UNIT 3

Financial Accounting

Double-entry bookkeeping is a method of recording transactions where for every

business transaction, an entry is recorded in at least two accounts as a debit or credit.

In a double-entry system, the amounts recorded as debits must be equal to the

amounts recorded as credits.

Advantages of Double Entry System

The double-entry system has several advantages over the single-entry system:

1. Recording method: Single-entry bookkeeping gives a one-sided picture of

transactions recorded in the cash register. In double entry, changes due to one

transaction are reflected in at least two accounts. The double-entry system is preferred

by investors, banks and buyers because it gives them a more complete financial

picture of an organization.

2. Error detection: In double entry, debits and credits must always be the same. If that

is not the case, then there is an error. This makes it easy to spot errors and ensure that

they are not carried forward to other journals and financial statements. In single entry,

there is no method for error correction or detection.

3. Company size: The single-entry system is only appropriate for small enterprises,

whereas the double-entry system can be used by all sizes of businesses, including

large ones.

4. Preparation of financial statements: The information recorded in a single-entry

system isn’t adequate for financial reporting or preparing profit and loss statements.

Bigger organizations rely on these reports to track their performance, so they need the

extra information captured by double-entry accounting.

PCharacteristics of Double Entry System

Double Entry System is characterized by:
Every transaction affects two or more accounts: In every business
transaction two accounts are involved, wherein one is debited while the other
is credited. When one transaction affects multiple accounts, the amount of the
accounts which are debited and credited are always equal.

Division of account in two parts: The basis of preparation

of ledger accounts are journal and subsidiary books. Each of them has two
sides wherein the left side is debit and the right-hand side is credit.

Principles of Double-Entry System

of Bookkeeping
The principles to be followed while recording the double-entry system of
bookkeeping are as follows:

 Debit is written to the left, credit on the right

 Every debit must have a corresponding credit

 Debit receives the benefit, and credit gives the benefit

There are rules to be kept in mind while posting the double-entry transactions
in the bookkeeping process. The following are the rules for the different types
of accounts:

 For Personal Accounts: Debit the receiver, credit the giver

 For Real Account: Debit what comes in, credit what goes out

 For Nominal Account: Debit all the expenses, credit all the incomes
Personal Accounts are general ledger accounts related to persons like
individuals, associations and firms. The Real Accounts are general ledger
accounts connected with assets and liabilities other than individuals and
people. The Nominal Accounts are general ledger accounts relating to all
expenses, incomes, gains and losses.

Journal

Journal is called a subsidiary book. Journal is known as the books of original Entry
or Books of prime entry. 
The transactions are recorded in the journal in chronological order.
With the help of a journal, ledger accounts are prepared.

Format of journal

Journal entry format usually consists of four columns: one column for the date
of the transaction, another for the account names, and columns for the debits
and credits. Here’s an example of a typical journal entry format.

As you can see the date is always listed on the far left side of the journal
entry. Since journal entries are made throughout the year, it is important to
properlThe essential elements of the journal entry format are as follows:
 A header line may include a journal entry number and entry date. The number is used to index
the journal entry, so that it can be properly stored and retrieved from storage.

 The first column includes the account number and account name into which the entry is
recorded. This field is indented if it is for the account being credited.

 The second column contains the debit amount to be entered.

 The third column contains the credit amount to be entered.

 A footer line may also include a brief description of the reason for the entry. An entry in the
footer line is highly recommended, since there are so many journal entries that it is easy to
forget why each entry was made.

The structural rules of a journal entry are that there must be a minimum of two line items in the
entry, and that the total amount entered in the debit column equals the total amount entered in
the credit column
What are the Debit and Credit Rules?

Debits and credits are the opposing sides of an accounting journal entry. They are used to
change the ending balances in the general ledger accounts when accrual basis accounting is
used. The rules governing the use of debits and credits in a journal entry are noted below.

Rule 1: Debits Increase Expenses, Assets, and Dividends

All accounts that normally contain a debit balance will increase in amount when a debit (left
column) is added to them, and reduced when a credit (right column) is added to them. The types
of accounts to which this rule applies are expenses, assets, and dividends.

Rule 2: Credits Increase Liabilities, Revenues, and Equity

All accounts that normally contain a credit balance will increase in amount when a credit (right
column) is added to them, and reduced when a debit (left column) is added to them. The types
of accounts to which this rule applies are liabilities, revenues, and equity.
Rule 3: Contra Accounts Offset Paired Accounts

Contra accounts reduce the balances of the accounts with which they are paired. This means that
(for example) a contra account paired with an asset account behaves as though it were a liability
account.

Rule 4: Entries Must Balance

The total amount of debits must equal the total amount of credits in a transaction. Otherwise, a
transaction is said to be unbalanced, and the financial statements from which a transaction is
constructed will be inherently incorrect. An accounting software package will flag any journal
entries that are unbalanced, so that they cannot be entered into the system until they have been
corrected.

Impact of the Debit and Credit Rules

By following these debit and credit rules, you will be assured of making entries in the general
ledger that are technically correct, which eliminates the risk of having an unbalanced trial
balance. However, just following the rules does not guarantee that the resulting entries will be
correct in substance, since that also requires a knowledge of how to record transactions within
the applicable accounting framework (such as Generally Accepted Accounting Principles or
International Financial Reporting Standards).
What is a ledger?
A ledger, also known as the second book of entry, is a record-keeping system that
records all of a company's classified financial data. Transactions are recorded in the
ledger in different accounts as debits and credits. The ledger is often referred to as a
general ledger, and it's intended to provide a record of every financial transaction that
takes place during an operating company's life.

It includes accounts for assets, liabilities, owners’ equity, revenues and expenses. The
ledger includes every active account that is listed. The complete list of accounts is
referred to as the chart of accounts and is required to produce financial statements. It is
also essential for auditing purposes.

An accounting ledger is an account or record used to store bookkeeping entries for balance-
sheet and income-statement transactions. Accounting ledger journal entries can include
accounts like cash, accounts receivable, investments, inventory, accounts payable, accrued
expenses, and customer deposits. Accounting ledgers are maintained for all types of balance
sheet and income statement transactions. Balance sheet ledgers include asset ledgers such as
cash or accounts receivable. Income statement ledgers include ledgers such
as revenue and expenses.

 ledger[1] is a book or collection of accounts in which account transactions are recorded. Each

account has an opening or carry-forward balance, and would record each transaction as either
a debit or credit in separate columns, and the ending or closing balance.

Here are the primary general ledger accounts:

 Asset accounts, such as cash, accounts receivable, fixed assets and

prepaid expenses
 Liability accounts, such as debt, accounts payable, notes payable and
lines of credit
 Stockholders’ equity accounts
 Revenue accounts
 Expense accounts
 Revenue and loss accounts, such as interest, investment and disposal
of an asset
 The difference between a journal and a ledger
 A journal is used to record the transactions, other than payroll, payments or
receipts. Entries in the journal include the date, account to which the amount is to
be debited, the account to which it is to be credited and a brief description. The
journal is the first place data is recorded.
 The journal uses the double-entry system that provides summarized records of
the transactions, and it is known as the primary book of accounting or the book of
original entry. Recording entries is called journalizing. The transactions are
recorded in chronological order for easy reference and there is no place to
balance in a journal.
 The ledger, also referred to as the principal book of accounting, contains the
information from the journal entry in the basic “T-account” format and documents
the balance for each line. Transferring the entries from the journal to the ledger is
called posting. The format of the entries requires a grouping of like transactions
into the associated account. This information is used to create the trial balance,
which is the basis of the income statement and balance sheet.
 Many transactions are posted in both the journal and ledger, however, there are
differences in the purpose of each of these accounting tools. Unlike a journal, a
ledger account could have an opening balance that would be the closing balance
of the previous year and everything should be balanced.
Trial Balance
A trial balance is a bookkeeping worksheet in which the balance of
all ledgers are compiled into debit and credit account column totals that
are equal. A company prepares a trial balance periodically, usually at
the end of every reporting period. The general purpose of producing a
trial balance is to ensure the entries in a company's bookkeeping
system are mathematically correct.

Purpose of Trial Balance

The preparation of the trial balance helps in developing financial statements. The assets
and liabilities find their place in the balance sheet. The Income and expenses appear in
the profit and loss account. Based on all these accounts, the preparation of Final
accounts takes Place.

Features of Trial Balance

1. Trial balance in accounting lists down all the ledgers, including the cash book.

2. It does not form a part of the Double-entry System of Accounting. It serves only as a
reference.

3. A trial balance can be prepared any time- weekly, monthly, quarterly, and year-end.

4. It serves as a vital tool to verify the arithmetical accuracy of the books.

5. It forms a connecting point between the Profit and Loss Account and Balance sheet.

6. It does not provide conclusive proof of the absence of error. Errors such as errors of
principal may still exist.
Objectives of Trial Balance
1. Bird Eye View: The trial balance gives the summary of all the ledgers. Since the net
amount gets displayed, you can save time by not viewing the concerned ledger again.

 2. Pointing out Error: The trial balance aids in pointing out errors. It is also used to
check the arithmetical accuracy of books of accounts.

Limitations of Trial Balance

1. The error of principle and compensating error may still exist even after the trial
balance matches.

2. The trial balance matches even when the transactions are completely omitted from
recording in the books if they are not accounted for.

Methods of Preparation of Trial Balance

Two methods used in the preparation of the trial balance are:

1. Balance Method: In this method, it is the net amount of a ledger that gets displayed
in a trial balance. It can either be debit or credit balance. Under this method, the  trial
balance can be prepared only after all the accounts get balanced. This is one of the
accurate methods for the preparation of final accounts.

2. Totals Method: In this method, the total of each side of the account (debit and credit)
gets posted in the trial balance. This method provides higher mathematical accuracy.
However, the preparation of final accounts is not usually conducted using this method
because of the scope of duplication, resulting in errors. 

Steps to prepare Trial Balance

Step 1: Understanding the Golden Rule of accounting: Understanding the golden
rules of accounting is vital. It helps in understanding which account needs to be
debited and which needs to be credited. As per the golden rule, debit comes under
Expenses and assets and credit under incomes, gains, and liabilities. Therefore, credit
is payables, whereas debit is receivables.

 Step 2: Pass the journal entries: After making sure which account is debited or
credited, a necessary journal entry is passed. If you are using Tally ERP 9, the entries
get passed automatically when the amount is input.

Step 3: Once the journal entries get passed, post the entries into their respective
ledgers. In the case of Tally ERP 9, this posting takes place automatically at the back
end. If you are maintaining manual accounts, then post them manually into the
respective accounts.
Step 4: In this step, all the ledgers get routed to the trial balance. If there is no
arithmetical mistake, the debit and credit sides will match up. In case of any difference,
record the same in the suspense account. 

Errors that cause a mismatch in Trial Balance

Both the sides of a trial balance must tally. But if that does not happen, it may be on
account of the following reasons.

1. When only one leg of the transaction is posted: Suppose goods are purchased on

credit. The Purchase account gets debited, but the Creditor's account was not credited.

2. Lack of accurate balancing: The Closing balances of the previous year have not
been accurately balanced in the current year.

3. Amounts mismatched: Suppose the sales ledger has a credit balance of Rs 10000,

but while posting it in the trial balance, Rs 1000 gets posted. As a result, there will be a
mismatch of Rs 9000 in the trial balance.

4. Mismatch issue: Suppose that the prepaid rent is paid. Instead of debiting the
prepaid rent account, the Vendor's account gets debited. This will cause a mismatch in
the trial balance.

Errors Not Reflected by Trial Balance

1. Omission: In this case, if a transaction gets missed in its entirety; the same will not
get detected by the trial balance.

2. Error of Principle: The trial balance will still match if a transaction gets recorded
against the generally accepted accounting principle. The error of principle includes
recording the Capital transaction as a revenue transaction in the books of accounts.

3. Error of Commission: Suppose Rs 5000 gets recorded as Rs 500 in both the debit

and credit sides  of the trial balance. The trial balance w ill fail to point out this error.

4. Compensating Error: In compensating error, one error compensates for

another. For example, you did not debit the purchase account of Rs 1000 in one
account but by mistake debited Rs 1000 in another account.

Format of Trial Balance

The trial balance has two formats, such as:

1. Journal Format: This is as per the format of a journal Folio. Under this format, there
is a column for the serial no., account name, ledger folio, the amount of debit and credit.
2. Ledger Format: This form of trial balance features two sides for debit and credit.
Each side will have the name of the ledger and the net amount of the ledger in the
amount column.

Here’s an example:  

Specimen of Trial Balance

____ Ltd Trial Balance as of 31 st march 2020
Particulars Debit Credit
Bank Balance 1,000 -
Sundry Debtors 1,500 -
Sundry Expenses 3,000 -
Advance Salary 26870 -
Prepaid Rent 55000 -
Office Property 1,50,000 -
Borrowing from Bank - 9,045
Creditors - 4,000
Profit and loss - 20,450
Capital Account - 1,25,000
Drawings Account 2,000 -
Profit on sale of Fixed Asset - 95,875
Salary and wages 15,000 -
Total 2,54,370 2,54,370
Accounts in trial Balance
The debit side of the trial balance has:

 Assets- Cash, Inventory, Building, land, plant, and Machinery.

 Trade Receivables- Debtors and Bills receivables.
 Expenses- Wages and salary.
 Losses- Loss on sale of PPE, land, etc., other than inventory.
 Consumption and Purchase Account

The Credit Side of the Trial Balance has:

 Liabilities- Expenses payable, Short term bank credits, loans, and other borrowings.
 Trade Payable- Bills payable and sundry creditors
 Sales and Revenue
 Profit and Gain- Profit on sale of assets such as land, building, or PPE.
 Reserves- These include accumulated Depreciation reserve, General reserve,
Securities Premium, etc
 Final Accounts is the ultimate stage of accounting process where
the different ledgers maintained in the Trial Balance (Books of
Accounts) of the business organization are presented in the
 specified way to provide the profitability and financial position of
the entity for a specified period to the stakeholders and other
interested parties i.e., Trading Account, Statement of Profit & Loss,
Balance Sheet.

Features
1. The final account is legally required for the entities. The financial
accounting and preparation Financial statements are obligatory for
the entities as well as getting those accounts audited.
2. These accounts are prepared for presenting and providing the
financial performance and status of the entity to the stakeholders,
users, investors, promoters, etc.
3. The presentation of comparable figures of the current period from the
previous period increases the utility of the statements of accounts.
4. It presents the accurate & fair view of the organization’s financial
performance by providing accurate & full information regarding the
business with proper notes and disclosures of the real facts.

Objectives of Final Accounts

1. They are prepared for the calculation of Gross profit & net profit
earned by the organization for the relevant period by presenting
the Statement of Profit & Loss.
2. The Balance sheet is prepared for providing the correct financial
position of the company as on the date.
3. These accounts use the bifurcation of direct expenses to obtain the
gross profit & loss and bifurcation in indirect expenses to ascertain
the Net profit & loss for the organization.
4. These accounts through the Balance sheet bifurcate the assets &
liabilities as per the holding & usage periods of the same.
 Importance
 As the size and the business of the organization grows, it becomes
necessary for the management of the organization to take proper
steps to maintain the growth of the organization as well as creating
the appropriate internal control in the organization for the
prevention of fraud & errors. It helps the management to find the
possible weak areas of the entity and also identifying the major areas
which need special attention.
 Final Accounts is the source for the external components like
shareholders and investors to study the status of the entity and the
entity’s business. Based on the entity, the investors decide whether to
invest their funds in the same business industry or not.
 It provides the authenticated information to the public, who is the
judge for the company based on who the company’s future lies.
Ultimately the company aims to satisfy its consumers. Final Accounts
provide just enough data and information to the users to assess the
worth of the entity.

Advantages
 The preparation of Final Accounts increases the accuracy as well as the
effectiveness of the accounts.
 During the preparation, any innocent mistakes or fraud can be
discovered and could be rectified quickly.
 This account shows the status of the entity and business for the
period, and the audit of the same create a check on the entity and its
processes, which reduces the risk of the fraud and misstatement.
 Provide the information for the valuation of the business and
evaluation of the real worth of the business.
Gross Profit:
Gross profit is the difference between sales revenue and the direct cost of
the goods sold.

Cost of Goods Sold:

It is the cost of purchasing the goods from suppliers (in case of retailing
business) or the cost of producing the goods that are sold.

Profit and Loss Account:

This account shows the net profit of the business. This statement is used
to show the “Net Profit or Net Loss” of your business at the end of
financial year.

Net profit = (Gross Profit – Expenses and Overheads) + Income from non
trading activities
Appropriation account is that part of the profit and loss account which
shows how the profit after tax is distributed. This profit can be distributed
as dividends or can be kept in the company as retained profits.

Balance Sheet:
Balance sheet is used to show the value of a business’s assets and
liabilities on a particular date. Balance sheet is used to record what the
firm owns (assets), what it owes (liabilities), what it is owed and how it is
financed (owner’s equity). You can use following formats to prepare final
accounts in your accounting….
Trading Account Format

Profit and Loss Account Format

Balance Sheet Format
 BASIS FOR
TRIAL BALANCE BALANCE SHEET
COMPARISON

Meaning Trial Balance is the list The Balance sheet is the

of all balances of statement which shows the
General Ledger assets, equity and liabilities of
Account. the company.

Division Debit and Credit Assets and equity & liabilities

columns heads

Stock Opening stock is Closing stock is considered.

considered.
 BASIS FOR
TRIAL BALANCE BALANCE SHEET
COMPARISON

Part of Financial No Yes

Statement

Objective To check the To ascertain the financial

arithmetical accuracy position of the company on a
in recording and particular date.
posting.

Balances Personal, real and Personal and real account

nominal account are are shown.
shown.

Preparation At the end of each At the end of the financial

month, quarter, half year.
year or financial year.

Use Internal Use External Use

P&L Appropriation Account is a separate account that shows how funds

transferred from the P&L Account will be spent. If the business made a loss for the
period, then there will be no use in creating a P&L Appropriation Account. Below are
the common ways in which funds will be allocated in the P&L Appropriation Account.

Funds Assigned for Dividends

Dividends are the annual return for shareholders for their capital investment. While the
company may decide not to pay a dividend in certain years, this is generally one of the
expenses that take priority.
New Investment Projects

New investment projects require a significant amount of capital investments where

companies have to accumulate funds over a period of time.

Retained Earnings

Retained Earnings contains a portion of profits that will be reinvested in the business in

any required manner. Companies commonly use these funds to purchase assets and
inventory, pay off outstanding debts and to make short-term investments. In some
years dividends, will not be paid and respective funds will also be transferred to
retained earnings.

What is the difference between P&L and P&L

Appropriation Account?
P&L vs P&L Appropriation Account
P&L account reports the profit P&L appropriation account shows how the profits wil
generated for an accounting period. be distributed to relevant aspects such as dividend
payments and reserves.

Preparation

P&L is an account prepared by all types P&L appropriation account is prepared by

of businesses. partnerships and companies.

Opening Balance and Closing Balance

P&L is prepared for a specific P&L Appropriation Account is brought forward from
accounting year, thus does not have an the previous year and will be carried forward to the
opening balance and closing balance. next, thus have an opening and closing balance.