeds the debit side , the difference is put on the debit side

of suspense account.