BASICS OF FINANCIAL ACCOUNTING

Account

• It is a unit of information that represents business records.

• There are five types of accounts: Asset, Liability, Equity, Revenue and Expense.

Accounting

• It is concerned with the use of which the records are put, their analysis and interpretation.

• It is the process of recording business activities that make changes to accounts.

• Sales of products, Revenue from services earned, Buying products and/or services and so on.

Attributes of Accounting

• It is the art of recording business transactions.• It is the art of classifying business

transactions.• The transactions or events of a business must

be recorded in monetary terms. • It is the art of summarizing financial

transactions.• The results should be communicated to users.

Functions

• Systematic record of business transactions.• Protecting the property of business.• Communicating results to users.• Compliance with legal requirements.

Users of Accounting Information• Owners• Creditors (Suppliers)• Investors• Employees• Government• Public• Research Scholars / Agencies• Managers

Branches of Accounting

• Financial Accounting (Record keeping)• Cost Accounting (Price fixation & Operating

efficiency)• Management Accounting (Analysis for

decision making)

Advantages

• Replacement of Memory• Evidence in court• Tax purpose• Comparative study• Sale of business• Assistance to the insolvent• For various parties

Limitations• Records only monetary transactions• Effect of price level changes not considered• No realistic information• Personal bias of accountant affects the

accounting statements• Permits alternative treatments (LIFO, FIFO)• No real test for managerial performance• Historical in nature

Accounting Terminology• Business: An organization created with the objective of

making a profit from the sale of goods or services. • Book keeping: The act of systematically recording the

financial transactions affecting a business. • Book Value: The net amount (original value plus or minus

any adjustments such as depreciation) showed in the accounts for an asset, liability, or owners' equity item.

• Calendar Year: An entity's reporting year, covering 12 months.

• Transactions: Exchange of goods or services between businesses or individuals. Can also be other events having an economic impact on a business.

Accounting Terminology• Journal: A book or original entry in a double-entry

bookkeeping system. The journal lists all transactions and indicates the accounts to which they are posted.

• Journal Entry: A recording of a transaction where debits equal credits.

• Ledger: A summary statement of all the transactions relating to a person, asset, expense or income which have taken place during a given period of time and show their net effect.

• Trial Balance: A listing of all account balances that provides a test of whether total debits equals total credits.

• Revenues: Increases in a company's resources from the sale of goods or services.

Accounting Terminology• Balance sheet: A balance sheet is an itemized

statement which lists the total assets and the total liabilities of a given business to show its net worth at a given moment in time (like a snapshot).

• Capital: Property or money used and owned by a business and used to acquire future income or benefits.

• Debtor: A debtor is a person who owes money. The amount due from his is called debt.

• Creditor: A person to whom money is owing or payable is called a creditor.

• Credit: An entry on the right side of a ledger account.

Accounting Terminology• Goods: This includes all articles, commodities or

merchandise in which the business deals. Thus, cloth would be goods for a dealer in cloth; furniture would be goods for a dealer in furniture and so on.

• Assets: Economic resources owned or controlled by a person or company.

• Net Assets: The difference between assets and liabilities.• Liquidity: The availability of cash or ability to obtain it

quickly. Also used to determine debt repayment ability. • Goodwill: An intangible asset that exists when a business is

valued at more than the fair market value of its net assets. • Interest: The cost of the use of money.

Accounting Terminology• Current Assets: Current assets are those assets of a company that

are expected to be converted to cash, sold, or consumed during the normal operating cycle of the business (usually one year). Examples are cash, accounts receivable, short-term investments, US government bonds, inventories, and prepaid expenses.

• Current Liabilities: Liabilities to be paid within one year of the balance sheet date.

• Drawings: Any amount or goods withdrawn by the owner of a business for personal use is called drawings.

• Bad Debt: An uncollectible Account Receivable. • Loss: A loss is expenditure without any benefit to the concern. On

the other hand, expense is incurred to result in some benefit. Thus, amount spent on lighting is an expense but loss due to fire is loss.

Accounting Terminology• Income: It is an inflow of assets which results in an increase in the

owner’s equity.• Expenditure: Expenditure takes place when an asset or service is

acquired. Expenditure will include both payment of a sum immediately and a promise to pay it at a future date.

• Expense: An expenditure whose benefit is finished or enjoyed immediately such as salaries, rent, etc.

• Turnover: It means total trading income from cash sales and credit sales.

• Net worth: It means assets minus outside liabilities. Profits of a business increase net worth whereas losses reduce the net worth of a business.

• GAAP - Refer to Generally Accepted Accounting Principles.

Basis of Accounting

• Cash basis

–Actual cash receipts and payments are recorded.

–Credit transactions are not recorded.

Basis of Accounting• Accrual basis

– The income whether received or not but has been earned or accrued during the period forms part of the total income of the period.

– The firm has taken benefit of a particular service, but has not paid within that period, the expenses will relates to the period in which the service has been utilized and not to the period in which payment for it is made.

Basis of Accounting

• Mixed basis

–Combination of cash and accrual basis.

System of Accounting• Single Entry System: This system has no

complete record of business transactions done during a specified period.

• Double Entry System: One account is given debit while the other account is given credit with an equal amount.

Classification of Accounts

Natural Persons

Accounts

Personal Accounts

Impersonal Accounts

Artificial Persons

Accounts

Representative Persons

Accounts

Real Accounts

Nominal Accounts

Tangible Real Accounts

Intangible Real Accounts

Types of Accounts• Natural Person’s Personal Account: An account recording

transactions with an individual human being is known as a natural person’s Personal Account. (eg. Krishna account)

• Artificial Person’s Personal Account: An account recording financial transactions with an artificial person created by law or otherwise is called an artificial person’s personal account. (eg. VSL College)

• Representative Person’s Personal Account: An account indirectly representing a person or persons is known as a representative account. (eg. Salaries account)

• Tangible Real Account: An asset which can be touched, seen, and measured. (eg. Machinery Account)

• Intangible Real Account: An asset which can’t be touched physically but can be measured in value. (eg. Goodwill)

Rules of Double Entry System

Accounts Rules

Personal• Debit the receiver• Credit the giver

Real• Debit what comes in• Credit what goes out

Nominal• Debit all expenses and losses• Credit all incomes and gains

Accounting cycleRecording monetary transactions in a systematic manner

Journal entries

Ledger

Trial balance

Trading and Profit & Loss Account

Balance Sheet

Accounting Concepts Business entity concept: The Business is distinct from the

persons who own it.

Going concern concept: It assumes that the business will continue for a long time.

Cost concept: All the transactions will be recorded at cost in the books. It means deducted depreciation from the assets yearly.

Dual aspect concept: Each transaction is twofold affect.

Money measurement concept: The transactions should be recorded in monetary aspect only. We should not record the transaction in kilograms, quintals, meters, liters, etc.

Accounting period concept: Measuring the profit, incomes or expenses of the period only are to be considered. Usually the period is one year (12 months).

Realization concept: If the revenue is recognized too early or too late, the company would not project the right financial position. It would look more profitable or less profitable than what it actually is.

Matching concept: Expenses incurred for a period are matched with the revenues for the same period to arrive as a reasonably correct measurement of the net income or the net loss. The difference between revenues and expenses is a measure of how effectively management has utilized the firm’s resources.

Objective evidence concept: All accounting transactions should be evidenced and supported by object documents.

Accounting Concepts

Convention of disclosure: Accounts should be prepared in such a way that all material information is clearly disclosed to the users.

Convention of consistency: An accounting method or procedure once chosen should be followed consistently from year to year.

Convention of conservatism: Any business while recording the transactions should ‘anticipate no profits but provide for all possible losses’.

Convention of materiality: Only those events should be recorded which have a significant bearing and insignificant things should be ignored. There is no formula for identifying material and immaterial events. It depends on the accountant discretion.

Accounting Conventions

JOURNAL, LEDGER & TRIAL BALANCE

Source Documents• Cash Memo: When goods are sold or purchased for

cash, the firm receives or gives cash memos which provide details regarding cash transactions.

• Invoice or Bill: This document is prepared when goods are sold or purchased on credit.

• Receipt: When a firm receives cash from customers it issues a receipt which is a proof for receiving cash.

• Pay in Slip: This is a form available from a bank for depositing cash or cheque in a bank account.

Contd…

Source Documents

• Cheque: It is a document in writing drawn upon a specified banker and payable on demand.

• Debit Notes: For the party from whom the money is recoverable this document becomes debit note.

• Credit Note: For the party who is to recover the amount the document becomes credit note. When goods returned from the customer, a proper credit note should be sent to him.

Journal

• The word journal is derived from the Latin word ‘Journ’ which means a day.

• Journal means a day book where in day-to-day business transactions are recorded in a chronological order.

• The process of recording a transaction in the journal is called Journalisation.

• The entries made in the book are called journal entries.

Proforma of Journal

Date Particulars L.F. Dr. () Cr. ()

xx-xx-xxxx Name of the a/c Dr. To Name of the a/c(being ______)

xxxxxxxx

Items in Journal• Date: The first column deals with the date of transaction.• Particulars: In the first line write about debit aspect and

in the second line write about credit aspect. In the third line write regarding brief explanation of the entry (narration).

• Ledger Folio (L.F.): It denotes page number on which its journal entry is found.

• Debit: Fourth column deals with the amount to be debited.

• Credit: Fifth column deals with the amount to be credited.

Points to be noted before journalising• Compound journal entry

• Cash or credit transaction

• Cash discount

• Trade discount

• Purchase of shares: When shares or securities are purchased, the entry is made at market value and not at face value. Brokerage paid on the purchase of such investment is also added in the amount of investment.

• Sale of shares: If shares or securities are sold, the entry should be passed at market value less brokerage, if any, paid on such shares.

Points to be noted before journalising

• Expenses incidental to the purchase of Fixed Assets

• Insurance of Life Policy (Debited to Drawings a/c)

• Goods given as charity

• Goods distributed as free samples

• Loss of stock by Fire

• Interest due on Loans (debited to interest account and credited to loan account)

Advantages of Journal• It provides a chronological (date wise) order of all

transactions and hence provides permanent record.

• It provides the information of debit and credit in an entry and an explanation to make it understandable properly.

• It reduces the possibility of error as both aspects of a business transaction are written side by side.

Ledger• It is a book which contains various accounts. It is

in ‘T’ form.• It is a summary statement of all the transactions

relating to a person, asset, expense or income which have taken place during a given period of time and shows their net effect.

• It is designed to accommodate the various accounts maintained by a trader.

• The process of transferring the entries from the journal into the ledger is called posting.

Proforma of LedgerDr. Cash a/c Cr.

Date Particulars L.F. Amount () Date Particulars L.F. Amount ()To Name of Credit a/c

By Name of Debit  a/c

Left side Right side

Posting of ledger• For each item a separate new account is to be

opened.

• For each account there must be a name. This should be written on the top of the account in the middle.

• The debit side of the journal entry is posted to the debit side of the account by starting with To.

• The credit side of the journal entry is posted on the credit side of the account by starting with By.

Trial Balance• A list of balances of the ledger accounts at a point of

time is called trail balance.• The balances of all the ledger accounts are extracted

and are written up in a statement known as Trial Balance and finally totaled up to see if the total of debit balances is equal to the total of credit balances.

• It is a list of ledger account titles and their respective balances.

• As per double entry system, every debit equals to corresponding equal credit. To prove this, statements of debits and credits will be prepared by accountant. This statement is called trail balance.

Proforma of Trial balance

Sl.No.

Name of the Account Debit () Credit ()

Errors• Omission of any entry in a subsidiary book.

• A wrong entry in a subsidiary book.

• Posting an item to the correct side but in the wrong account. Purchase from X and credited to Y.

• Compensating errors.

• Errors of principles. These errors will not affect the agreement of the Trial Balance as they arise from the debiting or crediting of wrong heads of accounts.

Disagreement of the Trial Balance• An item omitted to be posted from a subsidiary book into the

ledger

• Posting of wrong amount to a ledger account.

• Posting an amount to the wrong side of the ledger account.

• Wrong additions or balancing of ledger accounts.

• Wrong totaling of subsidiary books.

• An item in the subsidiary book posted twice to a ledger account.

• Balance of some accounts written to the wrong side of the Trial Balance.

• An error in totaling the trial balance.

Subsidiary Books• Cash book to record cash receipts and payments.

• Simple Cash Book: It makes a record of all the receipts and payments of cash. All cash received in the form of coin, notes, cheques, postal orders, bank drafts or treasury notes will be recorded on the debit side and payments on the credit side.

• Cash Book with Discount Column

• Cash Book with Discount and Bank Column (Three column cash book)

Subsidiary Books• Purchases book is for recording all credit purchases of goods.

• Sales book is for recording all goods sold on credit.

• Purchases returns book (returns outwards book) for recording all purchases returned to creditors.

• Sales returns book (returns inwards book) for recording all sales retuned by customers.

• Bills Receivable Book to keep a record of bills received from customers.

• Bills Payable Book to keep a record of bills payable to creditors.

• Journal proper to keep a record of those transactions for which there is no separate book.