Chapter -1 Basics Of Accounting

I. Basic of Accounting Origin & growth of Book-keeping: Book-keeping existed even in ancient times. But the modern system of book-keeping took its birth only in 1494. In that year, Luca pacioli, an Italian monk, published a book called ‘SUMMA’. It contained a section on book-keeping. In that section, the principles of double-entry book-keeping were stated. This book, thus laid down the foundation of modern double-entry system of book-keeping. The industrial revolution in the 18th century, led to further improvement in bookkeeping & book-keeping came to be used in several countries. Need for Book-keeping: “Profit to a business is like food to human body’. Profit is very essential for the development of a business. Every businessman starts business to earn profits. He earns profits through the transactions of his business, such as purchases of goods, sales of goods, receipts of incomes etc, so to know the profits of the business for a certain year; he must remember all the transactions of the business for the year. But it is not possible for any businessman to remember all the transactions of his business for the year, Thus every businessman is forced to record the business transactions in a set of accounts books called Books of Accounts. Thus, the inability of every businessman to remember all the transactions of his business has given rise to book-keeping. Definition of Book-keeping: 1. Book-keeping is defined as “the science & art of correctly recording in books of accounts all those transactions that result in the transfer of money or money’s worth” 2. Book-keeping is the art & science of recording business transactions in appropriate books of accounts in accordance with the principles of accountancy for the purpose of ascertaining the profit or loss & the financial position of the business.

Essential aspects of Book-keeping: 1. Book-keeping is the recording of only business transactions (i.e., only those activities of a business which results in transfer of money or money’s worth between the business & others dealing with the business. 2. It is the recording of business transactions in the books of accounts in a systematic manner according to the principles or rules of accountancy. 3. The recording of business transactions in the books of accounts is intended to ensure that information of the business, particularly about the profit & financial position of the business is readily available.

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Is Book-keeping an Art or a Science: An art generally refers to action or actual doing. Book-keeping involves actual recording of business transactions in accounts books. So book-keeping is an art. A science usually refers to any subject which has a set of accepted principles or rules for application in practice. Book-keeping has a set of accepted rules or principles for application, while recording the business transactions. So Book-keeping is also a science. So, we can rightly conclude that book-keeping is an art as well as a science. Objects of Book-keeping: 1. To have a permanent record of all the transactions of a business for future reference. 2. To ascertain the net profit or the net loss of the business for any particular year. 3. To know the exact financial position i.e. the assets, the liabilities & the capital in the business as on a particular date. Hence book-keeping records are called the eyes of a business. 4. Claims against a business by its creditors, & claims by the business against its debtors can be easily established & proved in a court of law by producing the book-keeping records as evidence. 5. To minimize errors & frauds by facilitating their quick detection. 6. To have valuable information for legal & tax purpose. 7. To know the progress of the business from year to year. Limitations/ Drawbacks of Book-keeping: 1. In Book-keeping only monetary transactions (i.e. transaction which can be measured in terms of money) are recorded & non monetary transactions are not recorded. Ex: death of a key employee. 2. Book-keeping records do not give the exact information. They give only approximate information. This is because, in Book-keeping, sometimes estimates are used, & the estimates depend on personal judgement. Ex: depreciation. 3. Final accounts prepared & presented under Book-keeping do not provide timely information to management for taking corrective action. This is because the final accounts are prepared only at the end of the accounting year. Definition & Meaning of Accounting: Accounting is the recording of business transactions in account books i.e. either in a single journal or in many subsidiary books, classifying the transactions recorded in the journal or the subsidiary books into appropriate heads or accounts in the ledger, summarizing the effects of the transactions classified in the ledger on the profit & the financial position of the business (i.e., the preparation & presentation of the financial statement like Profit & loss account & balance sheet), & the analysis & interpretation of the financial statements for the purpose of drawing conclusions about the profitability & the financial position of the business. In short, accounting is the recording, classifying & summarizing of business transactions & interpreting the results thereof. -2-

Essential aspects of Accounting: 1. Recording: It refers to recording (i.e., entering) of business transactions as & when they occur, either in a single book called the journal or general journal or in several books called the subsidiary books or special journals. 2. Classifying: It refers to grouping of transactions or entries of like nature into appropriate heads by posting or transferring the entries from the journal or subsidiary books to the appropriate accounts in the ledger. In short, it means the preparation of the necessary ledger accounts. 3. Summarizing: It means the preparation of the classified data in the ledger accounts through financial statement like Profit & loss account & the balance sheet at the end of the accounting year. 4. Analysis & Interpretation: It means the drawing of conclusions from the data found in the financial statement about the profitability & the financial position of the business. Difference between Book-keeping & Accounting: Book-Keeping 1. Book-keeping denotes the mere recording of business transactions in appropriate account books

Accounting 1. Accounting denotes the recording of business transactions in proper books of accounts as well as the preparation & analysis & interpretation of financial statements. So the scope of accounting is much wider than that of book-keeping. 2. The work of Book-keeping is of 2. The work of accounting is of routine nature, & so it does not complicated nature, & so it requires require any special knowledge & skill. special knowledge & skill 3. Book-keeping is concerned with the 3. Accounting lays down even the actual recording of business principles or rules to be followed in transactions. the recording of the business transactions. So we can say that while accountancy professes (i.e., lays down the principles) book-keeping practices. 4. Accounting Begins where Book-keeping ends. Branches of Accounting:

Financial Accounting

Cost accounting

Management Accounting

In order to satisfy the needs of different groups of people interested in the accounting information, different branches of accounting has been evolved / developed. They are -3-

1. Financial Accounting: It is concerned with the recording of business transactions in a set of books & the periodical presentation of the financial data recorded in the books of accounts, through financial statement like the profit & loss account & the Balance sheet to outsiders like shareholders, creditors, employees etc. 2. Cost Accounting: It is the special accounting mechanism for cost finding i.e. ascertainment of costs of the products or services, cost control, ascertainment of profitability of activities carried out or planned, & reporting / presentation of cost data to the management for decision making. 3. Management Accounting: It is the technique of analysis & interpretation & presentation of facts, results & information revealed by financial accounting, cost accounting & other books & records kept by the business for the benefit of persons who are in charge of managing the business. Meaning of Accountant: An accountant is an officer who is responsible for the introduction, development & efficient working of the accounting system in the organization. Role of an Accountant in a business organization. He performs a number of functions in a business organization. 1. Traditional Function: He collects financial information about the business & presents the same to the owners of the business at the end of the accounting period. 2. Finance Function: He ensures that the funds required for the business are obtained at the lowest cost, & they yield the highest return on their investment. 3. Planning Function: His planning covers investment on capital projects, budgeting of expenses, maximization of profits etc. 4. Control Function: He coordinates the activities of various departments & individual. 5. Other Function: a. He determines the tax policies. b. He supervises & coordinates the preparation of various report required to be submitted to the government. c. He carries out continuous appraisal of government policies, economic conditions & social forces & interprets their effects on the business. d. He ensures the physical protection of the assets of the business through adequate internal control & proper insurance coverage.

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Role of an Accountant in Society: 1. He has to educate the different section of the society, even petty traders the importance of maintaining accounts for their activities. 2. He has to educate the public the importance of complying with the tax laws & paying taxes regularly & in time. 3. He can advice the people about tax planning & avoidance of tax. However, he should not be party to evasion of tax by the public. 4. He can even advise the people about the importance of saving & investment. Accounting Concepts & Conventions: Principles of Accounting: Accounting is the language used for communicating financial information to all those who are interested in knowing them. As such, the language of business viz., the accounting should be clear to the persons to whom the communication is made. To make the language of business or accounting clear, to the different groups of persons, a number of rules have been agreed upon & followed by accountants in the writing up of accounts & in the presentation of financial statements. The general rules adopted in accounting are called accounting Principles. Division of Accounting Principles:

Accounting Concepts

Accounting Conventions A. Accounting Concepts: 1. Money measurement concept 2.Separate entity concept 3. Going concern concept 4. Cost concept 5. Dual-aspect concept 6. Accounting period concept 7. Objective evidence concept 8. Matching concept 9. Revenue recognition concept 10. Accrual concept 11. Legal aspect concept

Accounting concepts, generally mean the assumptions upon which accounting is based. They have been developed by accountants to make accounting convey the same meaning to all people as far as practicable. Accounting conventions refers to customs, traditions usages or practices followed by accountant as a guide in the preparation of financial statements. They are adopted to make the financial statements clear & meaningful. -5-

1. Money Measurement Concept or Common Denominator Concept: The money measurement concept means that, in accounting, a record is made only of those transactions or events which can be expressed in terms of money. Non monetary events (i.e. events which cannot be expressed in terms of money) like the retirement of the Managing Director of the concern, the good quality of products produced by the concern etc., are not recorded, though they are also material events, as they cannot be measured & expressed in terms of money. The money measurement concept has one great advantage. It helps a concern to express items of diverse nature, such as bank balance, stock in trade, furniture, machinery, buildings & so on, in terms of a common denominator viz., money & add them up for the purpose of knowing the total worth of assets at any particular time. But for this concept, adding up the diverse items which exist in different forms will not be possible. However, the money measurement concept has one serious limitation. As only monetary transactions are recorded in account books & no record is kept of nonmonetary events, accounting records do not give a complete picture of all the happenings in a concern. 2. Business Entity Concept or Separate Entity Concept: In accounting, every business undertaking, whether it is a sole-trading concern or a partnership firm or a joint stock company, is considered as a distinct entity from the persons who own it. As the business & the proprietors, who own the business are regarded as two separate entities, the transactions of the business are distinguished from those of the proprietors & in the books of the business, accounts are kept only for the transactions of the business, and not for those of the proprietors. This concept is useful in keeping the affairs of the business quite separate from the private affairs of the proprietor of the business. It is on account of this concept that the capital invested by the proprietor of the business is regarded as money borrowed by the business from the proprietor, and so, is shown as a liability of the business in the balance sheet of the business. Again, it is on account of this concept the drawing of the proprietor are regarded as amounts due from the proprietor to the business, & so are deducted from his capital on the liabilities side of the balance sheet. 3. Going –Concern Concept or Concept of Continuity: In accounting, an enterprise is considered as a going concern (i.e., a concern that will continue to operate for a fairly long time), & it is from this point of view, its transactions are recorded in its books.

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The significance of this concept is as follows: 1. It makes a distinction between revenue expenditures & capital expenditures possible & meaningful. 2. It is because of this concept that the fixed assets are valued for the purpose of balance sheet at their cost prices & their saleable values or market values are not taken into account. 3. It is because of this concept that the working life of the fixed assets is taken into consideration, while estimating the depreciation to be provided on the fixed assets. 4. It is because of this concept the outstanding expenses, outstanding incomes, prepaid expenses & pre-received income are taken into account, while preparing the final accounts. 4. Cost Concept: According to this concept, an asset acquired by a concern is recorded in the books of accounts at cost (i.e. at the price actually paid for acquiring the asset). It should be noted that the cost concept is of special significance only for fixed assets. This is because it is only the fixed assets that are shown in the balance sheet at cost less depreciation, if any. Current assets are not affected by this concept. That is why current assets are shown in the balance sheet at cost or market price; whichever is lower, though they are acquired at cost. If a concern has not paid anything for an item, then that item is, usually, not recorded in the books. It is for this reason that goodwill built by a business is usually, not recorded in its books as an asset. If a concern has paid something for goodwill on the acquisition of the business from another concern, then, goodwill will appear in its books at the cost Price.

1. 2. 3. 4.

Recording of an asset in the books of a business at its cost price is justified on many grounds. Cost price is the actual price that is agreed upon by both the parties to a contract so, there is some objectivity. This practice contributes to true accounting records. The cost concept prevents a concern from giving arbitrary value to an asset. The cost price of an asset is stable, while the market price of an asset is variable. 5. Dual Aspect Concept or Accounting Equation Concept: Every business transaction always results in receiving of some benefit of some value & giving of some other benefit of equal values. Thus every business transaction involves dual or double aspects of equal value. Each transaction will always result in equality of assets & liabilities & at any point of time, the total assets of the concern will be equal to its total liabilities plus the proprietor’s capital.

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Assets = Liabilities + Capital Assets - Liabilities = Capital Assets – Capital= Liabilities Liabilities –Assets = Deficiency of capital On the basis of the above accounting equation, the capital of the proprietor can be calculated at various points of time. The capital of the proprietor calculated at two different points of time (viz., at the beginning of the accounting year & at the end of accounting year) can be compared & the profit or loss of the business during the accounting year) can be easily ascertained. If the proprietor’s capital at the end of the accounting year is more than his capital at the beginning of the accounting year, the difference can be taken as the profit for the year. On the other hand, if the proprietor’s capital at the end of the accounting year is less than his capital at the beginning of the accounting year, the difference can be taken as the loss for the year. 6. Accounting Period Concept: The accounting period concept comes from the going–concern concept. According to going-concern concept, a business is likely to continue for an indefinitely long period of time. As such, financial results of the business operations (i.e., the profit or loss and the financial position of the business) can be ascertained only after the liquidation of the business. It is true that the financial results ascertained on liquidation of the business are accurate. But the ascertainment of the profit or loss and the financial position of a business only on its liquidation will not serve any useful purpose. It will not be helpful to the business in taking corrective steps at the appropriate time. Further, Income Tax Law requires business undertaking to calculate their profits yearly. Above all, for the purpose of reporting to outsiders like creditors, profits are required to be calculated & financial position is required to be ascertained yearly. So for measuring the financial results of the business the working life of the business is spilt into convenient period of time. Such a period of time is called accounting period. The length of the accounting period depends on the nature of the business. But, usually, one year is regarded as the ideal accounting period. In fact one year accounting period is compulsory under the Companies Act and the Taxation Law. The accounting year may be the English calendar year (i.e., from 1st January to 31st December of the year) or the Financial year (i.e., from 1st April of the year to 31st March of the next year) 7. Objective Evidence Concept: This concept means all the accounting entries should be evidenced and supported by business documents, such as invoices, vouchers, etc. It is only when the accounting entries are supported by objectively determined evidences, which are subject to verification by auditors, the accounting records will be accepted by various groups of people interested in accounting information with confidence. -8-

8. Matching Concept or Periodical Matching Concept: Every businessman invests money in the business with the main objective of earning profit. So naturally, he would like to know the amount of profit earned from the business. Further, information about the profit made by the business is necessary for Income Tax purposes. Again in the case of joint stock company, information about profit is necessary for dividend purposes. Above all, information about profit is useful to the management for planning for the future. Profit is the result of two factors viz., revenues and expenses & losses. The revenues increase the profit, & the expenses & losses decrease the profit. Thus, the net profit or loss of a business is determined by matching the expenses & losses with the revenues. 9. Realization Concept or Revenue Recognition Concept: According to the realization concept, revenue is recognized or is considered as being earned on the date on which it is realised. Revenue is considered as being realised not when goods are manufactured or order is received or contract is signed, but on the date on which goods or services are transferred to the customer & the customer becomes legally liable to pay for them. 10. Accrual Concept: While the realization concept is mainly concerned with the recognition of revenues, the accrual concept is concerned with recognition of both revenues & expenses. The accrual concept suggests that, when a transaction has been entered into, its consequences will certainly follow. So, all the transactions must be brought into record, whether they are settled in cash or not. That means if revenue is earned, but no payment is received the same should be recorded as revenue. Similarly if an expense is incurred, but no payment is made the same should be recorded as an expense. This concept also means that if there is a net increase in the owner’s capital during any year without any additional capital introduced by the proprietor, the net increase in the capital is the net profit for the year, and if there is a net decrease in the owner’s capital in any year without any withdrawals by the proprietor from business, the net decrease in the capital is the net loss for that year. 11. Legal Aspect Concept: This concept means that the accounting records & books should reflect the legal position. For ex: if goods are sold by a concern on approval basis, in accounting the customers to whom goods are sold on approval basis should not be shown as debtors unless the goods are approved by them. This concept also means that the accounting records & statements should conform to legal requirements. That is the accounting records should be kept & the statements should be prepared in the manner provided by law i.e., the relevant acts. -9-

B. Accounting Conventions: 1. Convention of Materiality 2. Convention of Conservatism 3. Convention of Consistency 4. Convention of Full Disclosure 1. Convention of Materiality: This convention means that in accounting a detailed record is made only of those business transactions which are material (i.e., important). No detailed record is made of transactions which are trivial (i.e., insignificant) as the work of recording the minute details of such transactions is not justified by the usefulness of the results. In the case of such trivial transactions, only a board view is taken. For Ex: A pencil purchased & supplied to the office is no doubt, an asset for the concern. Everyday when someone in the office writes the pencil, a portion of the pencil is used up, & as such, the value of the pencil decreases. Theoretically, it is possible to ascertain daily the part of the pencil that is used up & the part that remains. But the cost of such an effort will be very high. So, in accounting, a simpler, though less exact treatment is given to the pencil. The pencil is taken as used up at the time it is purchased or at the time it is issued to the office. 2. Convention of Conservatism: It means that, in the accounting records and the financial statements of a business, all the prospective losses, risks & uncertainties should be taken note of and provided for, but prospective profits should be ignored. In short, “provide for all possible losses, but anticipate no profits” is the implication of this convention. It is on account of this convention that provision for doubtful debts, provision for fluctuations in the prices of investments, etc., are made. Again, it is because of this convention that stock in trade is valued at cost price or market price whichever is lower, and intangible assets like goodwill are written off. The significance of this convention is that the financial statements should indicate the actual position. It should neither show a rosy or better picture by window dressing nor a worse picture by creating secret reserves. 3. Convention of Consistency: It signifies that the accounting practices & methods should remain consistent (i.e., unchanged) from one accounting year to another. For ex: when once a particular method of depreciation is adopted for a particular fixed asset, the same method should be followed for that asset year after year. The idea behind this convention is that, unless the same accounting practices and methods are followed from year to year, comparison of the accounting figures of one year with those of another year would be difficult, and consequently, drawing of conclusions about the progress of the concern over a number of years becomes difficult. - 10 -

This convention does not mean that the same method of valuation should be followed for both the current assets & fixed assets. What it really means is that, whatever accounting practices is followed for a particular asset, the same practice should be followed for that asset from year to year. Another point to be noted is that this convention does not mean that the accounting practices & methods once adopted should not be changed. The accounting practices & methods can be changed, when needed. But any change made in the accounting practices & methods should be clearly disclosed & adequately explained. 4. Convention of Full Disclosure: The convention of full disclosure means that the material facts must be disclosed in the financial statements. For instance, as regards the investments not only the various securities held by a concern should be disclosed, but also the mode of their valuation should be stated. In the case of sundry debtors, not only the total amount of sundry debtors should be disclosed, but also the amount of good & secured debtors, the amount of good, but unsecured debtors and the amount of doubtful debts should be mentioned. In the case of fixed assets, their cost prices and the depreciation written off to date should be disclosed. Similarly, in the Profit & loss account, all the expenses & incomes should be clearly stated. The idea behind this convention is that the financial statements are essentially meant for external users. It is on the basis of the information conveyed by the financial statements that the external users make decisions. As such, the financial statements should disclose as much details as possible. The convention of full disclosure has been given recognition by the Companies Act. To ensure that all material facts are disclosed to the shareholders, the Companies Act has prescribed the form of the financial statements to be presented by companies to their shareholders.

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Systems of Book-keeping:

Single Entry System

Double Entry System

1. Single Entry System of Book-keeping : Single entry system of book-keeping refers to any system of book-keeping which is not a complete double entry system. Under this system for some transactions both the aspects are recorded, for a few transactions, none of the aspects is recorded, and for most of the transactions only one aspect is recorded. As only one aspect is recorded for most of the transactions, this system is called single entry system. Main features of Single Entry System: Under this system, no hard & fast rules are observed for recording business transactions 1. For transactions involving personal accounts of debtors & creditors & cash account, generally, both the aspects are recorded. For instance, cash received from a debtor is recorded in cash account as well as in debtor’s account. Similarly, cash paid to a creditor is recorded in cash account and in creditor’s account. For most of the transactions, such as expenses paid, incomes received, goods purchased on credit and goods sold on credit, usually, only one aspects is recorded. For instance, rent paid is recorded only in the cash account, but not in the rent account. Similarly, interest received is recorded only in the cash account, but not in the interest account. Likewise goods brought on credit from a supplier, is recorded only in creditor’s account, but not in the purchases account. So also goods sold on credit to a customer is recorded in debtor’s account, but not in the sales account. For a few transactions, such as depreciation charged on fixed assets, stock destroyed by fire, etc., none of the aspects is recorded. For instance, depreciation charged on furniture is recorded neither in the depreciation account nor in the furniture account. 2. The name single entry system is not the correct name for this system, because this system does not imply that only one aspect is recorded for each & every transaction. Therefore in Modern Accountancy Practice, the name “Accounting from Incomplete Records” is used for this system. It should be noted that this system can be adopted by only sole-trading concerns & partnership firms. Joint stock companies cannot adopt this system because of legal restrictions.

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Advantages of the Single Entry Eystem: 1. It is a simple method of recording business transactions, because an elaborate accounting procedure is not involved in this system. 2. It is less costly when compared with the double entry system, because fewer books are maintained under this system. 3. This system is simple & less costly; it is suitable for small concern. Disadvantages of the Single Entry System: 1. As the two aspects of each & every transaction are not recorded it is not possible to prepare a Trial Balance & verify the arithmetical accuracy of the books of accounts. 2. As the arithmetical accuracy of the books of accounts cannot be checked by preparing a Trial Balance, it gives much scope for carelessness, misappropriation & fraud. 3. As the accounts of purchases, sales, returns, expenses & incomes are not kept under this system, it is not possible to prepare a trading & Profit & loss account to find out the correct profits or losses. The profits or losses are ascertained under this system only by comparing the capital at the end of the trading period (i.e., closing capital) with the capital at the beginning of the trading period (i.e., opening capital). The profits or losses ascertained by comparing the closing capital with the opening capital are inaccurate & unreliable. 4. As no real accounts (other than cash account) are maintained under this system, it is not possible to prepare a Balance Sheet for ascertaining the correct financial position of the business. The financial position of the business is ascertained under this system by preparing a statement of affairs. The values of various assets & liabilities shown in the statement of affairs are not proved by accounts, but are calculated mainly by physical inspection & estimate.

2. Double Entry System of Book-keeping: For every business transaction, there are two contracting parties. For each of the contracting parties, a business transaction involves exchange of equal values or benefits, i.e., the receiving of some benefit say something, right or service of some value, and the giving of some other benefit of equal value. For instance, in the case of the cash sale of goods, the seller receives cash of some value & gives goods of an equal value. The buyer, on the other hand, receives goods of some value & gives cash of an equal value. Similarly, in the case of credit sales of goods, the seller gets a claim or right against the buyer for some amount (the right to recover some amount from the buyer later) & gives goods of the same value. The buyer, on the other hand, gets goods of some value and gives to the seller the right to recover from him i.e., purchaser the value of the goods purchased by him. In the case of payment of salary to an employee, the employer receives the services of the employee, and gives cash in return. The employee, on the other hand, receives cash & gives his services. - 13 -

Thus from the point of view of each of the contracting parties, every business transaction has two elements or aspects viz; 1. The receiving of some benefit called the receiving aspects, the incoming aspects or the debit aspects & 2. The giving of some other benefit called the giving aspects, the outgoing aspects or the credit aspects The system of making two or double entries of equal value in two different accounts in opposite directions or sides in the books of each contracting party for recording a transaction completely is called the double entry system of bookkeeping.

Advantages of the Double Entry System: 1. It provides a complete record of all business transactions, as it record both the aspects of each and every transaction. 2. As both the aspects of every transaction are recorded, it is possible to prepare a Trial Balance i.e., a list of balances of ledger accounts & check the arithmetical accuracy of books of accounts. Thus the opportunities for misappropriation & fraud are reduced to the minimum. 3. As nominal accounts are maintained under this system, it is possible to prepare a Profit & loss Account and find out the true net profit or net loss for a particular year. 4. As correct information about assets, liabilities & capital are available under this system, it is possible to prepare a Balance Sheet i.e., a statement of assets, liabilities & owner’s capital & ascertain the true financial position of the business on any particular date.

Disadvantages of the double entry system: 1. The Trial Balance, prepared under this system, to test/check the arithmetical accuracy of the books of accounts does not disclose certain types of errors. 2. This system involves the maintenance of a number of account books, so it is costly. 3. This system requires strict adherence to the principles or the rules of Accountancy. As such a person without adequate knowledge of the Principles of Accountancy cannot maintain accounts under this system

Another way of classifying the systems of Book-keeping:

Cash System

Accrual system

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Hybrid System

1. Cash system of Book-keeping : Cash system of book-keeping is a system of book-keeping under which only actual cash receipts & cash payments are recorded in the books of accounts, and credit transactions are not recorded at all until cash is actually received or paid for them. As only the items of cash received and cash paid are recorded under the system, this system is known as the cash system of book-keeping. Under the cash system of book-keeping, incomes are recognized i.e., considered to be earned, only when they are actually received in cash, and expenses are recognized i.e., considered to be incurred, only when they are actually paid in cash. As such, under the cash system the profit or loss for a particular year is ascertained by considering the items of revenues or incomes actually received in cash during that year (i.e., whether they relate to the current year or the previous year or the next year) & the items of expenses actually paid in cash during that year (i.e., whether they relate to the current year or the previous year or the next year) Cash system of accounting is in use in small business organizations say, small retail stores, where most of the transactions take place in cash, it is also followed by Non Trading Organization like Club, Educational Institutions, Hospitals, Charitable Institutions etc., and certain Professional Management Consultants also keep their accounts on cash basis. 2. Accrual system of Book-keeping : The accrual system or mercantile system of book-keeping is the system of bookkeeping under which entries for the recording of transactions of a business are made the moment the amounts of those transactions become due for receipt or payment. Of course, entries are also made later when cash is actually received or paid for those transactions. It is also known as the mercantile system, as it is followed by most of the mercantile or business houses. Under the accrual system of book-keeping, incomes are recorded and credited to the year to which they relate, whether they have been actually received in cash in that year or not, and expenses are recorded and debited to the year to which they relate, whether they have been actually paid in cash in that year or not. That means, under the accrual system, the profit or loss for a year is ascertained by considering all the items of revenues or incomes relating to that year, whether they are actually received in cash in that year or not, & all the items of expenses relating to that year, whether they are actually paid in cash in that year or not. The accrual system of book-keeping is followed by most of the industrial & commercial undertaking. 3. Mixed system or Hybrid system of Book-keeping : Mixed system or Hybrid system of book-keeping is a system of book-keeping which is a mixture of both the cash system & the accrual system of book-keeping. In other words, it is a system of book-keeping under which some transactions are recorded on cash basis & some transactions are recorded on accrual basis. Generally, incomes are recorded on cash basis, & expenses are recorded on accrual basis. - 15 -

The hybrid system of accounting is followed by some professional persons like doctors, lawyers, chartered accountants etc. This system is not recognized under the Income Tax Act. Yet another way of classifying the Systems of Book-keeping:

Conventional system of book-keeping

Modern system of book-keeping

1. Conventional or Theoretical system of book-keeping : Under the conventional method of book-keeping, all the transactions of a business are first, recorded in a single book of original entry or first entry called journal or general journal as & when they take place. Then the entries in the journal are posted or transferred to the appropriate accounts in the book of second or final entry called the ledger periodically, say weekly, monthly, or quarterly, to know the exact position of each account on any particular date. Finally at the end of the accounting year, from the ledger account balances whose, arithmetical accuracy is checked by a Trial Balance, Final Account i.e., Trading & Profit & loss account & the Balance Sheet are prepared to ascertained the net profit or net loss of the business for the accounting year and the financial position of the business as on the last date of the accounting year. Formerly this was the only system available for any concern, whether big or small, for the recording of business transactions. But it has been found inconvenient and unsuitable for big concerns with a large volume of transactions. So today, this method is followed only by small concerns with relatively less volume of transactions 2. Modern or Practical System of Book-keeping : Under the modern or practical system of book-keeping, the transactions of a business are first recorded in a number of books of original entry called special journal or subsidiary books, as & when they take place. Then, the entries in the various subsidiary books are posted or transferred to the appropriate accounts in the books of final entry called the ledger periodically, say weekly, monthly or quarterly, to know the exact position of each account on any particular date. Finally, at the end of the accounting year, from the ledger account balances, whose arithmetical accuracy is checked by a Trial balance, Final accounts i.e., the Trading & Profit & loss account & Balance Sheet are prepared to ascertain the net profit or loss of the business for the accounting year and the financial position of the business as on the last date of the accounting year. This system of book-keeping is quite popular. It is followed by big concerns which have a large volume of business transactions.

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Explanation of certain terms used in Book-keeping 1. Business Transaction: A Business transaction refers to any activity, dealing or event which has value measurable in terms of money, & which involves transfer of money or money’s worth between the business & any other person, including the proprietor of the business dealing with the business. Capital introduced into the business by the proprietor, amount withdrawn by the proprietor from the business for his domestic or personal use, purchase of goods for cash / credit, sale of goods for cash /credit, purchase of property, payment made to creditors on account, receipt of money from the debtor on account, borrowing of loan, repayment of loan, payment of expenses, loss of cash by theft, receipt of a revenue or income, are examples of business transactions. However sending of a price list, receiving of a price list, placing of an order, receipt of an order, appointment of an employee, dismissal of an employee, etc, cannot be considered as business transactions as they do not involve any transfer of money between the business and others. Similarly if any of the domestic or private expenses of the proprietor are paid out of the funds of the business, or if the sale proceeds of any of the private properties of the proprietor or any of the private incomes of the proprietor are brought into the business, they become business transactions, as they affect the business. Types of business transactions :

Cash transactions

Credit transactions

Barter transactions

Paper transactions

a. Cash transaction: It refers to any business transaction which involves immediate payment or receipt of cash. Ex: purchase or sale of goods for cash.

b. Credit transaction: It refers to a business transaction where the payment or the receipt of money is postponed to a future date. Ex: Purchase or sale of goods on credit. In a cash transaction, personal account may or may not be involved. But in a credit transaction, personal account is definitely involved. c. Barter transaction: It refers to a business transaction where no doubt, receiving of something & giving of something take place simultaneously, but there is no exchange of cash. Ex: Sale of furniture in exchange of purchase of type-writer. - 17 -

d. Non -Cash transaction or paper transaction: It refers to a business transaction where there is no payment or receipt of cash either immediately or at a future date. Example of non-cash or paper transactions are depreciation charged on any fixed asset, bad debts written off, & loss of goods by fire etc. 2. Goods: Goods refer to merchandise, commodities, products, articles or things in which a trader deals. In other words, they refer to commodities or things meant for resale. For example: for a stationery merchant, stationery articles like books, pens, pencils, etc, are his goods. In the context of goods, it may be noted that, if a single account called ‘goods account’ or ‘stock account’ is maintained for all the transactions relating to goods, it will not serve any useful purpose. The goods account will not give separate information of each type of movement of goods, & the balance of goods account will not show the stock in hand. So the goods account is generally divided into six heads, viz., purchase account, sales account, purchase return account, sales returns account, opening stock account & closing stock account. 3. Purchase returns / return outwards / returns to suppliers: Goods returned by a business to its suppliers out of the purchases already made from them are called purchases returns. 4. Sales returns / return inwards / returns from customers: Goods returned to a business by its customers out of the sales already made to them are called Sales returns. 5. Opening Stock: Unsold goods lying in a business at the beginning of a year, are called opening stock. 6. Closing stock: Unsold goods lying in a business at the end of a year, are called closing stock. 7. Assets: It refers to things or rights of value owned by a business and also debts due to the business from others. Assets include: a. Physical or real properties or things called tangible assets like lands, buildings, machinery, vehicles, furniture, stock of goods, cash etc, owned by a business.

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b. Rights in certain things or certain rights having money value called intangible assets, such as goodwill, patent right or patents, trade marks & copy rights possessed by the business. c. Debts due to the business from others, e.g., sundry debtors, bills receivable, prepaid expenses, outstanding incomes, etc. Difference between Goods & Assets: a. Goods refer to things in which a business deals. But assets refer to things with which a business deals. b. Goods are meant for resale, whereas assets are meant for use in the business. c. The scope of the term assets is wider than that of the term goods because the term asset includes goods as well as other things. d. Goods are tangible, whereas the assets may be tangible or intangible. e. Goods are the items of Trading Account. But assets are the items of Balance Sheet. 8. Liabilities: It means debts or amounts due from a business to others either for money borrowed or for goods or assets purchased on credit or for services received on credit. Loan borrowed, bank overdraft, creditors, bills payable, outstanding expenses, etc are examples of liabilities. Difference between Assets & liabilities: a. Assets refer to properties or things owned by a business and amounts due to a business from others. On the other hand, liabilities refer to amounts due from a business to others. b. Assets such as debtors, bills receivable, outstanding incomes, prepaid expenses, loans given to others etc, make others indebted to a business. But all liabilities make a business indebted to others. c. A concern must necessarily have some assets. But a concern may or may not have liabilities. d. If the amount of assets of a business is more than the amount of its liabilities, the financial position or strength of the business will be stronger. On the other hand, if the amount of liabilities of a business is greater than the amount of its assets, the financial position of the business will be weaker. e. Accounts of assets show debit balances. But accounts of liabilities show credit balance. 9. Capital: It refers to the money or money’s worth i.e., goods, furniture, building etc. invested by the proprietor or owner in the business. In other words, it is the money or money’s worth with which the proprietor has started his business. It is the excess of the assets of the business over the liabilities, which belong to the owner. - 19 -

10. Drawings: It refers to cash, goods or any other asset withdrawn by the proprietor from his business for his personal or domestic use. It also includes the personal or domestic expenses of the proprietor paid by the business. 11. Debtors : A debtor is a person who owes money to the business because he has received some benefits from the business. A debtor may be (a) a trade debtor (b) a loan debtor (c) a debtor for an asset sold on credit or (d) a debtor for the service rendered on credit. a. A trade debtor is a person who owes money to the business for the goods supplied to him on credit. b. A loan debtor is a person who owes money to the business for the loan advanced to him. c. A debtor for asset sold is a debtor who owes money to the business for any asset say furniture or machinery sold to him on credit. d. A debtor for service rendered is a debtor who owes money to the business for the services rendered to him on credit e.g., commission due from a person. 12. Debt : The amount due from a debtor to the business is called debt. 13. Book Debt : It is the amount due from the debtor as per the Books of account. 14. Good Debt : It refers to fully recoverable debt. 15. Bad Debt : A debt which is irrecoverable is called a bad debt. 16. Doubtful Debt : A debt whose recovery is doubtful is called a doubtful debt. 17. Creditors : A creditor is a person to whom the business owes money because he has given some benefits to the business. A creditor may be (a) a trade creditor (b) a loan creditor (c) a creditor for an asset purchased on credit or (d) expense creditor.

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a. A trade creditor is a person to whom the business owes money for goods purchased from him on credit b. A loan creditor is a person to whom the business owes money for the loan borrowed from him. c. A creditor for asset purchased is a creditor to whom the business owes money for any asset say, furniture or machinery purchased from him on credit. d. A Expense creditor is a creditor to whom the business owes money for any services received from him on credit. In short, it means an unpaid or outstanding expense e.g., unpaid salaries, unpaid rent, etc. 18. Solvent : A businessman is said to be solvent, when he is able to pay his liabilities in full (i.e., when his assets exceed his liabilities) 19. Insolvent : A businessman is considered to be insolvent when he is not able to pay his liabilities in full (i.e., when his assets are less than his liabilities) 20. Revenue : It refers to the earnings of a business. It includes the sale proceeds of goods, receipts for services rendered and earnings from interest, dividend, rent, commission discount etc 21. Expense : It refers to an expenditure in return for which some benefit is received, and the benefit received is enjoyed and exhausted immediately. Cost of goods sold, salaries, printing & stationery, postage and telegram, rent, interest, commission, etc are examples of expenses. 22. Loss : It refers to money or money’s worth given up without any benefit in return. In other words, it refers to any expenditure in return for which no benefit is received. Loss of goods by fire, loss of cash by theft, damages paid to others, etc are examples of losses. 23. On Account : It means: a. Purchase or sale of goods or an asset on credit. b. Receipt or payment of money in part settlement of an existing account. c. Receipt or payment of money on account of previous dues receivable or payable.

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24. Debit : It means the benefit received by an account. In book-keeping the term debit may be used in three ways viz (a) as a noun, (b) as an adjective & (c) as a verb. When it is used as a noun, it is termed ‘debit’. The term ‘debit’ means an entry on the debit side or left hand side of an account. In other words, it means an amount charged to an account or the value recorded on the debit side of an account for the benefit received by that account. When it is used as an adjective, it is termed ‘debit side’. The term ‘debit side’ means left hand side of an account. When it is used as a Verb, it is termed ‘to debit’. The term ‘to debit’ means to make an entry on the debit side or the left hand side of an account. 25. Credit : It means the benefit given by an account. In book-keeping the term credit may be used in three ways viz (a) as a noun, (b) as an adjective & (c) as a verb. When it is used as a noun, it is termed ‘credit’. The term ‘credit’ means an entry on the credit side or right hand side of an account. In other words, it means an amount of reward given to an account or the value recorded on the credit side of an account for the benefit given by that account. When it is used as an adjective, it is termed ‘credit side’. The term ‘credit side’ means right hand side of an account. When it is used as a Verb, it is termed ‘to credit’. The term ‘to credit’ means to make an entry on the credit side or the right hand side of an account. 26. Difference between debit & credit : a. Debit is given to an account, when that account has received some benefit. But credit is given to an account, when that account has given some benefit. b. Debit results in increase in the amount of an asset, decrease in the amount of a liability, decrease in the amount of capital, increase in the amount of an expense or decrease in the amount of an income. On the other hand, credit results in decrease in the amount of an asset, increase in the amount of a liability, increase in the amount of capital, decrease in the amount of an expense or increase in the amount of an income.

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27. Account : It refers to a summary statement of all the transactions relating to a particular person, an asset, an expense or an income which have taken place during a given period of time, showing their net effect. 28. Books of accounts : It refers to suitably ruled books in which business transactions are recorded. There are two types of books of accounts maintained by a business concern. They are: a. Journal or subsidiary books & b. Ledger. 29. Journal : A Journal is a daily record of business transactions. It is a book of original, prime or first entry in which all the business transactions are first entered in the specified manner in the order of dates. It is maintained under the theoretical system of book-keeping. 30. Subsidiary books: Subsidiary books are sub-division of the journal, where business transactions are first recorded. They are also books of original, prime or first entry. They are maintained under the modern system of book-keeping. 31. Ledger: A ledger is an account book which contains all the accounts of a business in a well arranged form. It is a book of final entry, in the sense that all the transactions are finally recorded in the ledger. It is a principal or main book of accounts because it is from this book that a businessman can obtain the final information relating to his business. 32. Entry : It refers to the record in the journal or in any subsidiary book. However in practice, the record of a transaction made in journal or a ledger is called an entry. 33. Journal Entry: An entry in the journal is called a ‘journal entry’ 34. Journalizing: It refers to the recording of a transaction in the journal (i.e. making an entry in the journal).

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35. Narration: Narration is a brief explanation to a journal entry, given below the journal entry, within brackets. It indicates the purpose of the journal entry (i.e. it explains the reason for debiting one account & crediting another account in the journal entry). 36. Ledger entry: An entry in the ledger is called a ‘ledger entry’. 37. Posting: It is a process of entering in the ledger the information already recorded in the journal or in any of the subsidiary books (i.e. transfer of an entry from the journal or from a subsidiary book to the ledger). It is made periodically i.e. weekly, fortnightly or monthly, depending upon the convenience of the business concern. 38. Voucher: It refers to any written document in support of a financial transaction. It is a proof that a particular transaction has taken place for the value stated in the voucher. 39. Receipt: A receipt is a written acknowledgment of the receipt of money or the acceptance of the delivery of goods given by the receiver of money or goods to the giver of money or goods. 40. Folio: It means the page of a journal or a ledger. 41. Folioing or paging: It means entering the folio (the page) number of the journal in the ledger, and the folio (the page) number of the ledger in the journal is called folioing Folioing serves as cross reference between the journal & the ledger, & helps in tracing the entries from the journal to the ledger or from the ledger to the journal. Further, it helps the clerk engaged in posting to see that no entry in the journal remains unposted. 42. Carried Forward: Carried Forward (abbreviation ‘c/f’) is used at the bottom of a page of journal or ledger to indicate that the total amount at the bottom of that page has been carried forward to the top of the next page.

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43. Brought Forward: Brought Forward (abbreviation ‘b/f’) is used at the top of a page of journal or ledger to indicate that the total amount at the top of that page has been brought forward from the bottom of the previous page. 44. Carried down: Carried Down (abbreviation ‘c/d’) is written in a ledger account at the time of its closing to indicate that the balance in that account has been carried down to the next period. 45. Brought Down: Brought Down (abbreviation ‘b/d’) is written in a ledger account at the time of its opening to indicate that the opening balance in that account has been brought down from the previous period.

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Classification of Accounts or Kinds of Accounts: Why classification of accounts is necessary; Accounts are classified into different kinds for the following reasons. a. The account to be debited & credited in a transaction can be easily determined, if the accounts involved in the transaction are classified into different kinds according to their nature. b. Different accounts provide different kinds of information. For e.g. personal accounts provide information about the amounts due to the creditors or the amounts due from the debtors. Real accounts provide information about the values of the assets held by a business. Nominal accounts provide the information about the amounts of various items of expenses and incomes. So, to get the various kinds of information, accounts are required to be classified into different kinds. Every transaction affects two accounts, & under the double-entry system of book-keeping, every transaction has to be recorded in two accounts. Every business concern deals with other persons, firms or companies. For instance, a concern may buy goods from other parties or sell goods to other parties on credit. Again, it may borrow money from other parties or lend money to other parties. Secondly, a business concern has certain properties or assets, such as goods, cash, furniture, building, etc., in which or with which the business is carried on. Thirdly, it may incur certain expenses, such as salaries, rent, advertisement, stationery, etc. and may earn some incomes, such as commission, interest, etc., in the course of the business. Thus it is clear that every business concern has three classes of transactions viz, a. Transactions relating to persons, b. Transactions relating to assets & c. Transactions relating to expenses & incomes. So, if a concern likes to keep a complete record of all the transactions, it must maintain accounts for all these three classes of transactions. Classification of Accounts or Kinds of Accounts:

Personal account

Impersonal Account

Real Account

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Nominal account

I. Personal Accounts: Personal accounts are accounts of persons with whom a concern carries on business. Personal accounts may be: a. Accounts of Natural or Physical persons: It is an account of human beings e.g. Ram’s Account, Sita Account. b. Accounts of Artificial or Legal persons: It is an Accounts of Artificial or legal persons e.g. accounts of Partnership Firms, Companies, Clubs, Associations, Banks, Government Institution, School & Colleges etc. c. Representative personal Account: Accrued expenses account, outstanding expenses account, prepaid expenses account, accrued income account, outstanding income account & income received in advance account etc. These accounts are called representative personal accounts, as they represent certain persons behind them. For instance, outstanding wages account represents all those workers to whom wages are to be paid. A prepaid rent account represents the account of the landlord to whom rent has been paid in advance. II. Real Accounts: Real accounts are accounts of properties, assets or things owned by a concern & in which or with which the business is carried on. Real accounts may be: a. Accounts of Tangible assets: Assets which have physical existence & which can be seen, touched, felt, bought & sold, such as goods account, cash account, furniture account, vehicles account, machinery account, building account, land account, etc. b. Accounts of Intangible assets: Assets which do not have physical existence & which cannot be seen, touched, but can be bought & sold such as goodwill account, patent right account, copy right account & trade mark account. III. Nominal Accounts: Nominal accounts are accounts of expenses & losses which a concern incurs, & income & gains which a concern earns in the course of its business. These accounts are called nominal accounts, because they do not really exist and they cannot be seen or touched. They are not represented in any type of tangible or visible things or assets. They exist only in names. Nominal accounts may be: a. Revenue account: Revenue accounts or income accounts, i.e. accounts of revenues, incomes, gains or profits, such as commission earned, interest received, discount received. b. Expenses account: Expenses accounts i.e. accounts of expenses or losses, such as salaries paid, rent paid, discount allowed, bad debts, etc. - 27 -

Differences between Personal Account and Real Account: a. Personal accounts may represent assets or liabilities. But real accounts represent assets. b. Personal accounts may show debit balance or credit balance, whereas real accounts generally show debit balance. Differences between Real Account & Nominal Account: a. Real accounts generally show debit balance, whereas nominal accounts may show either debit balance or credit balance. b. At the end of every accounting year, real accounts are balanced, and their balances are carried from one year to another. On the other hand, at the end of every accounting year, nominal accounts are not balanced, but are closed by transfer to Trading Accounts or Profit & loss Account. Differences between Personal Account & Nominal Account: a. Personal accounts may represent assets or liabilities. But nominal accounts are accounts of expenses & losses and income & gains of a business. b. At the end of every accounting year, Personal accounts are carried from one year to another. On the other hand, at the end of every year, nominal accounts are not balanced, but are closed by transfer to Trading Accounts or Profit & loss Account. Rules for Recording Business Transactions under the Double Entry System: The account which receives the benefit of the transaction must be debited, and the account which gives the benefit of the transaction must be credited. This is the golden, fundamental or general rule of the double-entry system of book-keeping. As there are three classes of accounts, the general rules for debit and credit is adjusted in accordance with the types of accounts and three sets of rules are laid down for the three classes of accounts. I. Personal Accounts: A person, who enters into a business transaction with a business either receives some benefit from the business or gives some benefit to the business. Debit the receiver and Credit the giver II. Real Accounts: An asset is a lifeless thing. As such, it cannot receive or give any benefit. It can only come into the business or go out of the business. Debit what comes in and Credit what goes out

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III. Nominal Accounts: Nominal account may be expenses or losses, or incomes & gains for the business. Debit expenses & losses and Credit income & gains Alternative Rules of Debit & credit: American accountant have developed alternative rules of debit and credit for recording various transactions. They have classified the accounts into five categories, and laid down five sets of rules of debit & credit for the five categories of accounts. I. Assets: Debit increase in an asset and Credit decrease in an asset II. Liabilities: Debit decrease in a liability and Credit increase in a liability III. Capital: Debit decrease in capital and Credit increase in capital IV. Income & Gains: Debit decrease in an income and Credit increase in an income V. Expenses & losses: Debit increase in an expense and Credit decrease in an expense

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II. Process of Book-keeping

Conventional / Traditional Method

Modern/Practical Method

Recording all the transactions in a single journal

Recording all the transaction in a number of subsidiary books or special journal

Preparation of ledger accounts

Preparation of ledger accounts

Preparation of Final Accounts

Preparation of Final Accounts

In the process of book-keeping, first, the business transactions are recorded either in single journal or in many subsidiary books or the special journal. Secondly, the entries in the journal are posted or transferred to the appropriate accounts in the ledger, periodically i.e., either weekly, fortnightly, monthly or quarterly, depending upon the convenience of the business to ascertain the exact position of each account on any particular date. Finally, after checking the arithmetical accuracy of the entries in the ledger accounts, through the preparation of a Trial Balance, Final Accounts viz., Trading & Profit & Loss Account & Balance Sheet are prepared at the end of the accounting year. The Trading & Profit & loss Account is prepared to know the net profit or net loss of the business for the accounting year. The Balance Sheet is prepared to know the financial position of the business as on the last day of the accounting year.

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