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ACCOUNTING PROCESS BASES OF ACCOUNTING In general, accounting is known as the recording of financial transactions.

In this process, accountants are required to recognize revenues and costs. Following are three approaches or bases of accounting for recording revenues and costs: 1. Cash Basis 2. Accrual Basis 3. Hybrid Basis CASH BASIS OF ACCOUNTING Cash basis of accounting under which revenues and expenses are recognized and recorded when they are received or paid in cash. It means that revenues will be recorded only when they are received or paid in cash. It means that revenues will be recorded only when they are received in cash. Similarly expenses will be recorded when they are paid in cash. No recording is made if an income or expense is merely due. Under cash basis, income is measured as the excess of cash receipts over cash payments. Merits Cash basis of accounting has following merits. (i) (ii) Demerits. Following are the demerits of cash basis of accounting (i) Cash basis of accounting does not make clear-cut distinction between revenues items. The whole amount paid for the purchase of an asset is set off against the cash receipts in the year in which payment for the asset is made. Similarly, if an asset is sold, it is taken as cash revenue which results in overstatement of profit. Cash basis of accounting is not incompatible with the matching principle because revenues are recognized on the basis of its collection and not on its realization. Further, costs are recognized on the basis of payment and not on its incurrence. Financial statements prepared under cash basis of accounting do not include accrued incomes and outstanding expenses but include unearned incomes and expenses paid in advance. Cash basis of accounting is a very simple approach in the sense that it requires fewer estimate and judgements. Cash basis of accounting is reliable as transactions are recorded only when all phases of transactions are complete.

(ii)

(iii)

(iv)

Under the approach, it is possible to manipulate the profits. By delaying the payment of expenses and by vigorously collecting the amount of credit sales, profits may be inflated. Tax is paid on the difference between the cash receipts and cash payments for the given accounting year and not on the income. On the basis of above mentioned merits and demerits, it may be concluded that cash basis of accounting is not a sound system at it violates generally accepted accounting principles. Financial statements do not show true and fair view of financial position and operational results. However, cash basis of accounting is used by small business and service organisations and professionals like advocates medical practioners, chartered accountants etc. The government accounting is, more or less, similar to cash basis of accounting. However, the use of cash basis of accounting is declining. ACCRUAL BASIS OF ACCOUNTING Accural means recognition of revenues as it is earned and of costs as they are incurred irrespective of the fact when revenues are received and costs are paid. Accrual basis of accounting is the method of recording transactions by which revenues, costs, assets and liabilities are reflected in the accounts in the period in which they accrue. Accrual basis of accounting is based on the revenue-recognition principle and the matching principle. This basis is also known as merchantile system of accounting. Following are the essential features of accrual basis of accounting: (i) Revenue is recognized as it is earned irrespective of whether cash is received or not. (ii) Expenses are matched against revenue earned in relation thereto. (iii) Expenses, which can be clearly identified with the accounting period, are also treated as expenses for the period. Salaries , rent etc. are period costs and are expenses in the relevant period. (iv) Expenses, which are not charged to income, are carried forward and are kept under continuous review. Any expense, that appears to have lost its utility, is written off as a loss. Thus, accrual basis makes a distinction between the receipts of cash and right to receive cash and legal obligation to pay cash and cash payment. The focus of the accrual basis is on realization of revenues, the incurrence of cost and the matching of revenue realized with expired costs. Merits

Accrual basis of accounting is better than cash basis of accounting due to following reasons:

(i) (ii) (iii) (iv)

Accrual basis of accounting makes a clear-cut distinction between capital items. It gives correct picture of operating results and financial position of the business. Accrual basis of accounting ensures the recording of all revenues and expenses even If there are due or paid. Thus, it gives a complete picture of the business. Accrual basis is based on generally accepted accounting principles and is considered more systematic, scientific and reliable. Accrual basis is mandatory in case of companies under the provisions of Companies Act. Distinction between cash Basis and Accrual Basis Basis of Distinction ( i) Legal position Cash Basis It is not recognized under the Companies Act ( ii) Recognition of It is based on collection of incomes and cash and payment of cash expenses ( iii) Capital and It does not distinguish revenue between capital and revenue items. ( iv )Estimates and personal It is simple as it does not judgement require use of estimates and personal judgement Accrual Basis It is recongnised under the Companies Act. It is based on accrual of income and expenses irrespective of the fact whether cash is received or paid. It distinguishes between capital and revenue items It is not simple as it requires use of estimates and personal judgement.

HYBRID BASIS OF ACCOUNTING Hybrid basis of accounting is the mixture of cash and accrual basis. Under hybrid basis of accounting, revenues, and assets are recorded on cash basis where as expenses and liabilities are recorded on accrual basis. Professional people like doctors, lawyers etc., prepared Receipts and Expenditure Account to ascertain their net income during a period. They ignore outstanding incomes but take into account outstanding expenses. The idea is to claim deduction for expenses even if they are unpaid at the end of accounting year. Hybrid basis of accounting is an approved and acceptable system in accordance with pronouncements of the courts.

DOUBLE ENTRY SYSTEM A business transaction involves the exchange of money and goods or services for money or for a right to claim money in future. Each business transaction involves two parties i.e. two aspects. There cannot be a business transaction with one aspect. A transaction is just like a scale which must have equal weight on each of the two sides in order to balance the scale. Following are some examples which emphasize the two aspects of a transaction. (1) If a business firm acquires an asset for cash, it has to give up some other asset say cash or the obligation to pay for it in future. Thus, a giver necessarily implies a receiver and a receiver necessarily implies a giver. (2) If goods of Rs. 30,000 are sold to Jitendra on credit, the business firm gives goods and acquires an obligation to receive payment in future. Thus, goods and Jitendra are two aspects of this transaction. (3) Double entry system recognizes both the aspects of a business transaction. Double entry may be defined as a system o accounting in which both the aspects of a transaction are recorded. Every transaction affects at least two accounts and, thus, requires a debit and a credit simultaneously. For every debit, there must be a corresponding credit and vice-versa. Double entry system is based on Dual Aspect Concept of accounting. ACCOUNTING EQUATION The literal meaning of the word equation is a formula affirming equivalence of two expressions by = (sign of is equal to ). Accounting equation is, thus, an accounting formula expressing equibalance of total assets and equities of an enterprise. Accounting equation shows the equality of assets i.e. resources and liabilities i.e. sources of financing the resources. It may be expressed as under: Assets= Capital + Liabilities Or Assets = Equities At any pint of time, the assets of a business enterprise will be equal to the total claims or equities (internal as well as external). Any claim that can be enforced against the assets of the business entity is termed as equity. There are two types o f equities, namely, creditors equities or liabilities and owner equities comprising capital and retained

earnings i.e. reserve and surplus. Every transaction has two aspects. A transaction is just like a scale to be balanced. There can be no increase an in item without a decrease in other item. If there is change in assets, there will be change in liabilities or owners equity. Development of an accounting equation requires following steps: (1) First of all, variables of an equation affected by a transaction are ascertained. (2) (2)The next step is to find out the effect i.e increase or decrease of variables of an equation. (3) Finally, the effect is put on the concerned side of equation. After recording of every transaction, there will be a new equation.

Illustration 1 Anil had the following transactions. Use accounting equation to show their effect on his assets, liabilities and capital. (a) Commenced business with cash Rs. 50,000 (b) Purchased goods for cash Rs. 20,000 and credit Rs. 30,000 (c) Sold goods for cash Rs. 40,000, costing Rs. 30,000 (d) Rent paid Rs. 500 (e) Rent outstanding Rs. 100 (f) Bought furniture for Rs. 5,000 on credit (g) Bought refrigerator for personal use Rs. 5,000 (h) Purchased building for cash Rs. 20,000 Assets, liabilities and capital are three basic elements of every transaction. The relationship between them remains unchanged. No business transaction can upset the relationship between these terms. Accounting equation approach gives a true picture of financial position of a business concern. Following points reveal the importance of accounting equation. (i) Accounting equation emphasizes that business and its owner are two distinct entities. Accounting equation treats owners claim different from creditors claims. In this way, it gives a better perspective about the business.

(ii) Accounting equation facilitates even a layman to understand and apply accounting rules. Accounting equation makes us to understand the effect of business transactions on the financial position of the business. (iii) Accounting equation provides the details of assets, liabilities and capital and, thus, helps in preparing Balance Sheet. RECORDING OF TRANSACTIONS The recording of transactions starts with identification of transactions. Transactions are the events which result in the change in the value of assets and equity. Transactions may be classified into two groups: (j) External transactions (k) Internal transactions External or exchange transactions involve transactions between an outsider and the business organisation e.g. sale of good, payment of salaries, purchase of raw material etc. Internal transactions occur entirely between the internal wings of an enterprise e.g. supply of raw-material by stores department to the manufacturing department, depreciation on fixed asset etc. Business transactions are recorded on the basis of source documents i.e. voucher. Source documents provide documentary evidence of the transactions. These documents are preserved till the audit of the accounts and tax assessments for the relevant period are completed. ACCOUNT In accounting, all the transactions of like nature pertaining to a particular type of item are recorded at a one place so as to know their cumulative effect at the end of the accounting period. Such a record of individual items is called an account. In other words, recording of all the transactions of the similar nature concerning a particular item at the same place is called an account. An account is a basic unit of recording business transactions. According to Kohler, An account is a normal record of a particular type of transaction expressed in money. An account has two sides: debit a nd credit. Debit is the left side of an account while credit is the right side of an account. The book, in which all accounts are maintained, is known as Ledger. Under traditional approach accounts are grouped under the following heads: (i) Personal Accounts

(ii) Real Accounts (iii) Nominal Accounts Personal Accounts: Personal Accounts are the account which record dealings of business with persons. Personal Accounts may be of three types: 1. Natural Personal Accounts: Natural Personal Accounts are the personal accounts of individuals. For example, Ashoks A/C, Ajays A/C, Nitins A/C. 2. Artificial personal Accounts: Artificial Personal Accounts are the personal accounts of individuals. For example, Bank A/c, Gaurav & Co. A/c, Ahaan Ltd. A/c. 3. Representative Personal Accounts: Representative Personal Accounts are the personal accounts which represent a person or persons. For example, Salaries Outstanding A/c, Interest Received in Advance A/c, Accrued Interest A/c. Salaries Outstanding A/c represents amount due to an employee or employees. Real Accounts: Real Accounts are the accounts which record dealings in or with assets. Real Accounts may be of two types: 1. Tangible Real Accounts: Tangible real accounts are the accounts related to assets having physical existence. Tangible assets can be felt and measured directly. Its examples are Land A/c Building A/c, Cash A/c, and Stock A/c etc. 2. Intangible Real Accounts: Intangible real accounts are the accounts related to assets having no physical existence. Tangible assets can be felt and measured indirectly. Its examples are Goodwill, Trademarks, Patent Rights, and Copyrights. 3. Nominal Accounts. Nominal Accounts are the accounts which record dealings of to profit, gains, expenses and losses. Nominal accounts are in name only. Examples of nominal accounts are as under: 1. Profit and Gain. Discount, received, Interest received, Rent received, Dividends received, commission received. 2. Expenses. Discount allowed, Interest paid, Commission paid, Rent paid, Insurance premium paid. 3. Loss. Loss by fire, Bad Debts, Loss by theft. Under modern approach, accounts are grouped under the following heads: (i) Asset Accounts

(ii) (iii) (iv) (v)

Liabilities Account Capital Account Revenue Account Expenses Account

Note: Technically, both the approaches are same. We shall follow traditional approach throughout the book.

JOURNAL Journal records all daily transactions of a business in the order in which they occur. A journal may 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, journal is called the book of original record. There are five columns in the Journal: 1. Date: The date of the transaction is recorded here. 2. Particulars. The two aspects of the transaction are recorded in this column. It means that details regarding accounts to be debited and credited are written here. 3. L.F. It means Ledger Folio. The transactions entered in the Journal are later on posted to the Ledger. In this column, the page numbers on which the various accounts appear in the ledger are recorded. 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 FOR DEBITING AND CREDITING Following are the rules for recording transactions in Journal. Rule No. 1 for Personal Accounts Debit the receiver and credit the giver. Interpretation. When any transaction involves a personal account, either the person involved will be the receiver or giver. If the person involved is the receiver, he should be debited but in case the person involved in the giver, he should be credited.

Example: Cash received from Ashok In this transaction, Ashoks account is a personal account; therefore, Ashoks account should be credited. Rule No. 2 for Real Accounts Debit what comes in and credit what goes out. Interpretation. Whenever any transaction involves a real account, either the nominal account involved will represent an expense/loss or gain/profit. If the nominal account involved represents expense/loss, it should be debited. On the other hand, if there is gain/profit, it should be credited. Example. Profit on sale of furniture Rs. 2,000. In this transaction, profit on sale of furniture account is a nominal account. Since the profit on sale of furniture is a profit, it should be credited. The process of recording transactions in a journal is termed as journalizing. The first step of journalizing is to ascertain what accounts are affected by the transaction. Name of the account to be debited and name of the account to be credited are written in particulars column. The word To is written before the account to be credited. Date of transaction and the amount are written in their respective column. Sometimes, two or more transactions of a similar nature occur on the same day. Instead of making a separate entry for each such transaction, we combine them and pass a compound journal entry. In compound entry, there will be more than one accounts is debit side or credit side for one or more accounts in its opposite side. In the beginning, the closing balances of the accounts relating to the previous accounting period are recorded in the new set of books. Such an entry is called an opening entry. Opening entry is the first journal entry in an accounting period. Opening entry is given as follows: Sundry Assets A/c To Sundry Liabilities A/c To Capital A/c DISTINCTION BETWEEN GOODS AND ASSETS

Goods are the commodities in which business deals. Goods are purchased for resale. Assets are items of value used by the business in its operations. Assets are not meant for sale. For example, if a cloth merchant purchases cloth, cloth will be goods. But it he purchases some furniture, it will be an asset of the business. Goods Account is classified into five accounts for the purpose of passing the Journal entries. (i) (ii) (iii) (iv) (v) Purchase A/c Purchases Return A/c Sales A/c Sales Return A/c Stock A/c

TRADE DISCOUNT AND CASH DISCOUNT Trade discount is an allowance allowed by a trader to customers when they make purchases in large quantities. Trade discount is deducted from the total amount payable and the rest is recorded in the books of the accounts. For example, goods worth Rs. 5,000 were purchased and a trade discount of 10% was allowed. Journal entry will be passed with Rs. 4,500 (5,000-500). The entry will be Purchases A/c Dr 4,500 4,500

To Suppliers Personal A/c

Cash discount is an allowance allowed to customers when they make the payment within a fixed period. Cash discount is recorded along with the journal entry for payment. For example, in the above case if the trader offers a cash discount of 10%, following journal entry will be passed in the books of supplier. Cash A/c Discount A/c To Customer A/c Distinction between Cash Discount and Trade Discount Dr Dr 4,050 450 4,500

Basis of Distinction Cash Discount ( 1) Purpose Cash discount is allowed To motivate the customers for making the payment in time or before the due date (2) Timing Cash discount is allowed only if the payment is made within a fixed period. It is recorded in the journal It is not deducted from the Invoice

( 3) Recording ( 4) Deduction From invoice IIIustration 2

Trade Discount Trade discount is Allowed by wholesalers to The retailers with the Purpose of selling more Goods. Trade discount is allowed Immediately when the Goods are sold. It is not recorded in the Journal It is deducted from the Invoice.

Journalise the following transactions in the books of Monu: August 1, 2009 Assets: Furniture Rs. 15,000; machinery Rs. 30,000; Stock Rs. 12,000; Cash-in-hand Rs. 1,650; Cash at Bank Rs. 22,350; Amount due from Ramesh & co., Rs. 3,000 and amount due from Shri Krishna Rs. 6,000. Liabilities: Amount due to Jitendra Rs. 13,500; Amount due to Pankaj Rs. 6,000 and due to Archana Rs. 4,500. 2009 August 01 August 03 August 05 August 10 August 12 August 13 August 16 August 17 August 18 Purchased goods from Sanjeev Sold goods for cash Paid to Yogesh by cheque Deposited in bank Sold goods on credit to Dinesh Paid for postage Received cash from Rakesh Paid telephone charges Cash Sales 750 4,500 Rs. 13,500 4,500 16,500 8,400 5,100 300 6,600

August 20 August 22

Purchased Government Securities Purchased goods worth Rs. 4,800 less

1,500

25% trade discount for cash and supplied them To Ramesh & Co., at list price 10% trade discount. August 25 August 27 Cash purchases 4,950

Goods worth Rs. 1,500 were damaged in transit; A claim was made on the railway authorities for the same.

August 28

Shri Krishan is declared insolvent and a dividend of 50 paise A rupee is received from him in full settlement.

August 29

Bought a horse for Rs. 7,800 and a carriage For Rs. 3,600 for delivering goods to customers.

August 30

The horse bought on August 20 dies and carriage was Sold for Rs. 3,000

August 31 August 31

Allowed interest on capital for the month @ 10% p.a. Paid for: Rent 450 180

IIIustration 3 Give Journal entries for the following: (1) (2) (3) (4) (5) (6) (7) Goods, worth Rs. 500 given as charity and Rs. 1000 withdrawn for private use. Received Rs. 975 from Harsh in full settlement of his account for Rs. 1,000. Received a dividend of 60 paise in the rupee Jay who owed us Rs. 1,000. Received cash for a bad debt written off last year Rs. 500. Rent due to landlord Rs. 800 and salaries due to clerks Rs. 5,000 Depreciation on office furniture Rs. 100 Paid Rs. 1,500 as wages on installation of machinery

(8) Sold old machinery of Rs.4,000 to Sudhir for Rs. 5,000 (9) Interest on drawings Rs. 100 (10) Goods destroyed by fire Rs. 5,000.

LEDGER For each and every item or group of items of similar nature, an account is opened in a Separate book called Ledger. Ledger is a set of account. Ledger is a book in which various account of personal, real and nominal nature are opened. Entries are made into the Ledger accounts from the various subsidiary books of journal. A Ledger is the ultimate destination of all transactions, and therefore, is called the Book of Final Entry. Ledger is the book for analytical record. Every account has followings two parts: (i) The left side known as the debit side. (ii) The right side known as the credit side. Each side of the account has following columns: 1. Date. The date of the transaction is recorded here. 2. Particulars. The name of the corresponding account is recorded in this column. On the debit side, the name of the account credited in the journal entry is recorded while on the credit side, the same name of the account debited in the journal entry is recorded. On the debit side, every entry begins with the word to and, on the credit side; every entry begins with the word by. 3. J.F. It means Journal Folio. The transactions entered in the Journal are later on posted to the ledger. In this column, the page number from which an entry is posted in the ledger is recorded. 4. Amount. In this column, the amount is entered. The task of preparing ledger accounts from the Journal is known as posting. Posting is the process of entering in the Ledger the information given in the Journal. Posting is done periodically, say, weekly, fortnightly or monthly as per convenience and requirements of the business. Following are the rules for posting transactions from journal to ledger: (a) The debit side of the journal entry is recorded to the debit side of the account by writing the item of the credit side of the journal entry. Such an account is preceded by the word To.

(b) The credit side of the journal entry is recorded to the credit side of the account by writing the item of the debit side of the journal entry. Such an account is preceded by the word By. After posting journal entries, the difference of the totals of debit and credit sides of an account is ascertained. Such a difference is called Balance of Account. Balancing is the process of writing of the difference between the amount columns of the two sides in the lighter side so that the totals of the two sides of an account become equal. Debit balance means excess of debit total over the credit total and the words By Balance c/d are written on the credit side. On the other hand, credit balance excess of credit total over debit total and the words To Balance c/d are written on the debit side. Then these balances are brought down to the next accounting period on the opposite side. It should be noted that at the end of the accounting period, nominal accounts are not balanced; nominal accounts are closed by transferring them to Trading and Profit and Loss Account. Distinction between Journal and Ledger Following table shows the distinction between journal and Ledger: Basis of Distinction Journal 1. Entry It is the book of original Entry i.e. first entry 2. Record It is the book of Chronological record. 3. Importance It enjoys greater importance As legal evidence. 4. Basis Transaction is the basis of Classification of data Within the journal. 5. Process Ledger It is the book of second Entry. It is the book of analytical Record. It enjoys lesser importance as Legal evidence Account is the basis of Classification of data Within the Ledger.

Process of recording in the Process of recording in the Journal is called journalizing. Ledger is Called Posting.

SUBSIDIARY BOOKS (SUB-DIVISION OF JOURNAL) If a business is small, one journal and one ledger book are sufficient because transactions are few. If a business is big, there are a large number of transactions and recording of all transactions in one journal and one ledger is practically inconvenient. Further, it may cause delay in collecting the information required for decision-making.

It is, therefore, considered desirable to sub-divide journal on the basis of the nature of transactions. A separate book is used for each kind of transactions. These books are known as subsidiary books. The process of splitting the journal into various subsidiary books is known as sub-division of journal. Sub-division of journal means that all the transactions are recorded in special journals, each meant for recording all the transactions of a similar nature. Following are the various special journal or subsidiary books used in a business: (1) (2) (3) (4) (5) (6) (7) Cash Book. Purchase Book. Purchase Returns Book. Sales Book Sale Returns Book Bills Receivable Book Journal Proper.

Advantages of Sub-division of Journal or Subsidiary Books. Following are the advantages of sub-division of journal or special journals or subsidiary books: (i) (ii) Sub-division of journal facilitates division of work among several persons which is must for an organisation having a large number of transactions. Sub-division of ensures availability of information relating to each class of transactions at one place. Thus, one can get desired information quickly and easily. Sub- division of journal facilitates installation of internal check system in the organisation. Sub-division of journal permits division of accounting work among several persons which ensures easy location of error and mistakes in recording transactions. Sub-division of journal brings about economy by ensuring saving of clerical labour and less wastage of stationery because there will be no repetition of journal entries.

(iii) (iv)

(v)

CASH BOOK Cash book is used to record cash receipts and cash payments side by. Cash Book is ruled like a ledger account with the debit and credit sides and the balance represents cash in hand at the end of accounting period. Besides, being a book of original entry,

the cash book also serves as a ledger account. As such, there is no need to open a separate cash account in the ledger. The basic form of cash book remaining the same, additional columns may be provided on either side if necessary. Cash book may be of following types: (a) Simple Cash Book. (b) Two-column Cash Book (c) Three-column Cash Book (d) Multi-column Cash Book (e) Petty Cash Book Simple Cash Book. Simple cash book has only one amount column on each side. This book serves the purpose of Cash Account. It is suited to concerns which have only cash transactions. Two-column Cash Book. Two column Cash Book has two amount columns, one for cash and another for bank on each side. This book serves the purpose of Cash Account as well as Bank Account. It is suited to concerns which have cash transactions and banking transactions. A business concern need not maintain a separate account for the banking transactions. At the end of the accounting period. The cash book reveals not only cash in hand but balance at bank also. There may be a two-column cash book containing cash column and discount column also. On the debit side, all cash receipts and discount allowed to customers are recorded. On the credit side, all cash payments and discount received from creditors are recorded. Three-column Cash Book. Three-column cash book is prepared when there are a large number of cash and banking transactions. This cash book has three amount columns on each side namely cash column, bank column and discount column. Multi-column Cash Book. Sometimes a three columns cash book does not satisfy the needs of business. In this case, cash book on each side is divided into many columns covering regular receipts and regular payments. Now a-days multi-column cash book is becoming more popular as all the regular items of receipts and payments are recorded in the columns. It saves labour in sorting out various items. In two column cash book containing cash and bank columns or in three column cash book, there are some transactions affecting the cash balance and bank balance simultaneously. For example, cash deposited into bank or cash withdrawn from bank

for office purposes. Such transactions are recorded on both the sides, i.e. Dr. and Cr sides of Cash Book. Such entries do not require posting in the Ledger as only cash and bank accounts are affected. These entries are known as Contra Entries. Contra entries are indicated by the word C in L.F. Column. Petty Cash Book. In order to make the task of the cashier easy, a petty cashier is appointed and handed over a small sum of money. He meets out small payments like stationery, postage, conveyance, cartage etc. At the end of the given period, the petty cashier submits the account to the cashier who reimburses him for payments. Under imprest system, petty cashier will have again the same fixed amount in the beginning maintains a petty cash book. Petty cash book is in the columnar from, making a detailed analysis of the petty payments under suitable account heads. Following are the advantages of maintaining a petty cash book: (i) (ii) (iii) Petty cash book saves the time and labour of head cashier as he is not bothered to make petty expenses and record their entries. Petty cash book reduces the Possibility of mistakes. Petty cash book facilitates control over payments which reduces the chances of fraud and wrong payment.

Purchases Books. Purchases Book is used solely for the purpose of recording the credit purchases of goods. Entries in this book are made from invoices. It contains the columns of date, particulars, invoice number ledger folio and amount. Purchases Book is also known as Invoice Book or Purchase Journal. Purchases Returns Book. It is also known as Returns Outward Book. This book is used to record returns of goods purchased. It is prepared with the help of Debit Note. Sales Book. Sales book or Sales Journal or Sales Day Book is meant for recording credit sales of goods. Transactions are recorded with the copy of the invoice sent to the customer. Sales Book records only credit sales. A Sales Book has column for the date, invoice number of party folio, rate amount and details of goods sold. Bills Receivable Book. Bills Receivable Book is used to record the details of bills receivable on which business enterprise will receive the amount from other parties in future. Its columns include the name of debtor, the terms, due date, amount and other details.

Bills Payable Book. It is used to record the particulars of the bills payable accepted by the business enterprise for the purpose of paying at a future date. Its columns include the name of the drawer, the name of the payee the period, due date and other details. Journal Proper. Journal Proper is used to record those transactions which cannot be recorded in any subsidiary books like cash book, sales book purchases book etc. Such transactions occur so infrequently that they do not warrant the setting up of a special book. Opening entries, closing entries, adjustments entries, transfer entries etc., are recorded in Journal Proper. IIIustration 5 Prepare a Two-column Cash Book from the following transactions: March 2009 1. Cash balance 2. Bank balance (Dr) 3. Cash Sales 4. Rent paid by cheque 8. Cash deposited in Bank 10. Wages Paid 10. Rent paid 12. Received cheque from Ram 14. Goods purchased on cash 16. Withdrawn from bank for office use 18. Issued cheque to Hari 20. Withdrawn cash for personal use 22. Received cheque from Shyam and deposited in bank 24. Shyam dishonoured the cheque 26. Furniture purchased and cheque issued 29. Received interest on investments by cheque 30. Paid salaries in cash 3,000 4,800 20,000 14,000 4,000 10,000 10,000 6,000 Rs. 7,000 1,00,000 60,000 24,000 60,000 1,000 1,800 8,000 4,000

BANK RECONCILIATION STATEMENT When a business concern opens a bank account, there is debtor-creditor relationship between business concern and bank. With regard to money deposited, the banker becomes a debtor to the business concern and business concern becomes a creditor to the banker. All banking transactions are recorded by a business concern in Cash Book and by the bank in the Pass Book. In this way, the balance as per Cash Book should be the same as the balance as per Pass Book on a particular day. If the two balances do not agree, it becomes necessary to reconcile them by preparing a statement which is known as Bank Reconciliation statement. Accordingly, a Bank Reconciliation Statement may be defined as a statement which is prepared to reconcile the bank balances as per Cash Book and Pass Book and to ascertain the causes of difference so that necessary followup action may be taken. The main purpose of preparing Bank Reconciliation Statement is to locate the errors and frauds of cash and cheques. Bank Reconciliation Statement brings delays in collection of cheques and non-payment of cheque in light. Bank Reconciliation Statement can be prepared on any day. The first item in the statement generally the balance as per Cash Book. Thereafter the causes of difference between cash book and Pass book balance are recorded. By doing so, we arrive at the balance as per Pass book. Following is the proforma of bank reconciliation statement: Bank Reconciliation Statement as on Bank balance as per Cash Book Add: (1) Cheques issued but not presented (2) Cheque deposited into bank, but not recorded in The Cash Book ( 3) Interest credited by bank but not recorded in the Cash Book (4) Dividend collected by bank but not recorded in the Cash Book. Less: (1) Cheque deposited but not credited by bank (2) Cheque debited in the Cash Book but omitted To be sent to the Bank ( 3) Bank charges debited but not recorded in Rs. .. .. . .

the Cash Book . (4) Insurance premium paid by the bank but not recorded in the Cash Book . (5) Cheque dishonoured but not recorded in the Cash Book. . (6) Bank met a liability but not recorded in the Cash Book. Bank balance as per pass Book.

TRIAL BALANCE After journalizing the transactions and posting the same to proper heads of accounts in the ledger. It becomes necessary to know whether the entries made in the accounts are arithmetically accurate or not. The balances of all ledger accounts are written up in a schedule or statement with a view to test the arithmetical accuracy of the books. Such as statement is known as Trial Balance. Thus, Trial Balance s a list or schedule of balances prepared on a particular date to determine the arithmetical accuracy of accounts. Trial Balance is prepared to achieve following objectives: 1. Trial balance provides a basis to test the arithmetical accuracy of transactions recorded. If the two sides of trial balance do not agree, it means that there are some errors which must be detected and rectified. 2. Trial balance provides a basic summary for the preparation of financial statements and, thereby, helps in ascertaining the profit or loss for a given period and financial position on a given date. Errors disclosed by Trial Balances. Following are the errors which are disclosed by the trial balance: (i) (ii) (iii) (iv) (v) (vi) (vii) Wrong balancing of an account Posting an account on the wrong side. Wrong totaling of the subsidiary books Wrong posting i.e. recording the wrong amount. Omitting to post an amount from a subsidiary book Omitting to post the total of subsidiary books into ledger. Omitting to enter the cash book balance in the trial balance.

(viii) Omitting to record the balance of an account in the trial balance. (ix) Totalling the trial balance wrongly. Errors not disclosed by Trial Balance. Trial Balance is not a conclusive proof of the accuracy of the books of account because there are many errors which remain undetected in spite of agreement of its both the sides. Following are the errors which are not disclosed by the trial balance even its sides agree: (i) (ii) (iii) Errors of Omission Errors of Commission Errors of Principle

Errors of Omission. When transaction has been omitted either wholly or partly in the books of account, errors of omission arises. It may be of two types: complete omission and partial omission. For example, credit purchases of goods in Purchase Book is not recorded at all. It is a case of complete omission. When a credit purchase already entered in Purchases Book is not posted to the credit of creditors account, it is a case of partial omission. Errors of complete omission do not affect the agreement of trial balance. Errors of Commission. When any transaction is incorrectly recorded either wholly or partly, error of commission arises. It may consist of incorrect posting, calculation and balancing. Such error is committed when an item is posted to the credit instead to the debit of an account or vice-versa. For example, a credit purchase of Rs. 675 is entered in the purchases book as Rs. 576 or posting of Rs. 2,000 to the credit of Ranu instead of the credit of Manish. Such error have no effect on the agreement of Trial Balance. Other examples of such errors are sales to Ram recorded as sales to Ramesh and payment from Madan recorded as payment from Mohan. Errors of Principle. Error of principle is committed when a transaction is recorded in a fundamentally incorrect manner. Such error involves an incorrect allocation of expenditure or receipt between capital and revenue. For example, freight paid for bringing a new machinery is posted to freight account and asset purchased is recorded in the purchases book. Other examples of such errors are purchase of furniture recorded in Purchases Book and wages paid for installation of machinery recorded as wages.

Compensating Errors. An error, which is counter-balanced by another error or errors in such a way that it is not disclosed by the trial balance, is compensating error. Compensating errors mutually compensate and do not affect the agreement of two sides of trial balance. For example purchase book and sales book are both undercast by Rs. 1,000. Other example of such errors are undercasting of salaries by Rs. 500 while overcasing of printing by Rs. 300 and of rent by Rs. 200. RECTIFICATION OF ERRORS Rectification of errors means correction of errors by way of rectifying entries. For the purpose of rectification of error, errors may be classified into two parts: One Sided Errors. One sided errors are those which affect only on account. Such errors are found and corrected during the course of the accounting period before the books are closed. Such errors include totaling errors, balancing errors, errors of omission of posting, errors of posting of wrong account and errors of posting on the reverse side of the ledger. Two Sided Errors. Two sided errors are those which affect two or more than two accounts at the same time. Such errors are found and corrected by passing a journal entry. Such errors include error of complete omission, error of commission, error of principle and compensating errors. SUSPENSE ACCOUNT If the two sides of trial balance do not agree, it implies that there are certain one-sided errors in the books of account. If it is not possible to locate the errors, the amount of difference in the trial balance is put in an account known as Suspense Account till such time that errors are located. Thus, Suspense Account is an account in which the amount of difference in the trial balance is put temporarily. If the debit side of trial balance exceeds the credit side, the difference in the trial balance is transferred to the credit side of the Suspense Account and Vice-versa. The rationale behind the opening of a Suspense Account is to avoid delay in the preparation of final accounts (financial statements). However, Suspense Account should be opened by an accountant only when he has failed to locate the errors inspite of his best efforts. It should not be a normal practice because the very existence of Suspense Account creates doubt about the authenticity of the books of accounts. When the errors affecting the Suspense Account are located, they are rectified with the help of Suspense Account. When all the errors affecting the trial balance are located and

rectified, the Suspense Account will automatically stand balanced and closed. If all the errors affected the trial balance have not been rectified. Suspense Account will show certain balance. Debit balance of Suspense Account is shown on the asset side while credit balance of Suspense Account is shown on the liabilities side of the Balance Sheet. Final Accounts of a sole Trader Financial accounting involves recording, classifying and summarizing various business transactions. The end-products of financial accounting are the financial statements. Preparation of financial statements is the last phase of the accounting process. Financial statements may be defined as statements of financial data showing a summary of the accounts of a business enterprise. Financial statements are the major sources financial information of an enterprise. Financial statements are the basis for decision-making by various groups of persons who are interested in the affairs of the enterprise. The primary objective of financial statements assist the various groups in the decisionmaking. Since the financial statements constitute the last phase of financial accounting they are popularly known as Final Accounts. Final accounts or financial statements are reports prepared to present a periodical review of the performance and the financial position of a business enterprise. There are two basic financial statements: (i) (ii) Income Statement or Profit and Loss Account. Balance Sheet.

Income statement or Profit and Loss Account refers to a statement which is prepared to determine the operational performance of the enterprise i.e. revenues earned and expenses incurred for earning that revenue during the accounting period. Balance sheet refers to a statement of financial position of a business enterprise on a certain date generally on the last day of the accounting year. OBJECTIVES OF FINACIAL STATEMENTS Following are the objectives of financial statements. (i) To provide information about economic resources and obligations of a business: Financial statements are prepared to provide adequate, reliable and periodical information about economic resources and obligations of a company to investors and other external parties who have limited authority ability or resources to obtain information.

(ii)

(iii)

(iv)

(v)

To provide information about the earning capacity of the business: Financial statements are to provide useful financial information which can gainfully be utilized to predict, compare and evaluate the companys earning capacity. To provide information about cash flow: Financial statements are to provide information useful to investors and creditors for predicting, comparing and evaluating, potential cash flows in terms of amount, timing and related uncertainties. To judge effectiveness of management: Financial statements supply information useful for judging managements ability to utilise the resources of a business effectively. To report the social activities of a company: Financial Statements provide the summary of activities of the company affecting the society.

LIMITATIONS OF FINANCIAL STATEMENTS Following are the important limitations of financial statements: ( I ) Only Quantitative Information: Financial statements show only that information which can be quantitatively measured i.e. which can be measured in terms of money. Events that cannot be measured in terms of money will not find a place in the financial statements even though it is important for the business. For example, policies of the government have a direct effect on the working of the business but financial statements will not record its impact because it cannot be measured in terms of money. ( ii) Historical in Nature: Financial statements are historical in the nature in the sense that accounting data are summarized only at the end of accounting period. Financial statements throw light on what has happened during a particular period. The impact of future uncertainties i.e. what will happen has no place in financial statements. It does not suggest what should be done to increase the efficiency of the enterprise. (iii) Recording of Actual Costs: Only actual cost figures relating to purchase of materials, property or other assets are recorded in the account books, Accountants ignore the changes in the values of assets which may be absolutely different from the recorded values. Recorded values do not provide correct information about assets. Conflict between Accounting Principles: There is a conflict between different accounting principles. For example, principles of prudence (conservatism) require that stock should be valued on the basis of cost or market price whichever is/less. This principle is in conflict with principle of consistency

(iv)

which requires that either cost of market price basis should of consistently followed. (vi) Personal Judgement: Financial statements are influenced by the personal judgement of the accountant. An accountant uses his personal judgement with regard to the adoption of accounting policies. Due to this, financial statements may not be objective and comparable. (vii) Not Exact: Financial statements may not reflect the realistic position as some of the information are based on estimates which may not be accurate all the times. For example, depreciation is an estimated figure. (viii) Not Suitable for Cost Control: Financial statements fail to provide data for comparison of costs of different periods, jobs, departments, operations etc., and Financial statements disclose only the net result of the collective activities of the business as a whole. Hence, cost control is not possible. CAPITAL AND REVENUE The determination of net income requires the matching of business receipts against the cost of the same period. The emphasis is clearly on the same period. Therefore, an accountant should have clear understanding of revenue items and capital items so that financial statements should disclose correct net income and financial position of the business. It may be noted that revenue items and capital items are included only in Income Statement (Profit and Loss Account) and capital items are included in Balance Sheet. If there is an incorrect classification of items into revenue items and capital items, financial statements will not disclose the true and fair view of the financial position and income of the accounting period. Revenue items include revenue receipts and revenue expenditures which are taken to Revenue Account i.e. Profit and Loss Account. Similarly, capital items include capital receipts and capital expenditures which are taken to Balance Sheet.

CAPITAL EXPENDITURE A capital expenditure is defined as an expenditure which has been incurred for the purpose of long-term advantages for the business. Kohler, in Dictionary for Accountants, has defined capital expenditure as an expenditure intended to benefit future periods. Capital expenditure is incurred either for the acquisition of an assets or for increasing the revenue earning capacity of the business. Following are the examples of capital expenditure.

(1) Expenditure resulting in the acquisition of long-lived (fixed) assets e.g. land, building, machinery, furniture, motor car, trademarks. (2) Expenditure resulting in extension or improvements of fixed assets e.g. amount spent on increasing the seating accommodation in the picture hall. (3) Expenditure in connection with the purchase, receipt of plant, expenses on cartage insurance. (4) Expenditure incurred for acquiring the right to carry on business e.g. purchase of patent rights, copyright, goodwill etc., (5) Expenditure incurred for substituting an exsisting asset by a new asset. REVENUE EXPENDITURE Revenue expenditure is defined as on expenditure which is incurred for day-to-day running of the business and maintenance of capital assets. Kohler, in Dictionary for Accountants, has defined revenue expenditure as an expenditure charged against operation. In other words, revenue expenditure is the expenditure that arises out of and in the course of regular business transactions of a concern. The benefit of revenue expenditure is exhausted in the accounting period. Revenue expenditure does not increase the earning capacity but maintains the earning capacity of the business enterprise. Following are the examples of revenue expenditure: (1) Expenses incurred for the day-to-day running of the business e.g. cost incurred in manufacturing the products, administration expenses, selling expenses. (2) Expenses incurred for the upkeep of fixed assets e.g. cost of repairs and maintenance. (3) Expenses incurred on purchase of stocks of material and goods to the extent they are used up during the year, the remaining amount being treated as asset. (4) Depreciation of fixed tangible assets. (5) Amortization of intangible fixed assets like patent, copyrights, goodwill, trademarks. (6) Interest on loans for the business. (7) Amortization of fictitious assets like formation expenses.

Distinction between Capital and Revenue Expenditure Basis of Capital Expenditure Revenue Expenditure

Distinction (1) Benefit (2) Purpose

(3) Nature

(4) Appearance

(5) Earning Capacity (6) Examples

Its benefit extends to more Than one year. It is incurred for acquisition Of fixed assets or improving Permanent assets for use in the Business. It is normally a nonrecurring item It is shown in the asset side of The Balance Sheet. It increases earning capacity of a business enterprise. Its examples are purchase of machinery, installation of machinery, extension of machinery etc.,

Its benefit extends to a period Within one year. It is incurred for the conduct of Business.

It is normally a recurring item

It is shown in the Profit and Loss Account. It increase earning of a business

Its examples are purchase of rawmaterial, manufacturing expenses, administration expenses.etc.

DEFERRED REVENUE EXPENDITURE The benefit of revenue expenditure is consumed in the year in which such expenditure is incurred. But there are some revenue expenses whose benefit extends over a number of years. Hence, such expenses cannot be transferred to Profit and Loss Account of a particular year and are deferred over a number of years so that deferred revenue expenditure. Deferred revenue expenditure is a type of revenue expenditure which is incurred during the accounting period but is applicable either wholly or in part to future period. The Guidance Note on Terms used Financial Statements issued by the Institute of Chartered Accountants of India has defined the deferred revenue expenditure as an expenditure for which payment has been made or a liability incurred but which is carried forward on the presumption that it will benefit over a subsequent period or periods. Examples of deferred revenue expenditure are as under:

(i) (ii) (iii) (iv) (v) (vi)

Preliminary expenses Brokerage on issue of shares and debentures Discount on issue of shares and debentures Heavy advertisement Research and development expenses Exceptional repairs incurred in shifting the business to more convenient premises.