Basic Accounting Principles

2

Table of Contents: 1. Accounting Concepts: a. Business Entity Concept/Accounting Entity Concept. b. Money Measurement. c. Going Concern. d. Accounting Period e. Accrual Concept. f. Historical Cost. Pg.3 Pg.3 Pg.4 Pg.4 Pg.5 Pg.6 Pg.6

2. What is Accounting? * 3. Purpose of Accounting.* 4. Accounting Equation.* 5. Elements of Accounting Equation: * a. Assets. b. Liabilities. c. Owner¶s Equity.

Pg.7 Pg.8 Pg.8 Pg.10

6. Rules of Debit and Credit. * 7. Classification of Accounts. * a. Personal Accounts. b. Real Accounts. c. Nominal Accounts. d. Final Accounts:

Pg.10 Pg.11 Pg.11 Pg.12 Pg.12 Pg.12

8. Source Documents. * 9. Journals. 10. Ledger. * *

Pg.13 Pg.13 Pg.14 Pg.14 Pg.14 Pg.15 Pg.15 Pg.15

11. Trial Balance.* 12. Cash Book. * 13. Bank Reconciliation Statement (BRS). 14. Depreciation. 15. Calculation of Depreciation (Methods).

3

1.

Accounting Concepts: Let us take an example. In India there is a basic rule to be followed by everyone that one should walk or drive on his/her left hand side of the road. It helps in the smooth flow of traffic. Similarly, there are certain rules that an accountant should follow while recording business transactions and preparing accounts. These may be termed as accounting concept. Thus, this can be said that: Accounting concept refers to the basic assumptions and rules and principles, which work as the basis of recording of business transactions and preparing accounts. The main objective is to maintain uniformity and consistency in accounting records. These concepts constitute the very basis of accounting. All the concepts have been developed over the years from experience and thus they are universally accepted rules. Following are the various accounting concepts that have been discussed in the following sections:

a. Business Entity Concept/Accounting Entity Concept: This concept assumes that, for accounting purposes, the business enterprise and its owners are two separate independent entities. Thus, the business and personal transactions of its owner are separate. For example, when the owner invests money in the business, it is recorded as liability of the business to the owner. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not treated as business expense. Thus, the accounting records are made in the books of accounts from the point of view of the business unit and not the person owning the business. This concept is the very basis of accounting. Let us take an example. Suppose Mr. Sahoo started business investing Rs100000. He purchased goods for Rs40000, Furniture for Rs20000 and plant and machinery of Rs30000. Rs10000 remains in hand. These are the assets of the business and not of the owner. According to the business entity concept Rs100000 will be treated by business as capital i.e. a liability of business towards the owner of the business. Now suppose, he takes away Rs5000 cash or goods worth Rs5000 for his domestic purposes. This withdrawal of cash/goods by the owner from the business is his private expense and not an expense of the business. It is termed as Drawings. Thus, the business entity concept states that business and the owner are two separate/distinct persons. Accordingly, any expenses incurred by owner for himself or his family from business will be considered as expenses and it will be shown as drawings.

Significance: The following points highlight the significance of business entity concept: y This concept helps in ascertaining the profit of the business as only the business expenses and revenues are recorded and all the private and personal expenses are ignored. y This concept restraints accountant from recording of owner ¶s private/ personal transactions.

4 y It also facilitates the recording and reporting of business transactions from the business point of view. y It is the very basis of accounting concepts, conventions and principles.

b. Money Measurement Concept: This concept assumes that all business transactions must be in terms of money that is in the currency of a country. In our country such transactions are in terms of rupees. Thus, as per the money measurement concept, transactions which can be expressed in terms of money are recorded in the books of accounts. For example, sale of goods worth Rs.200000, purchase of raw materials Rs.100000, Rent Paid Rs.10000 etc. are expressed in terms of money, and so they are recorded in the books of accounts. But the transactions which cannot be expressed in monetary terms are not recorded in the books of accounts. For example, sincerity, loyalty, honesty of employees are not recorded in books of accounts because these cannot be measured in terms of money although they do affect the profits and losses of the business concern. Another aspect of this concept is that the records of the transactions are to be kept not in the physical units but in the monetary unit. For example, at the end of the year 2006, an organization may have a factory on a piece of land measuring 10 acres, office building containing 50 rooms, 50 personal computers, 50 office chairs and tables, 100 kg of raw materials etc. These are expressed in different units. But for accounting purposes they are to be recorded in money terms i.e. in rupees. In this case, the cost of factory land may be say Rs.12 crore, office building of Rs.10 crore, computers Rs.10 lakhs, office chairs and tables Rs.2 lakhs, raw material Rs.30 lakhs. Thus, the total assets of the organization are valued at Rs.22 crore and Rs.42 lakhs. Therefore, the transactions which can be expressed in terms of money is recorded in the accounts books, that too in terms of money and not in terms of the quantity.

Significance:

The following points highlight the significance of money measurement concept: y y This concept guides accountants what to record and what not to record. It helps in recording business transactions uniformly. If all the business transactions are expressed in monetary terms, it will be easy to understand the accounts prepared by the business enterprise. y It facilitates comparison of business performance of two different periods of the same firm or of the two different firms for the same period.

c. Going Concern Concept:

This concept states that a business firm will continue to carry on its activities for an indefinite period of time. Simply stated, it means that every business entity has

5 continuity of life. Thus, it will not be dissolved in the near future. This is an important assumption of accounting, as it provides a basis for showing the value of assets in the balance sheet; For example, a company purchases a plant and machinery of Rs.100000 and its life span is 10 years. According to this concept every year some amount will be shown as expenses and the balance amount as an asset. Thus, if an amount is spent on an item, which will be used in business for many years, it will not be proper to charge the amount from the revenues of the year in which the item is acquired. Only a part of the value is shown as expense in the year of purchase and the remaining balance is shown as an asset.

Significance: The following points highlight the significance of going concern concept: y y y This concept facilitates preparation of financial statements. On the basis of this concept, depreciation is charged on the fixed asset. It is of great help to the investors, because, it assures them that they will continue to get income on their investments. y In the absence of this concept, the cost of a fixed asset will be treated as an expense in the year of its purchase. y A business is judged for its capacity to earn profits in future.

d. Accounting Period Concept: All the transactions are recorded in the books of accounts on the assumption that profits on these transactions are to be ascertained for a specified period. This is known as accounting period concept. Thus, this concept requires that a balance sheet and profit and loss account should be prepared at regular intervals. This is necessary for different purposes like, calculation of profit; ascertaining financial position, tax computation etc. Further, this concept assumes that, indefinite life of business is divided into parts. These parts are known as Accounting Period. It may be of one year, six months, three months, one month, etc. But usually one year is taken as one accounting period, which may be a calendar year or a financial year. Year that begins from 1st of January and ends on 31st of December is known as Calendar Year. The year that begins from 1st following year is known as financial year. As per accounting period concept, all the transactions are recorded in the books of accounts for a specified period of time. Hence, goods purchased and sold during the period, rent, salaries etc. paid for the period are accounted for and against that period only. of April and ends on 31st of March of the

Significance: y y It helps in predicting the future prospects of the business. It helps in calculating tax on business income calculated for a particular time period. y It also helps banks, financial institutions, creditors, etc to assess and analyze the performance of business for a particular period.

6 y It also helps the business firms to distribute their income at regular intervals as dividends.

e. Accrual Concept: The meaning of accrual is something that becomes due especially an amount of money that is yet to be paid or received at the end of the accounting period. It means that revenues are recognized when they become receivable. Though cash is received or not received and the expenses are recognized when they become payable though cash is paid or not paid. Both transactions will be recorded in the accounting period to which they relate. Therefore, the accrual concept makes a distinction between the accrual receipt of cash and the right to receive cash as regards revenue and actual payment of cash and obligation to pay cash as regards expenses. The accrual concept under accounting assumes that revenue is realized at the time of sale of goods or services irrespective of the fact when the cash is received. For example, a firm sells goods for Rs.55000 on 25th March 2005 and the payment is not received until 10th April 2005, the amount is due and payable to the firm on the date of sale i.e. 25th March 2005. It must be included in the revenue for the year ending 31st March 2005. Similarly, expenses are recognized at the time services provided, irrespective of the fact when actual payments for these services are made. For example, if the firm received goods costing Rs.20000 on 29th March 2005 but the payment is made on 2nd April 2005 the accrual concept requires that expenses must be recorded for the year ending 31st March 2005 although no payment has been made until 31st March 2005 though the service has been received and the person to whom the payment should have been made is shown as creditor. In brief, accrual concept requires that revenue is recognized when realized and expenses are recognized when they become due and payable without regard to the time of cash receipt or cash payment.

Significance: y It helps in knowing actual expenses and actual income during a particular time period. y It helps in calculating the net profit of the business.

f. Historical Cost Concept: Historical cost accounting is an accounting concept that states that all assets in the financial statement should be reported based on their original cost. Historical cost is a generally accepted accounting principle requiring all financial statement items be based upon original cost. Historical cost means what it cost the company for the item. It is not fair market value. This means that if a company purchased a building, it is recorded on the balance sheet at its historical cost. It is not recorded at fair market value, which would be what the company could sell the building for in the open market. Example: James buys a building for Rs.2000000.00 ten years ago, the value of the building now is Rs.3000000.00 but in James's accounting records, the building is still

7 recorded as Rs.2000000.00 (less depreciation). No account is taken of the increase in value.

2.

What is Accounting?
The definition of accounting depends. It depends, to whom you are asking. For the accountant, it is one area of business activity that they use to derive an income. A more professional way of putting that could be, that accounting is an occupation that is engaged in the service of providing reliable and relevant financial information that can be used by others to make informed decisions. One µofficial¶ definition of accounting is provided by the American Accounting Association, which defines accounting as- "the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.´ For the rest of us, the definition and purpose of accounting could be any one or a combination of the following: Professors of Accounting may call it ³The language of business.´ Economists may define it as the practical application of economic theory in that it measures income and values assets. Corporate managers may define it as a set of timely gauges that helps them actually manage the organization Labor unions may see it as a monitor of an organizations activities and performance, particularly in relation to the benefits secured by employees Vs owners. A Board of Directors or a Chief Executive Officer (CEO) may see accounting as a data process and reporting system that provide the information needed for sound financial or economic decision making for their organization. Banks and other providers of loan funds may see it as a process of providing reports showing the financial position of an organization in relation to the assets owned, amounts owed to others and monies invested as well as the profitability of the organization¶s operations in relation to repaying the loan with interest. Governments may see it as a way of making organizations accountable to the general community by way of taxation contributions and transparency in the outcomes from their decision-making. Potential investors may see it as a method of evaluating an organization¶s effectiveness in relation to industry benchmarks and the investor¶s required returns.

We can see from these definitions that accounting can be divided into two main elements:
y

An information process that identifies, classifies and summarizes the financial events that take place within an organization and

8
y

A reporting system that communicates relevant financial information to interested persons which allows them to assess performance, make decisions and/or control the economic resources in the organization.

3.

Purpose of Accounting:
The basic purpose of accounting is derivation of information. Keeping track of transactions and recording revenue and expenses are important business processes that are often assigned to an accounting department or financial manager. Accounting is a business discipline that allows companies to record, analyze and retrieve critical financial information that can be used to determine a company's financial status and provide reports and insights needed to make sound financial decisions. The primary purpose of accounting is to identify and record all activities that impact the organization financially. All activities such as purchases, sales, the acquisition of capital and interest earned from investments can be classified in monetary terms and posted to a specified account as an accounting record. These transactions are typically recorded in ledgers and journals and are part of the process known as the accounting cycle. Accountants develop systems and processes to evaluate and analyze the different types of transactions that a company is involved with. Every transaction that involves the acquisition or sale of goods and services must be reported in the general ledger and posted to relevant accounts. Bookkeeping is the function of accounting that helps maintain these types of transactions as debits and credits; this data can then be used to create accurate and timely financial reports. Accounting is a crucial discipline for keeping track of quantifiable factors for a business or individual. Accountants are primarily employed to track the flow of money through an organization. In some cases, they are charged with ensuring legal compliance. In others, they are more specialized in optimizing that cash flow. Accountants also organize and aggregate financial information and produce reports for people less experienced in the discipline.

4.

Accounting Equation:
From the large, multi-national corporation down to the corner beauty salon, every business transaction will have an effect on a company¶s financial position. The financial position of a company is measured by the following items: 1. Assets (what it owns) 2. Liabilities (what it owes to others) 3. Owner¶s Equity (the difference between assets and liabilities)

9 The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is: Assets = Liabilities + Owner¶s Equity The accounting equation for a corporation is:

Assets = Liabilities + Stockholders¶ Equity

Assets are a company¶s resources²things the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner¶s (or stockholders¶) equity.

Liabilities are a company¶s obligations²amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways: (1) (2) as claims by creditors against the company¶s assets, and

a source along with owner or stockholder equity of the company¶s assets.

Owner¶s equity or stockholders¶ equity is the amount left over after liabilities are deducted from assets: Assets ± Liabilities = Owner¶s (or Stockholders¶) Equity. Owner¶s or stockholders¶ equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners. If a company keeps accurate records, the accounting equation will always be ³in balance,´ meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a company¶s accounts. For example, when a company borrows money from a bank, the company¶s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double entry accounting.

10 A company keeps track of all of its transactions by recording them in accounts in the company¶s general ledger. Each account in the general ledger is designated as to its type: asset, liability, owner¶s equity, revenue, expense, gain, or loss account.

5.

Elements of Accounting Equation:
Accounting is built upon the fundamental accounting equation: Assets = Liabilities + Owner's Equity This equation must remain in balance and for that reason our modern accounting system is called a dual-entry system. This means that every transaction that is recorded in accounting records must have at least two entries; if it only has one entry the equation would necessarily be unbalanced. The equation¶s three parts are explained as follows: 1. Assets = what the business has or owns (equipment, supplies, cash, accounts receivable) 2. Liabilities = what the business owes outsiders (bank loan, accounts payable) 3. Owner¶s Equity = what the owner owns (investment and business profit) The Accounting Equation can be expressed in three ways: y y y Assets = Liabilities + Owner¶s Equity Liabilities = Assets ± Owner¶s Equity Owner¶s Equity = Assets ± Liabilities

6.

Rules of Debit and Credit:
There are three Golden Rules for Debit & Credit. Whole of the accounting depends upon these three rules: y y y Debit what comes in & Credit what goes out. Debit the receiver & Credit the giver. Debit all losses/expenses & Credit all gains/profits.

Debit and Credit are two actions of opposing nature that are relevant to the process of accounting. They are as fundamental to accounting as addition (+) and subtraction (-) are to mathematics. It would not be appropriate to apply this mathematical analogy in all cases, as it would give a distorted meaning. Thus, it

11 would not be appropriate to consider debit to be an equivalent of addition and credit to be an equivalent of subtraction. One just need to understand that debit and credit are two actions that are opposite in nature. An element (account) that is affected by an accounting transaction is either debited or credited (with an amount that is reflected in the transaction) depending on the nature of the account and the rule applicable to it. Example:  A purchase of furniture worth Rs.10000.00 for Cash.

This transaction would result in ± i.) ii.)  Furniture a/c being debited by an amount of Rs.10000.00 and Cash a/c being credited by a similar amount.

A payment of Rs.5000.00 received from Mr. Narayan by Cheque.

This transaction would result in ± i.) ii.) Mr. Narayan a/c being credited to the extent of Rs.5000.00 and The Bank a/c being debited with a similar amount.

7.

Classification of Accounts:

a. Personal Accounts: Accounts recording transactions relating to individuals or firms or company are known as personal accounts. Personal accounts may further be classified as: i.) Natural person's personal accounts: The accounts recording transactions relating to individual human beings e.g., Anand's A/c, Remesh's A/c, Pankaj's A/c are classified as natural person's personal accounts. ii.) Artificial person's personal account: The accounts recording transactions relating to limited companies, bank, firm, institution, club etc. e.g. Delhi Cloth Mill; Hans Raj College; Gymkhana Club are classified as artificial persons' personal accounts.

12 iii.) Representative personal accounts: The accounts recording

transactions relating to the expenses and incomes are classified as nominal accounts. But in certain cases due to the matching concept of accounting the amount, on a particular date, is payable to the individuals or recoverable from individuals. Such amount (a) relates to the particular head of expenditure or income and (b) represents persons to whom it is payable or from whom it is recoverable. Such accounts are classified as representative personal accounts e.g. "Wages Outstanding Account", Pre-paid Insurance Account. etc. b.) Real Accounts: The accounts recording transactions relating to tangible things (which can be touched, purchased and sold) such as goods, cash, building, machinery etc., are classified as tangible real accounts. Whereas the accounts recording transactions relating to intangible things (which do not have physical shape) such as goodwill, patents and copy rights, trade marks etc., are classified as intangible real accounts. c.) Nominal Accounts: The accounts recording transactions relating to the losses, gains, expenses and incomes e.g., Rent, salaries, wages, commission, interest, bad debts etc. are classified as nominal accounts. As already discussed, wherever a nominal account represents the amount payable to or receivable from certain persons it is known as representative personal account. d.) Final Accounts: Accounts made up only at the end of a firm's financial year. For a manufacturing firm, the final accounts consist of (1) manufacturing account, (2) trading account, (3) profit and loss account, and (4) profit and loss appropriation account. A trading firm's final accounts will include all of the above except the manufacturing account. Together, these accounts generate the gross profit, net income, and distribution of net income figures of the firm. Rules of Debit and Credit (classification based):    Personal Accounts: Debit the receiver; Credit the giver (supplier). Real Accounts: Debit what comes in, Credit what goes out. Nominal Accounts: Debit expenses and losses, Credit incomes and gains.

13

8.

Source Documents:
The Source Document is the original record of a transaction. During an audit, source documents are used as evidence that a particular business transaction occurred. Examples of source documents include:
y y y y y y y y y y y

Cash receipts Credit card receipts Cash register tapes Cancelled checks Customer invoices Supplier invoices Purchase orders Time cards Deposit slips Notes for loans Payment stubs for interest At a minimum, each source document should include the date, the amount, and a

description of the transaction. When practical, beyond these minimum requirements source documents should contain the name and address of the other party of the transaction. When a source document does not exist, for example, when a cash receipt is not provided by a vendor or is misplaced, a document should be generated as soon as possible after the transaction, using other documents such as bank statements to support the information on the generated source document. Once a transaction has been journalized, the source document should be filed and made retrievable so that transactions can be verified should the need arise at a later date.

9.

Journals:
Journal is a record that keeps accounting transactions in chronological order, i.e. as they occur. According to Rowland- the basic book of accounting is called Journal. Precisely it is the book of prime entry, which means - Day Book. Traders record their, total daily transactions in it. The process of recording the transaction into journal is called 'Journalizing'.

14

10.

Ledger:
A ledger/general ledger is a set of accounts used in accounting to keep track of all the financial transactions of the company. All financial postings have an impact on the general ledger, whether or not they post to a sub-ledger, such as accounts receivable or cash. The values in the general ledger accounts drive the information used to generate all the financial statements. General Ledger severs as the central repository & ultimate destination of all corporate financial information. Function of GL is to collect financial information into a chart of accounts (i.e. a/c's defined by company for recording transactions that takes place). Using general ledger, Management & Financial reports are prepared to view the financial status of the company at any point of time.

11.

Trial Balance:
Trial balance is a bookkeeping worksheet in which the balances of all ledgers are compiled into debit and credit columns. A company prepares a trial balance periodically, usually at the end of every reporting period. The general purpose of producing a trial balance is to ensure the entries in a company's bookkeeping system are mathematically correct. Preparing a trial balance for a company serves to detect any mathematical errors that have occurred in the double-entry accounting system. Provided the total debts equal the total credits, the trial balance is considered to be balanced, and there should be no mathematical errors in the ledgers. However, this does not mean there are no

errors in a company's accounting system. For example, transactions classified improperly or those simply missing from the system could still be material accounting errors that would not be detected by the trial balance procedure.

12.

Cash Book:
Cashbooks are simple accounting books that are used to record basic information about cash receipts and payments. Once available in hard copy form only, cashbooks are often included in different types of money management software. Providing an easy way of keeping up with how much money is coming in and what bills are getting paid, the cashbook can be effectively utilized by just about anyone.

15 A Cash Book is a subsidiary book. It has the peculiarity of being both a journal as well as a ledger. If a transaction is entered in the Cash Book, both the recording aspect as well as the posting aspect are complete, i.e. it amounts to writing the journal entry as well as posting into the ledger.

13.

Bank Reconciliation Statement (BRS):
The process of comparing and reconciling accounting records with the records presented on the bank statement. Sometimes discrepancies between the records might occur due to the timing differences when the data is recorded in the accounting and in the bankbooks. The purpose of bank reconciliation is to check whether the discrepancies are due to timing rather than error. It is the report a bank sends to a customer each month containing all transactions that have taken place during the one-month reporting period---money in, money out---so that the customer can compare that information with his own records and be sure there has been no error.

14.

Depreciation:
Depreciation is a term used in accounting, to spread the cost of an asset over the span of several years. In common speech, depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors. Depreciation is defined as the decline in value, according to the book value of the asset, over a specific period of time. In accounting, however, depreciation is a term

used to describe any method of attributing the historical or purchase cost of an asset across its useful life, roughly corresponding to normal wear and tear. Depreciation and its related concept, amortization (generally, the depreciation of intangible assets), are non-cash expenses.

15.

Calculation of Depreciation:
Depreciation is a systematic and rational process of distributing the cost of tangible assets over the life of assets. Depreciation is a process of allocation.

Cost to be allocated = Acquisition cost - Salvage value

Allocated over the estimated useful life of assets. Allocation method should be systematic and rational.

16

Formula for calculating depreciation: Value of the asset ± Scrap Value Depreciation = --------------------------------------------Total number of years Depreciation Methods: 1. Straight-line depreciation

2. Sinking fund depreciation.

3. Declining balance depreciation

4. Activity depreciation

5. Sum of years digits depreciation

1.

Straight-line depreciation: Straight-line depreciation is the most commonly used way to calculate

depreciation. The way it works is that the company estimates the salvage value of an asset. The salvage value is an estimated value of the asset whenever it will be sold. This could be zero. The depreciation expense is determined by the cost of the asset divided by the length of its useful life. This number is subtracted for each year of the life of the asset, and is considered its depreciation. 2. Sinking fund depreciation: The sinking fund technique of calculating depreciation sets the depreciation expense as a particular amount of an annuity. The depreciation is calculated so that at the end of the useful life of the annuity, the amount of the annuity equals the acquisition cost. The sinking fund method calculates more depreciation closer to the end of the useful life of the asset, and isn't used very often. 3. Declining balance depreciation: This way of calculating depreciation falls under the accelerated depreciation category. This means that it sets depreciation expenses as higher earlier on, more realistically reflecting the current resale value of an asset.

The way that declining-balance depreciation is calculated is by taking the net book value

17 from the previous year, and multiplying it by a factor (usually 2), which has been divided by the useful life of the asset. Depreciation expense = previous period NBV x factor / useful life 4. Activity depreciation: This way of calculating depreciation bases the depreciation expense on the activity of an asset, like a machine. Multiply the per-whatever (mile, cycle, etc) rate by the actual activity level of the asset to determine the depreciation expense for the year. 5. Sum of years digits depreciation: This way of calculating depreciation falls between accelerated and straight-line depreciation. Here's the formula ± N = depreciable life. B = cost basis. S = salvage value. D (t) = Depreciation charge for year t. Sum = N (N + 1) /2 D (t) = (N - t + 1) x ((B = S) / Sum)

18