ECO-01>>BLOCK1>>UNIT 1 BASIC CONCEPT OF ACCOUNTING⇓
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After studying this unit you should be able to :
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appreciate the need for accounting
•
define accounting and outline its scope
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distinguish between book-keeping, accounting and accountancy
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identify the parties interested in accounting information
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describe the advantages and limitations of accounting
•
explain the accounting concepts to be observed at the recording
stage
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explain the systems of book-keeping
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classify accounts
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analyse the transactions and identify the accounts to be debited
and credited
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identify the stages involved in accounting
Introduction to Accounting
Top↑
In business numerous
transactions take place every day. It is humanly impossible to remember all of
them. The recording of business transactions is the main function served by
Accounting. With the help of accounting records the businessman is able to
ascertain the profit or loss and the financial position of his Business at the
end of a given period and communicate such information to all interested
parties. Here, we intend to have an overview of Accounting and discuss its
nature, scope and importance. We shall also discuss the basic concepts which to
be observed at the recording stage and explain the principle of double entry
i.e., the rules of debit and credit.
Accounting-An Overview Top↑
You know there is a limit
to human memory. You cannot remember everything you do or each transaction you
make. If you are given Rs. 5,000 and asked to buy a number of items you will
find it difficult to remember the detail of various items you purchased. Hence,
it becomes necessary for you to write them on a piece of paper or a note book.
It is still more difficult in case of business which usually involves a large
number of transactions. In business you have to buy and sell more frequently.
You make payments and receive payments every now and then. It becomes almost
impossible to remember all these transactions unless you record them properly
you cannot obtain any financial information you need. For example, you cannot
easily ascertain the amounts to be received from various customers to whom the
goods were sold on credit. You will not know the detail of how much you owe to
your suppliers. You may also find it difficult to work out the profit earned or
loss incurred during a particular period. It is, therefore, necessary to
maintain a proper record of all the transactions which take place from time to
time. The recording of business transactions in a systematic manner is the main
function served by accounting. Whichever the form of business organisation-a
sole proprietorship, a partnership, a company, or a co-operative society, it
has to maintain proper accounts. The accounting information is useful both for
the management and the outside agencies like tax authorities, banks, creditors
etc. The management needs it for purposes of planning, controlling and decision
making. The banks and creditors require it for assessing the credit worthiness
of the business and the tax authorities use it for determining the amount of
income tax, sales tax, etc. In fact, accounting is necessary not only for
business organisations but also for non-business organisations like schools,
colleges, hospitals, clubs etc.
Objectives of Accounting
Top↑
The objectives of
accounting can be stated as follows :
1. To maintain systematic records: Accounting is used to maintain systematic record of all
financial transactions like purchase and sale of goods, cash receipts and cash
payments, etc. It is also used for recording various assets and liabilities of
the business.
2. To ascertain net profit or net loss of the business: A businessman would be interested in periodically finding the
net result of his business operations i.e., whether the business has earned
profit or incurred some loss. A proper record of all, income and expenses help
in preparing a Profit and Loss Account and ascertain the net result of business
operations during a particular period.
3. To ascertain the financial position of the business: The businessman is also interested in ascertaining the financial
position of his business at the end of a particular period i.e., how much it
owns and how much it owes to others. He would also like to know what happened
to his capital, whether it has increased or decreased or remained constant. A
systematic record of assets and liabilities facilitates the preparation of a
position statement called Balance Sheet which provides the necessary
information. ‘
4. To provide accounting information to interested parties: Apart from owners there are various parties who are interested
in the accounting information. These are: bankers, creditors, tax authorities,
prospective investors etc. They need such information to assess the
profitability and the financial soundness of the business. The accounting
information is communicated to them in the form of an annual report.
Definition and Scope of
Accounting Top↑
The subject of
‘Accounting’ has been defined in different ways by different authorities. So,
it is very difficult to define the subject through a single definition.
However, the following definitions would give a general understanding of the
subject.
According to the American
Accounting Association “Accounting is the process of identifying, measuring and
communicating economic information to permit informed judgments and decisions
by users of the information”. This definition stresses three aspects viz.,
identifying, measuring, and communicating economic information.
In the words of the
Committee on Terminology, appointed by the American Institute of Certified
Public Accountants, “Accounting is the art of recording, classifying and
summarising in a significant manner and in terms of money, transactions and
events which are, in part at least, of a financial character and interpreting
the results thereof. This is a popular definition of accounting and it outlines
fully the nature and scope of accounting activity.
You
know a business is generally started with the proprietor’s funds known as
capital. The proprietor may also borrow some funds from banks and other
agencies. These funds are utilised to acquire the assets needed for the
business and also to carry out various business activities. In the process a
number of transactions take place.
The accountant has to identify the transactions to be recorded, measure them in
terms of money, and record them in appropriate books of account. Then he has to
classify them under separate heads of account, prepare a summary in the form of
Profit and Loss Account and Balance Sheet, and analyse, interpret and
communicate the results to the interested parties. This is the sum and
substance of accounting. The scope of accounting can, therefore, be outlined as
follows:
Accounting is concerned
with the transactions and events which are of a financial character. Such
transactions have to be identified by the accountant. He can do so with the
help of various bills and receipts.
Having identified the
transactions, they should be measured and expressed in terms of money, if not
expressed already. Transaction are recorded in books only in terms of money and
not in terms of physical quantities.
The transactions which
are identified and measured are to be recorded in a book called – ‘Journal’ or
in one of its sub-divisions.
The recorded transactions
have to be classified with a view to group transactions of similar nature at
one place. This work is done in a separate book called ‘Ledger’. In the ledger,
a separate account is opened for each item so that all transactions relating to
it can be brought at one place. For example, salaries paid at different times
are brought under ‘Salaries Account’.
The transactions which
are recorded and classified will result in a mass of financial data. It is,
therefore, necessary to summarise such data periodically (at least once a year)
in a significant and meaningful form. This is done in the form of a Profit and
Loss Account which reveals profit or loss, and a Balance Sheet which indicates
the financial position of the business.
The summarised results
have to be analysed and interpreted with the help of statistical tools like
ratios, averages, etc., and examined critically. Later on, this data will be
communicated in the form of reports to the interested parties.
Book-keeping, Accounting and
Accountancy
According to G.A. Lee,
the accounting system has following two stages :
i) the making of routine
records, in prescribed form and according to set rules, of all events which
affect the financial state of the organisation; and
ii) the summarisation
from time to time of the information contained in the records, its presentation
in a significant form to interested parties, and its interpretation as an aid
to decision making by these parties.
Stage (i) is called
Book-keeping and stage (ii) is called Accounting.
Book-keeping is thus a
narrow term concerned mainly with the maintenance of the books of account and
covers the first four activities listed in the scope of accounting viz.,
identifying the transactions and events to be recorded, measuring them in terms
of money, recording them in the books of prime entry, and posting them into
ledger. Accounting, on the other hand, is concerned with summarising the recorded
data, interpreting the financial results and communicating them to all
interested parties. In other words, accounting starts where bookkeeping ends.
But in practice, the accountants also direct and review the work of bookkeepers
and therefore the term accounting is generally used in a broader sense covering
all the accounting activities, Thus, Book-keeping is regarded as a part of
Accounting.
The term ‘Accountancy’
refers to a systematised knowledge of accounting and is regarded as an academic
subject like economics, statistics, chemistry, etc. It explains ‘why to do’ and
‘how to do’ of various aspects of accounting. In other words, while Accounting
refers to the actual process of preparing and presenting the accounts,
Accountancy tells us why and how to prepare the books of account and how to
summarise the accounting information and communicate it to the interested
parties.
Thus, Accountancy is a
science (a body of systematised knowledge) whereas; Accounting is the art of
putting such knowledge into practice.
In general usage,
however, Accountancy and Accounting are used as synonyms (meaning the same
thing). But, of late, the term accounting is becoming more and more popular.
Parties Interested in
Accounting Information
Many people are
interested in examining the financial information provided in the form of a
Profit and Loss Account and a Balance Sheet. This helps them
a) to study the present
position of business,
b) to compare its present
performance with that of its past years, and
c) to compare its
performance with that of similar enterprises.
The following people are
mainly interested in accounting information of the business.
Owners: Owners
contribute capital and assume the risk of business. Naturally, they are
interested in knowing the amount of profit earned by the business and so also
its financial position. If, however, the management of the business is
entrusted to paid managers, the owners also use the accounting information to
evaluate the performance of the managers.
Managers: Accounting
information is of immense use to managers. It helps them to plan, control and
evaluate all business activities. They also need such information for making
various decisions.
Lenders: Initially
the funds are provided by the owners. But, when the business requires more
funds, they are usually provided by banks and other lenders of money. Before
lending; money they would like to know about the solvency (capacity to repay
debts) of the enterprise so as to satisfy themselves that their money will be
safe and the repayments will be made on time.
Creditors: Those
who supply goods and services on credit are called creditors. Like lenders,
they too want to know about credit worthiness of the enterprise. This helps
them to determine the limits up to which credit can be granted.
Prospective Investors: A
person who wants to become a partner in a firm or a person, who wants to become
a shareholder of a company, would like to know how safe and rewarding the
proposed investment would be.
Tax Authorities: Tax
authorities of the Government are interested in the financial statements so as
to assess the tax liability of the enterprise.
Employees : The employees of the
enterprise are also interested in knowing the state of affairs of the
organisation in which they are working, so as to know how safe their interests
are in that organisation.
Accounting as we know it
today has evolved over many centuries in response to the changing economic,
social and political conditions. The economic development and technological
improvements have resulted in an increase in the scale of operations and the
advent of the company form of business organisation. This has made the
management function more and more complex and increased the importance of
accounting information.
This gave rise to special
branches of accounting. These are briefly explained below.
Financial accounting: The
purpose of this branch of accounting is to keep a record of all financial
transactions so that
a) the profit earned or
loss incurred by the business during an accounting period can be worked out,
b) the financial position
of the business at the end of the accounting period can be ascertained, and
c) the financial
information required by the management and other interested parties can be
provided.
Financial Accounting is
mainly confined to the preparation of financial statements and their
communication to the interested parties.
Cost Accounting: The
purpose of cost accounting is to analyze the expenditure so as to ascertain the
cost of various products manufactured by the firm and fix the prices. It also
helps in controlling the costs and providing necessary costing information to
management for decision making.
Management Accounting: The
purpose of management accounting is to assist the management in taking rational
policy decisions and to evaluate the impact of its decisions and actions.
Examples of such decisions arc: pricing decisions, make or buy decisions,
capital expenditure decision ect. This branch of accounting is primarily
concerned with providing the necessary accounting information about funds,
costs, profits, etc., to the management which may help them in such decisions
and also in planning and controlling business operations.Advantages
of Accounting
Replaces memory: Since
all the financial events are recorded in the books, there is no need to rely on
memory. The books of account will serve as historical records. Any information
required at any time can be easily had from these records.
Provides control over assets: Accounting provides information regarding cash in hand, cash at
bank, the stock of goods, the amounts receivable from various parties and the
amounts invested in various other assets. Information about such matters helps
the owners and the management to make use of the assets in the best possible
way.
Facilitates the preparation of financial statements: With the help of information contained in the accounting records
the profit and Loss account and the Balance Sheet can be easily prepared. These
financial statements enable the businessman to know the net result of business
operations during the accounting period and the financial position of the
business as at the end of the accounting period.
Meets the information requirements: Various interested parties such as owners, lenders, creditors,
etc., get the necessary information at frequent intervals which help them in
their decision making.
Facilitates a comparative study: With the help of accounting information one can compare the
present performance of the enterprise with that of its past and with that of
similar organisations. This enables the management to draw useful conclusions
about the business and make efforts to improve the performance.
Assists the management in many other ways: The accounting information provided to the management helps them
in taking rational decisions and in planning and controlling all business
activities.
Difficult to conceal fraud or theft: It is difficult to conceal fraud, theft, etc. because of the
periodic balancing of books of account. Further, in big organisations the
book-keeping work is divided among many persons which minimise the chances for
committing fraud.
Tax matters: The
government levies various taxes such as customs duty, excise duty, sales tax,
and income tax. Properly maintained accounting records will help in the
settlement of all tax matters with the tax authorities.
Ascertaining value of business: In the event of sale of a business firm, the accounting records
will help in ascertaining the correct value of business.
Acts as reliable evidence: Systematic
record of business transactions is generally treated by courts as good evidence
in case of disputes.
Limitations of Accounting Top↑
The accounting
information is used by various parties who form judgment about the
profitability and the financial soundness of a business on the basis of such
information. It is, therefore, necessary to know about the limitation of
accounting. These are as follows:
1. They do not record transactions and events which are not of a
financial character. Hence, they do not reveal a complete picture because facts
like quality of human resources, licenses possessed, locational advantage,
business contacts, etc. do not find any place in books of account.
2. The data is historical in nature- The accountants adopt historical cost as the basis in valuing
and reporting all assets and liabilities. They do not reflect current values.
It is quite possible that items like land and buildings may have much more value
than what is stated in the balance sheet.
3. Facts recorded in financial statements are greatly influenced by
accounting conventions and personal judgments. Hence, they do not reveal the true picture. In many cases,
estimates may be used to determine the value of various items. For example,
debtors are estimated in terms of collectability, inventories are based on
marketability, and fixed assets are based on useful working life. All these
estimates are materially affected by personal judgments.
4. Data provided in the financial statements is insufficient for
proper analysis and decision making. It only
provides information about the overall profitability of the business. No
information is given about the cost and profitability of different activities.
Basic Accounting Concepts Top↑
Accounting is a system
evolved to achieve a set of objectives. In order to achieve these objectives we
maintain systematic record of all business transactions and prepare annual
reports for the interested parties. Any activity that you perform is facilitated
if you have a set of rules to guide you. When you are driving your vehicle you
keep to the left. You are in fact following a traffic rule. If drivers do not
follow this rule, there will be a chaos on the road. The same thing is true of
accounting which has evolved over a period of several centuries. During this
period, certain rules and conventions have been adopted which serve as
guidelines in identifying the events and transactions to be accounted for,
measuring them, recording them in books of account, summarising them, and
reporting them to the interested parties. These rules and conventions are
termed as ‘Generally Accepted Accounting Principles’. To explain these
principles, the writers have used a variety of terms such as concepts,
postulates, conventions, underlying principles, basic assumptions, etc. The
same rule may be described by one author as a concept, by another as a
postulate and still by another as a convention. This often confuses the
learners. Hence, it is better to call all rules and conventions which guide
accounting activity and practice as ‘Basic accounting concept’. These are the
fundamental ideas or basic assumptions underlying the theory and practice of
financial accounting and are the broad working rules for all accounting activities
developed and accepted by the accounting profession. This brings about
uniformity in the practice of accounting. These concepts can be classified into
two broad groups as follows :
i) concepts to be
observed at the recording stage i.e., while recording the transactions,
and ii) concepts to be observed at the reporting stage i.e., at the time
of preparing the final accounts.
It must however be
remembered that some of them are overlapping and even contradictory.
Concepts to be Observed at the
Recording Stage Top↑
The concepts which guide
us in identifying, measuring and recording the transactions are :
Business Entity Concept
Money Measurement Concept
Objective Evidence
Concept
Historical Record Concept
Cost Concept
Dual Aspect Concept
Let us take them one by
one and learn the accounting implications of each concept.
Business Entity Concept: Business
entity means a unit of organised business activity. In that sense, a provision store,
a cloth dealer, an industrial establishment, an electricity supply undertaking,
a bank, a school, a hospital, etc. are all business entities.
From the accounting point
of view every business enterprise is an entity separate and distinct from its
proprietor(s) /owner(s).The accounting system gives information only about the
business and not its owner. In other words, we record those transactions in the
books of account which relate only to the business. The owner’s personal
affairs (his expenditure on housing, food, clothing, etc.) will not appear in
the books of account of his business. However, when personal expenditure of the
owner is met from business funds it shall also be recorded in the business
books. It will be recorded as drawings by the proprietor and not as business
expenditure.
Another implication of
business entity concept is that the owner of a business is to be treated as a
creditor who also has a claim over the assets of the business. As such, the
amount invested by him (capital) is regarded as a liability for the business.
The business entity concept is applicable to all forms of business
organisations. This distinction can be easily maintained in the case of a
limited company because the company has a legal entity of its own. But such distinction
becomes difficult in case of a sole proprietorship or partnership, because in
the eyes of the law the partner or the sole proprietors are not considered
separate entities. They are personally liable for all business transactions.
But for accounting purposes, they are to be treated as separate entities.
This enables them to ascertain the profit or loss of business more conveniently
and accurately.
Money Measurement concept: Usually, business deals in a variety of items having different
physical units such as kilograms, quintals, tons, meters, likes, etc. If the
sales and purchases of different items are recorded is terms of their physical
units, adding them together will pose problem. But, if these are recorded in a
common denomination, their total becomes homogeneous and meaningful.
therefore, we need a common unit of measurement. Money does this function. It
is adopted as the common measuring unit for the purpose of accounting. All
recording, therefore, is done in terms of the standard currency of the country
where business is set up. For example, in India it is done in terms, of Rupees,
in USA it is clone in terms of US Dollar and so on.
Another implication of
money measurement concept is that only those transaction and events are to be
recorded in the books of account which can be expressed in terms of money such
as purchases, sales, payment of salaries, goods lost in accident, etc. Other
happenings (non-monetary like death of an efficient manages or the appointment
of an accountant, howsoever important they may be, are not recorded in the
books of account. This is because their effect is not measurable or
quantifiable terms of money. This approach has its own drawbacks. The
value of money changes over a period of time. The value of rupee today is much
less than what it was in 1961. Such a change is nowhere reflected in accounts.
That is why the accounting data does not reflect the true and fair view of the
affairs of the business.
Hence now-a-days it is
considered desirable to provide additional data showing the effect of changes
in the price level on the reported income and the assets and. liabilities of
the business.
Objective Evidence Concept: The term objectivity refers to being free from bias or free from
subjectivity. Accounting measurements are to be unbiased and verifiable
independently. For this purpose, all accounting transactions should be
evidenced and supported by documents such as invoices, receipts, cash memos,
etc. These supporting documents (vouchers) form the basis for making entries in
the books of account and for their verification by auditors afterwards. As for
the items like depreciation and the provision for doubtful debts where no
documentary evidence is available, the policy statements made by management are
treated as the necessary evidence.
Historical Record Concept: You
know that after identifying the transactions and measuring them in terms of
money we record them in the books of account. According to the historical
record concept, we record only those transactions which have actually taken
place and not those which may take place (future transactions). It is because
accounting record presupposes that the transactions are to be identified and
objectively evidenced. This is possible only in the case of past (actually
happened) transactions. The future transactions can hardly be identified and
measured accurately. You also know that all transactions are to be recorded in
chronological (datewise) order. This leads to the preparation of a historical
record of all transactions. It also implies that we simply record the facts and
nothing else.
We also make provision
for some expected losses such as doubtful debts. This may be contrary to what
is stated in historical record concept. But this is done only at the time of
ascertaining the profit or loss of the business. It is not a routine item. This
is done in accordance with another concept called Conservatism Concept about
which you can learn in further posts.
Cost Concept: Business
activity, in essence, is an exchange of money. The price paid (or agreed to be
paid in case of a credit transaction) at the time of purchase is called cost.
According to the cost concept, all assets are recorded in books at their
original purchase price. This cost also forms an appropriate basis for all
subsequent accounting for the assets.
For
example, if the business buys a machine for Rs. 80,000 it would be recorded in
books at Rs. 80,000. In case its market value increases to Rs. 1,00,000 later
on (or decreases to Rs.50,000) it
will continue to be shown at Rs. 80,000 and not at its market value. This does
not mean, however, that the asset will always be shown at cost. You know that
with passage of time the value of an asset decreases. Hence, it may
systematically be reduced from year to year by charging depreciation and the
asset be shown in the balance sheet at the depreciated value. The depreciation
is usually charged as a fixed percentage of cost. It bears no relationship with
changes in its market value. In other words, the value at which the assets are
shown in the balance sheet has no relevance to its market value. This, no
doubt, makes it difficult to assess the true financial position of the business
and is therefore regarded as an important limitation of the cost concept. But
this approach is preferred because, firstly it is difficult and time consuming
to ascertain the market values, and secondly there will be too much of
subjectivity in assessing the current values. However, this limitation has been
overcome with the help of inflation accounting.
Dual Aspect Concept: This is
a basic concept of accounting. According to this concept every business
transaction has a two-fold effect. In commercial context it is a famous dictum
that “every receiver is also a giver and every giver is also a receiver”. For
example, if you purchase a machine for Rs. 8,000, you receive machine on the
one hand and give Rs. 8,000 on the other. Thus, this transaction has a two-fold
effect i.e., (i) increase in one asset and (ii) decrease in another asset.
Similarly, if you buy goods worth Rs. 500 on credit, it will increase an asset
(stock of goods) on the one hand and increase a liability (creditors) on the
other. Thus, every business transaction involves two aspects: (i) the receiving
aspect, and (ii) the giving aspect, In case of the first example you find that
the receiving aspect is machinery and the giving aspect is cash. In the second
example the receiving aspect is goods and the giving aspect is the creditor. If
complete record of transactions is to be made, it would be necessary to record
both the aspects in books of account. This principle is the core of double
entry book-keeping and if this is strictly followed, it is called ‘Double Entry
System of Book-keeping’ about which you will learn in detail later.
Let us understand another
accounting implication of the dual aspect concept. To start with, the initial
fund (capital) required by the business are contributed by the owner. If
necessary, additional funds are provided by the outsiders (creditors). As per
the dual aspect concept all these receipts increase corresponding obligations
for their repayment. In other words, a contribution to the business, either in
cash or kind, not only increases its resources (assets), but also its
obligations (liabilities/equities) correspondingly. Thus, at an given point of
time, the total assets and the total liabilities must be equal. This equality
is called ‘balance sheet equation’ or ‘accounting equation’. It is stated as
under :
Liabilities (Equities) =
Assets
or
Capital + Outside
Liabilities = Assets
The term ‘assets’ denotes
the resources (property) owned by the business while the term ‘equities’
denotes the claims of various parties against the business assets. Equities are
of two types: (i) owners’ equity, and (ii) outsiders’ equity. Owners’ equity
called capital is the claim of the owners against the assets of the business.
Outsiders’ equity called liabilities is the claim of outside parties like
creditors, bank, etc. against the assets of the business. Thus, all assets of
the business are claimed either by the owners or by the outsiders, Hence, the
total assets of a business will always be equal to its liabilities.
When various business
transactions take place, they effect the assets and liabilities in such a way
that this equality is always maintained. Let us take a few transactions and see
how this equality is maintained.
1. Mr.
Abhigyan started business with Rs.50,000 cash.
The cash received by the business is its asset. According to the business
entity concept, business and the owner are two separate entities. Hence, the capital
contributed by Mr. Abhigyan is a liability to the business. Thus
Capital = Assets
Rs. 50,000 = Rs. 50,000 (cash)
4. He purchased goods on
credit from Chakravarty for Rs. 5,000: This increases an asset (stock of goods)
on the one hand and a liability (creditors) on the other. Now the equation will
be :
Capital + Liabilities = Assets
Rs. 50,000 + Rs. 5,000 =
Rs. 5,000 + Rs.
50,000
Capital
Creditors Stock
Cash
3. He purchased furniture
worth Rs. 10,000 and paid cash: This increases one asset (furniture) and
decreases another asset (cash). Now the equation will be :
Capital
+ Liabilities =
Assets
Rs. 50,000 + Rs. 5,000 =
Rs. 10,000 + Rs.
5,000 + Rs. 40.000
Capital
Creditors Furniture
Stock
Cash
This equation can be
presented in the form of a Balance Sheet (a statement of assets and
liabilities) as follows :
Gyan Chand’s Balance Sheet
Capital and Liabilities
Capital
Creditors
(Mr. Chakravarty)
|
Rs.
50,000
5,000
55,000
|
Assets
Furniture
Stock of goods
Cash
|
Rs.
10,000
5,000
4,0000
55,000
|
Note that the totals on
both sides of the Balance Sheet are equal. This equality remains valid
irrespective of the number of transactions and the items affected thereby. It
is so because of their dual effect on the assets and liabilities of the
business.
Concepts to be Observed at the
Reporting Stage
The following concepts
have to be kept in mind while preparing the final accounts.
Going Concern Concept
Accounting Period Concept
Matching Concept
Conservatism Concept
Consistency Concept
Full disclosure Concept
Materiality Concept
Book-keeping as explained
earlier is the art of recording business transactions in a systematic manner.
Broadly, there are two systems of book-keeping: (i) Double Entry System, and
(ii) Single Entry System.
Under the dual aspect
concept every business transaction has two aspects: (i) the receiving aspect,
and (ii) the giving aspect. For example, when you purchase goods for cash,
goods come in and cash goes out. Thus, a transaction affects two items (also
called accounts) at the same time. When you record the transactions in the
books of account of a business, it would be better if you record the effects
relating to both the items. In the above example the items affected are goods
and cash, stock of goods increases and cash decreases.
So, we should record the
increase in stock of goods and also the decrease in cash. This involves two
entries, one in Goods Account and the other in Cash Account. This method of
recording business transactions is called ‘Double Entry System’. It recognises
and records both the aspects of every transaction. According to this system the
account which involves receiving aspect is debited and the account which
involves giving aspect is credited. Thus, for every debit there will be an
equivalent credit. For this purpose certain rules have been framed.
Advantage
The advantages of Double
Entry System are as follows :
It provides complete and
reliable record of all business transactions because it records both the
aspects.
It supplies full
information about the incomes, expenses, assets and liabilities of the
business. This helps the management in taking appropriate decisions.
The arithmetical accuracy
of the books of account can be easily verified by preparing a trial balance.
The financial result of
business organisations e.i. profit or loss, can be correctly ascertained.
The financial position of
the business can also be ascertained at any point of time.
Single Entry System does
not mean that only one aspect of a transaction is recorded. It simply refers to
incomplete records or the defective double enlry system. Under this system
neither all the transactions are recorded nor are all the account books
maintained. In certain cases the two aspects of a transaction are duly recorded
while in others only one aspect is recorded. Some transactions are simply
ignored; they are not recorded at all. The Single
Entry System is thus a
mixture of double entry, single entry and no entry. The accounts maintained
under this system are incomplete and unsystematic and, therefore, not reliable.
The main defect in this system is that the arithmetical accuracy of the books
of account cannot be checked, because a trial balance cannot be prepared. It
also becomes difficult to ascertain the correct amount of profit or loss. This
system is normally followed by small business firms.
Every business
transaction has dual effect and that under Double Entry System entries are made
in both the accounts affected. The account which involves receiving aspect is
debited and the account which involves giving aspect is credited. In order to
understand the rules of debit and credit you must know more about the term
‘account’. An account is a summarised record of all transactions relating to a
particular person, a thing, or an item of income or expense. It is vertically
divided into two halves and resembles the shape of the English alphabet ‘T’ as
under :
Name of the account
Dr.
Cr.
The left hand side is
called the ‘debit side’. It is indicated by ‘Dr.’ (abbreviation for debit) on
the left hand top corner of the account. The right hand side, known as the
‘credit side’, is indicated by ‘Cr.’ (abbreviation for credit) on the right hand
top comer of the account. The name of the account is written at the top in the
centre. The word ‘Account’ or its abbreviation ‘A/c’ is added to the name
of the account. For example, if the account is related to machinery, it is
written as ‘Machinery Account’.
Classification of
Accounts Top↑
All business transactions
are broadly classified into three categories: (i) those relating to persons,
(ii) those relating to property (assets), and (iii) those relating to incomes
and expenses. Thus, three classes of accounts are maintained for recording all
business transactions. They are: (i) Personal Accounts (ii) Real Accounts, and
(iii) Nominal Accounts. Real and Nominal Accounts taken together are called
Impersonal Accounts.
Personal Accounts: Accounts
which show transactions with persons are called ‘Personal Accounts’. A separate
account is kept in the name of each person for recording the benefit reached
from, or given to, the person in the course of dealings with him. Examples are:
Krishna’s Account, Gopal’s Account, Loan from Ratanlal’s Account, etc.
Personal accounts also
include accounts in the names of firms, companies or institutions such as
Hiralal & Sons’ Account, Nagarjuna Finance Limited Account, The Andhra Bank
Account, etc.
‘The accounts which
represent expenses payable, expenses paid in advance incomes receivable, and
incomes received in advance are also personal accounts, though impersonal in
name. For example, the salaries due to employees, which have not been paid
before closing of the books of account for the year, are recorded in ‘Salaries
Outstanding Account’. It is regarded as a personal account because it
represents the employees to whom salaries are payable by the business. Such a
personal account is called ‘Representative Personal Account’. Other examples of
representative personal accounts are: Interest Outstanding Account, Prepaid
Insurance Account, Rent Received in Advance Account, etc. Capital Account and
Drawings account are also treated as personal accounts as they show dealings
with the owner of the business.
Real Accounts: Accounts
relating to properties or assets are known as ‘Real Accounts’. Every business
needs assets such as machinery, furniture, etc. for running its activities. A
separate account is maintained for each asset owned by the business. All
transactions, relating to a particular asset are recorded in the concerned
asset account. Cash Account, Furniture Account, Machinery Account, Building
Account, etc., are some examples of real accounts. They are known as real
accounts because they represent things of value owned by the business.
Nominal Accounts: Accounts
relating to expenses, losses, incomes and gains are known as ‘Nominal
Accounts’. A separate account is maintained for each item of expense, loss;
income or gain. Wages Account, Salaries Account, Commission Received Account,
and Interest Received Account are some examples of nominal accounts.
Rules of Debit and
Credit Top↑
Every transaction affects
two accounts and according to Double Entry System, entries have to be made in
both the accounts. Before recording a transaction, I therefore, it is necessary
to find out which of the two accounts is to be debited and which is to be
credited. The general rule, as stated earlier, is to debit the account which
involves a receiving aspect and credit the account which involves a giving
aspect. But, for convenience, three different rules have been laid down for the
three classes of accounts.
These are as follows :
For Personal Accounts: The
account of the person receiving benefit (receiver) of the transaction (from the
business) is debited and the account of the person giving the benefit (giver)
of the transaction (to the business) is credited. Thus, the rule is debit the
receiver and credit the ‘giver. ‘
For Real Accounts: When an
asset is coming into the business, the account of that asset is debited. When
an asset is going out of the business, the account of that asset is credited.
Thus, the rule is ‘debit what comes in and credit what goes out.
For Nominal Accounts: When an
expense is incurred or loss suffered, the account representing the expense or
the loss is debited because the business receives the benefit thereof.
When any income is earned or gain made, the account representing the
income or the gain is credited. This is because the business gives some
benefit. Thus, the rule is ‘debit all expenses and losses and credit all
incomes and gains’.
We shall now see the
application of these rules, taking a few transactions.
Example 1: Paid
cash to Ramesh & Co. Rs.5,000.
ln this case the two
accounts affected are Rarnesh & Co’s Account and Cash Account.
Ramesh & CO’s Account
is a personal account and Cash Account is a real account. Ramesh & Co. has
received the benefit (cash Rs. 5,000) from the business and, therefore, it has
to be debited as per the first part of the rule for personal accounts ‘debit
the receiver’. As cash has gone out, Cash Account will be credited according to
the second part of the rule for real accounts ‘credit what goes out’.
Example 2: Received
cash from Ajay Rs. 1,000.
In this case Cash Account
and Ajay’s Account are the two accounts affected. Cash Account is a real
account and Ajay’s account is a personal account. As cash has come in, Cash
Account will have to be debited according to the first part of the rule for
real accounts ‘debit what comes in’. Ajay has given the benefit (cash Rs.
1,000) to the business and, therefore, his account will have to be credited as
per the second part of the rule for personal accounts ‘credit the giver’.
Example 3: Paid
rent Rs. 1,000.
In this case, the
accounts affected are Rent Account and Cash Account. Rent Account is a nominal
account and Cash Account is a real account. As per the first part of the rule
for nominal account ‘debit expenses and losses’, Rent Account will have to be
debited as it is an expense to the business. As cash has gone out, Cash Account
will have to be credited according to the second part of the rule for real
accounts ‘credit what goes out’.
Example 4: Received
Rs. 450 as commission,
In this case, Cash
Account and Commission Account are the two accounts affected, Cash
Account
is a real account and Commission account is a nominal account. As cash has come
in, Cash Account will have to be debited according to the 1st part of the rule for real accounts ‘debit what comes in’. As per second part of the rule for
nominal accounts, ‘credit the incomes and gains’, Commission Account will be
credited as it is an income to the business.
You have seen that the
three rules of debit and credit as explained above, make it convenient for you
to analyse the transactions and identify the accounts to be debited and
credited.
The accounting process
consists of the following four stages:
1.
i) Recording the Transactions
2.
ii) Classifying the Transactions
iii) Summarising the
Transactions
1.
iv) interpreting the Results
Let us now briefly
discuss these stages.
Recording the Transactions: The
accounting process begins with recording of all transactions in the book of
original entry. This book is called ‘Journal’. All transactions are recorded in
the Journal in a chronological order (datewise) with the help of various
vouchers, such as cash memos, cash receipts, invoices, etc.
Classifying the Transactions: The second stage consists of grouping the transactions of
similar nature and posting them to the concerned accounts in another book
called ‘Ledger’. For example, all transactions related to cash are to be posted
to Cash Account and the transactions related to different persons are entered
separately in the account of each person. The objective of classifying the
transactions in this manner is to ascertain the combined effect of all transactions
of a given period in respect of each account. For this purpose, all accounts
are balanced periodically.
Summarising the Transactions: The next step is to prepare a year-end summary known as ‘Final
Accounts’. But before preparing the final accounts, we prepare a statement
called Trial Balance in order to check the arithmetic accuracy of the books of
account. If the Trial Balance tallies, it means that the transactions have been
currently recorded and posted into ledger. Then, with the help of the Trial Balance
and some other relevant information we prepare the final accounts. The
objectives of preparing the final accounts are (i) to know the net result of
business activities, and (ii) to ascertain the financial position of the
business. The final account consists of an income statement called ‘Trading and
Profit and Loss Account’ and a position statement called ‘Balance Sheet’. The
Trading and Profit and Loss Account give us the information about the amount of
profit made or the loss incurred during the year and the Balance Sheet shows
the position of assets and liabilities of the business as at the end of the
year.
Interpreting the Results: The
last stage consists of analysing and interpreting the results shown by the
final accounts. This involves computation of various accounting ratios to
assess the liquidity, solvency, and profitability of the business. Such
analysis is meant for interested parties like management, investors, bankers,
creditors, etc. The balances on various accounts appearing in the Balance Sheet
will then be transferred to the new books of account for the next year,
Thereafter the process of recording transactions for the next year starts
again.
In business a number of
transactions take place every day. It is not possible to remember all of them.
Hence, the need to record them. The recording of business transactions in a
systematic manner is the main function served by accounting. It enables us to
ascertain the profit and loss and the financial positions of the business. It
also provides the necessary financial information to all interested parties.
Accounting is the process
of identifying, measuring, recording, classifying and summarising the
transactions, and analysing, interpreting and communicating the results
thereof. The accounting system has two stages: (i) Book-keeping, and (ii)
Accounting. Book-keeping is mainly concerned with the maintenance of books of
account, while accounting is concerned with summarising the recorded data,
interpreting the financial results and communicating them to all interested
parties. Changes in economic environment and increasing complexity of
management have given rise to the specialised branches of accounting such as
financial accounting, cost accounting and management accounting.
The accountants, over a
period of time, have developed certain guidelines for all accounting work.
These are called basic concepts of accounting. Certain concepts are to be observed
at the time of recording the transactions, while others are relevant at the
summarising and reporting stages. The concepts to be observed at the recording
stage are: business entity, money measurement, objective evidence, historical
record, cost and the dual aspect concepts.
According to Dual Aspect
concept every business transaction involves two aspects (i) the receiving
aspect, and (ii) the giving aspect. Under ‘Double Entry System’ both the
aspects must be recorded in books of account. As per rules the receiving aspect
is recorded on the debit side of account affected by transaction and giving
aspect on the credit side of the, account affected. For convenience, accounts
have been classified into personal, real and nominal accounts and separate rules
have been framed for debiting and crediting different classes of accounts.
These are called Rules of Debit and Credit.
The accounting process is
divided into four stages:
(i) recording the
transactions in the books of original entry,
(ii) classifying the
transactions,
(iii) summarising the
transactions, and
(iv) Interpreting the
results.
