TEMENOS

BOOK-KEEPING

INTRODUCTION

`Almost everything in business eventually boils down to the money sign’ – is an

apt statement. The main purpose of a business entity is to make profits. Hence, every
business organisation would at least like to know whether it is gaining money or losing
money in its business and how much it is gaining or losing.

In addition to these basic requirements, the business entity would also like to
know more and more about its financial position to enable it to take value based
decisions.

Book keeping or accounting, helps to keep track of financial transactions to know

how well the business is doing, to know what it owns and what it owes (which would
ultimately equate to its financial position) .

If we take the case of a bank for example, its main business is to accept deposits
and lend money. It offers various schemes with different interest rates for differing
maturities for taking deposits or lending. It also offers other allied services like money
transfer, safe deposit, issuing guarantees etc.

In addition to knowing how much of profit or loss it makes, expenses incurred on

interest payment, salaries, administrative expense, income from interest, services
provided, sale of its properties a bank would like to know its financial position like
amounts receivable from customers under various schemes, amounts payable to
customers under various schemes, , cash on hand etc. Some of these information will
also help the bank management to take decisions on which schemes and services it should
pursue and whether it should modify or add products and services. The bank may also
like to compare its performance for the current year with the previous year. This will
help it to fine tune its decisions better.

The banks may also be required to give various types of information to statutory
authorities.

To achieve all these ends, the bank has to maintain records of all its business
transactions systematically in some form or the other. The art of recording business
transactions in a systematic manner is known as Book-Keeping.
 Book-Keeping is said to be a science as well as an art. It is considered to be a
science because the recording of business transactions is based upon a set of well defined
principles, which are being followed throughout, in a uniform manner. It is an art in the
sense, the recording of transactions calls for practical application of human skill in
choosing the correct principle to be followed.

COMMON TERMINOLOGIES

Some of the terms commonly used in book-keeping are explained below:

DEBTOR: A person who owes something is called a debtor

CREDITOR: A person to whom something is owed is called a creditor.

For example, a Bank has lent 1 million US$ to M/s. John Miller & Co. Then, the bank
will treat M/s. John Miller & Co as its debtor.

In the books of account of M/s. John Miller & Co., the bank will be a creditor.

ACCOUNT: An Account is a list of transactions falling under the same

description.

For example, 1000 customers have deposited money with the bank today under its
various schemes and to avail its services. 500 customers have deposited money into their
Savings Account, 100 into their Current Account, 300 have paid loan installments, 80
have purchased demand drafts and 20 have paid locker rents. In addition to the above,
the bank has received cash from other sources also – It has disposed off old Newspapers,
books and periodicals. 2 staff members have refunded their tour advances as their tour
programme has been suddenly cancelled.

Instead of putting the entire money into one head of account called Cash receipts for the
day, the bank would like to credit all these amounts to suitable account heads to represent
the transactions better – like Savings Account, Current Account, Loan Principal Account,
Interest Account, Demand Drafts Issued Account, Commission on DDs issued Account,
Locker rent Account, Books and Periodicals Account and Tour advance Account.

(Accounts are classified as Personal Accounts, Real Accounts and Nominal

Accounts, which are explained in detail later)

TRANSACTION: A transaction is any business activity, which can be explained

in terms of money. It can be interpreted as to what a business receives and what a
business pays.
 DEBIT AND CREDIT: In book-keeping, the receiver of any benefit is debited
and giver of any benefit is credited. To debit an account means to enter a transaction on
the debit side of that account and to credit an account means to enter a transaction on the
credit side of that account.

ASSETS: Broadly called as Properties of the business. The assets of a business

provide the basis for and the infrastructure required for generating income For a bank,
they could be called as those that are owned by the bank like Loan Accounts, Premises,
Furniture etc.

LIABILITIES: Represent amounts due by a business to various persons. For a

bank, the deposits it has collected will be a major liability

CAPITAL: This is the excess of assets over liabilities. This is also shown as a
liability because a business is treated as separate from its owners and the capital denotes
how much the business owes to its owners. It is to be noted that even though the owners
own the business, for the purposes of accounting the owner is treated as a creditor.
 BUSINESS TRANSACTIONS

A transaction is any business activity, which can be explained in terms of money.

It can be interpreted as to what a business receives and what a business pays.

Mr. James Fowler invests 5000 US$ by paying cash with the Bank as Fixed
Deposit for 1 year at an interest rate of 5% per annum.

This is a transaction between Mr. James Fowler and the Bank. Mr. James Fowler
pays 5000 US$ and gets in return the Bank’s Fixed Deposit Receipt. On maturity of the
deal, he can get back his investment with interest when he surrenders the Fixed Deposit
receipt.

The Bank has issued Fixed Deposit Receipt and in consideration receives the
money. Consideration means something in return. A transaction is made up of the
following facts:

1) There must be two parties to the transaction

2) There must be an exchange or transfer of goods or services or money between
parties. One party must be receiving money or money’s worth and the other
party will be paying money or money’s worth.

The business transaction can be classified into two types:

1) Cash transaction
2) Credit transaction

A cash transaction is one where exchange of consideration takes place

simultaneously. A credit transaction is one where exchange of consideration does not
take place simultaneously. One of the parties to the transaction will be settling his
consideration at a later date only.

The bank purchases a computer and pays US$ 9000 immediately. This is a cash
transaction. The Fixed Deposit example stated earlier will be a credit transaction, as the
bank will be settling its consideration after one year.

RECORDING OF TRANSACTIONS:

The recording of a business transaction rotates on key factors called Debit and
Credit.. These terms have been explained already. Each transaction is basically analysed
as to `What the business receives’ and `what the business pays in return’.

What the business receives is taken to the debit side of one account and what the
business pays is taken to the credit side of another account. Thus a two fold effect is
created for each transaction.
DOUBLE ENTRY BOOK-KEEPING:

The method of recording each transaction with due emphasis on its two fold
aspect is known as Double Entry Book-keeping. For each debit entry made, a credit
entry is also made thus creating a balanced effect to each transaction. Each and every
transaction’s monetary effect is immediately recorded, whether it is cash or credit,
thereby ensuring that transactions are recorded then and there without any postponement
of writing them. This system enables us to understand the position of all transactions
pertaining to business.

The bank has the following business transactions and we are asked to write its
books of accounts:

1) Bank buys furniture for its new office for US$ 50,000

Analysis of two fold effect of the transaction

What the bank receives What the bank pays in return

Furniture worth US$ 50,000 received Cash US$ 50,000 paid

Furniture account is debited with US$ 50,000

Cash account is credited with US$ 50,000

2) Bank accepts fixed deposit of US $ 5,000 from David Smith.

What the bank receives What the bank pays in return

Cash US $ 5,000 received
While the bank gives nothing in return, it
has an obligation to pay the deposit on
maturity. Till such time, the depositor is a
creditor and to denote this, the Bank also
issues a Fixed Deposit Receipt.

Cash account is debited with US $ 5,000

Fixed Deposit account of David Smith is credited with US $ 5,000

3) Bank gives a loan of US $ 15,000 to David Green. It credits the proceeds to his
current account.

What the bank receives What the bank pays in return

Bank receives nothing. But David Green The bank pays US $ 15,000 to the current
has an obligation to pay the loan amount on account of David Green.
due date to the Bank. Till such time, the
Borrower is a debtor to the Bank. To
denote this, the Bank has executed loan
documents (contract) with David Green.
 Loan account of David Green is debited with US $ 15,000
Current account of David Green is credited with US $ 15,000

4) John Fowler pays by cash US$7,700 in full settlement of his loan of US$7,000 on the
due date of the loan.

What the bank receives What the bank pays in return

Bank receives cash of US$ 7,700.
The bank pays nothing. But the obligation
of John Fowler to the bank is now fully
extinguished as he pays US$ 7,000 towards
the original amount of loan and US$ 700
towards interest thereon. Hence the bank
returns back the loan documents duly
cancelled. He is no more a debtor to the
bank.

Cash account is debited with US$ 7,700.

Loan account is credited with US$ 7,000
Interest account is credited with US$ 700.

5) John Smith withdraws cash of US$ 1,000 from his Savings Account

What the bank receives What the bank pays in return

Bank does not receive anything. But its The bank pays cash US $ 1,000
obligation to pay to John Smith, a creditor,
is now reduced by US $ 1,000. Hence
what it owes to John Smith’s Savings
Account is now reduced.

Savings account of John Smith is debited with US$ 1,000

Cash account is credited with US $ 1,000.

6) Bank collects Share capital of US $ 100,000 from 100 shareholders

What the bank receives What the bank pays in return

Bank receives cash. Bank pays in return nothing but it has an
obligation to pay the 100 shareholders US$
100,000. Hence the 100 shareholders are
treated as creditors and share certificates
are issued to them

Cash account is debited with US$ 100,000.

The share capital account of the 100 share holders is credited with US$
100,000
 RECORDING TRANSACTIONS

We have earlier that an Account is list of transactions falling under the same
description.

Now let us look at the transactions that took place in the Bank between April 1
and April 3, 2002:

Date Debit/Credit Particulars of Transactions Amount

(US$)
1.4.2002 Debit – Dr Furniture purchased 50,000
Credit - Cr Cash paid 50,000
1.4.2002 Dr Cash received 5,000
Cr Fixed deposit accepted 5,000
2.4.2002 Dr Loan disbursed 15,000
Cr Current account credited 15,000
2.4.2002 Dr Cash received 7,700
Cr Loan repaid 7,000
Cr Interest received on loan repayment 700
3.4.2002 Dr Savings account withdrawal 1,000
Cr Cash paid 1,000
3.4.2002 Dr Cash received 100,000
Cr Share capital collected 100,000
TOTAL 357,400

The same set of transactions can be shown better in a JOURNAL. When the above
transactions are journalized, they look as under:

Date Particulars of Transactions Dr US $ Cr. US $

1.4.2002 Furniture Account Dr 50,000
To Cash Account 50,000
(being cash purchase of furniture)
1.4.2002 Cash Account Dr 5,000
To Fixed deposit Account 5,000
(being Fixed Deposits accepted from David Smith)
2.4.2002 Loan Account Dr 15,000
To Current account 15,000
(being Loan sanctioned to David Green and
disbursed thro his Current Account)
2.4.2002 Cash Account Dr 7,700
To Loan Account 7,000
To Interest received on loan repayment 700
(being Cash received from John Fowler towards his
loan account and interest due thereon)
3.4.2002 Savings account Dr 1,000
To Cash Account 1,000
(being cash withdrawal from Savings account of
John Smith)
3.4.2002 Cash Account Dr 100,000
To Share capital Account 100,000
(being share capital collected from 100 shareholders)
TOTAL 178,700 178,700

The effect of these transactions on the position of these accounts during the period
1.4.2002 to 3.4.2002 will be as below:

As on 1.4.2002 As on 2.4.2002 As on 3.4.2002

Furniture - 50,000 - 50,000 - 50,000
Cash + 45,000 + 37,300 - 61,700
Fixed Deposit + 5,000 + 5,000 + 5,000
Loan Nil - 8,000 - 8,000
Current Account Nil + 15,000 + 15,000
Interest Account Nil + 700 + 700
Savings Account Nil Nil - 1,000
Share Capital Nil Nil + 100,000

It may be observed that the effect is cumulative for any account. From the start of
business, the transactions keep on producing a cumulative effect on the respective
accounts. Hence, for a given period, there will be an opening balance in the account and
at the end of the period, after adding or reducing the effect of all the transactions, there
will be a closing balance on that account.

For the above transactions, this can be seen below:

Opening Cumulative Closing Opening

balance as on effect of balance as on balance as on
1.4.2002 transactions 3.4.2002 4.4.2002
during 1.4.2002
to 3.4.2002
Furniture - 100,000 - 50,000 - 150,000 - 150,000
Cash - 100,000 - 61,700 - 161,700 - 161,700
Fixed Deposit + 50,000 + 5,000 + 55,000 + 55,000
Loan - 50,000 - 8,000 - 58,000 - 58,000
Current Account + 100,000 + 15,000 + 115,000 + 115,000
Interest Account Nil + 700 + 700 + 700
Savings Account + 50,000 - 1,000 + 49,000 + 49,000
Share Capital + 50,000 + 100,000 + 150,000 + 150,000
 CLASSIFICATION OF ACCOUNTS

The accounts are classified into three groups :

1. Personal Accounts
2. Real Accounts
3. Nominal Accounts

PERSONAL ACCOUNTS:
As the name implies, these accounts relate to amounts given to / received from
persons (individuals) / firms & Companies. ( the latter are treated as persons in the eyes
of law or simply stated they are ‘legal entities’)

In a Bank, the various deposit and loan accounts are maintained for its customers
who are persons / firms / Companies. Hence, Savings Accounts, Current Accounts, Fixed
Deposit accounts and Share Capital in the above example are Personal Accounts

REAL ACCOUNTS:
These are accounts relating to tangible items. Tangible means that which can be
physically seen or felt.

Cash and furniture mentioned in the above example are Real Accounts

NOMINAL ACCOUNTS:

These relate to items, which are not tangible in nature. These accounts exist in
name only

Interest Account mentioned in the above example is a Nominal Account. Other

examples are salaries, rent, telephone charges, taxes, commissions received etc. As can
be seen, these relate to Income and Expenses.

3 FUNDAMENTAL RULES FOR ACCOUNTING:

We had seen earlier how accounting entries are passed when looked from the angle of
what the bank receives and what the bank pays in return. The overall rules for ‘Debit’
and ‘Credit’ can be restated as under:

Personal accounts: Debit the Receiver and Credit the Giver

Real accounts : Debit what comes in and Credit what goes out

Nominal accounts: Debit expenses/losses and Credit incomes/gains

 The key to understanding and applying the rules lies in being able to correctly
identify the nature of the ‘accounts ‘ involved in a transaction i.e. whether they are
‘Personal’ accounts or ‘Real’ accounts or ‘Nominal’ accounts.

Now, let us revisit the 6 transactions done earlier and see the validity of these
rules.

1) Bank buys furniture for its new office for US$ 50,000

Accounting entries passed

Furniture account debited with US$ 50,000

Cash account credited with US$ 50,000

Furniture account and Cash account are Real accounts and the cardinal Rule for Real
accounts is Debit what comes in and Credit what goes out. In this case, furniture has
come in and cash has gone out. Hence furniture account is debited and cash account is
credited.

2) Bank accepts fixed deposit of US $ 5,000 from David Smith.

Accounting entries passed :

Cash account debited with US $ 5,000

Fixed Deposit account of David Smith is credited with US $ 5,000

Cash account is a Real account while Fixed Deposit account of David Smith is a Personal
account. In this case, cash has come in and David Smith has given it for his Fixed
Deposit. Cardinal rule for Real account is Debit what comes in and for a Personal
account it is, Credit the giver. Hence Cash account is debited and Fixed Deposit account
of David Smith is credited.

3) Bank gives a loan of US $ 15,000 to David Green. It credits the proceeds to his
current account.

Accounting entries passed:

Loan account of David Green is debited with US $ 15,000
Current account of David Green is credited with US $ 15,000

Loan account and Current account are Personal accounts. Cardinal rules for Personal
accounts are Debit the receiver and Credit the giver. While the bank is giver of the loan,
Customer has received the loan. Hence, Customer’s loan account is debited. The loan is
generally given to the customer by way of cash. Then Cash account will be credited.
Presume that the customer pays this cash into his current account. Then, cash account is
debited and Current Account is credited (rule being Credit the Giver). In this case,
instead of paying the loan proceeds by cash, customer’s current account is credited,
which reflects these accounting entries.

NOTE: Whenever the debit entry is Personal a/c, the corresponding entry will be either
Real a/c or Nominal a/c. Also whenever the credit entry is Personal a/c, the
corresponding debit entry will be either Real a/c or Nominal a/c. In the above example,
we have compressed the two transactions into one and hence it superficially looks as
though the rules have not been followed..

4) John Fowler pays by cash US$7,700 in full settlement of his loan of US$7,000 on
the due date of the loan.

Accounting entries passed:

Cash account debited with US$ 7,700.
Loan account credited with US$ 7,000
Interest account credited with US$ 700.

Cash account is Real account, Loan account is Personal account and Interest account is
Nominal account. For Real accounts, what comes in should be debited. Cash has come
in and hence Cash account is debited. For Personal accounts, the giver should be credited.
The giver is the customer and hence his Loan account is credited . For a nominal
account all incomes are to be credited and hence interest account is credited.

5) John Smith withdraws cash of US$ 1,000 from his Savings Account

Accounting entries are:

Savings account of John Smith debited with US$ 1,000
Cash account credited with US $ 1,000.

Savings account is a Personal account while Cash is a Real account. Accordingly, the
receiver is debited and what goes out is credited.

6) Bank collects Share capital of US $ 100,000 from 100 shareholders

Accounting entries are:

Cash account debited with US$ 100,000.
The share capital account credited with US$ 100,000

Cash account is a Real account and hence when cash comes in, it is debited. Share
capital is a Personal account and hence the givers are credited.

Now you have seen that recording transactions is much easier if you are able to
classify the account properly as Personal, Real or Nominal accounts.
 THE FUNDAMENTAL CONCEPTS OF ACCOUNTING

The following seven concepts are guiding set of policies that underlie all
accounting rules and reporting.

The Entity
Cash and Accrual Accounting
Objectivity
Conservatism
Going concern
Consistency
Materiality

The Entity: Accounting reports communicate the activities of a specific entity and are
always looked from the perspective of that entity. For example, ABC Bank has 40
branches. It prepares reports for each of its 40 branches. It also reports for the Bank as a
whole. In the first instance, each report is for a specific branch while in the second
instance, the report is for the bank as a whole.

Cash and Accrual basis: Using cash basis accounting, transactions are recorded only
when cash changes hands. A bank has given loan of US $ 1,000 on April 2, 2002. The
loan will earn an interest of US $ 100 which is payable on April 1, 2003. This bank’s
accounting year is from April 1 to March 31. Under cash basis accounting, as it does not
receive interest till March 31, 2003, it will report its interest income as NIL. It will report
the entire interest income only the next year, though the loan is repaid on the first day of
the next year. This method does not match the costs of conducting business with the
related income.

All banks generally use the accrual accounting method. Accrual accounting
recognizes the financial effect of an activity when the activity takes place without regard
to the movement of cash. In the above instance, US $ 100 is the interest for 1 year.
Though it is collected in financial year 2004, a major part of it is for the financial year
2003. Hence, the bank will split the interest into two parts – one pertaining to FY 2003
(US $99.75) and the other pertaining to FY 2004 (US$ 0.25). It will account these
amounts in the respective years.

Objectivity: Accounting records contain only those transactions that have been
completed and that have a quantifiable monetary value. Expecting an increase in interest
rates to happen, a bank cannot book additional income that is likely to come from that
increase until that increase is effected.

Conservatism: When losses are probable and can be reasonably estimated, banks
record them, even if the losses have not been actually realized. When gains are expected,
banks postpone recording them until they are actually realized. A bank has disbursed
a loan to a customer and he is declared bankrupt. The loan is not yet due for repayment.
Still, the bank will reverse all the accrued income booked so far and make necessary
provisions in its books for writing off the loan.

Going concern: Accountants presume that the business entity will continue to
operate in the foreseeable future Hence, the values assigned to items in the accounting
records assume that the business is a going concern and not a `gone concern’ when only
distress sale value should be assigned.

Consistency: The consistency concept is crucial to readers of financial statements.

Accounting rules demand that an entity use the same accounting rules year after year.
That enables an analyst to compare past with current results.

What will be the effect if a bank chooses accrual basis of accounting in the first
year and cash basis in the second year? Let us look at the example given in the previous
para on Cash and Accrual basis of accounting.

“ A bank has given loan of US $ 1,000 on April 2, 2002. The loan will earn an interest
of US $ 100 which is payable on April 1, 2003. This bank’s accounting year is from
April 1 to March 31.”

If the bank follows accrual basis in the first year, it will report interest income of US$
99.75 in the first year. If it changes the accounting method to cash basis in the second
year, it will report interest income of US $ 100 in the second year. The overall income
shown is US$ 199.75 whereas the actual income is only US$ 100. This will only help
cover up bad results or purposely understate good results.

Hence, if a change of accounting method is essential for valid reasons, the

financial statements must state the reason in the footnotes to the reports and also state
how it has affected the profits and asset values for that year.

Materiality: An important aspect of financial statements is that they are not exact to the
last cent. They are only materially correct so that the reader can get a fairly stated view
of where an entity stands. For a small grocery shop’s financial statement, a distortion of
one hundred dollar may materially distort the records, whereas for a huge multinational
bank with an income of a few hundred billions, distortion of even ten thousand dollars
may not materially distort the picture of decision making.
 THE FINANCIAL STATEMENTS

The financial statements are the summary of all the individual transactions
recorded during a period of time. Financial statements are the final product of the
accounting function. They give users the opportunity to see what went on in the business.
While there are many financial statements, we shall look at the two most widely used and
essential statements, viz Balance Sheet and Profit & Loss statement.

THE BALANCE SHEET: The Balance sheet presents the assets owned by a company,
the liabilities owed to others, and the accumulated investment of its owners. The balance
sheet shows these balances as of a specific date. It is a snapshot of a bank’s holdings at a
given point in time. The balance sheet is the foundation for all accounting records.

A sample balance sheet of a bank is given below:

Balance sheet as at 31st March 2002

(Mln US$)

Schedule As at 31st As at 31st

March, 2002 March, 2001
CAPITAL AND LIABILITIES
Capital 1 14,000 14,000
Reserves and surplus 2 12,812 11,956
Employees’ Stock Options outstanding 17(B)(2) 1 -
Deposits 3 356,749 344,818
Borrowings 4 78,355 57,637
Other liabilities and provisions 5 29,948 23,197
Total 491,865 451,608
ASSETS
Cash and balances with central bank 6 26,658 39,511
Balances with banks and money at call 7 12,453 18,879
and short notice
Investments 8 252,460 212,392
Advances 9 172,499 160,464
Fixed assets 10 11,547 9,437
Other assets 11 16,248 10,925
Total 491,865 451,608
Contingent liabilities 12 805,618 379,351
Bills for collection 47,599 17,338
Principal accounting policies and notes form part of accounts

The balance sheet is as of a point, certain in time. It is only a snapshot of the bank’s
position as on ------.
Further detailed break-up is provided in schedules attached to the balance sheet and are
indicated by the schedule Nos. at the side of each item.

The total of assets equals the total of liabilities and owners’ equity (Capital).
Assets are the resources that the bank possesses for the future benefit of the business

Liabilities are obligations to repay borrowing, debts and other obligation to provide
service to others

Owners’ equity is the accumulated measure of the owners’ investment in the bank. It is
represented by the Share capital brought in so far and the accumulated profits in the form
of Reserves and Surplus. Accumulated losses are shown under the Assets side.

Balance sheets are also drawn in `T’ form – with Assets and Liabilities and Owners’
equity on either side. Traditionally, the Assets and liabilities are listed in order of their
liquidity – On the Assets side, Cash and other Current Assets at the top and long term
assets down and on the Liabilities side, current liabilities like wages and taxes payable
at the top and long term liabilities down.

The Fundamental Accounting Equation

As the name implies, the balance sheet is a “balance” sheet. The fundamental equation
that rules over accounting balance is:

Assets (A) = Liabilities (L) + Owners’ Equity (OE)

What the bank owns (assets) always equals the total of what it borrowed (liabilities) and
what the owners have invested (equity). This equation explains everything that happens
in the accounting records of a bank over time.

LIABILITIES
ASSETS
EQUITY

Examples of the `Ever Balancing’ Act:

When the bank was opened, owners’ equity was brought in. It came in the form of cash
and hence the assets side increased to balance equity.
The bank gave some loans out of this cash and hence cash decreased. At the same time,
the assets in the form of loans increased

The bank accepted deposits from the public and its liabilities increased. A part of this
was invested in Government securities, a part was given out as loans and the balance held
as cash. Hence, the assets moved up in the form of investments, loans and cash.

Thus, there is no way to affect one side of the balance sheet without a balancing entry.

Rules for entries into Accounts can now be restated as

LIABILITY ACCOUNTS
ASSET ACCOUNTS Debit Credit
Decrease Increase
Debit Credit OWNERS’ EQUITY ACCOUNTS
Increase Decrease Debit Credit
Decrease Increase

Now, let us revisit the 6 transactions done earlier and see the validity of these
rules.

1) Bank buys furniture for its new office for US$ 50,000

Accounting entries passed

Furniture account debited with US$ 50,000

Cash account credited with US$ 50,000

Furniture and Cash are Assets. By buying furniture, the assets in the form of furniture
increase and hence that account is debited. In the process, cash asset decreases as cash is
paid out. Hence that account is credited.

2) Bank accepts fixed deposit of US $ 5,000 from David Smith.

Accounting entries passed :

Cash account debited with US $ 5,000

Fixed Deposit account of David Smith is credited with US $ 5,000

Cash is an asset while fixed deposit is a liability as it has to be repaid in the future. Cash
asset has increased and hence that account is debited. Liability has increased by
accepting fixed deposits and hence that account is credited.

3) Bank gives a loan of US $ 15,000 to David Green. It credits the proceeds to his
current account.

Accounting entries passed:

 Loan account of David Green is debited with US $ 15,000
Current account of David Green is credited with US $ 15,000

Loan is an asset while Current account is a liability. By giving loan, the assets increase
and hence that is debited. When the money is placed in current account, the liabilities
increase and hence that is credited.

4) John Fowler pays by cash US$7,700 in full settlement of his loan of US$7,000 on
the due date of the loan.

Accounting entries passed:

Cash account debited with US$ 7,700.
Loan account credited with US$ 7,000
Interest account credited with US$ 700.

Cash is an asset. This has increased and hence it is debited. Loan is a liability and this is
reduced when the loan is repaid. Hence it is credited.
Interest account being an income account, eventually increases the Owners’ equity and
hence for increase in interest account, it is credited. You will see more about this at the
end of the session.

5) John Smith withdraws cash of US$ 1,000 from his Savings Account

Accounting entries are:

Savings account of John Smith debited with US$ 1,000
Cash account credited with US $ 1,000.

Savings account is a liability. To effect a decrease, the account has been debited. Cash
account is an asset. To effect a decrease to the asset, it has been debited.

6) Bank collects Share capital of US $ 100,000 from 100 shareholders

Accounting entries are:

Cash account debited with US$ 100,000.
The share capital account credited with US$ 100,000

Cash is an asset. It has increased. Hence, cash account is debited. Share capital is
owners’ equity. To effect increase to that, the account is credited.

Now you have seen that recording transactions is much easier if you are able to
identify what constitutes an asset or a liability or owners’ equity and if you know the
effect of transaction on increase or decrease to them.

PROFIT & LOSS ACCOUNT: It is also called as the INCOME & EXPENDITURE
STATEMENT or merely INCOME STATEMENT. We have seen earlier that the balance
sheet shows balances as of a specific date. The income statement shows the flow of
activity and transactions over a specific period of time. That period could be a month, a
quarter, a year or any period.
A sample profit and loss account of a bank is given below:

Profit and Loss account for the year ended 31st March 2002

(Mln US$)

Schedule Year ended 31st Year ended 31st

March, 2002 March, 2001
I. Income
Interest earned 13 53,910 42,378
Other income 14 6,957 5,514
Total 60,867 47,892
II. Expenditure
Interest expended 15 43,750 33,261
Operating expenses 16 10,256 6,267
Provisions and contingencies 4,926 2,265
Total 58,932 41,793
III.Profit
Net Profit for the year 19,355 60,987
Profit brought forward 59,672 34,144
Total 79,027 95,131
IV. Appropriations
Transfer to statutory reserve 4,839 1,678
Transfer to capital reserve 744 -
Proposed Dividend 10,799 18,648
Transfer to/from Investment (30) 30
Fluctuation Reserve
Balance carried over to balance sheet 62,671 59,672
Total 79,027 95,131
Principal accounting policies and notes form part of accounts

The surplus of income over expenditure is called profit and deficit is called
loss. All expenses incurred and all incomes earned during a period are taken into
account. Usually accrual accounting is used, which means that incomes and expenses
relating to a period are accrued for the period, irrespective of when the actual cash
payments occur.
The rules of ‘debit’ and ‘credit’ for Profit and Loss statement can be broadly
summarised as

Debit all expenses/losses and credit all incomes/gains

Now, let us revisit the transaction done earlier and see the validity of this rule:
John Fowler pays by cash US$7,700 in full settlement of his loan of US$7,000 on the
due date of the loan.

Accounting entries passed:

Cash account debited with US$ 7,700.
Loan account credited with US$ 7,000
Interest account credited with US$ 700.

Cash is an asset. This has increased and hence it is debited. Loan is a liability and this is
reduced when the loan is repaid. Hence it is credited.
Interest account is an INCOME and hence for increase in interest account, it is credited.

How the Profit & Loss Account links to the Balance Sheet: From the Profit &
Loss account of the bank shown earlier, you can see that the Bank had two profitable
years. It had net profit of US$ 19,355 million in the year ended March 31, 2002 and
US$ 60,987 million in the year ended March 31, 2001.

What is even more important than calculating the income is the understanding of
how the income statement relates to the balance sheet. The income statement is the result
of many activities during the year. Assets and liabilities are affected upward and
downward during the year through many individual transactions. At year’s end, the net
assets of the bank, as totaled by the balance sheet, had changed because of operating
activities.

We find that out of the net profit, various appropriations are done. Some of them
are statutory in nature. Then, a part is distributed to the owners by way of dividend. The
surplus in profit and loss account, which is not appropriated to any particular reserve
account is carried over to the balance sheet. It may be noted that reserves and surplus
along with equity capital represent owners’ equity.
 SUMMARY OF ACCOUNTING

I hope you have not struggled too hard through these pages. If the material given
above is totally new for you, you can get them in a nut shell as below:

 There are 2 basic and interdependent financial statements: Balance sheet

and Profit & Loss Account
 Accounting records and statements always balance
 Assets = Liabilities + Owners’ Equity
 In the Double Entry book-keeping system, debit and credit entries are
passed simultaneously to balance each other
 Hence, journal entries have at least two lines of data, a debit and a credit
 Debit entries increase an asset. Credit entries increase Liabilities and
Owners’ equity
 Credit entries decrease an asset. Debit entries decrease Liabilities and
Owners’ equity.

That is what basic accounting is all about.

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