Chapter - 1. Introduction to Financial Accounting & Book Keeping

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1 Chapter - 1 Introduction to Financial Accounting & Book Keeping Basic Concepts Accounting has been defined as "the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are of financial character, and interpreting results there of. The definition brings out the following as attributes of accounting: Events and transactions of a financial nature are recorded while the events of a non-financial nature cannot be recorded. The record should reflect the importance of the transactions so recorded both individually and collectively, which includes summarization, thereby making it amenable to analysis. The users of the financial statement should be able to obtain the message encompassed in such financial statement and it is the knowledge of accountancy which enables the user to understand the contents OL the financial statement. Now let us analyze the terms Recording: To get accounts, the accounting transactions must be recorded, in paper or in electronic form. Classifying: To give an organized and systematic look, the transactions are classified into various ledgers, groups etc. We will explain about them on later. But the essential point is that they must be classified properly to get meaningful result out of the recorded transactions. Summarizing: The vast records are then summarized to give an overall picture of the state of affairs of the business. All transactions are expressed in terms of money. Where a transaction is in kind or other nature, a rational and quantified monetary value is attached to it to reflect it in the accounting records.

2 Book Keeping Methods of Accounting Broadly 2 methods of accounting system are in vogue: 1. Single Entry System 2. Double Entry System. Single Entry System This system is based purely on cash accounting, i.e. accounted for when money is received or paid. Only cash transactions are taken into a/c and all credit transactions, accruals and liabilities are omitted. Normally, only government accounting is done on this system and commercial organizations do not follow this system. Examples- A job is done by a person on 16th March, 2002 and a bill prepared on that day: The payment was received on 6th April, In single entry system, the transaction is recorded on 6th April, 2002 and the accounts of financial year (i.e. April 2001-March 2002) will have no effect for the transaction. Double Entry System In the Double Entry System, both cash and credit transactions are recognized (accrual basis of accounting). All commercial organization follow this system. A cost incurred i.e. accrued is duly accounted irrespective of whether it is paid or not during the accounting period. Additionally, all transactions shall have dual aspects (Debit and Credit) and that is why it is called double entry system. In this system for every transaction, Debits and Credits must be equal. For all practical purposes, Double Entry System is the accepted method of accounting. Examples- In the previous example in the books for financial year , the related expenses, A/c will be debited and the persons A/c will be credited to reflect the transaction when the cost incurred. Again in financial year , on , at the time of payment, the transaction will be recorded reflecting payment to the person.

3 As double Entry System is the defective accounting system of business community in general, everything discussed in this study material hence forth follows the principles of Double Entry System. Books of Accounts Primary Books of Accounts The primary books of accounts maintained by a business organization may be conveniently classified into Cash Books, Journals and General Ledger. Cash Book This book records all receipts of and payments in cash and through Cheque. Normally the deposits into bank account maintained by the business withdrawals from such accounts and Cheque payments are also recorded in the cash book. Example: One cycle is purchased from Cycle Stores and payment is made by cash or Cheque. The entry is recorded in Cash Book. Journals This book records all non-cash transactions (transactions which are not recorded in Cash Book). For practical convenience, the journal is divided into several subsidiary books). General Ledger The General Ledger contains all the accounts of an organization. The transactions entered in all primary books i.e. Cash Books and Journal (including subsidiary books) are posted to General Ledger. In fact, it is a device for reclassifying and summarizing all information recorded in the Cash Book and Journal according to account heads (called Ledger Accounts). The recording of transactions in the Books of Accounts may be represented as under: Cash Transactions

4 Non-Cash Transactions Recorded in Cash Book Recorded in Journals Secondary Books of Accounts General Ledger: Classified Summary of all Transactions Subsidiary books of Journals are the secondary books of accounts. Following secondary/subsidiary books may constitute the Journal for an organization: 1. Purchase Books: It is used to record purchase transactions made in credit. 2. Purchase Return Book: It is used to record when purchase item is returned to the seller. Ex. 50 pieces of goods purchased from supplier on credit and payment will be made later. The entry is recorded in purchase book in the books of buyer. Out of 50 pieces of goods purchase from supplier, 10 pieces found defective and returned to supplier. The entry is recorded in Purchase Returns. Book in the books of buyer. 3. Sales Book: It records all credit sales transactions. 4. Sales Return Book: It is used to record all sales returns. 50 pens. of goods sold to customer or sundry debtor on credit for which payment will be received later. The entry is recorded in sales book in the books of the Seller. Out of 50 pens, 6 pens, was returned by debtor. The entry is recorded in sales return book in the books of the seller. 5. Journal Proper: It is used to record all such transactions that are not entered in purchase or sales register, or purchase/sales return register. Ex. On a loan of Rs. 10,000 taken from Amit Kumar. Interest amounting Rs is payable on 31st March, 2002 but not paid. On 31 st March, 2002 this transaction is recorded through a journal entry.

5 Classification of Accounts The accounts maintained in the General Ledger may be broadly classified into: Personal Accounts Impersonal Accounts Real Accounts Nominal Accounts Personal Accounts Accounts related to any person, firm, companies, banks etc. It deals with accounts of individuals like creditors, debtors, bank, etc. It shows the balance due to these individuals or due from them on a particular date. These accounts appear in Balance sheet. Real Account It represents fixed and current assets like plant and machinery, land & building, vehicle, cash etc. As on a particular date, this account shows the worth of the asset. These accounts also appear in Balance Sheet. Nominal Account It. consists of different types of expenses or incomes or loss or profit. These accounts show the amount of income earned or expenses incurred for a particular period say a month, a year etc. These accounts appear in Profit and Loss A/ c General Rules of Debit and Credit The dual aspect concept requires that when a transaction occurs both the debit and credit elements should be recorded in the books of accounts. To ensure a standardized method of recording of transactions, the rules for debit and credit of accounts were evolved. The Golden Rules goes with the classification. of accounts and may. The effects of debits and credits, in general may be represented as follows:

6 Assets Debits increase, credits decrease, normally debits Expenses Debits increases, credit decrease normally debit Liabilities Credits Increases, debits decrease, normally credit Capital Credits increase, debits decrease, normally credit Income Credits increase, debits decrease, normally credit Trial Balance & Final Accounts All monetary events are classified under into various Account Heads which are periodically summarized. This periodical summary is known.as Trial Balance. In other words, a Trial Balance is a summary of all General Ledger Balances outstanding as on a particular date. All the debit balances from the ledger are shown on one side and all the credit balance in on the other side. If all the debit and credit balances were recorded on the two sides of the Trial Balance, it stands to reason that the two sides should be equal, since in the journal for each item of, debit, there was a credit item. So in Trial Balance, debit and credit totals are balanced. In other words, Trial Balance is the closing balance of all accounts (all ledgers accounts except closing stock) for a specific date. Such statement is the unadjusted Trial Balance. After passing the adjustment entries at year end, an adjusted Trial Balance is prepared through which financial statements are prepared.) Financial Statements From the Trial Balance, the following financial statements are made: Profit & loss (or income and expenditure statement) for a specific period consisting of Nominal Accounts. Balance sheet (or statement of affairs) as on the last date of the period consisting of Real & Personal Accounts.

7 Profit & Loss Account From given Trial Balance we can prepare a trading and profit & loss account to determine the profit or loss made by a business organization during a particular period. At the time of preparation of Profit & Loss A/c the following points may be kept in mind: All expenses are debited to Profit & Loss A/c. All incomes are credited to Profit & Loss A/c. In addition to treating the incomes and expenses found in Trial Balance. We may have to give special treatment to certain 'adjustments' also. The profit is credited to Reserves A/c while the net loss, it is debited to Reserves A/c in the Balance Sheet, in the case of companies and in the case of sole trader and partnership firm, the net profit is credited to capital account and net loss is debited to capital account. Trading account is prepared to ascertain the Gross Profit. Gross Profit is the difference between sales and cost of goods sold. Cost of goods sold means (opening stock + Purchase + Direct Expenses) closing stock Profit and loss account is prepared to ascertain net profit. Some times it is possible to first determine the gross profit (arising out of trading operations) and then deducts all indirect expenses from Gross Profit and to determine the net profit. Net profit is calculated by deducting other indirect expenses (like general, administrative or selling and distribution expenses) from Gross profit. Whether a separate Trading account is prepared to determine gross profit or not, the net profit remains the same. It is necessary to emphasize here that Profit & Loss account (including trading account) is usually prepared on 'Accrual' basis. In other words, all expenses incurred and due are debited to Profit & Loss Account whether they are actually paid for or not. Similarly all incomes earned and due are credited to Profit and loss Account whether they are actually received or not.

8 Computerized Accounting When you opt for computerized accounting first time, you have to create all the ledgers and enter opening balances (in subsequent years you need not to create the ledgers again or carry forward previous year's closing balance as opening balance since it would be carried forward on its own by the software) and classify at this stage. Thereafter, you enter all transactions in vouchers (different type of vouchers to record diverse nature of transactions). That's all you have to do everything else (like posting to ledger, preparation of Trial Balance, Final Accounts etc.) is done by the software. In computerized accounting, while creating new ledger, you are required to classify it suitably under relevant Accounts Group to tell the software the nature of the ledger and where it will appear. This is necessary at this stage as all reports are prepared on-line the moment you enter transactions (vouchers). In case of Manual Book Keeping, this classification is done at later stage (after preparation of Trial Balance, Nominal Accounts are transferred to Profit & Loss A/c through Journal Entry, Real & Personal Accounts are posted to Balance Sheet under proper heading i.e. groups). Year End Entries - In manual book-keeping, you are required to pass Journal entries to transfer closing balance of all nominal account to prepare Profit & Loss A/c, which you are not required to do in case of computerized accounting. The software does this job on its own. In next year, only. Closing balance of Real & Personal accounts are carried and nominal accounts balance is zeroed by the software (for which you pass Journal Entries in manual book-keeping). The advantages are that your accounts are always open and any modification is instantly reflected.