ACCOUNTING: THE LANGUAGE OF BUSINESS

Accounting has rightly been termed as the language of business. The

basic function of a language is to serve as a means of communication.
Accounting also serves this function. It communicates the result of
business operations to various parties who have some stake in the
business viz., the proprietor, creditors, investors, Government and other
agencies.

Though accounting is generally associated with business, it is not only

business which makes use of accounting. Persons like housewives,
Government and other individuals also make use of accounting. For
example, a housewife has to keep a record of the money received and
spent by her during a particular period. She can record her receipts of
money on one page of her “household diary”, while payments for
different items such as milk, food, clothing, house, education etc. on
some other page or pages of her diary in a chronological order.

Such a record will help her in knowing about:

(i) The sources from which she received cash and the purposes
for which it was utilized.
(ii) Whether her receipt is more than her payments or vice-versa?
(iii) The balance of cash in hand or deficit, if any at the end of a
period.

The need for accounting is all the more greater for a person who is
running a business.

He know: (i) What he owns, (ii) What he owes, (iii) Whether he has
earned a profit or suffered a loss on account of running a business, (iv)
What his is financial position, i.e. whether he will be in a position to meet
all his commitments in the near future or he is in the process of
becoming a bankrupt.

DEVELOPMENT OF ACCOUNTING
Accounting is as old as money itself. In India, Chanakya in his
Arthashastra has emphasized the existence and need of proper
accounting and auditing. However, the modern system of accounting
owes its origin to Pacoili, who lived in Italy in the 18th century. In those
early days the business organizations and transactions were not so
complex due to their being small and easily manageable by the proprietor
himself. In recent years changes in technology have also brought a
remarkable change in the field of accounting. The whole concept of
accounting has changed. “It has come to be recognized as a tool for
mastering the various economic problems which a business organization
may have to face. It systematically writes the economic history of the
organization. It provides information that can be drawn upon by those
responsible for decisions affecting the organization’s future. This history is
written mostly in quantitative terms. It consists partly of files of data,
partly of reports summarising various portions of these data, and partly
of the plans established by management to guide its operations.

American Institute of Certified Public Accountants (AICPA) defined

accounting as follows:

“Accounting is the art of recording, classifying and summarizing in

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.”

American Accounting Association (AAA) defined accounting as follows:

“Accounting is the process of identifying, measuring and

communicating economic information to permit informed judgements
and decisions by users of the information.”

Accounting Principles Board (APB) of the American Institute of

Certified Public Accountants (AICPA) enumerated the functions of
accounting as follows:

“The function of accounting is to provide quantitative information,

primarily of financial nature, about economic entities, that is needed to
be useful in making economic decisions.”

Accounting may be defined as the process of recording, classifying,

summarizing, analyzing and interpreting the financial transactions
and communicating the results thereof to the persons interested in
such information.

An analysis of the definition brings out the following functions of

accounting:

1.Recording. This is the basic function of accounting. It is

essentially concerned with not only ensuring that all business
transactions of financial character are in fact recorded but also that
they are recorded in an orderly manner. Recording is done in the book
“Journal”. This book may be further sub-divided into various
subsidiary books such as Cash Journal (for recording cash
transactions), Purchases Journal (for recording credit purchase of
goods), Sales Journal (for recording credit sales of goods), etc. The
number of subsidiary books to be maintained will be according to the
nature and size of the business.
 2.Classifying. Classification is concerned with the systematic
analysis of the recorded data, with a view to group transactions or
entries of one nature at one place. The work of classification is done
in the book termed as “Ledger”. This book contains on different pages
individual account heads under which all financial transactions of
similar nature are collected. For example, there may be separate
account heads for Travelling Expenses, Printing and Stationery,
Advertising etc. All expenses under these heads after being recorded in
the Journal will be classified under separate heads in the Ledger. This
will help in finding out the total expenditure incurred under each of
the above heads.

3. Summarising. This involves presenting the classified data in a

manner which is understandable and useful to the internal as well as
external end-users of accounting statements. This process leads to the
preparation of the following statements:
(i) Trial Balance, (ii) Income Statement, and (iii) Balance Sheet.

4.Dealing with financial transactions. Accounting records only

those transactions and events in terms of money which are of a
financial character. Transactions which are not of a financial character
are not recorded in the books of account. For example, if a company
has got a team of dedicated and trusted employees, it is of great use
to the business but since it is not of a financial character and capable
of being expressed in terms of money, it will not be recorded in the
books of the business.

5. Analysing and Interpreting. The recorded financial data is

analysed and interpreted in a manner that the end- users can make a
meaningful judgement about the financial condition and profitability
of the business operations. The data is also used for preparing the
future plan and framing of policies for executing such plans.

A distinction here can be made between the two terms—‘Analysis’

and ‘Interpretation’. The term ‘Analysis’ means methodical
classification of the data given in the financial statements. The figures
given in the financial statements will not help one unless they are put
in a simplified form. For example, all items relating to ‘Current Assets’
are put at one place while all items relating to ‘Current Liabilities’ are
put at another place. The term ‘Interpretation’ means explaining the
meaning and significance of the data so simplified.
 However both ‘Analysis’ and ‘Interpretation’ are complementary to
each other. Interpretation requires Analysis, while Analysis is useless
without Interpretation.
6. Communicating. The accounting information after being
meaningfully analyzed and interpreted has to be communicated in a
proper form and manner to the proper person. This is done through
preparation and distribution of accounting reports, which include,
besides the usual income statement and the balance sheet, additional
information in the form of accounting ratios, graphs, diagrams, funds
flow statements, cash flow statements, etc. The initiative, imagination
and innovative ability of the accountant are put to test in this
process.

BOOK-KEEPING AND ACCOUNTING

Some people take book-keeping and accounting as synonymous

terms, but they are different from each other. Book-keeping is mainly
concerned with recording of financial data relating to the business
operations in a significant and orderly manner. A book-keeper may be
responsible for keeping all the records of a business or only of a minor
segment, such as a position of the Customers’ accounts in a
departmental store. A substantial portion of the book-keeper’s work is
of a clerical nature and is increasingly being accomplished through
the use of mechanical and electronically devices.

Accounting is primarily concerned with designing the systems for

recording, classifying and summarising the recorded data and
interpreting them for internal and external end-users. Accountants
often direct and review the work of the book- keepers. The larger the
firm, the greater is the responsibility of the accountant. The work of an
accountant in the beginning may include some book-keeping. An
accountant is required to have a much higher level of knowledge,
conceptual understanding and analytical skill than what is required
for a book-keeper.

The difference between book-keeping and accounting can be well

understood with the help of the following example: If A sells goods to
B on credit, the only fundamental principle involved is of “dual
aspect” and to give a true picture of the transaction, both the
aspects must be considered. On the one hand, A has lost one asset
i.e. good and
on the other hand, he has obtained another asset i.e. a “debt due
from B”.

The book-keeper should debit B’s account in A’s books and

credit the sales account. However, if at the end of a year, A has got
some stock of goods with him, they should be properly valued in order
to ascertain the true profit of the business. The principle to be
followed in valuing the stock and many adjustments that will have to
be made before the books of account can be closed and true profit or
loss can be ascertained, are all matters of accounting. Thus, book-
keeping is more of a routine work and a book- keeper, if instructed
properly, can record the routine transactions quite efficiently even if he
does not know much about accounting principles.
IS ACCOUNTING A SCIENCE OR AN ART?
Any organized knowledge based on certain basic principles is a
‘science’. Accounting is also a science. It is an organized knowledge
based on scientific principles which have been developed as a result of
study and experience. Of course, accounting cannot be termed as a
“perfect science” like physics or chemistry where experiments are
carried out and perfect conclusions drawn. It is a social science
depending much on human behaviour and other social and economic
factors. Thus, perfect conclusions cannot be drawn. Some people
therefore, though not very correctly, do not take accounting as a
science.
Art is the technique which helps us in achieving our desired
objective. Accounting is definitely an art. The American Institute of
Certified Public Accountants also defines accounting as “the art of
recording, classifying and summarising the financial transactions”.
Accounting helps in achieving our desired objective of maintaining
proper accounts, i.e., to know the profitability and the financial
position of the business, by maintaining proper accounts.
END-USERS OF ACCOUNTING INFORMATION
Accounting is of primary importance to the proprietors and the
managers. However, other persons such as creditors, prospective
investors, employees, etc. are also interested in the accounting
information.
1. Proprietors. A business is done with the objective of making
profit. Its profitability and financial soundness are, therefore, matters
of prime importance to the proprietors who have invested their
money in the business.
2. Managers. In a sole proprietary business, usually the proprietor
is the manager. In case of a partnership business either some or all the
partners participate in the management of the business. They,
therefore, act both as managers as well as owners. In case of joint
stock companies, the relationship between ownership and
management becomes all the more remote. In most cases the
shareholders act merely as renters of capital and the management of
the company passes into the hands of professional managers. The
accounting disclosures greatly help them in knowing about what has
happened and what should be done to improve the profitability and
financial position of the enterprise in the period to come.
3. Creditors. Creditors are the persons who have extended credit
to the company. They are also interested in the financial statements
because they will help them in ascertaining whether the enterprise will
be in a position to meet its commitment towards them both regarding
payment of interest and principal.
4. Prospective Investors. A person who is contemplating an
investment in a business will like to known about its profitability and
financial position. A study of the financial statements will help him in
this respect.
5. Government. The Government is interested in the financial
statements of business enterprise on account of taxation, labour and
corporate laws. If necessary, the Government may ask its officials to
examine the accounting records of a business.
6. Employees. The employees are interested in the financial
statements on account of various profit sharing and bonus schemes.
Their interest may further increase in case they purchase shares of
the companies in which they are employed.
7. Citizen. An ordinary citizen may be interested in the accounting
records of the institutions with which he comes in contact in his daily
life, e.g., bank, temple, public utilities such as gas, transport and
electricity companies. In a broader sense, he is also interested in the
accounts of a Government Company, a public utility concern etc., as
a voter and a tax payer.

BRANCHES OF ACCOUNTING
In order to satisfy needs of different people interested in accounting
information, different branches of accounting have developed. They
can broadly be classified into two categories:
ACCOUNTING

FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING

(i) Financial Accounting. It is the original form of accounting. It is

mainly confined to the preparation of financial statements for the use of
outsiders like shareholders, debenture holders, creditors, banks and
financial institutions. The financial statements, i.e., the Profit and Loss
Account and the Balance Sheet, show them the manner in which
operations of the business have been conducted during a specified
period.
(ii) Management Accounting. It is accounting for the management,
i.e., accounting which provides necessary information to the
management for discharging its functions. According to the Chartered
Institute of Management Accountants, London, “management
accounting is the application of professional information in such a way
as to assist the management in the formation of policies and in the
planning and control of the operations of the undertaking.” It covers
all arrangements and combinations or adjustments of the orthodox
information to provide the Chief Executive with the information from
which he can control the business, e.g., information about funds,
costs, profits, etc.
Management accounting covers various areas such as cost
accounting, budgetary control, inventory control, statistical methods,
internal auditing etc.
DIFFERENCE BETWEEN MANAGEMENT ACCOUNTING
AND FINANCIAL ACCOUNTING
Financial accounting and management accounting are closely
interrelated since management accounting is to a large extent the
rearrangement of the data provided by financial accounting.
Moreover, all accounting is financial in the sense that all accounting
systems are in monetary terms and the management is responsible for
the contents of the financial accounting statements. In spite of such a
close relationship between the two, there are certain fundamental
differences. These differences can be laid down as follows:
1. Objectives. Financial accounting is designed to supply
information in the form of Profit and Loss Account and Balance Sheet to
external parties like shareholders, creditors, banks, investors and
Government. Information is supplied periodically and is usually such in
which the management is not much interested. Management
accounting is designed principally for internal use by the
management.
2. Analysing performance. Financial accounting portrays the
position of business as a whole. Financial statements like income
statement and balance sheet report on the overall performance or
status of the business. On the other hand management accounting
directs its attention to the various divisions, departments of the
business and reports about the profitability, performance etc., of each
of them. Financial accounting deals with the aggregates and therefore
cannot reveal what part of the management action is going wrong and
why. Management accounting provides detailed analytical data for
these purposes.
3. Data used. Financial accounting is concerned with the monetary
record of past events. It is a post-mortem analysis of past activity and
therefore out of date for management action. Management
accounting is an accounting for future and, therefore, it supplies
detailed and analysed data both for the present and the future in
“management language”, so that it becomes a basis for
management action.
4. Monetary measurement. In financial accounting only such
economic events find a place which can be described in money.
However the management is equally interested in non-monetary
economic events, viz. technical innovations, personnel in the
organization, changes in the value of money, etc. These events affect
the management’s decision and therefore management accounting
cannot afford to ignore them. For example, a change in the value of
money may not find a place in financial accounting on account of
“growing concern concept”, but while effecting an insurance policy
on an asset or providing for replacement of an asset, the
management will have to take this factor into account.
5. Periodicity of reporting. The period of reporting is much longer
in financial accounting as compared to management accounting. The
Income Statement and the Balance Sheet are usually prepared yearly or
in some cases half-yearly. Management requires information at
frequent intervals, and, therefore, financial accounting fails to cater to
the needs of the management. In management accounting there is
more emphasis on furnishing information quickly and at comparatively
short intervals as per the requirements of the management.
6. Precision. There is less emphasis on precision in case of
management accounting as compared to financial accounting since the
information is meant for internal consumption.
7. Nature. Financial accounting is more objective while
management accounting is more subjective. This is because
management accounting is fundamentally based on judgement rather
than on measurement.
8. Legal compulsion. Financial accounting has more or less
become compulsory for every business on account of the legal
provisions of one or the other Act. However, a business is free to install
or not to install, a system of management accounting.
The above points of difference between financial accounting and
management accounting prove that management accounting has a
flexible approach as compared to the rigid approach in the case of
financial accounting. In brief, financial accounting simply shows how
the business has moved in the past while management accounting
shows how the business has to move in the future.

IMPORTANCE OF ACCOUNTING
Accounting has gained immense importance due to increase in the size
of business, divorce of ownership from management and increase in
the globalization and competition. It has now become an important
information tool providing recourse to various individuals for groups
about the economic activities of the organization. It is the means by
which most business information is communicated to different
stakeholders, viz., owners, creditors, employees, prospective investors
etc. The importance of accounting can be judged from the following
services provided by accounting:
 1. It keeps systematic records. Accounting is done to keep a
systematic record of financial transactions. In the absence of
accounting there would be a terrific burden on human memory
which, in most cases, would be impossible to bear.
2. It protects business properties. Accounting provides
protection to business properties from unjustified and unwarranted use.
This is possible on account of accounting supplying the following
information to the manager or the proprietor:
(i) The amount of the proprietor’s funds invested in the business
(ii) How much the business has to pay to others
(iii) How much the business has to recover from others
(iv) How much the business has in the form of (a) fixed assets, (b),
cash in hand, (c) cash in the bank, (d) stock of raw materials,
work-in-progress and finished goods
Information about the above matters helps the proprietor in
assuming that the funds of the business are not unnecessarily kept idle
or underutilized.

3. It ascertains the operational profit or loss. Accounting helps

in ascertaining the net profit earned or loss suffered. This is done by
keeping a proper record of revenues and expenses of a particular
period. The Profit and Loss Account is prepared at the end of a period
and if the amount of revenue for the period is more than the
expenditure incurred in earning that revenue, there is said to be a
profit. In case the expenditure exceeds the revenue, there is said to
be a loss.

The Profit and Loss Account will help the management, investors,
creditors, etc. in knowing whether running of the business has proved
to be remunerative or not. In case it has not proved to be
remunerative or profitable, the cause of such a state of affairs will
be investigated and necessary remedial steps will be taken.

4. It ascertains the financial position of business. The Profit

and Loss Account gives the amount of profit or loss made by the
business during a particular period. However, it is not enough. The
businessman must know about his financial position, i.e., where he
stands, what he owes and what he owns? These objectives are
served by the Balance Sheet or Position Statement. The Balance Sheet
is a statement of assets and liabilities of the business on a particular
date. It serves as a barometer for ascertaining the financial health
of the business.

5. It facilitates rational decision making. Accounting these days

has taken upon itself the task of collection, analysis and reporting of
information at the required points of time to the required levels of
authority in order to facilitate rational decision making. The American
 Accounting Association has also stressed this point while defining the
term ‘accounting’ when it says that accounting is, “the process of
identifying, measuring and communicating economic information to
permit informed judgements and decisions by users of the information.”
Of course, this is by no means an easy task. However, accounting
bodies all over the world and particularly the International Accounting
Standards Committee, have been trying to grapple with this problem
and have achieved success in laying down some basic postulates
on the basis of which the accounting statements have to be
prepared. These postulates have been explained in the next unit.
MEANING OF ACCOUNTING PRINCIPLES

Accounting principles1 may be defined as those rules of action

adopted by accountants universally while recording accounting
transactions. “They are a body of doctrines commonly associated with
the theory and procedures of accounting, serving as an explanation of
current practices and as a guide for selection of conventions or
procedures where alternatives exist.” These principles can be
classified into two categories:
(i) Accounting Concepts
(ii) Accounting Conventions

Accounting Concepts
The term ‘concepts’ includes those basic assumptions or conditions
upon which the science of accounting is based. The following are the
important accounting concepts:
(i) Separate Entity Concept
(ii) Going Concern Concept
(iii) Money Measurement Concept
(iv) Cost Concept
(v) Dual Aspect Concept
(vi) Accounting Period Concept
(vii) Periodic Matching of Cost and Revenue Concept
(viii) Realisation Concept

Accounting Conventions
The term ‘conventions’ includes those customs or traditions which
guide the accountant while preparing the accounting statements. The
following are the important accounting conventions.
(i) Convention of Conservatism
(ii) Convention of Full Disclosure
(iii) Convention of Consistency
(iv) Convention of Materiality
Each of the above concepts and conventions are being explained
below.
 ACCOUNTING CONCEPTS
1.Separate entity concept. In accounting business is considered to
be a separate entity from the proprietor(s). It may appear to be
ludicrous that one person can sell goods to himself but this concept is
extremely helpful in keeping business affairs strictly free from the effect
of private affairs of the proprietor(s). Thus, when one person invests Rs
10,000 in business, it will be deemed that the proprietor has given
that much money to the business which will be shown as a ‘liability’
in the books of the business. In case the proprietor withdraws Rs 2,000
from the business, it will be charged to him and the net amount
payable by the business will be shown only as Rs 8,000.
The concept of separate entity is applicable to all forms of business
organizations. For example, in case of a partnership business or sole
proprietorship business, though the partners or sole proprietor are
not considered as separate entities in the eyes of law, but for
accounting purposes they will be considered as separate entities.

2. Going concern concept. According to this concept it is assumed

that the business will continue for a fairly long time to come. There is
neither the intention nor the necessity to liquidate the particular
business venture in the foreseeable future. On account of this concept,
the accountant, while valuing the assets, does not take into account
the forced sale value of assets. Moreover, he charges depreciation on
fixed assets on the basis of their expected lives rather than on their
market value.
It should be noted that the ‘going concern concept’ does not imply
permanent continuance of the enterprise. It rather presumes that the
enterprise will continue in operation long enough to charge against
income, the cost of fixed assets over their useful lives, to amortize
over an appropriate period other costs which have been deferred under
the actual or matching concept, to pay liabilities when they become
due, and to meet contractual commitments. Moreover, the concept
applies to the business as a whole. When an enterprise liquidates a
branch or one segment of its operations, the ability of the enterprise
to continue as a going concern is normally not impaired.

The enterprise will not be considered as a going concern when it

has gone into liquidation or it has become insolvent. Of course, the
receiver or the liquidator may endeavour to carry on business
operations for some period pending arrangement with the creditors or
final buyer for the sale of the business as a going concern. The going
concern status of the concern will stand terminated from the date of
his appointment or will be at least regarded as suspended, pending
the results of his efforts.

3. Money measurement concept. Accounting records only

monetary transactions. Events or transactions which cannot be
expressed in money do not find place in the books of accounts
though they may be very useful for the business. For example, if a
business has got a team of dedicated and trusted employees, it is
definitely an asset to the business but since their monetary
measurement is not possible, they are not shown in the books of
the business.

Measurement of a business event in money helps in understanding

the state of affairs of the business in a much better way. For example,
if a business owns Rs 10,000 of cash, 600 kg of raw materials, two
trucks, 1,000 square feet of building space etc., these amounts cannot
be added together to produce a meaningful total of what the business
owns. However, if these items are expressed in monetary terms such as
Rs 10,000 of cash, Rs 12,000 of raw materials, Rs 2,00,000 of trucks
and Rs 50,000 of building, all such items can be added and a much
more intelligible and precise estimate about the assets of the
business will be available.

4. Cost concept. The concept is closely related to going concern

concept. According to this concept:
(a) an asset is ordinarily entered in the accounting records at the
price paid to acquire it, and
(b) this cost is the basis for all subsequent accounting for the
assets.

If a business buys a plot of land for Rs 50,000, the asset would

be recorded in the books at Rs 50,000 even if its market value at
that time happens to be Rs 60,000. In case, a year later, the market
value of this asset comes down to Rs 40,000, it will ordinarily
continue to be shown at Rs 50,000 and not at Rs 40,000.

The cost concept does not mean that the asset will always be
shown at cost. It has also been stated above that cost becomes the
basis for all future accounting for the asset. It means that the asset
is recorded at cost at the time of its purchase, but it may
systematically be reduced in its value by charging depreciation.

The cost concept has the advantage of bringing objectivity into the
preparation and presentation of financial statements. In the absence of
this concept the figures shown in the accounting records would have
depended on the subjective views of a person.

However, on account of continued inflationary tendencies, the

preparation of financial statements on the basis of historical costs has
become largely irrelevant for judging the financial position of the
business. This is the reason for the growing importance of inflation
accounting.
 5. Dual aspect concept. This is the basic concept of accounting.
According to this concept every business transaction has a dual effect.
For example, if A starts a business with a capital of Rs 10,000, there
are two aspects of the transaction. On the one hand the business has
an asset of Rs 10,000, while on the other hand the business has to
pay to the proprietor a sum of Rs 10,000 which is taken as proprietor’s
capital. This expression can be shown in the form of following
equation:
Capital (Equities) = Cash (Assets)
10,000 = 10,000
The term ‘assets’ denotes the resources owned by a business while
the term ‘Equities’ denotes the claims of various parties against the
assets, Equities are of two types. They are: owners’ equity and
outsiders’ equity. Owners’ equity (or capital) is the claim of owners
against the assets of the business while outsiders’ equity (for
liabilities) is the claim of outside parties, such as creditors, debenture-
holders etc., against the assets of the business. Since all assets of the
business are claimed by someone (either owners or outsiders), the
total assets will be equal to the total liabilities, Thus:
Equities = Assets
Or
Liabilities + Capital = Assets
In the example given above, if the business purchases furniture
worth Rs 5,000 out of the money provided by A, the situation will be
as follows:
Equities = Assets
Capital Rs 10,000 = Cash Rs 5,000 + Furniture Rs 5,000
Subsequently, if the business borrows Rs 30,000 from a bank, the
new position would be as follows:
Equities = Assets
Capital Rs 10,000 + Bank Loan Rs 30,000 = Cash 35,000 +
Furniture Rs 5,000.

The term ‘accounting equation’ is also used to denote the

relationship of equities to assets. The equation can be technically
stated as “for very debit, there is an equivalent credit”. As a matter of
fact the entire system of double entry book-keeping is based on this
concept.

6. Accounting period concept. According to this concept, the life

of the business is divided into appropriate segments for studying the
results shown by the business after each segment. This is because
though the life of the business is considered to be indefinite (according
to going concern concept), the measurement of income and studying
the financial position of the business after a very long period would not
be helpful in taking proper corrective steps at the appropriate time.
 It is, therefore, absolutely necessary that after each segment or
time interval the businessman must ‘stop’ and ‘see back’, how things
are going. In accounting, such a segment or time interval is called
‘accounting period’. It is usually of a year.

At the end of each accounting period an Income Statement and a

Balance Sheet are prepared. The Income Statement discloses the profit
or loss made by the business during the accounting period while the
Balance Sheet depicts the financial
position of the business as on the last day of the accounting period.
While preparing these statements a proper distinction has to be made
between capital and revenue expenditure.

7.Periodic matching of costs and revenue concept. This is

based on the accounting period concept. The paramount objective of
running a business is to earn profit. In order to ascertain the profit
made by the business during a period, it is necessary that ‘revenues’
of the period should be matched with the costs (expenses) of the
period. The term matching, means appropriate association of related
revenues and expenses.

In other words income made by the business during a period can be

measured only when the revenue earned during a period is compared
with the expenditure incurred for earning that revenue. The question
when the payment was received or made is ‘irrelevant’.

For example, if a salesman is paid commission in January, 1999, for

sales made by him in December, 1998, the commission paid to the
salesman in January, 1999 should be taken as the cost for sales made
by him in December, 1998. This means that revenues of December,
1998 (i.e., sales) should be matched with the costs incurred for earning
that revenue (i.e., salesman’s commission) in December, 1998 (though
paid in January, 1999).

On account of this concept, adjustments are made for all

outstanding expenses, accrued incomes, prepaid expenses and
unearned incomes, etc., while preparing the final accounts at the end
of the accounting period.

8.Realisation concept. According to this concept revenue is

recognised when a sale is made. Sale is considered to be made at
the point when the property in goods passes to the buyer and he
becomes legally liable to pay. This can be well understood with the
help of the following example:

A places an order with B for supply of certain goods yet to be

manufactured. On receipt of order, B purchases raw materials, employs
workers, produces the goods and delivers them to A. A makes
payment on receipt of goods. In this case the sale will be presumed
to have been made not at the time of receipt of the order for the
goods but at the time when goods are delivered to A.

However, there are certain exceptions to this concept:

(i) In case of hire-purchase, the ownership of the goods passes to
the buyer only when the last instalment is paid, but sales are
presumed to have been made to the extent of instalments
received and instalments outstanding (i.e. instalments due but
 not received).
(ii) In case of contracts accounts though, the contractor is liable to
pay only when the whole contract is completed as per terms of
the contract; the profit is calculated on the basis of work
certified year after year as per certain accepted accounting
norms.

ACCOUNTING CONVENTIONS

1. Conservatism. In the initial stages of accounting, certain

anticipated profits which were recorded, did not materialise. This
resulted in less acceptability of accounting figures by the end-users.
On account of this reason, the accountants follows the rule ‘anticipate
no profit but provide for all possible losses’, while recording business
transactions. In other words, the accountant follows the policy of
“playing safe”.
On account of this convention, the inventory is valued “at cost or
market price whichever is less”. Similarly a provision is made for
possible bad and doubtful debts out of the current year’s profits. This
concept affects principally the category of current assets.

The convention of conservatism has become the target of serious

criticism these days especially on the ground that it goes against the
convention of full disclosure. It encourages the accountant to create
secret reserves (e.g., by creating excess provision for bad and doubtful
debts, depreciation etc.), and the financial statements do not deficit a
true and fair view of state of affairs of the business. The Income
Statement shows a lower net income; the Balance Sheet understates
assets and overstates liabilities.

The research studies conducted by the American Institute of

Certified Public Accountants have indicated that the conservatism
concept needs to be applied with much more caution and care if the
results reported are not to be distorted.

Full disclosure. According to this convention accounting reports

2.
should disclose fully and fairly the information they purport to
represent. They should be honestly prepared and sufficiently disclose
information which is of material interest to proprietors, present and
potential creditors and investors.

The convention is gaining more importance because most big

businesses are run by joint stock companies where ownership is
divorced from management. The Companies Act, 1956, not only
requires that the Income Statement and Balance Sheet of a company
must give a true and fair view of the state of affairs of the company
but also gives the prescribed forms in which these statements are to
be prepared.1 The practice of appending notes to the accounting
statements (such as about contingent liabilities or market value of
investments) is in pursuant to the convention of full disclosure.

3.Consistency. According to this convention accounting practices

should remain unchanged from one period to another. For example, if
stock is valued at “cost or market price whichever is less”, this
principle should by followed year after year. Similarly, if depreciation
is charged on fixed assets according to the diminishing balance
method, it should be done year after year. This is necessary for the
purposes of comparison. However, consistency does not mean
inflexibility.

It does not forbid introduction of improved accounting techniques.

However, if adoption of such a technique results in inflating or deflating
the figures of profit as compared to the previous period, a note to that
effect should be given in the financial statements.

4.Materiality. According to this convention the accountant should

attach importance to material details and ignore insignificant details.
This is because otherwise accounting will be unnecessarily
overburdened with minute details. The question of what constitutes a
material detail, is left to the discretion of the accountant. Moreover, an
item may be material for one purpose while immaterial for another.

For example, while sending each debtor “a statement of his

account”, complete details have to be given. However, when a
statement of outstanding debtors is prepared for sending to the top
management, figures may be rounded to the nearest ten or hundred.
The Companies Act also permits ignoring of ‘paise’ while preparing
financial statements. Similarly for tax purposes, the income has to
be rounded to nearest ten.
Thus, the term ‘materiality’ is a subjective term. The accountant
should regard an item as material if there is reason to believe that
knowledge of it would influence the decision of the informed investor.
According to Kohler, “Materiality means the characteristic attaching to
a statement, fact or item whereby its disclosure or method of giving it
expression would be likely to influence the judgment of a reasonable
person.”
It should be noted that accounting is a man-made art designed to
help man in achieving certain objectives. “The accounting principles,
therefore, cannot be derived from or proven by laws of nature. They
are rather in the category of conventions or rules developed by man
from experience to fulfill the essential and useful needs and proposes in
establishing reliable financial and operating information control for
business entities. In this respect, they are similar to principles of
commercial and other social disciplines.”
SYSTEMS OF BOOK-KEEPING

Book-keeping, as explained earlier, is the art of recording pecuniary

or business transactions in a regular and systematic manner. This
recording of transactions may be done according to any of the
following two systems:
1. Single entry system. An incomplete double entry system can
be termed as a single entry system. According to Kohler, “it is a
system of book-keeping in which as a rule only records of cash and
personal accounts are maintained, it is always incomplete double
entry, varying with circumstances”. This system has been developed
by some business houses, who for their convenience keep only some
essential records. Since all records are not kept, the system is not
reliable and can be used only by small firms. The working of this system
has been discussed in detail later in a separate chapter.

2. Double entry system. The system of ‘double entry’ book-

keeping which is believed to have originated with the Venetian
merchants of the fifteenth century, is the only system of recording
the twofold aspect of the transaction. This has been, to some extent,
explained while discussing the ‘dual aspect concept’ earlier in this
chapter. The system recognizes that every transaction have a twofold
effect. If someone receives something, them either some other person
must have given it, or the first-mentioned person must have lost
something, or some service etc. must have been rendered by him.
Double Entry System and Single Entry System
The difference between the double entry system and single entry
system can be put as follows:

(a) Recording of transactions. In case of the double entry system,

the dual aspect concept is completely followed while recording
business transactions. In case of the single entry system, the
dual aspect concept is not followed for all transactions. In case
of some transactions both the aspects are recorded; for some,
only one aspect is recorded, while in the case of some other
transactions, no recording is at all done.

(b) Maintenance of books. In the case of the double entry system,

various subsidiary books viz. sales book, purchases book,
returns book, cash book, etc. are maintained. In case of the
single entry system, no subsidiary books except the cash book
is maintained.

(c) Maintenance of books of account . In the case of the double entry

system, all major accounts real, nominal and personal are
maintained. However, in the case of the single entry system,
 only personal accounts are maintained.
(d) Preparation of trial balance. In the case of the double entry
system, a trial balance is prepared to check the arithmetical
accuracy of the books of account. In the case of the single
entry system, the trial balance cannot be prepared. Hence, it
is not possible to check the accuracy of the books of
account.

(e) Accuracy of profits and financial position. In the double entry

system, the Trading and Profit and Loss Account gives the true
profit of the business while the Balance Sheet shows the true
and fair financial position of the business. In the single entry
system only a rough estimate of profit or loss can be made.
The Statement of Affairs prepared in the single entry system
also does not show the true financial position of the
business.

(f) Utility. The single entry system is used only by very small
business units. It has no utility for large business units. As a
matter of fact, they have to compulsorily adopt the double
entry system.
Accounting Equation
The system of the double entry system of book-keeping can very
well be explained by the “accounting equation” given below:
Assets = Equities
It has been explained in the preceding pages that every
accounting transaction results in a twofold effect. It may either result
in creation of some assets or benefits to the business on the one
hand, or some liabilities or loss to the business on the other hand.
Thus, in other words, every business transaction results in both
creation of an asset with an equivalent liability. This is technically
known as an accounting equation as per the double entry system of
book-keeping. The equation and its explanation are being given
below:

The properties owned by business are called ‘assets’. The rights to

the properties are called ‘equities’. Equities may be subdivided into
two principal types: the rights of the creditors and the rights of the
owners. The equity of creditors representing debts of the business are
called “liabilities”. The equity of owners is called “capital”, or
proprietorship or owner’s equity. Thus:
Assets – Liabilities = Capital
The accounting equation can be understood with the help of the
following transactions:
Transaction 1. A starts business with a capital of Rs 10,000.

There are two aspects of the transaction. The business has

 received cash of Rs 10,000. It is its asset but on the other hand it
has to pay a sum of Rs 10,000 to A, the Proprietor.
Thus:

Capital and Rs Assets Rs

Liabilities
Capital 10, Cash 10,000
000
Transaction 2. A purchases furniture for cash worth Rs 2,000. The
position of his business will be as follows:
Capital and Rs Assets Rs
Liabilities
Capital 10,0 Cash 8,000
00
Furniture 2,000
10,0 10,000
00
Transaction 3. A purchases cotton bales from B at Rs 5,000 on
credit. He sells for cash cotton bales costing Rs 3,000 for those of Rs
4,000 and Rs 1,000 for Rs 1,500 on credit to P.
As a result of these transactions the business makes a profit of Rs
1,500 (i.e., Rs 5,500–Rs 4,000). This will increase A’s Capital from Rs
10,000 to Rs 11,500. The business will have a liability of Rs 5,000 to B
and two more assets in the form of a debtor P for Rs 1,500 and stock
of cotton bales of Rs 1,000. The position of his business will now be as
follows:
Capital and Rs Assets Rs
Liabilities
Creditor (B) 5,00 Cash (Rs 8,000 + 12,000
0 4,000)
Capital 11,5 Stock of Cotton 1,000
00 Bales
Debtor (P) 1,500
Furniture 2,000
16,5 16,500
00

SYSTEMS OF ACCOUNTING
There are basically two systems of accounting:

(i) Cash system of accounting. It is a system in which accounting

entries are made only when cash is received or paid. No entry is made
when a payment or receipt is merely due. The Government system of
accounting is based mostly on the cash system.
 Certain professional people record their income on cash basis,
but while recording expenses they take into account the outstanding
expenses also. In such a case, the financial statement prepared by
them for determination of their income is termed as Receipts and
Expenditure Account.

Mercantile or accrual system of accounting. It is a system

(ii)
in which accounting entries are made on the basis of amounts having
become due for payment or receipt. This system recognises the fact
that if a transaction or an event has occurred, its consequences
cannot be avoided and therefore, should be brought into books in order
to present a meaningful picture of profit earned or loss suffered and
also of the financial position of the firm concerned.

The difference between the Cash System and Mercantile System of

accounting will be clear with the help of the following example:

A firm close its books on 31 December each year. A sum of Rs

500 has become due for payment on account of rent for the year
2000. The amount has, however, been paid in January, 2001.

In this case, if the firm is following the cash system of accounting,

no entry will be made for the rent having become due in the books of
accounts of the firm in 2000. The entry will be made only in January
2000 when the rent is actually paid. However, if the firm is following
the mercantile system of accounting, two entries will make:

(i) on 31 December, 2000, rent account will be debited while the

landlord’s account will be credited by the amount of outstanding
rent;
(ii) In January 2000, the landlord’s account will be debited while the
cash account will be credited with the amount of the rent
actually paid. (This has been discussed in detail later while
dealing with adjustments relating to final accounts.

The ‘mercantile system’ is considered to be better since it takes

into account the effects of all transactions already entered into. This
system is followed by most of the industrial and commercial firms.
 JOURNALISING TRANSACTIONS

is the art of recording, classifying and summarising the financial

transactions and interpreting the results therefore. Thus, the
accounting process or cycle involves the following stages:

1. Recording of transactions. This is done in the book termed as

‘Journal’.
2. Classifying the transactions. This is done in the book termed as
‘Ledger’.
3. Summarising the transactions. This includes preparation of the
trial balance, profit and loss account and balance sheet of the
business.
4. Interpreting the results. This involves computation of various
accounting ratios, etc., to know about the liquidity, solvency and
profitability of business. The recording of transactions in the Journal
is being explained in this unit.

JOURNAL
The Journal records all the daily transactions of a business in the
order in which they occur. A Journal may therefore be defined as a
book containing a chronological record of transactions. It is the book in
which the transactions are recorded first of all under the double entry
system. Thus, the Journal is the book of original record. A Journal
does not replace but precedes the Ledger. The process of recording
transactions in a Journal, is termed as Journalising. A pro forma of a
Journal is given below:

Date Partic L. Debit Cre

ulars F. Rs dit
R
s
(1) (2) (3 (4) (5)
)
Fig. 3.1 Pro Forma of a Journal

1. Date. The date on which the transaction was entered is

recorded here.
2. Particulars. The two aspects of transaction are recorded in
this column, i.e., the details regarding accounts which have to be
debited and credited.
 3.L.F. This stands for Ledger Folio. The transactions entered in
the Journal are later on posted to the ledger. The relevant ledger
folio is entered here. The procedure regarding posting the transactions
in the Ledger has been explained in the next chapter.
4. Debit. In this column, the amount to be debited is entered.
5. Credit. In this column, the amount to be credited is shown.

RULES OF DEBIT AND CREDIT

The transactions in the Journal are recorded on the basis of the rules of
debit and credit. For this purpose business transactions have been
classified into three categories:

(i) Transactions relating to persons

(ii) Transactions relating to properties and assets
(iii) Transactions relating to incomes and expenses

On this basis, it becomes necessary for the business to keep an

account of:
(i) Each person with whom it deals
(ii) Each property or asset which the business owns
(iii) Each item of income or expense

The accounts falling under the first heading are called ‘Personal
Accounts’. The accounts falling under the second heading are termed
‘Real Accounts’. The accounts falling under the third heading are termed
‘Nominal Accounts’. The classification of the accounts, as explained
above, can be put in the form of the following chart:

Fig. 3.2 Classification of Accounts

Each of the above categories of accounts and the relevant rule for
‘debit and credit’ have been explained in detail in the following
pages:

Personal accounts. Personal accounts include the accounts of

persons with whom the business deals. These accounts can be
classified into three categories:
 1.Natural Personal Accounts. The term ‘Natural Persons’ means
persons who are the creation of God. For example, Mohan’s Account,
Sohan’s Account, Abha’s Account, etc.

2.Artificial Personal Accounts. These accounts include accounts of

corporate bodies or institutions which are recognised as persons in
business dealings. For example, the account of a Limited Company,
the account of a Co-operative Society, the account of a Club, the
account of Government, the account of an Insurance Company etc.

3. Representative Personal Accounts. These are accounts which

represent a certain person or group of persons. For example, if the rent
is due to the landlord, an outstanding rent account will be opened in
the books. Similarly, for salaries due to the employees (not paid), an
outstanding salaries account will be opened. The outstanding rent
account represents the account of the landlord to whom the rent is to
be paid while the outstanding salaries account represents the
accounts of the persons to whom the salaries have to be paid. All such
accounts are therefore termed as ‘Representative Personal Accounts’.
The rule is:
For example, if cash has been paid to Ram, the account of Ram will
DEBIT THE
have to be debited. Similarly,RECEIVER
if cash CREDIT
has been received from Keshav,
the account of Keshav will have to be credited.

Real accounts. Real accounts may be of the following types:

1. Tangible Real Accounts. Tangible Real Accounts are those which

relate to such things which can be touched, felt, measured etc.
Examples of such accounts are cash account, building account,
furniture account, stock account, etc. It should be noted that a bank
account is a personal account; since it represents the account of the
banking company— an artificial person.
2. Intangible Real Accounts. These accounts represent such things
which cannot be touched. Of course, they can be measured in terms
of money. For example, patents account, goodwill account, etc.

The rule is:

For example, if a building
DEBIT IS has
WHAT been
COMES purchased for cash, the
building account shouldIN CREDIT
be debited (since it is coming in the
IS WHAT GOES
business), while the cash account should be credited (since cash is
going out the business). Similarly when furniture is purchased for cash,
the furniture account should be debited while the cash account should
be credited.

Nominal accounts. These accounts are opened in the books to

simply explain the nature of the transactions. They do not really
exist. For example, in a business, salary is paid to the manager,
rent is paid to the landlord, commission is paid to the salesman, cash
goes out of the business and it is something real; while salary, rent
or commission as such do not exist. The accounts of these items are
opened simply to explain how the cash has been spent. In the
absence of such information, it may difficult for the person concerned
to explain how the cash at his disposal was utilised.

Nominal Accounts include accounts of all expenses, losses, incomes

and gains. The examples of such accounts are rent, rates lighting,
insurance, dividends, loss by fire, etc.
The rule is:
DEBIT ALL EXPENSES AND
Tutorial Note. BothLOSSES
Real CREDIT
Accounts and Nominal
ALL GAINS AND Accounts come in
the category of Impersonal Accounts. The student should note that
when some prefix or suffix is added to a Nominal Account, it
becomes a Personal Account. A table is being given to explain the
above rule:
Table 3.1 Nominal and Personal Accounts
Nominal Personal Account
Account
1. Rent account Rent prepaid account, Outstanding rent
account.
2. Interest
account Outstanding interest account, Interest
received in advance account, Prepaid interest
account.

3. Salary account
Outstanding salaries account, Prepaid salaries
account.
4. Insurance
account
Outstanding insurance account, Prepaid
insurance account.
5. Commission
account Outstanding commission account, Prepaid
commission account.

Classification of Goods Account.

The term goods include articles purchased by the business for
resale. Goods purchased by the business may be returned to the
supplier. Similarly, goods sold by the business to its customers can
also be returned by the customers to the business due to certain
reasons. In business, it is desired that a separate record be kept of
all sale, purchase and return of goods. Hence, the Goods Accounts
can be classified into the following categories:

(i) Purchases Account. The account is meant for recording all

purchases of goods. Goods “come in” on purchasing of goods and,
therefore, the Purchases Account is debited on purchase of goods.
(ii) Sales Account. The account is meant for recording of selling of
goods. The goods “go out” on selling of goods, and therefore, on sale
of goods, the Sales Account is credited.
(iii) Purchases Returns Account. The account is meant for
recording return of goods purchased. The goods “go out” on
returning of goods to the suppliers and, therefore, the account should
be credited on returning goods purchased.
(iv) Sales Returns Account. The account is meant for recording
return of goods sold, by the customers. The goods “come in” and,
therefore, the Sales Returns Account should be debited on return of
goods.
The above classification of Goods Account can be shown in the
form of the following chart:
Fig. 3.3 Goods Account

LEDGER
A Ledger is a book which contains various accounts. In other words, a
Ledger is a set of accounts. It contains all accounts of the business
enterprise whether Real, Nominal or Personal. It may be kept in any
of the following two forms:

(i) Bound Ledger, or (ii) Loose Leaf Ledger

It is common to keep the Ledger in the form of loose-leaf cards these

days. This helps in posting transactions particularly when a mechanised
system of accounting is used.
POSTING

The term “Posting” means transferring the debit and credit items from
the Journal to their respective accounts in the Ledger. It should be
noted that the exact names of accounts used in the Journal should
be carried to the Ledger.

For example, if in the Journal, the Expenses Account has been

debited, it would not be correct to debit the Office Expenses Account
in the Ledger, though, in the Journal, it might have been indicated
clearly in the narration that it is an item of office expenses. The correct
course would have been to record the amount to the Office Expenses
Account in the Journal as well as in the Ledger.

Posting may be done at any time. However, it should be

completed before the financial statements are prepared. It is
advisable to keep the more active accounts posted to date. The
examples of such accounts are the cash account, personal accounts of
various parties etc.

The posting may be done by the book-keeper from the Journal to

the Ledger by any of the following methods:

He may take a particular side first. For example, he may take

(i)
the debits first and make the complete postings of all debits
from the Journal to the Ledger.
(ii) He may take a particular account and post all debits and credits
relating to that account appearing on one particular page of the
Journal. He may then take some other accounts and follow
the same procedure.
(iii) He may complete postings of each journal entry before
proceeding to the next journal entry.

It is advisable to follow the last method. One should post each

debit and credit item as it appears in the Journal. The Ledger Folio
(L.F.) column in the Journal is used at the time when debits and
credits are posted to the Ledger.

The page number of the Ledger on which the posting has been
done is mentioned in the L.F. column of the Journal.

Similarly, a folio column in the Ledger can also be kept where the page
from which the posting has been done from the Journal may be
mentioned. Thus, there are cross references in both the Journal and
the Ledger.
A proper index should be maintained in the Ledger giving the
names of the accounts and the page numbers.
RELATIONSHIP BETWEEN JOURNAL AND LEDGER
Both the Journal and the Ledger are the most important books used
under the Double Entry System of book-keeping. Their relationship can
be expressed as follows:

(i) The transactions are recorded first of all in the Journal and then
 they are posted to the Ledger. Thus, the Journal is the book of
first or original entry, while the Ledger is the book of second
entry.
(ii) The Journal records transactions in a chronological order, while
the Ledger records transactions in an analytical order.

(iii) The Journal is more reliable than the Ledger since it is the book
in which the entry is passed first of all.

(iv) The process of recording transactions is termed as

“Journalising” while the process of recording transactions in the
Ledger is called as “Posting”.
RULES REGARDING POSTING
The following rules should be observed while posting transactions in
the Ledger from the Journal:

(i) Separate accounts should be opened in the Ledger for posting

transactions relating to different accounts recorded in the
Journal. For example, separate accounts may be opened for sales,
purchases, sales returns, purchases returns, salaries, rent, cash,
etc.

(ii) The concerned account which has been debited in the Journal
should also be debited in the Ledger. However, a reference
should be made of the other account which has been credited in
the Journal. For example, for salaries paid, the salaries account
should be debited in the Ledger, but reference should be given
of the Cash Account which has been credited in the Journal.

(iii) The concerned account, which has been credited in the Journal
should also be credited in the Ledger, but reference should be
given of the account, which has been debited in the Journal. For
example, for salaries paid, Cash Account has been credited in
the Journal. It will be credited in the Ledger also, but reference
will be given of the Salaries Account in the Ledger.

Thus, it may be concluded that while making a posting in the

Ledger, the concerned account which has been debited or credited in
the Journal should also be debited or credited in the Ledger, but
reference has to be given of the other account which has been credited
or debited in the Journal, as the case may be. This will be clear with the
following example.

Suppose salaries of Rs 10,000 have been paid in cash, the following

entry will be passed in the Journal:
 Salaries Account (i) Dr. 10,000

To Cash Account (ii) 10,000

In the Ledger two accounts will be opened (i) Salaries Account, and
(ii) Cash Account. Since Salaries Accounts has been debited in the
Journal, it will also be debited in the Ledger. Similarly, since the
Cash Account has been credited in the Journal it will also be credited in
the Ledger, but reference will be given of the other account involved.
Thus the accounts will appear as follows in the Ledger:
Dr. SALARIES ACCOUNT Cr.

Particulars Rs Particulars
Cash A/c (ii) 10,0
00
CASH ACCOUNT
Particulars Rs Particulars Rs
Salaries A/c (i)

10,000
Use of the words “To” and “By”
It is customary to use words “To” and “By” while making posting in the
Ledger. The word “To” is used with the accounts which appear on the
debit side of a Ledger Account. For example, in the Salaries Account,
instead of writing only “Cash” as shown above, the words “To Cash”
will appear on the debit side of the account. Similarly, the word
“By” is used
with accounts which appear on the credit side of a Ledger Account. For
example, in the above case, the words “By Salaries A/c” will appear on
the credit side of the Cash Account instead of only “Salaries A/c”.
The words “To” and “By” do not have any specific meanings.
Modern accountants are, therefore, ignoring the use of these words.
Balancing of An Account
In business, there may be several transactions relating to one
particular account. In a Journal, these transactions appear on
different pages in a chronological order while they appear in a classified
form under that particular account in the Ledger. At the end of a period
(say a month, a quarter or a year), the businessman will be
interested in knowing the position of a particular account. This means,
he should total the debits and credits of the account separately and
find out the net balance.

This technique of finding out the net balance of an account, after

 considering the totals of both debits and credits appearing in the
account is known as ‘Balancing the Account’. The balance is put on
the side of the account which is smaller and a reference is given that
it has been carried forward or carried down (c/f or c/d) to the next
period. On the other hand, in the next period a reference is given that
the opening has been brought forward or brought down (b/f or b/d)
from the previous period.
TRIAL BALANCE
In case the various debit balances and the credit balances of the
different accounts are taken down in a statement, the statement so
prepared is termed as a Trial Balance. In other words, Trial Balance is
a statement containing the various ledger balances on a particular
date. For example, with the balances of the ledger accounts prepared
in Illustration 4.2, the Trial Balance can be prepared as follows:
TRIAL BALANCE

as on 31st January

Particulars Debit Credit

Rs Rs
Cash Account 12,000
Capital Account 10,000
Purchases Account 4,000
Mohan 2,000
Sales Account 4,000
16,000 16,000
Thus, the two sides of the Trial Balance tally. It means the books
of accounts is arithmetically accurate.

Objectives of Preparing a Trial Balance

1. Checking of the arithmetical accuracy of the accounting
entries. As indicated above, a Trial Balance helps in knowing
the arithmetical accuracy of the accounting entries. This is
because according to the dual aspect concept for every debit,
there must be an equivalent credit. Trial Balance represents a
summary of all ledger balances and, therefore, if the two sides
of the Trial Balance tally, it is an indication of this fact that the
books of account are arithmetically accurate. Of course, there
may be certain errors in the books of account in spite of an
agreed Trial Balance. For example, if a transaction has been
completely omitted from the books of account, the two sides of
the Trial Balance will tally, in spite of the books of account
being wrong.
 2. Basis for financial statements. Trial Balance forms the basis for
preparing financial statements such as the Income Statement
and the Balance Sheet. The Trial Balance represents all
transactions relating to different accounts in a summarised
form for a particular period. In case, the Trial Balance is not
prepared, it will be almost impossible to prepare the financial
statements as stated above to know the profit or loss
made by the business during a particular period or its
financial position on a particular date.

3. Summarised ledger. It has already been stated that a Trial

Balance contains the ledger balances on a particular date. Thus,
the entire ledger is summarised in the form of a Trial Balance.
The position of a particular account can be judged simply by
looking at the Trial Balance. The Ledger may be seen only
when details regarding the accounts are required.

Methods of preparing a Trial Balance. A trial balance may be

prepared according to either of the two methods:

(a) Totals method. In case of this method, the totals of debit and
credit of the accounts are shown in the trial balance. Trial balance is
prepared before the ledger accounts are balanced. The totals of the
debit and credit columns of the trial balance must be equal. This
method is not popular.

Balance method. In case of this method, the balances of the

(b)
ledger accounts are shown in the respective debit and credit columns
of the trial balance. The total of the balance of the debit column must
be equal to the total balance of the credit column. This is the most
common method of preparing a trial balance.

PRACTICAL PROBLEMS
1. Journalise the following transaction and post the entries in the
Ledger.

1999 Rs
Jan. 1 Surendra started business with cash 5,000
Jan. 2 Goods purchased from Prasad on credit 200
Jan 3 Goods sold to Prem 500
Jan. 4 Good purchased from Sohan for cash 400
Jan. 5 Paid for wages 50
Jan. 15 Goods purchased from Prem 100
Jan. 17 Goods sold to Om 50
Jan. 21 Goods purchased from Charanjit 300
Jan. 23 Paid for interest 15
Jan. 24 Goods purchased from Om 200
Jan. 28 Cash received from Prem 100
 Jan. 31 Cash paid to Charanjit 300
Jan. 31 Paid for Rent 10

FINAL ACCOUNTS

DETERMINATION OF BUSINESS INCOME & FINANCIAL

PORTION
Accuracy of the books of accounts is determined by means of preparing
a Trial Balance. Having determined the accuracy of the books of
accounts every businessman is interested in knowing about two more
facts. They are:
(i) Whether he has earned a profit or suffered a loss during the
period covered by the Trial Balance,
(ii) Where does he stand now? In other words, what is his financial
position?

The determination of the Profit or Loss is done by preparing a

Trading and Profit and Loss Account (or an Income Statement). The
financial position is judged by means of preparing a Balance Sheet of
the business. The two statements together, i.e., Income Statement and
the Balance Sheet are termed as Final Accounts. As the term indicates,
Final Accounts means accounts which are prepared at the final stage to
give the financial position of the business.

In the present unit we are dealing with the basic principles

concerning financial reporting particularly with reference to a non-
corporate entity i.e. a sole proprietary or a partnership firm.

TRADING AND PROFIT & LOSS ACCOUNT

The Trading and Profit and Loss Account is a final summary of such
accounts which affect the profit or loss position of the business. In other
words, the account contains the items of Incomes and Expenses
relating to a particular period. The account is prepared in two parts (i)
Trading Account, and (ii) Profit and Loss Account.
Trading Account

Trading Account gives the overall result of trading, i.e., purchasing

and selling of goods. In other words, it explains whether purchasing of
goods and selling them has proved to be profitable for the business or
not. It takes into account on the one hand the cost of goods sold and on
the other the value for which they have been sold.

In case the sales value is higher than the cost of goods sold, there
will be a profit, while in a reverse case, there will be a loss. The profit
disclosed by the Trading Account is termed as Gross Profit, similarly the
loss disclosed by the Trading Account is termed as Gross Loss.

Trading A/c in the books of ------- for the year ending --------
Dr Cr
Amount Amount Amount Amount
particulars particulars
(Rs) (Rs) (Rs) (Rs)
To Opening Stock XXXX By Sales XXX
To Purchases XXX Less: Sales Returns XXX XXX
Less: Purchase returns XXX XXXX
To Direct Expenses By Closing Stock XXXX
Freight and Insurance XXX
Carriage Inwards XXX
Wages XXX
Octroi XXX
Fuel ,Power and Lighting
XXX
Expenses
Packing Charges XXX
Duty on Purchases XXX
XXXX

To Gross Profit XXX By Gross Loss XXX

XXXX XXXX

Profit and Loss Account

The Trading Account simply tells about the gross profit or loss made by
a businessman on purchasing and selling of goods. It does not take into
account the other operating expenses incurred by him during the
course of running the business.

For example, he has to maintain an office for getting orders and

executing them, taking policy decisions and implementing them.

All such expenses are charged to the Profit and Loss Account.
Besides this, a businessman may have other sources of income. For
example, he may receive rent from some of his business properties. He
may have invested surplus funds of the business in some securities. He
might be getting interest or dividends from such investments.

In order to ascertain the true profit or loss which the business has
made during a particular period, it is necessary that all such expenses
and incomes should be considered.
 Profit and Loss Account considers all such expenses and incomes
and gives the net profit made or loss suffered by a business during a
particular period. It is generally prepared in the following form:
Profit And Loss A/c in the books of ------- for the year ending --------
Dr Cr
Amount Amount Amoun Amoun
particulars particulars
(Rs) (Rs) t (Rs) t (Rs)
To Management Expenses By Gross Profit b/d XXX
salaries XXX

Office rent, rates and taxes XXX

Other Incomes
printing and stationery XXX By discount Received XXX
telephone Charges XXX By Commssion Received XXX XXX
Postage and Telegrams XXX
insurance XXX By Non- Trading Incomes
audit fee XXX Bank Interest XXX
legal charges XXX Rent of Property let -out XXX
electricity charges XXX XXXX Dividend from shares XXX XXX

To Maintenance Expenses By Abnormal Gains

reparis and renewals XXX profit on sale of fixed assets XXX
depreciation on fixed assets (if
XXX XXXX XXX XXX
any) profit on sale of investments

To Selling & Distribution

Expenses
salaries to sales persons XXX
advertisement XXX
godown rent XXX
carriage outward XXX
Bad debts XXX
provisions for baddebts XXX
selling commissions XXX XXXX

To Fiancial Expenses
Bank charges XXX
interest on loans XXX
Discount on bills XXX
discount allowed to customers XXX XXXX

To Abnormal Losses
Loss on sale of fixed assets XXX
loss on fire XXX XXXX
To Net Profit XXX By Net Loss XXX
XXXXX XXXXX

BALANCE SHEET
The term balance sheet refers to a financial statement that reports
a company's assets, liabilities, and shareholder equity at a specific
point in time. Balance sheets provide the basis for computing rates of
return for investors and evaluating a company's capital structure.

In short, the balance sheet is a financial statement that provides a

snapshot of what a company owns and owes, as well as the amount
invested by shareholders.

Balance sheets can be used with other important financial

statements to conduct fundamental analysis or calculating financial
ratios.
Balance Sheet as on ___________ in the books of __________

Amount Amount Amount Amount

Liabilities Assets
(Rs) (Rs) (Rs) (Rs)
Land & Buildings XXX
capital XXX plant & Machinery XXX
Add: net profit XXX XXXX Furniture & Fixtures XXX
or Stock (closing) XXX
sundry Debtors XXX
capital XXX Bills Receivables XXX
Less: Net Loss XXX XXXX Other Investments XXX
Government Securities XXX
reserves & surplus XXX Cash At Bank XXX
outstanding expenses XXX cash in hand XXX
loans XXX vehicals, etc., XXX
trade creditors XXX
bills payables etc., XXX

XXXXX XXXXX
 Treatment of adjustments in Final Accounts

Adjustments Trading & P/L Account Balance Sheet

1.Closing Posted at the credit side of the Shown at the Assets side of
Stock Trading A/c Balance Sheet
2. Posted in the Debit side of the Shown as deduction from
Depreciation P/L A/c. concerned asset.
To be added to concerned asset.
If the appreciation amount is
huge it is to be added to capital
3.Appreciatio Posted on the Cr side of the P/L at the liabilities side and to be
n of assets a/c. added to capital at the liabilities
side and to be added to the
concerned as set at the assets
side of the B/S.
4.
Added to concerned expense at Shown on the liabilities side of the
outstanding
the dr side of the account B/S.
Expenses
Deduct from the concerned
5. prepaid Shown on the asset side of the
expense at the debit side of the
expenses B/S
a/c.
6. Accrued Added to the concerned income Shown on the assets side of the
Income at the Cr side of the A/c B/S
7. Unearned Deducted from concerned Shown on the liabilities side of the
income income on the Cr side of the A/c B/S.
8. interest on Added to capital on liabilities side
Shown on the Dr side of P/L a/c
capital of the B/S
9. Interest on Deduct from capital on liabilities
Shown on the Cr side of P/L a/c
Drawings side of the B/S
10. interest
Added to the concerned asset of
on Shown on the Cr side of P/L a/c
the B/S
investments
11. interest Added to loan on liabilities side of
Shown on the Dr side of P/L a/c
on loans the B/S
Deduct from the debtors in assets
12.bad debts Shown on the Dr side of P/L a/c
side of the B/S.
13. Provision Deduct from the debtors in assets
Shown on the Dr side of P/L a/c
for Bad Debts side of the B/S.
14. Provision
If new provision is more than
for Bad Debts
the old provision, the difference New provision is Deduct from the
(where
is shown on the Dr side of the debtors in assets side of the B/S.
provision
P/L a/c
already exist)
15. provision
Deduct from the debtors in assets
for discount Shown on the Dr side of P/L a/c
side of the B/S.
on debtors
16. provision
Deduct from creditors on
for discount Shown on the Cr side of P/L a/c
liabilities side of the B/S
on creditors
17.
outstanding
Shown on the Dr side of P/L a/c Shown on the liabilities of teh B/S
manager’s
commission
18. goods Amount of goods taken by the Amount of goods taken by the
taken by the proprietor will be deducted proprietor will be deducted from
proprietor for from purchases in dr side of capital a/c on liabilities side of the
personal use trading a/c B/S
19. goods
deducted from purchases in dr deducted from capital a/c on
given as
side of trading a/c liabilities side of the B/S
charity

Note: Debtors XXX

L: Bad debts XXX

XXX
L: Provision for Bad debts XXX

XXX
L: Discount on Debtors XXX

XXX
 FUNDS FLOW ANALYSIS

The funds flow statement reveals the sources from where the funds
are made available and the purpose for which funds are utilized in an
organization. In other words, a statement showing the sources and uses or
applications of funds is termed as funds flow statement.

It facilitates a comparison between the inflow and outflow of funds

in two different periods. In addition, it shows the changes in the financial
position of an organization by analyzing working capital, operating profit,
and changes in long-term assets and liabilities.

In the words of Almond Coleman, “The funds flow statement

summarizing the significant financial changes which have occurred in the
beginning and end of the accounting period.”

Preparation of Funds Flow Statement:

An organization needs to follow some basic rules while preparing funds

flow statements. The basic rules help to identify what is to be included in
a funds flow statement. It is essential to understand the causes of fund
inflow or outflow while preparing funds flow statements.
Generally, following aspects are considered while preparing funds
flow statement:
i. Increase in liability would be the inflow of funds; whereas,
decrease in liability results in outflow of funds
ii. Increase in assets would be the outflow of funds; whereas,
decrease in assets results in inflow of funds

iii. Change in the assets of the same category cannot result in the
change of funds. For example- when an organization buys goods
in cash, the transaction reduces cash but increases the stock.
This transaction does not affect the working capital of the
organization because both cash and stock are the part of working
capital.

iv. Change in the liability of the same category cannot result in the
change of funds. For example- an organization can make
payment to the creditors by raising short-term loans. Since, both
 the creditors and short-term loans are current liabilities;
therefore, their effect would be counterbalanced.
Any transaction affecting fixed assets and long-term liabilities does
not find place in funds flow statements. For example- a sum of Rs.500,000
is taken as a loan to purchase land. Since land is an asset, this transaction
would increase the total assets of the organization.

However, at the same time, the total liabilities of the organization

would also increase because it needs to pay the amount of loan and
interest. Therefore, this transaction would not bring any change in the
funds flow statement.

Importance of Funds Flow Statement:

The importance of funds flow statement is explained in the
following points:
i. Helps to understand the changes in assets and their sources that are
not readily evident in the income or financial statement of an
organization

ii. Shows the application of funds in different spheres of business

iii. Points out the financial strengths and weaknesses of the organization

In most of the cases, funds flow statement and balance sheet are
considered similar as both show the financial position of an organization
at a particular date. However, these two financial statements differ from
each other on the basis of meaning, utility, and purpose of preparation.

Limitations of Funds Flow Statement

Funds flow statement is not free from limitations, which are mentioned in
the following points:
i. Ignore the non-financial transactions, such as issue of bonus shares and
sweat equity shares.

ii. Requires the preparation of the cash flow statement as the cash
position of an organization cannot be determined by the funds flow
statement.
iii. Draws its data from the balance sheet and profit and loss account. If
these statements are wrong then the funds flow statement would not
reveal the true financial position of the organization.
 CASH FLOW ANALYSIS

In financial accounting, a cash flow statement, also known

as statement of cash flows, is a financial statement that shows how
changes in balance sheet accounts and income affect cash and cash
equivalents, and breaks the analysis down to operating, investing, and
financing activities. Essentially, the cash flow statement is concerned with
the flow of cash in and out of the business.

As an analytical tool, the statement of cash flows is useful in

determining the short-term viability of a company, particularly its ability
to pay bills. International Accounting Standard 7 (IAS 7) is
the International Accounting Standard that deals with cash flow
statements.

The cash flow statement (previously known as the flow of funds

statement), shows the sources of a company's cash flow and how it was
used over a specific time period. It is an important indicator of a
company's financial health, because a company can report a profit on its
income statement, but at the same time have insufficient cash to
operate.

The cash flow statement reveals the quality of a company's earnings

(i.e. how much came from cash flow as opposed to accounting treatment),
and the firm's capacity to pay interest and dividends.

The cash flow statement differs from the balance sheet and income
statement in that it excludes non-cash transactions required by accrual
basis accounting, such as depreciation, deferred income taxes, write-offs
on bad debts and sales on credit where receivables have not yet been
collected.

The cash flow statement is intended to:

1. provide information on a firm's liquidity, solvency and financial

flexibility (the ability to change cash flows in future circumstances)
2. help predict future cash flows and borrowing needs
3. Improve the comparability of different firms' operating performance
by eliminating the effects of different accounting methods.

The cash flow statement has been adopted as a standard financial

statement because it eliminates allocations, which might be derived from
different accounting methods, such as various timeframes for depreciating
fixed assets.
Cash flow activities
International Accounting Standard 7 specifies the cash flows and
adjustments to be included under each of the major activity categories.
Operating activities
Operating activities include the production, sales and delivery of the
company's product as well as collecting payment from its customers. This
could include purchasing raw materials, building inventory, advertising,
and shipping the product.
Operating cash flows include:

 Receipts for the sale of loans, debt or equity instruments in a trading

portfolio
 Interest received on loans
 Payments to suppliers for goods and services
 Payments to employees or on behalf of employees
 Interest payments (alternatively, this can be reported under financing
activities in IAS 7)
 Purchases of merchandise
Items which are added back to (or subtracted from, as appropriate) net
income (which is found on the Income Statement) to arrive at cash flows
from operations generally include:[citation needed]

 Depreciation (loss of tangible asset value over time)

 Deferred tax
 Amortization (loss of intangible asset value over time)
 Any gains or losses associated with the sale of a non-current asset,
because associated cash flows do not belong in the operating section
(unrealized gains/losses are also added back from the income
statement)
 Dividends received general reserves

Investing activities
Examples of investing activities are:

 Purchase or sale of an asset

 Loans made to suppliers
 Payments related to mergers and acquisitions

Financing activities
Financing activities include inflows and outflows of cash
between investors and the company, such as: [18]
 Dividends paid
 Sale or repurchase of the company's stock
 Net borrowings
 Repayment of debt principal, including capital leases
 Other activities which impact the company's long-term liabilities and
equity
Disclosure of non- cash activities:
Under IAS 7, non-cash investing and financing activities are disclosed in
footnotes to the financial statements. Under US General Accepted
Accounting Principles (GAAP), non-cash activities may be disclosed in a
footnote or within the cash flow statement itself. Non-cash financing
activities may include:[15]

 Leasing to purchase an asset

 Converting debt to equity
 Exchanging non-cash assets or liabilities for other non-cash assets or
liabilities
 Issuing share
 Payment of dividend taxes in exchange for assets

METHODS OF PREPARATION
The direct method of preparing a cash flow statement results in a more
easily understood report.[19] The indirect method is almost universally
used, because FAS 95 requires a supplementary report similar to the
indirect method if a company chooses to use the direct method.
Direct method
The direct method for creating a cash flow statement reports major
classes of gross cash receipts and payments. Under IAS 7, dividends
received may be reported under operating activities or under investing
activities. If taxes paid are directly linked to operating activities, they are
reported under operating activities; if the taxes are directly linked to
investing activities or financing activities, they are reported under
investing or financing activities.
Generally Accepted Accounting Principles (GAAP) vary from
International Financial Reporting Standards in that under GAAP rules,
dividends received from a company's investing activities is reported as an
"operating activity," not an "investing activity."
Indirect method
The indirect method uses net-income as a starting point, makes
adjustments for all transactions for non-cash items, then adjusts from all
cash-based transactions. An increase in an asset account is subtracted
from net income, and an increase in a liability account is added back to
net income. This method converts accrual-basis net income (or loss) into
cash flow by using a series of additions and deductions
 Rules (operating activities)

To Find Cash Flows

from Operating Activities
using the Balance Sheet and Net Income

For Increases in Net Inc Adj

Current Assets (Non-Cash) Decrease

Current Liabilities Increase

For All Non-Cash...

*Expenses (Decreases in Fixed Assets) Increase

*Non-cash expenses must be added back to NI. Such expenses

may be represented on the balance sheet as decreases in long
term asset accounts. Thus decreases in fixed assets increase NI.

The following rules can be followed to calculate Cash Flows from

Operating Activities when given only a two-year comparative balance
sheet and the Net Income figure. Cash Flows from Operating Activities can
be found by adjusting Net Income relative to the change in beginning and
ending balances of Current Assets, Current Liabilities, and sometimes
Long Term Assets.
When comparing the change in long term assets over a year, the
accountant must be certain that these changes were caused entirely by
their devaluation rather than purchases or sales (i.e. they must be
operating items not providing or using cash) or if they are non-operating
items.[23]

 Decrease in non-cash current assets are added to net income

 Increase in non-cash current asset are subtracted from net income
 Increase in current liabilities are added to net income
 Decrease in current liabilities are subtracted from net income
 Expenses with no cash outflows are added back to net income
(depreciation and/or amortization expense are the only operating items
that have no effect on cash flows in the period)
 Revenues with no cash inflows are subtracted from net income
 Non operating losses are added back to net income
 Non operating gains are subtracted from net income

FUNDS FLOW ANAL YSIS VS CASH FLOW ANALYSIS

RATIO ANALYSIS

Ratio analysis is a quantitative method of gaining insight into a

company's liquidity, operational efficiency, and profitability by studying
its financial statements such as the balance sheet and income
statement.

 Liquidity ratios are used to mesure the firm’s ability to meet

current obligations.
 Solvency ratios show the proportion of debt and equity in
financing the firm’s assets.
 Activity ratios are reflect the firm’s efficiency in utilizing the
assets
 Profitability ratios measure the overall performance and
effectiveness of the firm.
Interpretation of ratio analysis: