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Financial Accounting

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FUNDAMENTALS OF FINANCIAL ACCOUNTING
UNIT 1 Introduction to Accounting and Financial Statements UNIT 2 The Accounting Process 7

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The ICFAI University, Tripura, July, 2013. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means - electronic, mechanical, photocopying or otherwise - without prior permission in writing from The ICFAI University, Tripura.

Ref. No. FAFA 07201305 B1 For any clarification regarding this book, the students may please write to The ICFAI University, Tripura giving the above reference number of this book specifying chapter and page number. While every possible care has been taken in type-setting and printing this book The ICFAI University, Tripura welcomes suggestions from students for improvement in future editions.

COURSE INTRODUCTION
This course provides the inputs essential for Financial Accounting in the organizational context. It helps to understand the principles of recording transactions, accounting concepts and the preparation of financial statements. It also provides the basis for measurement, valuation and disclosure norms of the various components in the financial statements. It helps the users to analyze, interpret and report on the financial position and performance of an organization. The important topics covered in this course are: Accounting process that discusses in detail the steps beginning with identifying the transactions, recording and classifying them into ledgers. Accounting for inventories that deal with the various methods of inventory valuation including ascertaining the cost of inventories and any write-down thereof to net realizable value. Measurement and recognition of income and expenses that provides insight into the recognition and measurement of income and expenses that has a direct and most significant bearing on determining profit and the concept of revenue recognition and measurement and the various methods of recognizing revenue. Accounting for fixed assets, which discusses the concept of identification, measurement and accounting of fixed assets, depreciation and various methods of providing depreciation, borrowing cost and impairment of fixed assets. Accounting for intangible assets that deal with the recognition, measurement and disclosure of intangible assets which are very relevant to show a true and fair view of the financial statements. The preparation of trial balance, passing of adjustment entries and other aspects, preparation of trading and Profit and Loss account and preparation of Balance sheet. Preparation of Financial statements in case of companies and the provisions relating to auditors and boards report. Reporting and disclosure requirement in the preparation and presentation of financial statements of a company. Provisions pertaining to audit of accounts, appointment, removal, duties and rights of auditors and adoption and filing of annual reports. Emergence and functions of Management Accounting that discussed the role and scope of management accounting, compares with financial and cost accounting, tools and techniques of management accounting. Basic cost concepts explain the various types of costs, their behavior and estimation. Cost allocation process explains the classification and absorption of various types of overhead costs. Method of costing discusses various methods of costing and their applications.

The course contains Five blocks.

BLOCK 1

FUNDEMANTALS OF FINANCIAL ACCOUNTING

This is an introductory block for Financial Accounting. It briefly reviews the basic aspects of accounting. It covers the principles of accounting, accounting process of recording business transactions, classification of transactions, the books required for journalizing and their posting to ledger accounts. This block consists of two units.

Unit 1 outlines the nature, definition and scope of accounting, the basic principles, concepts and conventions that govern the recording of transactions and events and explains the double entry system of accounting.

Unit 2 deals with identifying the events and transactions, journalizing the transactions, and posting them into ledgers. It also deals with preparing of subsidiary books and recording for cash and bank transactions in different types of cash books.

Unit 1: Introduction to Accounting and Financial Statements


Structure
1.1 Introduction 1.2 Objectives 1.3 Accounting An Overview 1.4 Steps in Accounting 1.5 Branches of Accounting 1.6 Financial Statements 1.6.1 Uses of Financial Statements 1.6.2 Users of Financial Statements 1.6.3 True and Fair View of Accounts 1.6.4 Double Entry System of Financial Accounting 1.7 Form and Contents of Financial Statements 1.7.1 Form and Contents of Balance Sheet 1.7.2 Form and Contents of Income Statement 1.7.3 Components of Balance Sheet 1.7.4 Components of Income Statement 1.8 Accounting Conventions and Concepts and Generally Accepted Accounting Principles 1.9 Concept of Capital and Income 1.9.1 The Economists Concept of Capital and Income 1.9.2 Accountants Concepts of Capital Maintenance and the Determination of Profit 1.10 Summary 1.11 Glossary 1.12 Suggested Readings/Reference Material 1.13 Suggested Answers 1.14 Terminal Questions

1.1 INTRODUCTION
Accounting hardly needs any formal introduction. All of us do some accounting, often without realizing it. Consider that you are explaining to your father as to what you did with the 100 rupees he gave you last week. What you do is recollect all the events for which the money was spent and what you are doing is accounting for the money. Similarly, when you organize any function in your college with contributions from your college mates, you need to account for the money collected and probably even maintain a few documents as evidence. Here, accounting becomes a tad more serious than in the first example. Extrapolate it a

Financial Accounting

bit and you can easily understand its importance and seriousness in the business context. In business, however, it is a more robust matter. In all activities, whether business activities or non-business activities which require money and other economic resources, accounting is required to account for such resources. Same is the case in all forms of organizations whether business organizations or non-business organizations. In other words, wherever money is involved accounting is required to account for it. All this requires systematic record keeping on a daily basis and analyzing this information to aid in business decision-making. Although accounting is a discipline having universal applicability, yet its growth is closely related and associated with the growth in the business world. This unit is intended to provide an overview of the importance, scope and nature of accounting. It also discusses in detail a few steps in the accounting process beginning with identifying the transactions, recording and classifying them into ledgers. We shall also go into the fundamental principles that provide guidance in accounting for the events and the transactions taking place in a business enterprise.

1.2 OBJECTIVES
After going through the unit, you should be able to: Define accounting and outline the process of accounting; Recognize the financial statements and recall their form and contents; Identify the various streams of accounting; State the accounting conventions, concepts and Generally Accepted Accounting Principles; and Explain the concept of capital and its maintenance in the context of earning profit.

1.3 MEANING OF ACCOUNTING


The primary objective of most businesses is to earn profits. Accounting becomes indispensable to know how close or far you are from your objective. Accounting provides answers to how much of the business belongs to you and how much to the outsiders, where you have invested your and the outsiders money, which businesses are profitable and which are not etc. All this requires systematic recordkeeping of all that happens on a day-to-day basis in business and classifying, summarizing and analyzing this information. This whole process from recording to summarizing and analyzing constitutes accounting. In simple words, accounting merely means, reckoning or recounting. In an organizational context too, accounting has more or less the same meaning. Only, it has to be carried out so much more promptly, sincerely and meticulously that you find a whole functional department dedicated to it in any organization. We must also understand the difference between the terms accounting and bookkeeping:

Introduction to Accounting and Financial Statements

Accounting is broader in scope than bookkeeping, which is merely concerned with orderly record keeping. Going beyond the narrow confines of bookkeeping, accounting involves analysis and judgment at different stages such as recording of transactions, classification, summarization and interpretation. Accounting thus is the language of business which communicates the results and financial position of the business. As with every credible language Accountancy also has its own basic concepts, tenets, assumptions on which, in turn, are based its whole body of grammar and vocabulary (known as Accounting Standards, Guidelines). Any accounting exercise must conform to this framework of concepts, principles, etc. Further, like the English language, the accounting language has also its country-specific variations. For example, while preparing accounts for the US users, you must comply with the US GAAP (Generally Accepted Accounting Principles), not Indian GAAP and vice-versa. However, efforts are on for arriving at a consensus on a uniform set of standards applicable across the globe, the International Accounting Standards. The American Institute of Certified Public Accountants defines accounting as the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. Objectives of Accounting Following can be considered as the objectives of accounting: To maintain records of the business. To facilitate better control over the assets of the business. To ascertain the working results of the business entity on a periodic basis. To ascertain the financial health or position of the business entity. To meet the information needs of decision makers.

1.4 STEPS IN ACCOUNTING


Financial Accounting consists of creation of financial information and the subsequent use of such information. The utility of accounting information is greatly increased when it is compiled in a systematic manner and financial statements are prepared at periodic intervals. For the purpose of compilation, all monetary events are recognized as transactions and classified into various account heads. The account heads are then summarized under related and significant groups so that interpretation becomes possible. By the definition given by AICPA, we can enumerate the following tasks which together constitute the whole process of accounting: RECORDING Commences when a business transaction occurs and it has been quantified. A record of all these transactions is maintained in the order in which they occur in the Journal. Recording requires the following four fundamental questions to be resolved:

Financial Accounting

a.

What to Record: Only events and transactions, which are of financial character or in other words, which can be measured in terms of money, can, and need, be recorded. When to Record: Accounting is historical in nature because of which the recording is to be effected only after the occurrence of the subject transaction. Therefore, sale of goods cannot be recorded in the Books of Account when the goods are merely intended to be sold, but only after such sale is complete and the property in the goods has been transferred to the buyer. How to Record: The Double Entry Bookkeeping system is the practical base of accountancy. Entries are passed in the Journal and the entries are called Journal Entries.

b.

c.

Value at which it is to be Recorded: Once you have identified an event which ought to be recorded because it is monetary in nature, the question that arises is at what value it should be recorded. For the day to day recording of transactions like sales, purchases, expenses etc., this is not a big issue as the amount at which the transaction takes place is the value at which it is to be recorded. However, it ought to be kept in mind that value of money changes and does not remain stable over time for example, between the day a transaction takes place and the day you are reporting upon it. Also, the value of your assets and liabilities may undergo significant change over the period starting when they were acquired or undertaken and ending when they are being reported upon. So this question of value assumes greater significance at the stage of summarizing and reporting. At this stage, we have to choose from Historical cost, Market value, Current cost or Replacement cost, Realizable value and Present value to report various elements of the financial statements. d. CLASSIFYING Refers to the rational segregation of the recorded information into related groups so as to make the record useful. The book containing such classified information is called the Ledger Book consisting of a number of accounts. For example, all the receipts and payments of cash are grouped into a place called Cashbook to know the net cash position of the firm, all sales into a sales account and so on. SUMMARIZING After the Recording and Classification phases are complete the accounts containing relevant information in the Ledger Book are to be balanced and the balances listed. The Statement giving names of these accounts and their respective balances is called the Trial Balance. On the basis of the Trial Balance, the 10 Historical cost is the amount at which the transaction actually took place when it took place. This is also the most commonly used measurement. Market value is the price of an asset prevailing in a free market between an informed and willing buyer and seller in an arms length transaction. Current cost or Replacement cost is the amount that needs to be paid if the asset is to be acquired currently. It is significantly related to market value. Realizable value is the net amount collectible in the event of the assets disposal. It is also significantly related to the market value. Present value is the present discounted value of the future inflows that an item is expected to generate in the normal course of business.

Introduction to Accounting and Financial Statements

summaries are generated to provide information about the Profit/Loss and the position of the firm. The reporting of these summaries is done through Financial Statements. Financial Statements can be said to include the Balance Sheet, the Profit and Loss Account, Cash Flow Statement, Notes to the Accounts and other statements and explanatory material which are identified as an integral part of financial statements. Look at Figure 1.1 and note the activities that constitute the accounting process. Identification of transaction. All, and only, events expressible in monetary terms effecting the business are to be identified.

Step 1

Step 2

Recording of transaction in books of original entry.

For example, transactions are recorded in cashbook, purchase book etc.

Step 3

Posting to ledger.

All transactions recorded in the books of original entry are to be posted into the respective ledger accounts.

Step 4

Preparation of trial balance.

Trial balance is a summary of balances of all accounts in the ledger as well as cash account.

Step 5

Passing of adjustment entries.

Typical adjustment entries are those relating to depreciation, accrued income, expenses, etc.

Step 6

Adjusted trial balance is nothing but trial Preparation of adjusting trial balance. balance prepared after taking into account the adjustment entries.

Step 7

Preparation of financial statements.

Profit & Loss a/c, Balance Sheet, cash flow statement are prepared from the adjusted trial balance.

Figure 1.1: The Accounting Process

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1.5 BRANCHES OF ACCOUNTING


Accounting is generally classified into three different disciplines as below: Financial Accounting Accounting involves recording, classifying and summarizing of past events and thus is historical in nature. Primary objective of financial accounting is to determine the outcome of the business venture on a periodic basis and to assess its financial position taking into reckoning events which have occurred during the period being considered. But this information, though of immense vitality does not adequately aid the management in planning, controlling, organizing and efficiently conducting the course of the business as a result of which cost accounting and management accounting are in place. Cost Accounting It shows classification and analysis of costs on the basis of functions, processes, products, centers etc. It also deals with cost computation, cost saving, cost reduction, etc. Management Accounting It deals with the processing of data generated in financial accounting and cost accounting for managerial decision-making. It also deals with application of managerial economic concepts for decision-making. Self-Assessment Questions 1 a. How does AICPA define Accounting? . . . b. List the activities involved in accounting process. . . . c. What are the various branches of accounting and how are they different from each other? . . .

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Introduction to Accounting and Financial Statements

1.6 FINANCIAL STATEMENTS


Financial statements are the goal of the entire accounting endeavor and the various tasks of recording etc., involved in the accounting process. Without financial statements, books of account by themselves have little use to the purpose of financial analysis or decision-making. A relevant paragraph from Framework for the Preparation and Presentation of Financial Statements issued by the Institute of Chartered Accountants of India (ICAI) is apt to quote here: Financial statements form part of the process of financial reporting. A complete set of financial statements normally includes a balance sheet, a statement of profit and loss (also known as income statement), a cash flow statement and those notes and other statements and explanatory material that are an integral part of the financial statements. They may also include supplementary schedules and information based on or derived from, and expected to be read with, such statements. Such schedules and supplementary information may deal, for example, with financial information about business and geographical segments, and disclosures about the effects of changing prices. Financial statements do not, however, include such items as reports by directors, statements by the chairman, discussion and analysis by management and similar items that may be included in a financial or annual report. Thus when we say financial statements we mean: Profit and Loss Account (also called, Income Statement) Balance Sheet (also called Statement of Affairs) Cash Flow Statement.

And all other statements, schedules, notes, and explanatory materials that form integral part of the financial statements. A profit and loss account is an account showing how much and how, profit has been earned or loss suffered by a firm during a particular period. In general, it is the performance report of the organization. A balance sheet is a statement of what an organization owes and to whom and what it owns at any given point of time. In general, it is the report of financial position of the organization at any particular point of time. A cash flow statement is a statement of the sources from which funds or cash were raised and the uses to which these funds or cash were put during a certain period.

1.6.1 Uses of Financial Statements


The objective of financial statements is to provide information about the financial position, performance and cash flows of an enterprise that is useful to a wide variety of users in making economic decisions.

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Financial statements prepared for this purpose meet the common needs of most users. However, by its very nature, financial statements cannot satisfy all the information needs of all the users. The uses of financial statements are as varied as its users. So, it is fitting here to know who they are and for what purpose they use the information contained in the financial statements.

1.6.2 Users of Financial Statements


Management In a company form of organization the owners or the shareholders elect a group of people to manage the day-to-day affairs of the company. Since these managers are ultimately responsible for the financial performance, they must periodically compile and interpret the financial statements to know where the firm is heading. Shareholders, Security Analysts and Investors The major users of financial statements of business range from individuals with limited shareholding to institutions like insurance companies and mutual funds which have high stakes in the corporate world. The focus of this class of users is either on investment or stewardship or both. The financial position of the company is known to the shareholders through the financial statements which state the profit gained or loss suffered and the measure of its assets and liabilities. Lenders Banks, financial institutions and other lenders would willingly part with their money only if they are assured of the profitability and long-term solvency of the business in which they are asked to invest. They are interested in the profitability and liquidity of the business and the security available for the monies lent. Suppliers/Creditors Suppliers of raw material, etc., to the company would be particularly interested in the short-term liquidity of the company. The financial statements facilitate the creditors in ascertaining the capacity of the organization to pay on time the consideration for the goods/services to be supplied. The primary information for assessing the health of the firm is derived from such statements. Customers Legal obligations associated with guarantees, warranties and after sales service contracts tend to establish long-term relationship between a business and its customers. The financial statements may be used by the customers to draw inferences about the long-term viability of the firm. 14

Introduction to Accounting and Financial Statements

Employees Employees have a vested interest in the continued and profitable operations of the organization in which they work. Financial statements can be used as important sources for obtaining information regarding the current and future profitability and solvency. Sometimes, contracts tying remunerations to profits or payment of incentives based on certain financial measure would tend to magnify this interest. Government and Regulatory Agencies The correct assessment of income tax, sales-tax, excise duty, agreements with the government, enforcement of financial and economic legislations (for example, those relating to free trade, foreign exchange), compilation of national economic database are some of the purposes for which government and other bodies have to, directly or indirectly, wholly or partially, rely upon the information contained in the financial statements. Research Scholars, Academicians, researchers look into the financial statements for the information eventually used for their respective purposes.

INTERNAL

Management Directors Promoters/Partners Officers Financing Group Public Group Investors Lenders Suppliers Financial Institutions

Users of Financial Statements

EXTERNAL

Govt. Agencies Trade unions Customers Others for example, academicians, researchers,

Figure 1.2: Users of Financial Statements

1.6.3 True and Fair View of Accounts


If you refer to the Para Users of Financial Statements, you can clearly see the differing focus of various interest groups in the financial statements. Such discordant interests displayed by a varied group of constituents necessitate objective portrayal of the financial conduct of the business, without any bias

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towards any particular group of stakeholders, known in the accounting jargon as true and fair view. What constitutes true and fair has not been defined in the legislation. However, the Companies Act, 1956 states that every balance sheet of a company shall give a true and fair view of the state of affairs of the company at the end of the financial year, and every profit and loss account of a company shall give a true and fair view of the profit or loss of the company for the financial year. However, Section 211(5) of the Companies Act, 1956 states that the balance sheet and profit and loss account of a company shall not be treated as not disclosing a true and fair view of the state of affairs of the company if they do not disclose any matters which are not required to be disclosed by virtue of the provisions of Schedule VI to the Companies Act, 1956, or by virtue of any notification or any order. This has underscored the need for developing accounting concepts, principles and standards to ensure that financial statements satisfy the above necessity. Also, to impart further credibility to the reported financial statements, these are required to be attested by professional accountants who perform the task of auditing (which involves examination and verification) before expressing their opinion on whether financial statements reflect true and fair view. Self-Assessment Questions 2 a. What do you mean by financial statements? . . . b. List the various users of financial statements. . . . c. Explain the meaning and significance of true and fair view of financial statements. . . .

1.6.4 Double Entry System of Financial Accounting


Earlier, organizations used to maintain accounts in the single entry system which recognizes only cash transactions. But now, accounts are invariably maintained in the double entry system which recognizes both cash and credit transactions. Accounts are maintained on accrual basis under this system. A cost incurred (i.e. accrued) is duly accounted for irrespective of whether it is paid or not during that 16

Introduction to Accounting and Financial Statements

period. In addition, all transactions are supposed to have dual aspect a debit aspect and a credit aspect. We will see more of debits and credits later. Since the system records both the debit and credit aspects of a transaction it is known as double entry system. Legally, a sole proprietary business, a partnership firm or a business organized by a Hindu Undivided Family (HUF) is free to choose the method and system of accounting. For income tax purposes, persons carrying on business should get their accounts audited by an accountant if the total sales, turnover, or gross receipts exceed Rs.40 lakhs in a year. A person carrying on profession is also required to get his accounts audited if his gross receipts exceed Rs.10 lakhs in a year. However, in the case of companies registered under the Companies Act, 1956 (as private limited companies or as public limited companies) the provisions of the Companies Act stipulate that accounting records should be maintained, audited and presented to shareholders every year. Such audited accounts should also be filed with the Registrar of Companies. The format of the financial statements is specified in Schedule VI of the Companies Act.

1.7 FORMS AND CONTENTS OF FINANCIAL STATEMENTS


Now that we are familiar with the various parties interested in the financial statements, we need to dwell into the form and contents of these statements that reveal the financial position and performance of the business entity.

1.7.1 Forms and Contents of Balance Sheet


As per the Companies Act, 1956, the Balance Sheet of a company shall be drawn either in horizontal form or in vertical form. While the vertical form is the most commonly used by companies in practice, pedagogically it is more convenient to explain the contents of the balance sheet with reference to the horizontal form. Given below are the samples of both the forms. Horizontal Form Name of the Company. Balance Sheet as at Liabilities Share Capital Reserves and Surplus Secured Loans Unsecured Loans Current Liabilities Provisions Current Liabilities Provisions and Rs. xxx xxx xxx xxx xxx Assets Fixed Assets Investments Current Assets, Loans and Advances Current Assets Loans and Advances xxx xxx xxx Rs. xxx xxx

xxx xxx xxx xxx xxx

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Vertical Form Name of the Company. Balance Sheet as at Schedule No. Figures as at the End of Current Financial Year (3) Figures as at the End of Previous Financial Year (4)

(1) I. SOURCES OF FUNDS 1. Shareholders funds: a. Capital b. Reserves and Surplus 2. Loan funds: a. Secured loans b. Unsecured loans TOTAL II. Application of Funds 1. Fixed Assets a. Gross Block b. Less: Depreciation c. Net block d. Capital work-in-progress 2. Investments 3. Current assets, loans and advances a. Inventories b. Sundry debtors c. Cash and bank balances d. Other current assets e. Loans and advances Less: Current liabilities and provisions a. Liabilities b. Provisions Net current assets 4. a. Miscellaneous expenditure to the extent not written off or adjusted b. Profit and loss account TOTAL

(2)

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Introduction to Accounting and Financial Statements

1.7.2 Forms and Contents of Income Statement


Schedule VI to the Companies Act, 1956 deals with matters pertaining to the preparation of financial statements of companies registered under the said Act. More specifically, it specifies the: form and contents of the Balance Sheet of a company, disclosure requirements to be complied with in the preparation of the Balance Sheet, disclosure requirements to be complied with in the preparation of the Profit and Loss Account. As can be seen from the above, the Act does not prescribe any particular format for income statement which is also called as the Profit and Loss account but requires that the income statement must disclose specific information as given in the said schedule. However, given below are sample formats both in Horizontal and Vertical forms, which are fairly widely followed. Horizontal Form Name of the Company Profit & Loss A/c for the Year Ended Dr. Particulars To Opening Stock To Manufacturing Expenses To Gross Profit c/d To Administrative Expenses To Marketing Expenses To Depreciation To Interest To Provision for Tax To Net Profit c/d To Appropriations To Dividends To Transfer to Reserves To Balance c/d to Balance Sheet Cr. Rs. xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx Particulars By Sales By Closing Stock Rs. xxx xxx xxx xxx

By Gross Profit b/d

By Balance b/f By Net Profit for the Year

xxx xxx xxx

xxx

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Vertical Form Name of the Company Profit & Loss Account for the Year Ended Schedule No. Figures as at the end of Current Financial Year (3) Figures as at the End of Previous Financial Year

(1) Income Sales Other Income Expenditure Purchases Manufacturing and other expenses Depreciation Interest and other financial charges Profit for the Financial Year Before Tax (PBT) Provision for taxation Profit for the Financial Year After Tax (PAT) Balance of Profit & Loss a/c brought forward Proposed dividend Transfer to reserves Balance carried to Balance Sheet Notes: 1. 2.

(2)

(4)

3.

Separate schedules should be annexed wherever required, which would form an integral part of the Profit & Loss a/c. The figures in the Profit & Loss a/c may be rounded off to the nearest 000 or 00, as may be convenient or may be expressed in terms of decimals of thousands. Footnotes may be appended to the directors fees, managers and auditors remuneration, etc.

1.7.3 Components of Balance Sheet


Assets Broadly speaking, assets represent resources which are of some value to the firm. They have been acquired at a specific monetary cost by the firm for the conduct of its operations. Assets are classified as follows under the Companies Act: Fixed assets Investments Current assets, loans and advances Miscellaneous expenditure Profit and Loss Account (Losses). Fixed Assets: These are acquired for use over relatively long periods for carrying on the operations of the firm and they are ordinarily not meant for resale. Examples: Land, buildings, plant, machinery, patents and copyrights. 20

Introduction to Accounting and Financial Statements

Investments: Investments are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. These can be financial securities, immovable property, investments in subsidiaries, associates, joint ventures or partnership firms. Currents Assets, Loans and Advances: This category consists of cash and other resources which get converted into cash during the operating cycle of the firm. Examples: Cash, debtors, inventories, loans and advances and pre-paid expenses. Miscellaneous Expenditure and Losses: Miscellaneous expenditure represents certain outlays such as preliminary expenses and pre-operative expenses which have not been written off. Unlike in case of non-corporate entities, the share capital of a company cannot be reduced when a loss occurs. So, the loss is shown on the right hand side (the assets side) of the balance sheet. Liabilities Liabilities when defined very broadly represent obligations of the business entity. The Companies Act classifies liabilities as follows: Share capital Reserves and surplus Secured loans Unsecured loans Current liabilities and provisions.

Share Capital: Share Capital is of two types: equity capital and preference capital. The first represents the contribution of equity shareholders who are the actual risk bearers and owners of the firm. Preference capital represents the contribution of preference shareholders and the dividend rate payable on it is fixed.

Reserves and Surplus: There are two types of reserves: revenue reserves and capital reserves. Revenue reserves represent accumulated retained earnings from the profits of normal business operations.

Examples: General reserve, investment allowance reserve, capital redemption reserve, dividend equalization reserve, etc. Capital reserves arise out of gains which are not related to normal business operations.

Examples: Premium on issue of shares, unrealized gains on revaluation of assets. Surplus is the balance in the profit and loss account which has not been appropriated to any particular reserve account. Secured Loans: These are amounts borrowed against pledge/hypothecation of specific assets. Examples: Debentures, term loans etc. Unsecured Loans: These are borrowings of the firm against which no specific security has been provided.

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Current Liabilities and Provisions: Current liabilities are obligations which are expected to mature in the next twelve months. Examples: Loans which are payable within one year from date of balance sheet, sundry creditors, provision for taxation, outstanding expenses, advance payments received for goods or services.

1.7.4 Components of Income Statement


Net sales appearing in the Income Statement is the sum of the invoice price of goods sold and services rendered during the period less value of goods returned by the customers. Cost of goods sold is the sum of costs incurred for manufacturing the goods sold during the accounting period. It consists of direct material cost, direct labor cost and factory overheads. Gross profit is the difference between net sales and cost of goods sold. Operating expenses consist of general administrative expenses, selling and distribution expenses and depreciation. Operating profit is the difference between gross profit and operating expenses. As a measure of profit it reflects operating performance and is not affected by nonoperating gains/losses, financial leverage and tax factor. Non-operating surplus/deficit represents gains/losses arising from sources other than normal operations of the business for example, investments, disposal of fixed assets, etc. Profit/Earnings Before Interest and Taxes (PBIT/EBIT) is the sum of operating profit and non-operating surplus/deficit. Interest is the expense incurred on borrowed funds. Profit before tax is obtained by deducting interest from profits before interest and taxes. Tax means income tax expense for the year. Profit after tax is the difference between the profit before tax and tax for the year. Dividends represent the amount earmarked for distribution to shareholders. Retained earnings are the residual of profits after dividends. The end-users of financial statements need not necessarily be those with finance background. They might not be in a position to understand the complex technicalities of financial statements. People who do not have detailed understanding of financial accounting process and the related legal provisions are sure to fail to make any sense out of the vast plethora of information presented in the annual reports. One outcome of this dissatisfaction on the part of the end-users of the annual report has been the highlighted summarized versions of the Balance Sheet and Profit and Loss Account in non-technical language. Experts however feel that in this process of summarization, the true meaning and content of vital financial information may be diluted or lost. However, one should clearly understand that summary report neither is meant to, nor can, eliminate or substitute the regular financial statements but would just serve as primary information for the average or non-financial users of financial statements. 22

Introduction to Accounting and Financial Statements

1.8 ACCOUNTING CONVENTIONS AND CONCEPTS AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
As already mentioned, accounting is the language of business which communicates the results and financial position of the business and has its own concepts, tenets, assumptions on which, in turn, are based its whole body of grammar and vocabulary (Accounting Standards, Guidelines or commonly known as Generally Accepted Accounting Principles GAAP). Any accounting exercise must conform to this framework of concepts, principles, etc. Generally accepted accounting principles specifies which economic resources and obligations should be recorded as assets and liabilities and at what amounts; which changes in assets and liabilities should be recorded and when; how the assets and liabilities and changes in them should be measured; what information should be disclosed and which financial statement should be prepared. Most countries have an apex body governing, regulating and promoting the profession of accountancy in their domestic domain. In India, it is the Institute of Chartered Accountants of India (ICAI). This body pronounces various standards and guidelines to be complied with in the preparation of financial statements. To standardize the accounting information, every organization has to establish its accounting policies within the bounds of GAAP. Accounting policies encompass the principles, bases, conventions, rules and procedures adopted by management in preparing and presenting financial statements. Let us examine them one by one. Money Measurement Concept In financial accountancy, a record is made only of information that can be expressed in monetary terms. Thus, if a certain event, no matter how significant for the health or even existence of the business, cannot be measured in monetary terms, such an event is not recorded in accounting. For example, purchase of an inconsequential asset, which is easily measured in rupee terms, is accounted for in the business. However, the retirement or death of the Chairman of a company, even though it might have far reaching consequences for the health of the business, is not accounted for, since no monetary measurement of the event is feasible. It is necessary not only that events be measured in terms of money but that they should be expressed in the same currency. You cannot prepare a balance sheet with the assets side in rupees and the liabilities side in, say, dollars. Historical Cost Concept All transactions are recorded at the amount at which they took place and all assets and liabilities generally carried at the amount at which they were acquired or undertaken. Please note that generally is underlined. This is to highlight the fact that there are quite a few exceptions which must be adopted strictly in accordance with the relevant accounting standards. For example, Accounting Standard-10, Fixed Assets, permits revaluation of fixed assets in certain circumstances and subject to certain conditions. Further, it does not apply to current assets which are to be stated at cost or net realizable value, whichever is less.

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Financial Accounting

Time Period Concept Financial statements in general and profit and loss account and cash/funds flow statements in particular are prepared for a particular time period. Balance sheet is prepared with reference to a particular date, usually the last date of the period to which the profit and loss account relates. This period is known as accounting period. An accounting period need not be exactly a whole year but can be shorter or longer than it. Again it need not be a calendar year or fiscal year but can start on any date. This is however is subject to the applicable laws governing the enterprise like Companies Act, 1956, Income Tax Act, 1961 etc. Conservatism Concept No profit/income should be anticipated whereas all known or foreseeable losses/expenses must be provided for. The idea behind this principle is that recognition of revenue requires better evidence than recognition of expenses. This principle emphasizes that revenues are to be recognized only when they are reasonably certain and expenses are to be recognized as soon as they are reasonably possible. For example, if a business holds, on the date that it draws up its balance sheet inventories the cost of production of which is Rs.10,000 and market price Rs.17,000, it cannot claim to have earned the excess of Rs.7,000 of market price over cost, however favorable the market might be and however confident it might be of being able to sell them at this price. On the other hand, if in the same example, if the market price were Rs.6,000, conservatism concept requires that it must provide for the anticipated loss of Rs.4,000. Note: This concept should not be construed as allowing you to understate profits/income or overstate expenses/losses. Consistency Concept In order to render the financial statements of an enterprise comparable from one period to another, it is necessary that accounting policies (accounting policies are specific accounting principles and the methods of applying those principles adopted by the enterprise in the preparation and presentation of financial statements) be followed consistently from one period to another. A change in an accounting policy is made only in certain exceptional circumstances and with adequate disclosures of its nature and impact on financial statements. Business Entity Concept In accounting, the business is a separate and distinct entity from its owners. In other words, any transaction between the owner(s) and the business is like any other transaction, so far as its accounting is concerned. This is so irrespective of the constitutional set-up of the business (for example, sole-proprietorship, partnership, private limited or public limited company) and whether or not the business is having distinct legal entity. It is in accordance with this concept that when an owner (shareholders or sole proprietor) brings capital into the business, the business in turn is deemed to owe the capital to the owner and required to record the same accordingly as a liability in the books of Business, although law does not distinguish between the business and personal assets and liabilities of a sole proprietor. Going Concern Concept The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation in the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an 24

Introduction to Accounting and Financial Statements

intention or need exists, the financial statements may have to be prepared on a different basis altogether and, if so, the basis used is disclosed. for example, fixed assets are carried at its historical cost less depreciation mainly because when the business has no intention or need to liquidate in the foreseeable future, it makes no sense to carry them at market value. But if the going concern assumption is not valid, the above logic is altered upside down and fixed assets must be stated at their realizable value. Duality or Accounting Equivalence Concept Note the following fundamental equations in accounting: Owners equity + Outsiders liability = Total Assets Every transaction affects the variables in the above equation such that the equilibrium is always maintained. That means any transaction must either affect the same side of the equation in opposite directions with same amount or both sides of the equation in the same direction with the same amount. We shall see that the entire mechanics of financial accounting revolves around this equation. Realization Concept Realization concept deals with the point in time at which revenue may be deemed to be realized or when a sale can be said to have taken place. Revenue is normally recognized only when goods are transferred or services are rendered and a reward or a promise of reward is forthcoming. Matching Concept In order to determine the profits or losses earned or suffered in an accounting period, the expenses must relate to the goods or services sold during the period and all expenses/costs associated with the earning of revenue must be matched against those revenues. Thus it is clear that the cost derives its relevance only from the sale and not vice-versa. It is for this reason that revenue recognition always precedes the matching of cost. Self-Assessment Questions 3 a. List the various concepts and conventions of accounting. ... .. .. b. State whether the following statements are True or False: i. ii. GAAP stands for Globally Accepted Accounting Principles. ... Consistency principle emphasizes that revenues are to be recognized only when they are reasonably certain and expenses are to be recognized as soon as they are reasonably possible. . iii. Owners equity + Outsiders liability = Total Assets is referred to as Fundamental Accounting Equation.

1.9 CONCEPT OF CAPITAL AND INCOME


According to the Accountants Concept of Capital and Income, Capital is the contribution made by the owner(s) in the business and is regarded as a liability to the business in the nature of owners equity. The underlying feature for this treatment is the distinction between the owner(s) and that of the business owned by 25

Financial Accounting

them as a result of which the business is vested with an implied obligation to repay such sum to the owner(s). The income of the business is arrived at by matching the revenues of a defined period with the expenses of the same period, and it accrues to the owner(s). This matching of revenues and expenses can either be on an Accrual basis or Cash basis or the Hybrid (mixture of both accrual and cash bases).

1.9.1 The Economists Concept of Capital and Income


Capital for an economist refers to assets which are used to produce goods and services. This concept has an asset orientation and is applicable to a certain point of time. If the inventory of wealth at a point of time is called the Capital, the benefit derived from such wealth during a certain defined period is called income. Income is computed by deducting the Capital at the end of the period and the Capital as at the beginning of the period. The capital represented by the assets of the firm is valued by discounting the expected future cash flows at the cost of capital of the business to find the Present value [Cost of capital and Present value will be explained in Financial Management]. Ex ante income = Original expectation of expected future cash flows at the end of the period Original expectation of expected future benefits at the beginning of the period; Revised expectation of expected future cash flows at the end of the period Original expectation of expected future benefits at the beginning of the period;

Ex post income =

The economists concept though more elegant is riddled with subjectivity.

1.9.2 Accountants Concepts of Capital Maintenance and the Determination of Profit


Though they might hold different views on the definition, scope of capital and the basis and techniques for its measurement, economists and accountants of all hues however agree on the following: That profit earned during any period is the excess of capital at the end of the period over that at the beginning. Thus, the prerequisite for having profit is maintaining the initial capital at its original level at any given point of time. Only when you have anything above that level can you say that you have profit. This pre-condition to the earning of profit is called Capital Maintenance Concept. We have already discussed the economists concept of capital. When it comes to the accountants, we have again two different varieties of capital maintenance: Physical (Real) Capital Maintenance: Under this concept, a profit is earned only if the physical productive capacity (or operating capability) of the enterprise at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. The physical capital maintenance concept requires the adoption of the current cost basis of measurement. Financial Capital Maintenance: Under this concept, a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the

26

Introduction to Accounting and Financial Statements

period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. Nominal Financial Capital Maintenance: Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains are, conceptually, profits. They may not be recognized as such, however, until the assets are disposed of in an exchange transaction. Purchasing Power Maintenance: When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity.

Example 1 Z has started a business with Rs.5,000 as capital. Assuming that his activity is trading of goods, he buys goods for Rs.5,000 and sells them for Rs.7,500. As the business is to be separated from the personal transactions of the owner, the position of the firm is that it possesses Rs.7,500 in cash and owes Rs.7,500 to Z. In terms of nominal financial capital maintenance, the profit earned in this transaction is Rs.2,500 which even if drawn by Z leaves the capital of Rs.5,000 undisturbed. Here we do not bother about either the change in the general level of prices in the economy or the change in the level of prices of the specific goods he deals in. Under this concept of maintaining the capital income shall be revenue less the historical cost of goods sold.

If the present capital of Rs.5,000 be shown in terms of units where the price is Rs.10, thus 500 units. The 500 units is the Real or physical capital and Rs.5,000 is the monetary capital. Even after withdrawing Rs.2,500, if there are no price fluctuations, Z will be in a position to purchase 500 units. Thus both the monetary and the physical capital are maintained. But if the price per unit goes up to Rs.15 and Rs.2,500 representing the profit (as per nominal capital concept) from the earlier transaction is withdrawn then obviously Z will be prevented from buying 500 units with only Rs.5,000 in hand and thus will not be able to operate at the same scale, size and efficiency with which he had started. In other words, if the physical Capital Maintenance Concept is followed, Z should not withdraw Rs.2,500 as the full amount of Rs.7,500 is required to make the purchases of 500 units required to restore his original operating level. The accounting based on the Physical Capital Maintenance Concept by taking into account specific price levels is known as Current Cost Accounting. Income shall be revenues less the current cost of goods sold.

This approach accounts for only the general level of price increase and not on the specific rise. Thus in our example if the cost of goods sold are restated in 27

Financial Accounting

terms of the general increase brought by inflation, and if the increase in rate is assumed to be 20 percent, then the cost of 500 units shall be Rs.6,000. The excess of Rs.7,500 over Rs.6,000 is the profit that can be withdrawn while maintaining the purchasing power of capital originally invested. The accounting that takes into account the general level of price change in the economy is called the constant purchasing power accounting. Income is the revenue less the cost of goods sold restated in terms of the general price inflation. To put it differently, profit is equal to nominal capital at the end of the period less that at the beginning restated to reflect its original purchasing power. Self-Assessment Questions 4 a. Examine capital maintenance from the perspective of an Economist. . . . b. Examine the two different types of capital maintenance concepts from the perspective of an Accountant. . . .

1.10 SUMMARY
The primary function of financial accounting is to provide relevant financial information to users for making decisions and taking actions. The primary means of providing financial information to investors, creditors and other external users is through financial statements. Financial statements are nothing but systematic and meaningful summarization of underlying data recorded and classified in the books of account. One must be mindful of various accounting concepts, conventions and Generally Accepted Accounting Principles (GAAP). Accounting concepts are: Money Measurement Concept, Historical Cost Concept, Time Period Concept, Conservatism Concept, Consistency Concept, Business Entity Concept, Going Concern Concept, Duality or Accounting Equivalence Concept, Realization Concept, Matching Concept. GAAP (also known as Accounting Standards) are issued by the concerned regulatory body responsible for the conduct of profession of accountancy in the country. As financial statements draw the interests of various stakeholders, who are very diverse in their focus, it becomes imperative that financial statements convey a true and fair view of the accounts. Various components of a balance sheet are: intangible assets, fixed assets, currents assets, fictitious assets on the assets side and capital, reserves and surplus, secured loans, debentures, unsecured loans, current liabilities and provisions, etc., balance sheet can be presented either in horizontal or vertical format. Profit and Loss A/c contains information such as sales, other income, cost of goods sold, opening and closing inventory, interest, 28

Introduction to Accounting and Financial Statements

depreciation, and other elements of expense and income as may be appropriate to the particular organization, gross profit and net profit. Profit is said to be earned when and to the extent, the closing capital exceeds the opening capital. Thus, capital maintenance is a precondition to earning profit. Economists concept of capital is asset-centric while his concept of income is more based on estimation of future profits which renders it too difficult to be practicable. From accountants perspective, capital maintenance can be either seen in terms of physical capital, nominal financial capital or constant purchasing power. Physical capital concept requires current cost accounting to be adopted, nominal financial takes only historical cost into reckoning whereas constant purchasing power accounting takes the general level of changes in prices in the economy as a whole.

1.11 GLOSSARY
Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. Bookkeeping is the orderly maintenance of day-to-day records. Constant Purchasing Power Accounting is that which takes into account the general level of price change in the economy rather than in the specific asset or asset class. Cost Accounting is the classification and analysis of costs on the basis of functions, processes, products, centers, etc. It also deals with cost computation, cost saving, cost reduction, etc. Current Cost Accounting is that which takes into account the change in levels of prices of specific assets or group of assets. Ex ante Income = Original expectation of expected future cash flows at the end of the period Original expectation of expected future benefits at the beginning of the period. Ex post Income = Revised expectation of expected future cash flows at the end of the period Original expectation of expected future benefits at the beginning of the period. Financial Statements generally mean and include balance sheet, profit and loss account, cash flow statement and other statements, schedules, notes attached or annexed to them which form integral part of financial statements. Management Accounting is the processing of data generated in financial accounting and cost accounting for managerial decision-making. It also deals with application of managerial economic concepts for decision-making. Nominal Financial Capital is the excess of historical cost of assets over that of liabilities. Physical Capital is the physical productive capacity or the operating capability of a business.

29

Financial Accounting

1.12 SUGGESTED READINGS/REFERENCE MATERIAL


Meigs and Meigs, Financial Accounting, McGraw Hills Inc. Ashok Sehgal and Deepak Sehgal, 2006, Fundamentals of Financial Accounting, 3.Taxmann Publications. How to Read a Balance Sheet, Oxford and IBH Publishing Co. P. Ltd.

1.13 SUGGESTED ANSWERS Self-Assessment Questions 1


a. American Institute of Certified Public Accountants defines accounting as the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. b. The activities involved in accounting process are Identification of transactions, Recording of transaction in Books of original entry, Posting to ledger, preparation of trail balance, passing adjusting entries, Preparation of adjusted trial Balance and preparation of financial statements. c. Accounting is generally classified into three different disciplines as below: Financial Accounting Accounting involves recording, classifying and summarizing of past events and thus is historical in nature. Primary objective of financial accounting is to determine the outcome of the business venture on a periodic basis and to assess its financial position taking into reckoning events which have occurred during the period being considered. Cost Accounting It shows classification and analysis of costs on the basis of functions, processes, products, centers etc. It also deals with cost computation, cost saving, cost reduction, etc. Management Accounting It deals with the processing of data generated in financial accounting and cost accounting for managerial decision-making. It also deals with application of managerial economic concepts for decision-making.

Self-Assessment Questions 2
a. Financial statements form part of the process of financial reporting. A complete set of financial statements normally includes a balance sheet, a statement of profit and loss (also known as income statement), a cash flow statement and those notes and other statements and explanatory material that are an integral part of the financial statements.

30

Introduction to Accounting and Financial Statements

b.

The users of financial statements are Management, Shareholders, Security Analysts and Investors, Lenders, Suppliers/Creditors, Customers, Employees, Government and Regulatory Agencies, and Researchers. What constitutes true and fair has not been defined in the legislation. However, the Companies Act, 1956 states that every balance sheet of a company shall give a true and fair view of the state of affairs of the company at the end of the financial year, and every profit and loss account of a company shall give a true and fair view of the profit or loss of the company for the financial year. However, Section 211(5) of the Companies Act, 1956 states that the balance sheet and profit and loss account of a company shall not be treated as not disclosing a true and fair view of the state of affairs of the company if they do not disclose any matters which are not required to be disclosed by virtue of the provisions of Schedule VI to the Companies Act, 1956, or by virtue of any notification or any order. This has underscored the need for developing accounting concepts, principles and standards to ensure that financial statements satisfy the above necessity. Also, to impart further credibility to the reported financial statements, these are required to be attested by professional accountants who perform the task of auditing (which involves examination and verification) before expressing their opinion on whether financial statements reflect true and fair view.

c.

Self-Assessment Questions 3
a. The various concepts and conventions of accounting are Money Measurement Concept, Historical Cost Concept, Time Period Concept, Conservatism Concept, Consistency Concept, Business Entity Concept, Going Concern Concept, Duality or Accounting Equivalence Concept, Realization Concept, and Matching Concept. b. i. ii. False: GAAP stands for Generally Accepted Accounting Principles. False: Conservatism principle emphasizes that revenues are to be recognized only when they are reasonably certain and expenses are to be recognized as soon as they are reasonably possible. iii. True: Owners equity + Outsiders liability = Total Assets is referred to as Fundamental Accounting Equation.

Self-Assessment Questions 4
a. Capital for an economist refers to assets which are used to produce goods and services. This concept has an asset orientation and is applicable to a certain point of time. If the inventory of wealth at a point of time is called the Capital, the benefit derived from such wealth during a certain defined period is called income. Income is computed by deducting the Capital at the end of the period and the Capital as at the beginning of the period.

31

Financial Accounting

The capital represented by the assets of the firm is valued by discounting the expected future cash flows at the cost of capital of the business to find the Present value [Cost of capital and Present value will be explained in Financial Management]. Ex ante income = Original expectation of expected future cash flows at the end of the period Original expectation of expected future benefits at the beginning of the period; Ex post income = Revised expectation of expected future cash flows at the end of the period Original expectation of expected future benefits at the beginning of the period; The economists concept though more elegant is riddled with subjectivity. b. From accountants perspective, capital maintenance can be in terms of physical capital, nominal financial capital or constant purchasing power. Physical capital concept requires current cost accounting to be adopted, nominal financial takes only historical cost into reckoning whereas constant purchasing power accounting takes the general level of changes in prices in the economy as a whole.

1.14 TERMINAL QUESTIONS


A. Multiple Choice 1. Accounting is the language of a. Business b. c. d. 2. Books Industry Economy.

Accounting standards or principles are formed by the a. b. c. d. Accountant Government ICAI ICSI.

3.

Accounting does not include a. b. c. d. Recording Classifying Summarizing Decision-making.

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Introduction to Accounting and Financial Statements

4.

Which of the following is true? a. b. c. d. Accounting and bookkeeping are identical. Accounting is much broader a function than bookkeeping. Bookkeeping is much broader a concept than accounting. Both are similar with small differences.

5.

Financial statements do not include: a. b. c. d. Profit & Loss account Balance Sheet Directors Report Cash Flow Statement.

B. Descriptive 1. 2. 3. Define and explain the term accounting. Explain the various steps in the process of accounting. What are the various components of Balance Sheet and Profit & Loss accounts? Briefly explain each of them.

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Unit 2: The Accounting Process


Structure
2.1 Introduction 2.2 Objectives 2.3 Mechanics of Double Entry 2.3.1 Symbols for Sources and Uses 2.3.2 Types of Accounts and Rules of Debit and Credit 2.4 Books of Accounts 2.4.1 Recording of Transactions 2.4.2 Books of Original Entry: Journal 2.4.3 Ledger Posting 2.5 Bank Reconciliation Statement 2.5.1 Advantages of Bank Reconciliation Statement 2.5.2 Steps in Preparation of Bank Reconciliation Statement 2.6 Summary 2.7 Glossary 2.8 Suggested Readings/Reference Material 2.9 Suggested Answers 2.10 Terminal Questions

2.1 INTRODUCTION
If accounting be the language of business, double entry system is its basic syntax and debits and credits, the accounting equivalent of binary in computer languages, on which is based the whole edifice of the accounting system. In Unit 1, you have learnt that the accounting process comprises of recording, classification and summarization of transactions. You have also learnt the framework of accounting principles that govern the recording and process of financial information. In this unit, we shall discuss the double entry system which is the only scientific and comprehensive system of accounting. The Fundamental Equation forms the foundation to the double entry bookkeeping system.. After determining the dual effect of the events on the accounting equation, the transactions are recorded in a journal and then the debit and credit from the journal are posted in the Ledger, also called the Principal book. We shall also discuss in this unit how the events and transactions are recorded in the journal and posted in the ledgers using this double entry system of accounting. The final information pertaining to the financial position of a business emerges only from these accounts.

2.2 OBJECTIVES
After going through the unit, you should be able to: Describe the basics of debit and credit using fundamental equation; State the rules of Debit and Credit under the account type approach;

The Accounting Process

Journalize the transactions; Enumerate the Books of Accounts; Be acquainted with recording the transactions in various books; Be acquainted with posting of entries in Ledger Accounts; and Prepare the Bank Reconciliation Statement.

2.3 MECHANICS OF DOUBLE ENTRY


As already learnt in the Duality Concept, every transaction or event has two aspects such that the fundamental equation is always balanced. The double entry system captures these two aspects of the transaction in the recording process. You may recall from previous unit, the fundamental accounting equation: Total Liabilities = Total Assets or Owners Equity + Outside Liability = Assets Let us denote the left and right hand sides of this equation by credit and debit respectively. The equation now becomes: Total credit = Total debit. The left hand side of the equation is the sources of funds and the right hand side, the uses to which they are put. In the context of individual transactions: any increase in owners equity, anything resulting in increase in owners equity, any increase in outside liability, any decrease in assets, any increase in income, and any decrease in expense.

Is a Credit or a Source of Funds any increase in assets, any decrease in owners equity, anything resulting in decrease in owners equity, any decrease in outsiders liability, any increase in expense, and any decrease in income.

Is a Debit or an use of Funds. This equilibrium is maintained at any point of time. Any transaction, however petty or grand it might be in size, occurring in the business affects this equation but affects so that equation is valid nevertheless. 35

Financial Accounting

Any transaction has two aspects to it one debit and one credit, both of the same amount. Debit and credit each must fall within their respective definitions listed out above. In other words, the aspect of transaction giving rise to the debit must be accompanied by another giving rise to credit. It is warranted now that we elaborate a bit as to how expense and revenue fit into the scheme of balance sheet which is made of assets and liabilities. At the outset, any individual item of expense, when seen in isolation, is a decrease in owners equity. And any item of revenue, an increase. When we say seen in isolation, we mean without bothering about the benefits the business might derive out of an item of expense or the costs associated with a particular item of revenue. For example, when you pay Rs.10,000 for purchase of goods, you do not clutter your mind with the sales you will be effecting but restrict your judgment to this purchase as an isolated transaction to determine what effect it has on the balance sheet (assets and liabilities). Thus viewed, we can conclude the purchase is a reduction in cash (a credit) accompanied by an equal reduction in Owners Equity as this expense or loss or outflow of resource ultimately results in decrease in owners equity (a debit). Now let us say you sell the goods for Rs.12,000. Again if we see this transaction in isolation without getting in way the associated costs, we can conclude that the sale is an increase in cash (a debit) accompanied by an equal increase in owners equity as this revenue/gain ultimately results in owners equity (a credit).

2.3.1 Symbols for Sources and Uses


Since Sources and Uses are relatively longer words. The symbol Cr., commonly pronounced as CREDIT and the symbol Dr., commonly pronounced as DEBIT, are used to represent the above items respectively. In accounting, the terms CREDIT and DEBIT are merely two different sounds and do not have the same implications as they have in English language. The connotation of debit and credit may be summarized through the following matrix. Increase Liability, Revenue and Profit Asset, Expenses and Loss CR = Source DR = Use Decrease DR = Use CR = Source

2.3.2 Types of Accounts and Rules of Debit and Credit


We have discussed above that any source of funds is a credit and any utilization, a debit. To further help us in determining the debit and credit involved in a transaction, we can classify the accounts into the following types and frame up certain rules, which are given in figure 1. Personal Account: 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. Real Account: It represents assets like plant and machinery, land and buildings, goodwill, etc. As on a particular date, this account shows the worth of the asset.

36

The Accounting Process

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 under a particular head. Examples: Sales, Purchases, Advertisement, Wages, Commission earned, etc. Whether an Account has to be debited or credited is decided by using the rules indicated in Figure 1. Figure 2.1: Rules of Debit and Credit Rules of Debit and Credit

Personal Accounts Debit: The receiver

Real Accounts What comes in

Nominal Accounts All expenses and losses

Credit: The giver

What goes out

All incomes and gains

Self-Assessment Questions 1 a. Any increase in asset or decrease in liability is a debit, any increase in liability or decrease in asset is a credit. How do you fit in the income and expense in this scheme? ........................................................................................ ........................................................................................ ........................................................................................ b. Bring out, with explanation, the debit and credit aspects of the following transactions: purchase of goods for cash, payment of advertisement expenses, deposit of cash into bank, receipt and deposit of customers cheque into bank account. ........................................................................................ ........................................................................................ ........................................................................................ c. Classify the following items according to the type of their accounts: Cash, freight outwards, printing and stationary, ABC (a customer), XYZ(a supplier), petrol, vehicle maintenance, land, closing stock, trademarks and copyrights. ........................................................................................ ........................................................................................ ........................................................................................

37

Financial Accounting

2.4 BOOKS OF ACCOUNTS


A business organization maintains three important books of accounts, namely cash book, subsidiary books, and ledger. The Cash book records cash receipts and payments including receipts and payments through a bank. Journal record non-cash transactions like credit sales, credit purchases, sales returns, purchase returns, year-end adjustments. These books are also called subsidiary books. Ledger contains a classified summary of all transactions recorded in Cashbook and journal. A ledger is not an independent record. The transactions recorded in a ledger are derived from either Cashbook or journal.

2.4.1 Recoding of Transactions


The recording of transactions in the books of accounts may be represented as in Figure 2.2. Figure 2.2: Recording of Transactions Cash Transactions Recorded in Cashbook Ledger Classified Summary of all Transactions Non-Cash Transactions Recorded in Journal

2.4.2 Books of Original Entry: Journal


As the name suggests, these are where you record any transaction at the first instance. In other words, these are the primary books. All other books and statements are secondary in the sense that they draw upon the basic data in the primary books. Cash book and journal constitute the books of original entry. Journal and Subsidiary Books The daily business transactions are recorded in a book called Journal. The journal is called book of original entry. All the transactions are first entered in the journal in the order of their occurrence. Recording of entries in the journal is known as journalizing. Format of a Journal Date Steps in Journalizing 1. 2. 3. 4. 5. Analyze the transaction and identify the two accounts that are being affected by the transaction. Ascertain the nature of the accounts involved as real, personal or nominal. Determine which rule of debit and credit is applicable for each of accounts involved. Ascertain the account to be debited and the account to be credited. Write the name of the account to be debited along with the abbreviation Dr on the same line against the name of the account in particulars column and Particulars L.F. Debit Rs. Credit Rs.

38

The Accounting Process

the amount to be debited in the debit amount column against the name of the account. 6. Write the name of the account to be credited in the next line preceded by the word To at a few spaces towards the right in the particulars column, and the amount to be credited in the credit amount column against the name of the account. Write Narration (a brief description of the transaction) within brackets in the next line in particulars column.

7.

Example 1: XYZ Ltd. received Rs.1,000 from Geet & Co. on 5-1-2013. Recording the journal entry in the books of XYZ Ltd. Applying the above steps, the following journal entry is made. Journal Date Particulars L.F. Debit. Rs. 1,000 Credit Rs. 1,000

5.1.2013 Cash a/c Dr. To Geet & Co. a/c (Being cash received from Geet & Co.)

With the growth in business, and consequent increase in the number of transactions, it became imperative that all transactions of a particular nature which occur repetitively be recorded in a separate book. Therefore, to facilitate recording of similar transactions, large concerns maintain special journals also known as subsidiary books. Now the purpose of journal (also referred to as journal proper) is restricted to recording special entries like opening, closing, transfer, rectification and entries which cannot be entered in other subsidiary books. Some of the common types of journals for recording routine and homogenous transactions which are also known as Day Books or Subsidiary Books are: Purchase book, Sales book, Purchase return book, Sales return book, Bills receivable book, Bills payable book, Cash book and Journal proper. The purchase book is restricted to the entries pertaining to credit purchases and the sales book to credit sales. This is so because the cash sales and cash purchases are captured in the cash book. Similarly, sales returns of earlier credit sales are entered in sales return and purchase return book is used to write return of goods purchased on credit. Given below is a sample format of Purchase Journal or Purchase Book or Purchase Day Book. Purchases Book Date Particulars (Name of Supplier, etc.) Ledger Folio Inward Invoice No. Amount Rs.

Cash Book A cash book is a chronological record of all cash transactions. The peculiarity of a cash book is that, unlike other subsidiary books and journal, it is both a primary book and a ledger primary book because books all cash transactions are recorded in the first instance in this book, like in the case of other subsidiary books, and a ledger because it contains all the transactions pertaining to cash account in one

39

Financial Accounting

place and readily enables the calculation of balance of this account. Cash book can be of the following types: Simple Cash Book or Single-column Cash Book: All the cash transactions are recorded in chronological order. All cash receipts are entered on the debit side and cash payments on the credit side of the cash book. The difference between the two sides is the cash-in-hand. Double Column Cash Book: It can be either, with cash and discount columns. This cash book is an extension of simple cash book. An additional column is maintained to record discount involved in the settlement of debtors and creditors in the double column cash book. Cash discount usually occurs in the settlement of trade debts. It is an allowance made by the receiver of cash to the payer for the prompt payment. Cash received from debtors is recorded in the cash column and discount allowed in the discount column on the debit side of the cash book. Similarly, credit side of the cash book records cash paid to the creditors in cash column and discount received in the discount column. Or with cash and bank columns. In this type of cash book, the transactions involving cash and transactions involving receipts and payments by cheques are recorded. It facilitates and enables the business to maintain both cash and bank accounts simultaneously. Three Column Cash Book (Cash Book with Cash, Discount and Bank Columns): With the development of banking sector, and frequent use of banking instrument, cash book with additional column for bank transactions came into existence. Thus, the three column cash book is nothing but ledger accounts for cash and bank with additional information about discount allowed and discount received. Given below is a sample format of triple column cash book.
Dr. Cash Book Cr.

Date Particulars LF

Discount Allowed

Cash

Bank

Date

Particulars

LF

Discount

Cash

Bank

Contra Entries: If the two accounts involved in a transaction are cash account and bank account, the entry for recording the transaction in a double column cash book with cash and bank columns or in a triple column cash book is called a contra entry. Entries which are made on both sides of the cash book are called contra entries. For contra entries no posting is required because the double entry is completed in the cash book itself. For example, cash deposited into bank and cash withdrawn from bank affect cash and bank account only. Both aspects of these transactions are recorded in cash column and bank column of the cash book respectively. No ledger posting is required, because both aspects of the transaction are recorded in the cash book itself. This fact is indicated in the cash book by writing C in L.F. column. Petty Cash Book: In order to keep the cash book from getting unnecessarily crowded with numerous petty expenses occurring in any business, a separate cash book called petty cash book is maintained to record such transactions into different columns depending upon their nature. Total of these columns are periodically transferred to respective ledger accounts by passing journal entry. The Imprest System: When petty cash is maintained at a fixed amount by periodically reimbursing the petty cash expenses incurred during the period from the main cash book, it is called imprest system of petty cash. 40

The Accounting Process

2.4.3 Ledger Posting


Ledger contains a classified account-wise or head-wise summary of all transactions recorded in cash book and journal. It is the main book of account. Ledger is also called Principal book (do not confuse this with primary books which are cash book and journal) as final information pertaining to the financial position of a business emerges only from the accounts. Given below is a sample format of ledger.
Dr. Date Particulars J.F. Account Title Amount Date Particulars J.F. Cr. Amount

The date column records the year, month and date of the transactions. Particulars column records the title of the other account affected. Name of the account in particulars column on the debit and credit side are preceded by the words To and By respectively. Journal Folio (J.F.) column records the page number of the journal from which the posting to the ledger has taken place. Amount column on debit and credit side records the amount mentioned in journal entry against the title of the account prepared. Steps in Ledger Posting The amount to be debited is posted as follows: First of all the opening balance (if any) has to be posted. The opening entry for various assets should be posted by writing To Balance b/fon the debit side of the relevant account. Similarly, liabilities accounts should be posted by writing By Balance b/f on the credit side of the relevant account. 1. 2. Enter the date of the transaction on the debit side of the relevant account. The title of the account to be credited is preceded by the word To is entered in the particulars column. In Journal Folio (J.F.) column enter the page number of the journal on which the journal entry is passed. Amount column records the amount mentioned in the journal against title of the account under consideration.

3.

4.

For posting of the account to be credited, above mentioned steps are followed but with one difference. Now the recording is done on the credit side of the account and in the particulars column title of the amount to be debited is preceded by the word By. Let us take an example For our earlier transaction Cash received from Geet & Co. Rs.1,000 on 5.1.2013, the journal entry we made was Cash a/c To Geet & Co. a/c Dr. Rs.1,000 Rs.1,000 41

Financial Accounting

Now, following the ledger posting steps learnt above, the two aspects of the transaction are posted in two ledgers as follows:

Dr. Date Particulars J.F.

Cash Account Rs. 1,000 Date Particulars J.F.

Cr. Rs.

5.1.2013 To Geet & Co.

Dr. Date Particulars J.F.

Geet & Co. Rs. Date Particulars J.F. Rs.

Cr.

5.1.2013 By Cash a/c

1,000

Self-Assessment Questions 2 a. Journalize the following transactions: i. ii. iii. On 1.4.2013 started business with Rs.20,00,000. On 4.4.2013 purchased goods worth Rs.50,000 on credit from Tom. On 7.4.2013 sold goods for Rs.65,000 on credit to Shekhar.

...................................................................................... ...................................................................................... ...................................................................................... b. What do you mean by Books of Original Entry? ...................................................................................... ...................................................................................... ...................................................................................... c. Give examples of some subsidiary books. ......................................................................................

2.5 BANK RECONCILIATION STATEMENT


The Bank Reconciliation Statement is an aid used to ensure the accuracy of transactions appearing in the bank columns of the cash book. Such transactions can be verified through an external record, namely, the bank statement received periodically from the banker. A bank statement for a period typically contains the following particulars: opening balance, transactions conducted during the period and closing balance. Reasons for difference between Bank Balances as per Cash book and Passbook or bank statement. Bank balance as appearing in the cash book and in the bank statement may differ for the following reasons: i. Cheques issued by the business to its suppliers or other parties may not have been presented for payment. In cash book cheques issued are accounted as

42

The Accounting Process

and when they are issued but bank statement would reflect the same only if it has been presented to the bank for payment. Till that time, cash book (bank) balance will be less than passbook balance. ii. Cheques received from customers and deposited may not have been collected by the banker. Cheques received are recorded as bank receipts in the bank book as soon as they are deposited into the account but bank credits it only on actual collection of the cheque. Till that time, cash book (bank) balance will be more than passbook balance. Deposits may have been directly made by the customers into the bank account of the enterprise. In this case, bank accounts for it but in the cash book it can be accounted only when the entity comes to know this either from the customer or the bank statement itself. Till then, passbook balance will be more than bank balance in the cash book. Collection charges, service charges and interest on overdraft are charged by the banker. The business can ascertain the exact amount of charges and record them in the cash book only after the receipt of the bank statement. Till it does, cash book (bank) balance will be more than passbook balance. Interest credited by bank for the balance maintained with it and any other income such as interest on securities, dividend, etc., collected by the bank on behalf of the business can be ascertained only from the bank statement. Till they are accounted for in cash book, cash book (bank) balance will be less than passbook balance. Wrong entries or omission of entries either in the cash book or by the bank in its ledger. Depending upon the nature of mistake, passbook balance can be either more or less than the cash book (bank) balance.

iii.

iv.

v.

vi.

On receipt of the bank statement, a comparison of the entries in the Cash book with those appearing in the bank statement will help in identifying the items causing the difference in the two balances. These items are put in a statement called Bank Reconciliation Statement (BRS). BRS does not form part of the double entry system. But it is very useful in initiating actions to set the difference right. For example, items of the nature (iii), (iv), (v) have to be accounted in the books while that of nature (vi) requires rectifications on part of either party.

2.5.1 Advantages of Bank Reconciliation Statement


The advantages of Bank Reconciliation Statement are:i. ii. Error Detection: Errors either on part of the bank or the business is disclosed in the BRS. Delay in Collection Revealed: The delay in the collection of cheques, bills, etc., if any, is revealed, when BRS is prepared. It prompts corrective action to avoid delay in future. Completion of Cash Book: Business enterprises make certain entries for bank charges, cheques dishonored, direct payments, direct deposits, etc., in the cash book from information from the bank statement only. Chances of Embezzlements are Reduced: For example, entry for cash deposit appearing in the Cash book but not in passbook may indicate fraud being committed by the staff. This type of frauds come to light when Bank Reconciliation Statement is prepared. 43

iii.

iv.

Financial Accounting

2.5.2 Steps in Preparation of Bank Reconciliation Statement


Take either the cash book (Bank column) or passbook balance as starting point. The following points have to be noted while taking the opening balance. i. ii. iii. iv. Dr. bank balance as per cash book indicates favorable balance. Cr. bank balance as per cash book means overdraft or unfavorable balance. Dr. balance as per passbook means overdraft or unfavorable balance. Cr. balance as per passbook means favorable balance.

If the starting point denotes a favorable balance as per cash book or passbook, take it as a positive figure. However, if the starting point denotes unfavorable balance, take it as a negative figure. If the starting point amount is the passbook amount, add to it all the items that we have discussed above causes cash book balance to exceed the passbook balance. Deduct out of the resultant figure the items which cause the passbook balance to exceed cash book balance. The final figure will be the balance as per the cash book. If the starting point amount is the cash book (bank column) amount, add to it the items which cause the passbook balance to exceed cash book balance. Deduct out of the resultant figure all the items that cause cash book balance to exceed the passbook balance. The final figure will be the balance as per the passbook.

Example 2 The following transactions have taken place during a particular period in the business of M/s Fundo enterprises. You are required to give the required journal entries, explaining the logic of debits and credits in them. i. ii. iii. iv. v. vi. Sold goods to Mr. Ved on credit Rs.1,00,000. Furniture purchased for re-sale Rs.80,000. Sales to Mr. Uday for cash Rs.1,50,000. Purchases from Prithvi for Rs.1,20,000. Sales returns from Mr. Ved for Rs.15,500. Payment of rent in respect of business made by the proprietor out of personal cash Rs.27,000.

vii. Drawings by the proprietor: Rs.3,000. viii. Sold furniture out of those meant for resale Rs.56,000. ix. x. xi. Fresh capital of Rs.2,00,000 brought into the business by the proprietor by way of cash. Cash deposited into current account with ICICI Bank Rs.90,000. Cash purchases from Anjaan Rs.45,000.

xii. Goods returned to Mr. Prithvi Rs.15,000. 44

The Accounting Process

xiii. Mr. Ved remits cash Rs.72,200 full settlement acknowledged. xiv. Cartage on goods inwards Rs.24,000 paid by cash. xv. Furniture purchased from M/s Dream decors for office purpose Rs.50,000. xvi. Cash paid to Mr. Prithvi in full settlement of his dues Rs.1,00,000. xvii. Cartage on goods sold Rs.33,000 paid by cash. xviii. Rent paid to Mr. Shakti, the landlord Rs.27,000. Solution In the Books of Fundo Enterprises Journal Entries Date i. Ved a/c To Sales a/c (Being goods sold to Ved on credit) ii. Purchases a/c To Cash a/c (Being furniture purchased on cash for re-sale) iii. Cash a/c To Sales a/c (Being goods sold for cash) iv. Purchases a/c To Prithvi a/c (Being goods purchased from Prithvi on credit) v. Returns Inward a/c To Ved a/c (Being goods returned by Ved) vi. Rent a/c To Capital a/c (Being rent paid out of personal cash) vii. Drawings a/c To Cash (Being cash withdrawn for household expenses) viii. Cash a/c To Sales a/c (Being furniture meant for resale sold for cash) 45 Dr. 56,000 56,000 Dr. 3,000 3,000 Dr. 27,000 27,000 Dr. 15,500 15,500 Dr. 1,20,000 1,20,000 Dr. 1,50,000 1,50,000 Dr. 80,000 80,000 Particulars Dr. L.F Debit Rs. 1,00,000 1,00,000 Credit Rs.

Financial Accounting

Date ix. Cash a/c

Particulars Dr.

L.F

Debit Rs. 2,00,000

Credit Rs. 2,00,000

To Capital a/c (Being cash invested in the business) x. Bank a/c To Cash a/c (Being cash deposited in the Bank) xi. Purchases a/c To Cash a/c (Being goods purchased from Anjaan for cash) xii. Prithvi a/c To Returns outward a/c (Being goods returned to Prithvi) xiii. Cash a/c Discount Allowed a/c To Ved a/c (Being cash received from Ved and allowed him discount) xiv. Cartage Inward a/c To Cash a/c (Being cartage paid on goods purchased) xv. Furniture a/c To Cash a/c (Being furniture purchased on cash for office) xvi. Prithvi a/c To Cash a/c To Discount Received a/c (Being cash paid to Mr. Prithvi and received discount) xvii. Cartage Outwards a/c To Cash a/c (Being cartage paid on goods sold) xviii. Rent a/c To Cash a/c (Being rent paid in cash) Dr. 27,000 Dr. 33,000 Dr. 1,05,000 Dr. 50,000 Dr. 24,000 Dr. Dr. 72,200 12,300 Dr. 15,000 Dr. 45,000 Dr. 90,000

90,000

45,000

15,000

84,500

24,000

50,000

1,00,000 5,000

33,000

27,000

46

The Accounting Process

Explanation i. Sold goods to Mr. Ved on credit Rs.1,00,000: sales, a nominal account, represents income (credit) and Mr. Ved, a personal account, is the receiver (debit). Furniture purchased for re-sale Rs.80,000: cash, a real asset, goes out (credit) and purchases is an expense, a nominal account (debit). Sales to Mr. Uday for cash Rs.1,50,000: cash, a real asset, comes in (debit) and sales, a nominal account, represents income (credit). Purchases from Prithvi for Rs.1,20,000: Purchases, a nominal account, is an expense (a debit) and Prithvi, a personal account, is the giver (credit). Sales returns from Mr. Ved for Rs.15,500: Return inwards, a nominal account, is the opposite of income (debit) and Ved, a personal account, is the giver (credit). Payment of rent made by the proprietor out of personal cash Rs.27,000: cash, a real asset, goes out (credit) and capital account, a personal account, represents the giver (credit).

ii. iii. iv. v.

vi.

vii. Drawings by the proprietor Rs.3,000: cash, a real asset, goes out (credit) and drawing account, a personal account, represents the receiver (debit). viii. Sold furniture out of those meant for resale Rs.56,000: cash, a real account, is what comes in (debit) and sales is an income, a nominal account (credit). ix. Fresh capital of Rs.2,00,000 brought into the business: Accounts involved cash and capital. Cash, a real asset, comes in (debit) and capital account, a personal account, here represents the giver (credit). Opened a bank account with ICICI Bank for Rs.90,000: Bank account, a personal one, is the receiver (debit) and cash, a real asset, goes out (credit). Cash purchases from Anjaan Rs.45,000: Purchases, a nominal account, represents expense (debit) and cash, a real asset, goes out (credit).

x. xi.

xii. Goods returned to Mr. Prithvi Rs.15,000: Return outward, a nominal account, represents decrease in purchases (credit) and Prithvi, a personal account, is the receiver (debit). xiii. Mr. Ved remits cash Rs.72,200. Full settlement acknowledged: cash Rs.72,200, a real asset, comes in (debit) and Ved, a personal account, represents the giver (credit). But being full settlement, we credit to his account Rs.84,500. The balance Rs.12,300 is discount allowed, a nominal account being an expense (debit). xiv. Cartage on goods inwards Rs.24,000 paid by cash: cash, a real asset, goes out (credit) and carriage inwards is an expense, a nominal account (debit). xv. Furniture purchased from M/s Dreamdecors for office purpose Rs.50,000: cash, a real asset, goes out (credit) and furniture, another real account, represents what comes in (debit). xvi. Cash paid to Mr. Prithvi in full settlement of his dues Rs.1,00,000: cash of Rs.1,00,000, a real asset, goes out (credit) and Prithvi, a personal account, is the receiver (debit). But he acknowledges full settlement of Rs.1,05,000. 47

Financial Accounting

Balance Rs.5,000 represents discount received, a nominal account being income (credit). xvii. Cartage on goods sold Rs.33,000 paid by cash: cash, a real asset, goes out (credit) and carriage outwards is an expense, a nominal account (debit). xviii. Rent paid to Mr.Shakti, the landlord Rs.27,000: cash, a real asset, goes out (credit) and rent, a nominal account, represents an expense (debit). Example 3 Mr. Appa Rao has transacted the following transactions in his new business during the month of May, 2013. Date 1. 1. 1. 2. 3. 3. 4. 4. 5. 5. 5. 6. 6. 7. 7. 8. 8. 8. 9. 10. 10. 11. 13. 15. 18. 19. 20. 22. 22. 22. 25. 28. 48 Particulars Commenced business with cash Paid cash towards deposit to landlord Opened current account with SBI Credit purchases from Unni Purchased goods for cash Sold goods to abc & co. Purchase goods from M/s. Thakur bros. Paid Arup an advance for goods ordered Goods returned by abc & co. Sold goods to peter Deposited cheque received from Chenoy as advance for goods ordered by him Furniture purchased. Payment made by cheque Chenoys cheque dishonoured Paid wages by cash Additional capital deposited in bank Received goods from Arup Received commission (in cash) New cheque received from Chenoy and deposited Goods returned to Unni Goods sold to Nayan Goods dispatched to Chenoy Postage and telegrams expenses met by cash Goods returned by Nayan Purchased stationery for cash Deposited into bank Paid to Unni by cheque Cash sales Cash purchases Received cheque from abc & co. and deposited Discount allowed to abc & co. for prompt payment Salaries paid by cash Rent paid Rs. 72,000 3,000 52,000 30,000 1,000 32,000 13,000 2,000 3,000 3,000 3,000 2,000 3,000 500 10,000 12,000 600 5,000 200 10,000 12,000 200 500 200 500 9,000 750 1,000 19,000 950 700 500

The Accounting Process

Date 28. 29. 29. 30. 31. 31. 31. 31. 31. Paid to Unni by cheque

Particulars Cheque issued to thakur bros. Discount received from Unni for prompt payment Purchased goods payment by cash Withdrawal by Mr. Appa Rao Paid to Unni by cash Discount received from Unni for prompt payment Received cheque from abc & co. and deposited Discount allowed to abc & co. for prompt payment

Rs. 5,000 5,000 1,000 5,000 1,000 5,000 1,000 5,000 250

Prepare triple column cash book, other required subsidiary books, post all the transactions to respective ledgers. Statement sent by State Bank of India shows a favorable balance of Rs.61,875. On scrutiny of the statement the following are known: a. b. c. d. e. f. g. Cheque issued to Unni on 19.05.13 is not yet cleared by the bank. Cheque received from abc & co. on 22nd is not yet collected. Bank has charged Rs.125.00 as follows: Rs.50.00 towards cheque dishonoured, Rs.75.00 towards monthly charges. Cheque issued to Thakur Bros. on 28th was actually for Rs.500.00. Bank has wrongly made a charge of Rs.1,000.00. It has conceded the mistake. Chenoy has deposited direct into the bank account an amount of Rs.3,000. Cheque received from abc & co. on 31st not yet collected by the bank.

Also prepare the bank reconciliation statement. Solution Cash Book, Subsidiary Books and General Ledger Cash Book
Dr. Date Receipts Ledger Discount Cash Folio allowed Rs. 2013 May 1 May 1 May 5 May 7 May 8 May 8 To Capital a/c To Cash a/c To Chenoy a/c To Capital a/c To Commission a/c To Chenoy a/c C 750 600 C 72,000 Bank Rs. 2013 May. 1 52,000 May 1 3,000 May 3 10,000 May 4 May 6 5,000 May 6 500 May 7 May 11 By Landlord a/c By Bank a/c By Purchases a/c By Arup a/c By Furniture a/c By Chenoy a/c By Wages a/c By Postage & Telegrams a/c May 22 To abc & co. May 31 To abc & co. 950 250 19,000 May 15 5,000 May 18 May 19 May 22 By stationery a/c By Bank a/c By Unni By Purchases a/c 1,000 C 200 500 9,000 500 200 C 3,000 52,000 1,000 2,000 2,000 3,000 Date Payments Ledger Discount Cash Folio received Rs. Cr. Bank Rs.

May 18 To Cash a/c May 20 To Sales a/c

49

Financial Accounting
Dr. Date Receipts Ledger Discount Cash Folio allowed Bank Date May25 May28 May28 May29 May 30 May 31 May 31 May31 To Balance c/d 2,000 3,200 73,350 94,500 Jun.1 To Balance b/d 1,200 750 70,500 Jun.1 By Balance b/d May31 Payments By Salaries a/c By Rent a/c By Thakur bros. By Unni By Purchase By Drawings By Unni By Balance c/d 1,000 5,000 1,000 1,000 5,000 1,200 750 70,500 Ledger Discount Cash Folio received 700 500 5,000 5,000 Cr. Bank

3,200 73,350 94,500 2,000

Note: The letter C in the Ledger Folio column denotes a contra entry. That is an entry for which the debit and credit aspects are found in the Cash book itself. Purchases Book Date 2013 May 2 May 4 May 8 Name of Supplier Ledger Folio Inward Invoice No. Rs.

Unni Thakur bros. Arup January Total Purchases Returns Book

30,000 13,000 12,000 55,000

Date 2013 May 9

Name of Supplier Unni January total

Ledger Folio

Debit Note No.

Rs. 200 200

Sales Book Date 2013 May 3 May 4 May 10 May 10 Name of Customer Ledger Folio Outward Invoice No. Rs.

abc& co. Peter Nayan Chenoy January total Sales Returns Book Name of Customer Ledger Folio Credit Note No.

32,000 3,000 10,000 12,000 57,000 Rs.

Date 2013 May 5 May 13

abc & co. Nayan January total

3,000 500 3,500

50

The Accounting Process

General Ledger Capital Account Dr. Date Particulars JF Rs. No. Date Particulars JF No. Cr. Rs. 72,000 10,000 82,000 Cr. JF Rs. No. 3,000 3,000 Cr. Rs. 30,000

May 31 To Balance c/d

2013 By Cash a/c May 1 82,000 May 7 By Bank a/c 82,000 Jun.1 By Balance b/d Landlord A/c JF Rs. No. 3,000 Date Particulars

Dr. Date

Particulars

2013 To Cash a/c May 1 Jun.1 To Balance b/d Dr. Date 2013 May 9 May 19 May 29 May 29 May 31 May 31 May 31

2013 By Balance c/d May 31

3,000 Unni Account JF No. Rs. Date Particulars

Particulars To Purchases returns To Bank a/c To Bank a/c To Discount received a/c To Cash a/c To Discount received a/c To Balance c/d

JF No.

200 2013 By Purchases a/c May 2 9,000 5,000 1,000 5,000 1,000 8,800 30,000 Jun. 1 By Balance b/d Thakur Bros.

30,000 8,800 Cr. Rs. 13,000

Dr. Date 2013 May 28 May 31

Particulars Bank To Balance c/d

JF No.

Rs.

Date

Particulars

JF No.

5,000 2013 By Purchases a/c May 4 8,000 13,000 Jun.1 By Balance b/d Chenoy Account JF No. Rs. Date Particulars JF No.

13,000 8,000 Cr. Rs. 3,000 5,000 7,000 15,000

Dr. Date

Particulars

2013 To Bank a/c May 6 May 10 To Sales a/c

Jun 1

To Balance b/d

3,000 2013 By Bank a/c May 5 12,000 May 8 By Bank a/c May 31 By Balance c/d 15,000 7,000

51

Financial Accounting

ABC & Co. Account Dr. Date 2013 May 3 Particulars To Sales a/c JF No. Rs. Date Particulars By Sales return a/c By Bank a/c By Discount allowed a/c By Bank a/c By Discount allowed a/c By Balance c/d JF No. Cr. Rs. 3,000 19,000 950 5,000 250 3,800 32,000

32,000 2013 May 4 May 22 May 22 May 31 May 31 May 31

Jun 1 Dr. Date 2013 May 4 Jun 1

To Balance b/d

32,000 3,800 Peter Account

Particulars To Sales a/c To Balance b/d

JF No.

Rs. 3,000

Date

Particulars

JF No.

Cr. Rs. 3,000

2013 By Balance c/d May 31

3,000 Purchases Account Cr. Rs.

Dr. Date 2013 May 3 May 22 May 30 May 31

Particulars To Cash To Cash a/c To Cash a/c To Sundry (as per Purchase Book) To Balance b/d

JF No.

Rs.

Date

Particulars

JF No.

1,000 2013 By Balance c/d May 31 1,000 5,000 55,000

62,000

Jun. 1

62,000 62,000 Sales Account

62,000

Dr. Date 2013 May 31 Particulars To Balance c/d JF No. Rs. 57,750 Date Particulars JF No.

Cr. Rs. 750 57,000 57,750 Jun. 1 By Balance b/d 57,750

2013 By Cash a/c May 20 May 31 By Sundry (as per sales book)

57,750

52

The Accounting Process

Purchases Returns Account Dr. Date Particulars JF No. Rs. 200 Date Particulars JF No. Cr. Rs. 200

2013 To Balance c/d May 31

2013 By Sundries a/c May 9 (as per purchase return book) Jun.1 By Balance b/d

200

200

Sales Returns Account Dr. Date Particulars JF No. Rs. Date Particulars JF No. Cr. Rs. 3,500

2013 To Sundries a/c May 13 (as per sales return book)

3,500 2013 By Balance c/d May 31 3,500

3,500

Jun.1

To Balance b/d

3,500 Arup Account

Dr. Date 2013 May 4 May 31 Particulars To Cash a/c To Balance c/d Rs. Date Particulars JF No.

Cr. Rs. 12,000

2,000 2013 By Purchases a/c May 31 10,000 12,000 Jun.1 Wages Account By Balance b/d

12,000 10,000

Dr. Date 2013 May 7 Jun.1 To Cash a/c JF No. Rs. 500 500 To Balance b/d 500 Commission Received Account Dr. Date Particulars Rs. 600 600 Jun.1 By Balance b/d Date Particulars JF No. Date Particulars JF No.

Cr. Rs. 500 500

2013 By Balance c/d May 31

Cr. Rs. 600 600 600 53

To Balance c/d 2013 May 31

2013 By Cash a/c May 8

Financial Accounting

Nayans Account Dr. Date 2013 May 10 Particulars To Sales a/c JF Rs. No. Date Particulars Cr. JF Rs. No. 500 9,500 10,000

By Sales 10,000 2013 May 13 returns a/c May 31 By Balance c/d 10,000

Jun.1

To Balance b/d

9,500 Postage and Telegrams Account

Dr. Date Particulars JF Rs. No. 200 200 Jun.1 To Balance b/d 200 Stationery Account Dr. Date Particulars JF No. Rs. Date Particulars JF No. Date Particulars JF No.

Cr. Rs. 200 200

2013 To Cash a/c May 12

2013 By Balance c/d May 31

Cr. Rs. 200 200

2013 To Cash a/c May 15

200 2013 By Balance c/d May 31 200

Jun.1

To Balance b/d

200 Salaries Account

Dr. Date Particulars JF No. Rs. 700 700 Jun.1 Dr. Date 2013 May 28 Jun.1 54 To Balance b/d 700 Rent Account Particulars To Cash a/c JF No. Rs. Date Particulars By Balance c/d Date Particulars JF No.

Cr. Rs. 700 700

2013 To Cash a/c May 25

2013 By Balance c/d May 31

To Balance b/d

500 2013 May 31 500 500

Cr. JF Rs. No. 500 500

The Accounting Process

Drawings Account Dr. Date Particulars JF No. Rs. Date Particulars JF No. Cr. Rs. 1,000 1,000

2013 To Cash a/c May 31

1,000 2013 By Balance c/d May 31 1,000

Jun.1

To Balance c/d

1,000 Furniture Account

Dr. Date 2013 May 6 Particulars To Bank a/c JF No. Rs. Date Particulars By Balance c/d JF No.

Cr. Rs. 2,000 2,000

2,000 2013 May 31 2,000

Jun.1

To Balance b/d

2,000 Bank Reconciliation Statement

Particulars Balance as per cash book Add: Cheques issued but not cleared by bank to Unni on 19.05.13 Cheque issued to Thakur Bros. on 28th wrongly overstated in cash book Amount deposited by Chenoy direct into the bank a/c

Rs.

Rs. 70,500

9,000 4,500 3,000 16,500 87,000

Less: Cheques deposited but not collected: From abc & co. on 22nd From abc & co. on 31st

19,000 5,000 24,000

Charges debited by bank but not accounted in cash book: Cheque dishonored charges 50 Monthly charges 75 Erroneous charge to be rectified by bank 1,000 1,125 Balance as per bank statement 25,125 61,875

Bank reconciliation is no substitute for adjustments/rectifications required in the books or elsewhere. For example, in the above illustration, the cheque issued to Thakur Bros. and wrongly recorded in the books needs to be rectified, charges made by the bank recorded in the books and erroneous charge made by the bank pursued with the bank for rectification.

55

Financial Accounting

Self-Assessment Questions 3 a. Examine the need to prepare a Bank Reconciliation Statement. ....................................................................................... ....................................................................................... ....................................................................................... b. What are the items that cause difference between bank balance as per cash book and as per bank statement? ....................................................................................... ....................................................................................... .......................................................................................

2.6 SUMMARY
Accounting is based on the double entry system of accounting which recognizes the dual effect of any transaction known as debits and credits. Overall, credit represents a source of fund and debit, an utilization thereof. Another approach to determine debits and credits is rules based on account types. The starting point of accounting is passing journal entries. Instead of passing journal entry for each individual transaction, they are grouped on the basis of their nature in one of the various books: Cash Book, Sales Book, Purchases Book etc., and only the residual transactions are recorded individually in Journal Proper. Entries in day books are posted into individual ledger accounts. Cash book acts as both a book of primary entry and a ledger. Bank reconciliation statement is prepared for reconciling the difference of bank balance as appearing in the bank statement and in the cash book.

2.7 GLOSSARY
Bank Reconciliation Statement is the statement showing the reasons for difference between bank balance as per cash book and as per bank statement. Double Entry is the system whereby both the aspects, debit and credit, of a transaction are recorded. Imprest System when petty cash is maintained at a fixed amount by periodically reimbursing the petty cash expenses incurred during the period from the main cash book, it is called imprest system of petty cash. Nominal Account it deals with 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 under a particular head. Personal Account 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. Real Account it representing assets other than personal accounts is called a real account.

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2.8 SUGGESTED READINGS/REFERENCE MATERIAL


Rajesh Agrawal and R. Srinivasan, 1995, The Accounting Primer, New Age International Publishers. Robert N. Anthony, 1997, Accounting Principles, A.I.T.B.S Textbooks.

2.9 SUGGESTED ANSWERS Self-Assessment Questions 1


a. Any individual item of expense, when seen in isolation, is a decrease in owners equity. And any item of revenue, an increase in owners equity. Increase Liability, Revenue and Profit Asset, Expenses and Loss b.
Transaction Purchase of goods for cash Account Debited Purchases a/c Reason for the Debit Account Credited Reason for the Credit Cash a/c is a Real a/c. The rule of Credit what goes out applies. Cash a/c is a Real a/c. The rule of Credit what goes out applies. Cash a/c is a Real a/c. The rule of Credit what goes out applies. Customer a/c is a Personal a/c. The rule of Credit the giver applies. Purchases a/c in Cash a/c Nominal a/c. The Rule is Debt all Expenses. Advertisement expenses Nominal a/c. The Rule is Debt all Expenses. Cash a/c

Decrease

CR = Source DR = Use DR = Use CR = Source

Payment of advertisement Advertisement expenses expenses a/c

Deposit of cash into bank

Bank a/c

Bank a/c is a personal Cash a/c a/c the rule of Debit the receiver applies. Bank a/c is a personal Customer a/c a/c the rule of Debit the receiver applies.

Receipt and deposit of customers cheque into bank account.

Bank a/c

c.

Personal Account: ABC (a customer), XYZ (a supplier). Real Account: Cash, land, closing stock, trademarks and copyrights. Nominal Account: Freight outwards, printing and stationary, petrol, vehicle maintenance.

Self-Assessment Questions 2
a. Date 1-4-08 Cash a/c To Capital a/c (Being cash invested in the business) 4-4-08 Purchases a/c To Tom a/c (Being goods purchased from Tom on credit) 7-4-08 Shekhar a/c To Sales a/c (Being goods sold to Shekhar on credit) 57 Dr. 65,000 65,000 Dr. 50,000 50,000 Particulars Dr. L.F Debit Rs. 20,00,000 20,00,000 Credit Rs.

Financial Accounting

b.

The daily business transactions are recorded in a book called Journal. The journal is called book of original entry. All the transactions are first entered in the journal in the order of their occurrence. Some of the common types of journals for recording routine and homogenous transactions which are also known as Day Books or Subsidiary Books are: Purchase book, Sales book, Purchase return book, Sales return book, Bills receivable book, Bills payable Book, Cash book and Journal proper. i. ii. Error Detection: Errors either on part of the bank or the business is disclosed in the BRS. Delay in Collection Revealed: The delay in the collection of cheques, bills, etc., if any, is revealed, when BRS is prepared. It prompts corrective action to avoid delay in future. Completion of Cash Book: Business enterprises make certain entries for bank charges, cheques dishonored, direct payments, direct deposits, etc., in the cash book from information from the bank statement only. Chances of Embezzlements are Reduced: For example, entry for cash deposit appearing in the Cash book but not in passbook may indicate fraud being committed by the staff. This type of frauds come to light when Bank Reconciliation Statement is prepared.

c.

Self-Assessment Questions 3
a.

iii.

iv.

b.

Bank balance as appearing in the cash book and in the bank statement may differ for the following reasons: i. ii. iii. iv. v. Cheques issued by the business to its suppliers or other parties may not have been presented for payment. Cheques received from customers and deposited may not have been collected by the banker. Deposits may have been directly made by the customers into the bank account of the enterprise. Collection charges, service charges and interest on overdraft are charged by the banker. Interest credited by bank for the balance maintained with it and any other income such as interest on securities, dividend, etc., collected by the bank on behalf of the business can be ascertained only from the bank statement. Wrong entries or omission of entries either in the cash book or by the bank in its ledger.

vi.

2.10 TERMINAL QUESTIONS


A. Multiple Choice 1. Which of the following statements is false? a. b. c. d. Wages paid on installation of machinery should be credited to cash account. A sale of computer that has been used in the business should be debited to cash account. Error of posting of a correctly recorded transaction affects one or more accounts. Withdrawal of goods by the proprietor of the business should be credited to capital account.

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The Accounting Process

2.

Which of the following transactions of a business is/are recorded in journal proper? a. b. c. d. Purchase of goods on credit. Sale of office furniture for cash. Discounting of bill of exchange with a bank. Endorsement of a bill of exchange in settlement of debt of the business.

3.

Which of the following statements is/are true? a. b. c. d. Drawings account is a nominal account. Capital account is a real account. Sales account is a nominal account. Outstanding salaries account is a nominal account.

4.

The entry to record the collection of cash from sundry debtors would involve a i. ii. iii. iv. a. b. c. d. Debit to sundry debtors Debit to cash account Credit to sundry debtors Credit to cash account. Only (i) above Only (ii) above Only (iii) above Both (ii) and (iii) above.

5.

Which of the following statements is true? a. b. c. d. Bank charges increase debit balance shown as per bank column of the cash book. Bank charges increase debit balance as per bank passbook. A cash sale of a non-trading asset is recorded in the journal proper. Cash discount allowed by the business will appear on the debit side of the debtors account.

B. Descriptive 1. 2. Discuss the mechanics of double entry system of accounting. What are the books of account maintained under the double entry system of accounting?

C. Problems 1. Journalize the following transactions. 1st July started business by bringing in cash Rs.1,00,000 land Rs.5,00,000 bank balance Rs.3,00,000. 5th July purchased plant Rs.1,00,000 from Capital Limited on credit. 6th July purchased furniture Rs.50,000 by issuing cheque.

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Financial Accounting

7th July paid to Viswakarma as advance on contract for construction of building Rs.20,000 cash. 5th August building construction completed. Viswakarma raises bill for Rs.2,25,000. Bill verified and passed. 10th August Rs.50,000 cheque issued to Viswakarma. 15th August Rs.25,000 cheque issued to Capital Limited. 16th August Rs.10,000 cash paid for installation of plant. 17th August raw materials purchased from Raw Limited Rs.25,000 on credit. 18th August raw materials purchased from Extra Limited Rs.10,000 on credit. 25th August weekly wages paid Rs.12,000. 26th August sold goods to Raju for cash Rs.28,000. 27th August sold goods to Ramu on credit Rs.35,000. 29th August amount received from Ramu Rs.10,000 by cheque. 30th August cash paid to Raw Limited Rs.25,000. 31st August cheque issued to Viswakarma Rs.25,000, Extra Limited Rs.5,000 and Capital Limited Rs.25,000. 2. During May 2013, M/s Blackbox transacted the following business: Date May 1 1 1 2 3 3 4 4 5 4 5 6 6 7 7 8 8 8 9 10 10 11 13 60 Transaction Commenced business with cash Opened current account with SBI Purchased goods on cash Purchased goods on credit from Ram Purchased goods for cash Sold goods to Tvk Ltd. Purchases goods from Ashok Paid Andhra Traders an advance for goods ordered Goods returned by Tvk Ltd. Sold goods to Ross Deposited cheque received from Murthy as advance for goods ordered by him Purchased furniture for office use by cheque payment Goods returned by Ross Paid wages by cash Drawings for personal use Received goods from Andhra Traders Received goods from Andhra Traders Purchased goods from Xing Ltd. Goods returned to Xing Ltd. Goods sold to Quamal Goods dispatched to Murthy Paid for postage and telegrams Goods returned by Quamal Rs. 4,00,000 3,50,000 20,000 1,30,000 1,000 80,000 26,000 21,000 5,000 30,000 31,000 22,000 1,000 5,000 10,000 15,000 15,000 45,000 500 11,000 21,000 2,000 5,000

The Accounting Process

Date 15 18 19 20 22 22 22 25 26 26 28 28 29 29 30 31 31 31 31 Paid for stationery

Transaction Paid into bank Paid to Andhra Traders by cheque Goods sold for cash Bought goods for cash Received cheque from Quamal and deposited Discount allowed to Quamal for prompt payment Paid salaries Sold goods to Raghu Goods returned by Raghu Paid rent Cheque issued to Ram Cash received from Tvk Ltd. Discount allowed to Tvk Ltd. for prompt payment Purchased goods payment by cheque Drew cash for personal use Paid to Ram by cash Discount received from ram for prompt payment Received Cheque from Raghu and deposited

Rs. 2,000 500 9,000 11,750 1,500 9,000 500 7,000 50,000 300 5,000 1,00,000 30,000 1,000 5,000 1,000 10,000 5,000 15,000

31 Discount allowed to Raghu for prompt payment 250 Prepare triple column cash book, other required subsidiary books, post all the transactions to respective ledgers. Find out the bank balance as per bank statement on 31.05.13 from the following particulars: i. ii. iii. iv. Bank charges for the month: Rs.500. Cheque received from Raghu on 31st not yet realized. Cash deposited by Raghu directly into the account on 30th Rs.2,000. Cheque issued to Ram on 28th not yet cleared by the bank.

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NOTES

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NOTES

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Financial Accounting
Block Unit Nos. I 1. 2. II 3. 4. 5. 6. III 7. 8. IV 9. 10. 11. V 12 13 14 15 Unit Title

Fundamentals of Financial Accounting Introduction to Accounting and Financial Statements The Accounting Process Accounting for Assets Accounting for Inventories Measurement and Recognition of Income and Expense Accounting for Fixed Assets Accounting for Intangible Assets Financial Statements Trial Balance and Adjustments Preparation of Financial Statements Corporate Financial Statements Principal Financial Statements of Companies Statutory Audit Limitations of Financial Statement Introduction to Costing Introduction to Management Accounting Basic Cost Concepts Cost Allocation Methods of Costing