Basic Accounting Principles
2 Table
of Contents: -
1. Accounting Concepts:
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a. Business Entity Concept/Accounting Entity Concept.
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b. Money Measurement.
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c. Going Concern.
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d. Accounting Period
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e. Accrual Concept.
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f. Historical Cost.
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2. What is Accounting? *
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3. Purpose of Accounting.* Accounting. *
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4. Accounting Equation.*
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5. Elements of Accounting Equation: *
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a. Assets. b. Liabilities. c. Owner¶s Equity.
6. Rules of Debit and Credit. *
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7. Classification of Accounts. *
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a. Personal Accounts.
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b. Real Accounts.
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c. Nominal Accounts.
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d. Final Accounts:
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8. Source Documents. *
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9. Journals.
*
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10. Ledger.
*
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11. Trial Balance.*
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12. Cash Book.
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*
13. Bank Reconciliation Statement (BRS).
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14. Depreciation.
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15. Calculation of Depreciation (Methods).
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3
1.
Accounting Concepts: Let us take an example. In India there is a basic r ule to be f ollowed ollowed by ever yone that one shou hould walk or drive on his/ his/her her lef lef t hand side of the f the road. It helps helps in the smooth f low low of tra f traff ff ic. ic. Similarly, imilarly, there are certain r ules les that an accou accountant shou hould f ollow ollow while recording busine business ss trans transactions actions and preparing accou accounts nts. Thes hese may may be termed as accou accounting concept. Thus, this this can be said that: Accou ccounting concept ref ref er er s to the basic assumption ssumptionss and r ules les and principles, principles, which work a work as the basis of recording f recording of busine business ss trans transactions actions and preparing and preparing accou accounts nts. The main o bjective bjective is to maintain unif nif ormity ormity and cons consistency tency in accou accounting records records. Thes hese concepts concepts cons constitu titute the ver y basis of accou accounting. All the concepts concepts have been been developed over the year s f rom rom experience and thus thus they they are univer sally ally accepted r ules les. Following are the various various accou accounting concepts concepts that have been dis discussed ussed in the f ollowing ollowing sections ections:
a. Business Entity Concept/Accounting Entity Concept: -
This his concept assume ssumess that, that, f or acco or accou unting p nting pu urpos rposes, the busine business ss enterpris enterprise and its its owner s are two separate independent entities entities. Thus, the busine business ss and per sonal trans transactions actions of it f itss owner are owner are separate. For example, example, when the owner inve owner invessts money money in the busine business, ss, it is recorded as lia bilit bility y of the busine business ss to the owner. Similarly, imilarly, when the owner takes takes away away f rom rom the busine business ss cas cash/goods goods f or or his/ his/her her per per sonal use use, it is not treated as busine business ss expens expense. Thus, the accou accounting records records are made in the book s of acco f accou unts nts f rom rom the point of view of the busine business ss unit and not the per son owning the busine business ss.. This his concept is the ver y ba basis of acco f accou unting. Let us take an example. Su ppo Su pposse Mr. Sahoo started busine business ss inves investing Rs100000. Rs100000. He pu purchas rchased goods goods f or or Rs40000, Furnit Furnitu ure f or or Rs20000 and plant and machiner y o f Rs30000. Rs30000. Rs10000 remains remains in hand. Thes hese are the asset ssetss of the f the busine business ss and not of the f the owner. According to the busine business ss entity entity concept Rs100000 will be treated by busine business ss as capital i.e. a lia bilit bility y of busine business ss towards towards the owner of the busine business ss.. Now su ppos ppose, he takes takes away away Rs5000 cas cash or goods goods worth Rs5000 f or or his his domes domestic pu purpos rposes. This his business ss is his withdrawal of ca f cassh/goods goods by the owner f owner f rom rom the busine his private expens expense and not an
expens expense of the f the busine business ss.. It is termed as Drawing Drawingss. Thus, the busine business ss entity entit y concept states tates that busine business ss and the owner are owner are two separate/ eparate/dis distinct per sons ons. Accordingly, ccordingly, any any expens expenses incu incurred by owner f or or hims himself elf or or his his f amily amily f rom rom busine business ss will be cons considered as expens expenses and it will be shown as drawings drawings.
Significance:
The f ollowing business ss entity ollowing points points highlight the signif ignif icance icance of busine entit y concept: y
This his concept helps helps in ascertaining the prof prof it it of the f the busine business ss as only only the busine business ss expens expenses and revenu revenues are recorded and all the private and per sonal expens expenses are ignored.
y
This his concept res restraints traint s accou accountant f rom rom recording of owner ¶s private/ private/ per sonal trans transactions actions.
4
y
It als also f acilitates acilitates the recording and reporting of busine business ss trans transactions actions f rom rom the busine business ss point point of view. f view.
y
It is the ver y ba basis of acco f accou unting concepts, concepts, conventions conventions and principle and principless.
b. Money Measurement Concept: -
This his concept assume ssumess that all busine business ss trans transactions actions must ust be in terms terms o f money money that is in the currency rrency o f a cou countr y. In our cou countr y such such trans transactions actions are in terms terms o f r u pees pees. Thus, as per the money money measu measurement rement concept, concept, trans transactions actions which can be express expressed ed in terms terms of mone f money y are recorded in the book s of acco f accou unts nts. For example, example, sale s ale of good f goodss worth Rs. Rs.200000, p 200000, pu urchas rchase of raw f raw materials materials Rs. Rs.100000, R ent ent Paid Rs. Rs.10000 etc. are express expressed ed in terms terms of money, money, and so they they are recorded in the book book s of acco f accou unts nts. But But the trans transactions actions which cannot be express expressed ed in monetar y terms terms are not recorded in the book s of accou accounts nts. For example, example, sincerity, incerit y, loy loyalty, alty, hones honest y of employ emplo yees ees are not recorded in book s of acco f accou unts nts becaus ecausee thes these cannot be measu measured red in terms terms of mone f money y althou although they they do aff ect ect the pro the prof f its its and loss lossees of the f the busine business ss concern. Another as pect of thi f thiss concept is that the records records of the f the trans transactions actions are to be kept not in the phys physical ical units nits but bu t in the monetar y unit. unit. For example, example, at the end of the f the year 2006, an organization may may have a f actor actor y on a piece of land f land measu measuring ring 10 acres, acres, off ice ice building building containing 50 rooms, rooms, 50 per sonal compu computer s, s, 50 off ice ice chair s and ta ble bles, s, 100 kg of raw f raw But f or urpos materials materials etc. Thes hese are express expressed ed in diff diff erent erent units nits. But or accou accounting p nting pu rpo ses they they are to be recorded in money money terms terms i.e. in r u pees pees. In this this cas case, the cos cost of f actor actor y land may may be be say Rs. Rs.12 crore, building of Rs. Rs.10 crore, Rs.10 lakhs, crore, off ice ice building crore, compu computer s Rs. lakhs, off ice ice chair s and ta ble bless Rs. Rs .2 lakhs, lakhs, raw material Rs. Rs.30 lakhs lakhs. Thus, the total asset ssetss of the f the organization are valu valued at Rs. Rs.22 crore and Rs. Rs.42 lakhs lakhs. Theref heref ore, ore, the trans transactions actions which can be express expressed ed in terms terms o f mone f money y is recorded in the accou accounts nts book book s, s, that too in terms terms of mone f money y and not in terms terms of the f the quantit quantity y.
Significance:
The f ollowing ollowing points points highlight the signif ignif icance icance of mone f money y measu measurement rement concept: y
This his concept guides ides accou accountants ntants what to record and what not to record.
y
It helps helps in recording busine business ss trans transactions actions unif nif ormly ormly. If all the busine business ss trans transactions actions are express expressed ed in monetar y terms, terms, it will be easy easy to under stand the accou accounts nts prepared by the busine business ss enterpris enterprise.
y
It f acilitates acilitates comparis comparison of busine business ss per f formance o rmance of two diff diff erent erent periods periods of the same f irm irm or o or of the f the two diff diff erent erent f irms irms f or the or the same period. ame period.
c. Going Concern Concept:
This his concept states tates that a busine business ss f irm irm will continu continue to carr y on its its activities activitie s f or or an indef indef inite inite period of time. Simply imply stated, tated, it means means that ever y busine business ss entity entity has has
5 continu continuity ity of li f lif f e. e. Thus, it will not be diss dissolved olved in the near fut future. This his is an important assumption ssumption of acco f accou unting, nting, as it provide it providess a basis f or or showing the valu value of a f asset ssetss in the balance balance sheet; For example, example, a company company pu purchas rchases a plant and machiner y of Rs. Rs.100000 and its its lif lif e s pan is 10 year year s. According to this this concept ever y year some amou amount will be shown as expens expenses and the balance amou amount as an asset. sset. Thus, if an f an amou amount is s pent s pent on an item, item, which will be used used in busine business ss f or or many many year year s, s, it will not be be proper to charge the amou amount f rom rom the revenu revenues of the f the year in which the item is f the valu shown as expens acqu acquired. ired. Only nly a part of the value is shown expense in the year o ear of pu purchas rchase and the remaining balance is shown shown as an asset. sset.
Significance:
The f ollowing ollowing points points highlight the signif ignif icance icance of going f going concern concept: y
This his concept f acilitates acilitates preparation of f inancial inancial statements tatement s.
y
On the basis of thi f thiss concept, concept, depreciation is charged on the f ixed ixed asset. sset.
y
It is of great help to the inves investor s, s, becaus ecausee, it assure ssuress them that they they will continu continue to get income on their inves investments tments.
y
In the a bsence bsence of thi f thiss concept, concept, the cos cost of a f a f ixed ixed asset sset will be treated as an expens expense in the year o ear of it f itss pu purchas rchase.
y
A busine business ss is judged judged f or or its its capacity capacity to earn pro earn prof f its its in fut future.
d. Accounting Period Concept:
All the trans transactions actions are recorded in the book s of accou accounts nts on the assumption ssumption that prof prof its its on thes these trans transactions actions are to be ascertained f or or a s pecif pecif ied ied period. This his is known as accou accounting period nting period concept. Thus, this this concept requ require iress that a balance sheet and pro and prof f it it and loss loss accou account shou hould be prepared at regu regular intervals intervals. This his is necess necessar ar y f or or diff diff erent erent pu purpos rposes like, like, calcu calculation of prof prof it; it; ascertaining f inancial inancial pos position, ition, tax compu computation etc. Further Further , this this concept assume ssumess that, that, indef indef inite inite lif lif e of busine business ss is divided into parts parts. Thes hese parts parts are known as Acco A ccou unting Period. It may may be be of one f one year , six months, months, three months, months, one month, month, etc. But But usuall usually y one year is taken as one accou accounting period, period, which may may be a calendar year or a f inancial inancial year. Year that ear that begins egins f rom rom 1st 1st of Jan Janu uar y and ends ends on 31st 31st of Decem Decem ber ber is known as Calendar Calendar Year. The year that ear that begins egins f rom rom 1st 1st
of A pril and ends ends on 31st 31st of March March of the f the
f ollowing ollowing year i ear is known as f inancial inancial year. As per accou accounting period concept, concept, all the trans transactions actions are recorded in the book s of accou accounts nts f or or a s pecif pecif ied ied period of time. f time. Hence, ence, goods goods pu purchas rchased and sold during the period, period, rent, rent, salarie salariess etc. paid etc. paid f or the or the period period are accou accounted f or or and agains against that period that period only only.
Significance: y
It helps helps in predicting in predicting the fut future pro re pross pects pects of the f the busine business ss..
y
It helps helps in calcu calculating tax on busine business ss income calcu calculated f or or a particu particular time period.
y
It als also helps helps bank s, s, f inancial inancial ins institu titutions, tions, creditor s, s, etc to asse ssess and analy analyze the per f formance o rmance of busine business ss f or a or a particu particular period. period.
6
y
It als also helps helps the busine business ss f irms irms to dis distri bute bute their income at regu regular intervals intervals as dividends dividends.
e. Accrual Concept:
The meaning of accr f accr ual is something that becomes ecomes due es pecially pecially an amou amount of money money that is yet yet to be paid or received at the end of the f the accou accounting period. nting period. It means means that revenu revenues are recognized when they they become receiva ble. ble. Thou hough cas cash is received or not received and the expens expenses are recognized when they they become become pa pay ya ble ble thou though cas cash is paid or not paid. Both trans transactions actions will be recorded in the accou accounting period to which they they relate. Theref heref ore, ore, the accr ual concept makes makes a dis distinction between the accr ual receipt of cas cash and the right to receive cas cash as regards regards revenu revenue and actu actual pay payment of cas cash and o bligation bligation to pay pay cas cash as regards regards expens expenses. The accr ual concept under accou accounting assume ssumess that revenu revenue is realized at the time of sale sale of good f goodss or s or services ervices irres irres pective of the f the f act act when the cas cash is received. For example, example, a f irm irm sells ells goods goods f or or Rs. Rs.55000 on 25th 25th March 2005 and the pa the pay yment is not received until 10th 10th A pril 2005, the amou amount is due and pay paya ble ble to the f irm irm on the date of sale s ale i.e. 25th 25th March 2005. 2005. It must ust be inclu included in the revenu revenue f or or the year ending 31st 31st March 2005. 2005. Similarly, imilarly, expens expenses are recognized at the time services ervices provided, provided, irres irres pective of the f the f act act when actu actual pay payments ments f or or thes these services ervices are made. For example, example, if the f the f irm irm received goods goods cos costing Rs. Rs.20000 on 29th 29th March 2005 but but the pay payment is made on 2nd A pril 2005 the accr ual concept requ require iress that expens expenses must ust be recorded f or or the year ending 31st 31st March 2005 althou although no pay payment has has been made until 31st 31st March 2005 thou though the service has has been received and the per son to whom the pa the pay yment shou hould have been made is shown shown as creditor. In brief, rief, accr ual concept requ require iress that revenu revenue is recognized when realized and expens expenses are recognized when they they become due and pay paya ble ble withou without regard to the time of cas cash receipt or ca or cassh pay payment.
Significance: y
It helps helps in knowing actu actual expens expenses and actu actual income during a particu particular time period.
y
f.
It helps helps in calcu calculating the net pro net prof f it it of the f the busine business ss..
Historical Cost Concept:
Historical cos cost accou accounting is an accou accounting concept that states tates that all asset ssetss in the f inancial inancial statement shou hould be reported based on their original cos cost. Historical cos cost is a generally generally accepted accou accounting principle requ requiring iring all f inancial inancial statement items items be ba based u pon original cos cost. Historical cos cost means means what it cos cost the company company f or or the item. It is not f air air market valu value. T his his means means that if a company company pu purchas rchased a building building,, it is recorded on the balance sheet at its its his historical cos cost. It is not recorded at f air market air market valu value, which wou would be what the company company cou could sell the building building f or or in the open market. Example: James ames buys a building building f or or Rs. Rs.2000000. 2000000.00 ten year s ago, ago, the valu value o f the building building now is Rs. Rs.3000000. 3000000.00 but but in James's ames's accou accounting records, records, the building building is still
7 recorded as Rs. Rs.2000000. 2000000.00 (less less depreciation). No accou account is taken of the increas increase in valu value.
2.
What is Accounting? The def def inition inition o f acco f accou unting depends depends. It depends, depends, to whom you are asking. For the accou accountant, ntant, it is one area of busine business ss activity activity that they they use use to derive an income. A more prof prof essional ssional way way o f p f pu utting that cou could be, that accou accounting is an occu occu pation that is engaged in the service of providing f providing relia ble ble and relevant f inancial inancial inf inf ormation ormation that can be be used used by other s to make inf inf ormed ormed decis decisions ions. One µoff icial¶ icial¶ def def inition inition of acco f accou unting is provided by the American Accou ccounting Association Association,, which def def ines ines accou accounting as- "the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.´ For the res rest of us, the def def inition inition and pu purpos rpose of acco f accou unting cou could be any any one or a bination of the f the f ollowing: com bination ollowing: Professors of Accounting may may call it ³T he he language of business.´ Economists may may def def ine ine it as the practical the practical application of economic f economic theor y in that it measu measure ress income and valu values asset ssetss. Corporate managers may may def de f ine ine it as a set of timel f timely y gau gauges ges that helps helps them actu actually ally manage the organization Labor unions may may see see it as a monitor o monitor of an f an organizations organizations activities activities and per f formance, o rmance, particu particularly larly in relation to the benef enef its its sec secu ured by employ employees ees Vs owner s. A Board of Directors or a Chief Executive Officer (CEO) may may see see accou accounting as a data process process and reporting system system that provide the inf inf ormation ormation needed f or or sound f inancial inancial or economic decis decision making f or or their organization. their organization. Banks and other provider provider s o f loan f loan fund fundss may may see s ee it as a process process o f providing providing reports reports showing the f inancial inancial pos position o f an organization in relation to the asset ssetss owned, owned, amou amounts nts owed to other s and monies monies inves invested as well as the prof prof ita ita bilit bility y o f the f the organization¶s organization¶s operations operations in relation to repay repaying the loan with interes interest. Governments may may see see it as a way way o f making f making organizations organizations accou accounta ble ble to the general commu community nity by way way of taxation contri bution butionss and trans trans parency parency in the outcomes tcomes f rom rom their deci their decissionion-making. Potential investors may may see it as a method of evalu evaluating an organization¶s organization¶s eff ectiveness ectiveness in relation to indus industr tr y benchmark benchmark s and the inves investor ¶s ¶s requ required ired retu returns rns.
We can see f rom rom thes these def def initions initions that accou accounting can be divided into two main elements elements: y
An inf inf ormation ormation process process that identif identif ies, ies, class classiif ies ies and summarize summarizess the f inancial inancial events events that take place take place within an organization and
8
y
A reporting system system that commu communicates nicates relevant f inancial inancial inf inf ormation ormation to interes interested per sons ons which allows allows them to asse ssess per f formance, o rmance, make decis decisions ions and/ and/or control the economic res resources rces in the organization.
3.
Purpose of Accounting: The basic pu purpos rpose of accou accounting is derivation of inf inf ormation. ormation. K eeping eeping track of trans transactions actions and recording revenu revenue and expens expenses are important busine business ss process processees that are of ten ten assigned ssigned to an accou accounting department or f inancial inancial manager. Accou ccounting is a busine business ss dis discipline that allows allows companies companies to record, record, analy analyze and retrieve critical f inancial inancial inf inf ormation ormation that can be used used to determine a company's company's f inancial inancial status tat us and provide reports reports and ins insights ights needed to make sound f inancial inancial decis decisions ions. The primar y pu purpos rpose of accou accounting is to identify identify and record all activities activities that impact the organization f inancially inancially. All activities activities such such as pu purchas rchases, sales, ales, the f capital and interes acqu acquiisition o f capital interest earned f rom rom inves investments tments can be class classiif ied ied in monetar y terms terms and pos posted to a s pecif pecif ied ied accou account as an accou accounting record. Thes hese trans transactions actions are ty pically pically recorded in ledger s and journals rnals and are part of the process process known as the accou accounting cycle. Accou ccountants ntants develop system systemss and proce and process ssees to evalu evaluate and analy analyze the diff diff erent erent ty pes pes of tran f transsactions actions that a company company is involved with. Ever y trans transaction that involves involves the acqu acquiisition or sale o f goods goods and services ervices must ust be reported in the general ledger and pos posted to relevant accou accounts nts. Bookkeeping is the function function o f accou accounting that helps helps maintain thes these t y pes pes of tran f transsactions actions as de bit bitss and credits credits; this this data can then be used used to create accu accurate and timely timely f inancial inancial reports reports. Accou ccounting is a cr ucial dis discipline f or or keeping track of quanti qu antif f ia ia ble ble f actor actor s f or or a busine business ss or individu individual. Accou cco untants ntants are primarily primarily employ emplo yed to track the f low low o f mone f money y throu through an organization. In some cas cases, they they are charged with ensu ensuring ring legal compliance. In other s, s, they they are more s pecialized in optimizing that cas cash f low. low. Accou ccountants ntants als also organize and aggregate f inancial inancial inf inf ormation ormation and produ produce reports reports f or or people less less experienced in the dis discipline.
4.
Accounting Equation: From the large, large, multilti-national corporation down to the corner b corner beau eaut y salon salon,, ever y busine business ss trans transaction will have an eff ect ect on a company¶s company¶s f inancial po inancial possition. The f inancial inancial pos position of a f a company company is measu measured red by the f ollowing ollowing items items: 1. Asset Assetss (what (what it owns owns) 2. Lia bilitie bilitiess (what (what it owes owes to other s) 3. Owner ¶s ¶s Equit Equity y (the (the diff diff erence erence between asset ssetss and lia bilitie bilitiess)
9 The accounting equation (or basic accou accounting equation) quation) o ff er er s us a simple way way to under stand how thes these three amou amounts nts relate to each other. The accou accounting equation quation f or or a sole proprietor ole proprietor ship is: Assets = Liabilities + Owner¶s Equity
The accou accounting equation quation f or or a corporation is:
Assets = Liabilities + Stockholders¶ Equity
Asset Assetss are a company¶s company¶s res resources² rces² things things the company company owns owns. Examples xamples o f asset ssetss inclu include cas cash, accou accounts nts receiva ble ble,, inventor y, y, prepaid insu insurance rance,, inves investments, tments, land, land, building buildings, s, equipment quipment,, and goodwill. From the accou accounting equation quation,, we see that the amou amount of asset ssetss must ust equal qual the com bined bined amou amount of lia bilitie bilitiess plus plus owner ¶s ¶s (or stockholder s¶) s¶) equit quity y.
Lia bilitie bilitiess are a company¶s company¶s o bligation bligations² s² amou amounts nts the company company owes owes. Examples xamples of lia bilitie bilitiess inclu include notes notes or loans loans pay paya ble ble,, accou accounts nts pay paya ble ble,, salaries alaries and wages wages pay paya ble ble,, interes interest pay paya ble ble,, and income taxes taxes pay paya ble ble (if the company company is a regu regular corporation). Lia bilitie bilitiess can be viewed in two ways ways:: (1) (1)
as
claims claims
by
creditor s
agains against
the
company¶s company¶s
asset ssets, s,
and
(2) (2)
a source along with owner or owner or sstockholder e tockholder equit quity y of the f the company¶s company¶s asset ssetss.
Owner ¶s ¶s equit quity y or stockholder s¶ s¶ equit quity y is the amou amount lef lef t over af ter ter lia bilitie bilitiess are dedu deducted f rom rom asset ssetss: Assets ± Liabilities = Owner¶s (or Stockholders¶) Equity.
Owner ¶s ¶s or stockholder s¶ s¶ equit quity y als also reports reports the amou amounts nts inves invested into the company company by by f the company the owner s plus plus the cumulative net income of the company that has has not been withdrawn or di or disstri buted buted to the owner s. If a company company keeps keeps accu accurate records, records, the accou accounting equation quation will always always be ³in balance balance,´ ,´ meaning the lef lef t side shou hould always always equal qual the right side. The balance is maintained becaus ecausee ever y busine business ss trans transaction aff ects ects at leas least two of a company¶s company¶s accou accounts nts. For example, example, when a company company borrows orrows money money f rom rom a bank , the company¶s company¶s asset ssetss will increas increase and its its lia bilitie bilitiess will increas increase by the same amou amount. When a company company pu purchas rchases inventor y f or or cas cash, one asset sset will increas increase and one asset sset will decreas decrease. Becaus ecausee there are two or more accou accounts nts aff ected ected by ever y trans transaction, action, the accou accounting system system is ref ref erred erred to as doub double le entr y accou accounting.
10 A company company keeps keeps track of all f all o f its its trans transactions actions by recording them in accou accounts nts in the company¶s company¶s general ledger. Each accou account in the general ledger i ledger is des designated as to its its ty pe: asset sset,, lia bilit bility, y, owner ¶s ¶s equit quity, y, revenu revenue, expens expense, gain, gain, or lo or loss ss accou account.
5.
Elements of Accounting Equation: Accou ccounting is buil builtt u pon the fundamental fundamental accou accounting equation: quation: Assets = Liabilities + Owner's Equity
This his equation quation must ust remain in balance and f or or that reas reason our modern accou accounting system system is called a dualal-entr y system. system. This his means means that ever y trans transaction that is recorded in accou accounting records records must ust have at leas least two entries entries; if it only only has has one entr y the equation quation wou would necess necessaril arily y be be un balanced. balanced. The equation quation¶s ¶s three part three partss are explained as f ollows ollows: 1. Assets = what the busine business ss has has or owns owns (equipment quipment,, su pplies, pplies, cas cash, accou accounts nts receiva ble) ble) 2. Liabilities = what the busine business ss owes owes outsider s (bank (bank loan loan,, accou accounts nts pay paya ble) ble) 3. Owner¶s Equity = what the owner own owner ownss (inve (invesstment and busine business ss pro prof f it) it) The Accou ccounting Equation Equation can be express expressed ed in three ways ways::
6.
y
Asset Assetss = Lia bilitie bilitiess + Owner Owner ¶s ¶s Equit Equity y
y
Lia bilitie bilitiess = Asset Assetss ± Owner Owner ¶s ¶s Equit Equity y
y
Owner ¶s ¶s Equit Equity y = Asset Assetss ± Lia ± Lia bilitie bilitiess
Rules of Debit and Credit: There are three Golden Rule Ruless f or or De bit bit & Credit. Whole o f the f the accou accounting depends depends u pon u pon thes these three r ules les: -
y
Debit what comes in & Credit what goes out.
y
Debit the receiver & Credit the giver.
y
Debit all losses/expenses & Credit all gains/profits.
De bit bit and Credit are two actions actions of oppo f oppossing natu nature that are relevant to the process process of acco f accou unting. T hey hey are as fundamental fu ndamental to accou accounting as addition (+) (+) and subtraction subtraction (-) (-) are to mathematics mathematics. It wou would not be appropriate to apply apply this this mathematical analogy analogy in all cas cases, as it wou would give a dis distorted meaning. Thus, it
11 wou would not be appropriate to cons consider de bit bit to be an equivalent quivalent of addition and credit to be an equivalent quivalent of subtraction. subtraction. One just just need to under stand that de bit bit and credit are two actions actions that are oppos opposite in natu nature. An element (accou account) that is aff ected ected by an accou accounting trans transaction is either de bited bited or credited (with an amou amount that is ref ref lected lected in the trans transaction) depending on the natu nature of the f the accou account and the r ule applica ble ble to it. Example:
A pu purchas rchase of furnit furnitu ure worth Rs. Rs.10000. 10000.00 f or C or Cash.
This his trans transaction wou would resu result lt in ±
i.)
Furnit Furnitu ure a/c being de bited bited by an amou amount of Rs. Rs.10000. 10000.00 and
ii.)
Cash a/c being credited by a similar amou amount.
A pay payment of Rs. Rs.5000. 5000.00 received f rom rom Mr. Naray arayan by Che Chequ que. e.
This his trans transaction wou would resu result lt in ±
7.
i.)
Mr. Naray Rs. 5000. 5000.00 and arayan a/c being credited to the extent of Rs.
ii.)
The Bank a ank a/c being de bited bited with a similar amou amount.
Classification of Accounts:
a. Personal Accounts:
Accou ccounts nts recording trans transactions actions relating to individu individuals als or f irms irms or company company are known as per sonal accou accounts nts. Per sonal accou accounts nts may may further further be class classiif ied ied as: i.)
atural N atural
person's personal accounts: The accou accounts nts recording
trans transactions actions relating to individu individual human beings eings e.g., e.g., Anand's nand's A/c A/c, R emes emesh's A/c A/c, Panka j's A/c are class classiif ied ied as natu natural per son's on's per sonal accou accounts nts. ii.)
Artificial
person's personal account: The accou accounts nts recording
trans transactions actions relating to limited companies, companies, bank , f irm, irm, ins institu titution, tion, club club etc. e.g. Delhi Cloth Mill; Hans ans R a j College; College; Gymkhana Gymkhana Club are class classiif ied ied as artif artif icial per icial per sons' ons' per per sonal accou accounts nts.
12 iii.)
Representative
personal
accounts:
The
accou accounts nts
recording
trans transactions actions relating to the expens expenses and incomes incomes are class classiif ied ied as nominal accou accounts nts. But But in certain cas cases due to the matching concept of accou accounting the amou amount, nt, on a particu particular date, date, is pay paya ble ble to the individu individuals als or recovera or recovera ble ble f rom rom individu individuals als. Such Such amou amount (a) relates relates to the particu particular head of expenditu expenditure or income and (b) (b) repres represents ents per sons ons to whom it is pay paya ble ble or f rom rom whom it is recovera ble. ble. Such Such accou accounts nts are class classiif ied ied as repres representative per sonal accou accounts nts e.g. "W "Wage agess Out Outstanding Accou ccount", nt", Pre Pre-- paid Insurance surance Accou ccount. etc. b.)
Real Accounts:
The accou accounts nts recording trans transactions actions relating to tangi ble ble things things (which (which can be be tou touched, ched, pu purchas rchased and sold) such such as goods, goods, cas cash, building building,, machiner y etc., etc., are class classiif ied ied as tangi ble ble real accou accounts nts. Whereas hereas the accou accounts nts recording trans transactions actions relating to intangi ble ble things things (which do not have phys physical ical shape) such such as goodwill, goodwill, patents patents and copy cop y rights, rights, trade mark s etc., etc., are class classiif ied ied as intangi ble ble real accou accounts nts. c.)
Nominal Accounts:
The accou accounts nts recording trans transactions actions relating to the loss lossees, gains, gains, expens expenses and incomes incomes e.g., e.g., R ent, ent, salaries, alaries, wages, wages, commiss commission ion,, interes interest, bad de bt bts etc. are class classiif ied ied as nominal accou accounts nts. As already already dis discussed ussed,, wherever a nominal accou account repres represents ents the amou amount pay paya ble ble to or receiva ble ble f rom rom certain per sons ons it is known as repres representative per entative per sonal accou account. d.)
Final Accounts:
Accou ccounts nts made u p only only at the end o f a f irm's irm's f inancial inancial year. For a (1 ) manuf (2) manuf manuf actu acturing f irm, irm, the f inal inal accou accounts nts cons consist of (1) manuf actu acturing accou account, nt, (2) trading accou account, nt, (3) (3) prof prof it it and loss loss accou account, nt, and (4) (4) prof prof it it and loss loss appropriation accou account. A trading f irm's irm's f inal inal accou accounts nts will inclu include all o f the f the a bove bove except the manuf manuf actu acturing accou account. Together , thes these accou accounts nts generate the gross gross prof prof it, it, net income, income, and dis distri bution bution of net f net income f igu igures res of the f the f irm. irm. Rules of Debit and Credit (classification based):
Per sonal Accou ccounts nts: De bit bit the receiver; Credit the giver (su pplier).
R eal eal Accou cco unts nts: De bit bit what comes comes in, in, Credit Credit what goes goes out.
Nominal Nominal Accou ccounts nts: De bit bit expens expenses and loss lossees, Credit Credit incomes incomes and gains gains.
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8.
Source Documents: ource Document is the original record of a trans The S ource transaction. During During an audit, dit,
source docu documents ments are used used as evidence that a particu particular busine business ss trans transaction occu occurred. Examples xamples of so source docu documents ments inclu include:
y
Cash receipts receipts
y
Credit card receipts receipt s
y
Cash regis register tape ter tapess
y
Cancelled check s
y
Customer Customer invoices invoices
y
Su pplier invoice pplier invoicess
y
Purcha Purchasse order s
y
Time cards cards
y
Depos eposit slips lips
y
y
Note Notess f or or loans loans Payment stubs f or or interes interest At a minimu minimum, each source docu document shou hould inclu include the date, date, the amou amount, nt, and a
des description o f the trans transaction. When practical, practical, beyond thes these minimu minimum requ requirement irementss source docu documents ments shou hould contain the name and address address of the other party party o f the trans transaction. When a source docu document does does not exis exist, f or or example, example, when a cas cash receipt is not provided by a vendor or is mis mis placed, placed, a docu document shou hould be generated as soon as poss possii ble ble af ter ter the trans transaction, action, using using other doc other docu uments ments such such as bank b ank statements tatements to su pport the inf inf ormation ormation on the generated source docu document. Once a trans transaction has has been been journalized, rnalized, the source docu document shou hould be f iled iled and made retrieva ble ble so that trans transactions actions can be verif verif ied ied shou hould the need aris arise at a later date.
9.
Journals: Journal is a record that keeps keeps accou accounting trans transactions actions in chronological order , i.e. as they they occu occur. According to R owlandowland- the basic book of acco f accou unting is called Journal. Precis recisely el y it is the book of prime prime entr y, y, which means means - Day Book. B ook. Trader s record their , total daily daily trans transactions actions in it. T he process process o f recording the trans transaction into journal is called 'Jo 'Journalizing' rnalizing'.
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10.
Ledger: A ledger /general ledger is a set of acco f accou unts nts used used in accou accounting to keep track of all the f inancial inancial trans transactions actions o f the f the company company. All f inancial inancial pos postings ting s have an impact on the general ledger , whether or whether or not they they pos post to a sub-ledger sub-ledger , such such as accou accounts nts receiva ble ble or cas cash. The valu values in the general ledger accou accounts nts drive the inf inf ormation ormation used used to generate all the f inancial inancial statements tatements. General Ledger sever s as the central repos repositor y & ultimate des destination of all corporate f inancial inancial inf inf ormation. ormation. Function Function o f GL is to collect f inancial inancial inf inf ormation ormation into a chart of acco f accou unts nts (i.e. a/c's def def ined ined by company company f or or recording trans transactions actions that takes takes place). Using Using general ledger , Management & Financial F inancial reports report s are prepared to view the f inancial inancial status tat us of the f the company company at any any point of time. f time.
11.
Trial
Balance:
Trial balance is a bookkeeping work sheet in which the balances alances o f all f all ledger s are compiled into de bit bit and credit colu columns mns. A company company prepares prepares a trial balance periodicall alance periodically, y, usuall usually y at the end o f ever y reporting period. The general pu purpos rpose of prod f produ ucing a trial balance balance is to ensu ensure re the entries entries in a company's company's bookkeeping bookkeeping system system are mathematically mathematically correct. Preparing a trial balance f or or a company company serve s ervess to detect any any mathematical error s that have occu occurred in the doub double le--entr y accou accounting system. system. Provided the total de bt bts equal qual the total credits, credits, the trial balance is cons considered to be balanced, alanced, and there shou hould be no mathematical error s in
the
ledger s. However , this this does does not mean there are no
error s in a company's company's accou accounting system. system. For example, example, trans transactions actions class classiif ied ied improperly improperly or thos those simply imply miss missing ing f rom rom the system system cou could still be material accou accounting error s that wou would not be detected by the trial balance proced alance procedu ure.
12.
Cash Book: Cash book book s are simple accou accounting book s that are used used to record basic inf inf ormation ormation a bo bout cas cash receipts receipts and pa and pay yments ments. Once availa ble ble in hard copy cop y f orm orm only, only, cas cash book book s are of ten ten inclu included in diff diff erent erent ty pes pes of mone f money y management sof tware. tware. Providing an easy easy way way of keeping f keeping u p with how much money money is coming in and what bills ills are getting paid, paid, the cas cash book book can can be eff ectively ectively utilized utilized by just just a bo bout any anyone.
15 A Ca C ash Book is a subsidiar subsidiar y book. book. It has has the pecu peculiarity liarit y o f being b eing both a journal as well as a ledger. If a If a trans transaction is entered in the Cash Book , both both the recording as pect as well as the pos posting as pect are complete, complete, i.e. it amou amounts nts to writing the journal entr y as well as pos posting into the ledger.
13.
Bank Reconciliation Statement (BRS): The process process o f comparing and reconciling accou accounting records records with the records records
pres presented on the bank statement. Sometimes ometimes dis discrepancies crepancies between the records records might occu occur due to the timing diff diff erences erences when the data is recorded in the accou accounting and in the bank book book s. The p he pu urpos rpose of bank bank reconciliation reconciliation is to check whether check whether the the dis discrepancies crepancies are due to timing rather than rather than error. It is the report a bank s ank sends ends to a customer ustomer each each month containing all trans transactions actions that have taken place taken place during the oneone-month reporting period reporting period-----mone money y in, in, money money out---so ---so ustomer can compare that inf sure there that the customer inf ormation ormation with his his own records records and be sure has has been been no error. 14.
Depreciation: Depreciation is a term used used in accou accounting, nting, to s pread the cos cost of an f an asset sset over the s pan o f several several year s. In common s peech, peech, depreciation is the redu reduction in the valu value o f an f an asset sset due to usage usage,, pass passage age of time, time, wear and tear , technological outdating or o bsole bsolesscence, cence, depletion, depletion, inadequ inadequac acy, y, rot, rot, r ust ust, decay decay or other or other su such ch f actor actor s. Depreciation is def def ined ined as the decline in valu value, according to the book valu value of the f the asset sset,, over a s pecif pecif ic ic period of time.
In accou accounting, nting, however , depreciation is a term
used used to des descri be be any any method of attri buting buting the his historical or p or pu urchas rchase cos cost of an asset sset across across its its use useful ful lif lif e, rou roughly ghly corres corres ponding to normal wear and wear and tear. Depreciation and its its related concept, concept, amortization (generally, generally, the depreciation of intangi ble ble asset ssetss), are nonnon-cas cash expens expenses.
15.
Calculation of Depreciation: Depreciation is a systematic systematic and rational process process o f dis distri buting buting the cos cost of tangi ble ble asset ssetss over the over the lif lif e of a f asset ssetss. Depreciation is a process process of allocation. f allocation.
Cost to be allocated = Acquisition cost - Salvage value
Allocated over the over the estimated use useful ful lif lif e of a f asset ssetss. Allocation method shou hould be systematic systematic and rational.
16
Formula for calculating depreciation: Value of the asset ± Scrap Value Depreciation =
------------------------------------- -------------------------------------------------Total
number of years
Depreciation Methods:
1. Straighttraight -line depreciation
2. Sinking fund depreciation.
3. Declining balance depreciation
4. Activity ctivity depreciation
5. Sum Sum of year year s digits digits depreciation
1.
Straight-line depreciation :
Straighttraight -line depreciation is the mos most commonly commonly used used way way to calcu calculate depreciation. The way way it work s is that the company company estimates timates the salvage valu value o f an asset. sset. The salvage valu value is an estimated valu value o f the f the asset sset whenever it whenever it will be sold. This his cou could be zero. The depreciation expens expense is determined by the cos cost of the f the asset sset divided by the length of its its use useful ful lif lif e. e. This his num ber ber is subtracted subtracted f or or each year of the lif lif e of the asset sset,, and is cons considered its its depreciation. 2.
Sinking fund depreciation:
The sinking fund fund techniqu techniquee o f calcu calculating depreciation sets ets the depreciation expens expense as a particu particular amo lar amou unt of an f an annu annuity ity. The depreciation is calcu calculated so that at the end o f the use useful ful lif lif e o f the annu annuity, ity, the amou amount of the annu annuity ity equal qualss the acqu acquiisition cos cost. The sinking fund fund method calcu calculates lates more depreciation clos closer to the end of the use useful ful lif lif e of the f the asset sset,, and isn't used used ver y of ten. ten. 3.
Declining balance depreciation:
This his way way o f calcu calculating depreciation f alls alls under the accelerated depreciation categor y. This his means means that it sets ets depreciation expens expenses as higher earlier on, on, more realis realistically tically
ref ref lecting lecting
the
current
res resale
valu value
of
an
sset. asset.
The way way that declining-b declining-balance alance depreciation is calcu calculated is by taking the net book valu value
17 f rom rom the previous previous year , and multiply ltiplying it by a f actor actor (usuall (usually y 2), which has has been divided by the use useful ful lif lif e of the f the asset. sset. Depreciation expense = previous period NBV x factor / useful life 4.
Activity depreciation:
This his way way o f calcu calculating depreciation bases the depreciation expens expense on the activity activit y of an f an asset sset,, like a machine. Multipl Multiply y the per -whatever (mile, mile, cycle, cle, etc) rate by the actu actual activity activity level o f the f the asset sset to determine the depreciation expens expense f or the or the year. 5.
Sum of years digits depreciation:
This his way way o f calc f calcu ulating depreciation f alls alls between accelerated and straighttraight-line depreciation. Here's the formula ±
N = deprecia ble ble lif lif e. e. B = cos cost basis. S = salvage salvage valu value. D (t) (t) = Depreciation Depreciation charge f or or year t. Sum Sum = N (N + 1) 1) /2 D (t) (t) = (N - t + 1) 1) x ((B = S) S) / Sum) Sum)
18
