BASIC ACCOUNTING CONCEPTS
The Entity Concept: In accounting, the entity of business is considered separate from the existence of its owners. Accounts are kept for the entity as distinct from owners. When the owners invest money in the business or earn profits, their capital accounts are credited and when they draw money or goods from the business, their capital accounts are debited. This concept applies to corporate bodies (entity is separate from the shareholders who own it) and non-corporate bodies (proprietors and partnerships). The Money Measurement Concept: Money being a common unit of measurement for goods and services, all transactions in account books are recorded in terms of money.
The Going Concern Concept: The going concern concept is the backbone of accounting and is based on the following assumptions: i) Business has an indefinite life. ii) Assets are depreciated on the basis of their expected life without caring for their current values. The Cost Concept: According to this concept, all transactions and events are recorded in the books of account at the actual price involved, i.e., cost. All assets are carried in the books of account from year to year at their acquisition cost (historical cost) irrespective of any change in their market value. Acquisition cost is considered highly objective, reliable, definite and free from bias. However, there are problems:
The Cost Concept: i) When due to price rise, the prices of all commodities go up substantially, the financial position of a firm depicted on cost concept basis does not reflect true picture. ii) Some assets reflect their immediate realisable value; e.g. marketable securities, Sundry Debtors. iii) Inventories are valued on cost or market price whichever is Lower. Dual Aspect Concept: Every transaction entered into by a firm has two aspects, debit and credit. The total assets of a business are, therefore, always equal to its total liabilities. Or Assets = Liabilities + Capital
Materiality: It states that the cost of data collection in terms of time, efforts, and expense should not exceed the benefits to be derived from such an effort. The convention emphasises that accounting should be concerned with significant and material events for recording purposes. Consistency: According to this convention, an enterprise should be consistent in the accounting policies from one accounting period to another period. This, however, does not prevent adoption of changes in accounting policies and practices if these are warranted by changed conditions. Reasons for such changes and the implications of changed policies need to be disclosed in the annual report.
Conservatism: This concept states that ³anticipate no profit and provide for all possible losses´, i.e., all likely losses should be recognized even if they have not yet occurred and profits should be recognized only when they have been earned. In other words, the profits should never be overstated, though they may be understated. For example, costing of inventory, investments etc.
Accounting Equation The accounting equation is a statement of equality between debit and credit. It signifies that the assets of a business always equal the total liabilities and capital (owner¶s equity). Assets = Liabilities + Capital 1.If a proprietor starts business with say, Rs. 30,000, the firm will have so much money but the firm will also owe that amount to the proprietor, so that Cash = Capital Rs. 30,000 = Rs. 30,000
2.The proprietor purchases furniture for Rs. 3,000 Cash + Furniture = Capital Rs. 27,000 + 3,000 = Rs. 30,000
3.Goods purchased on credit for Rs. 7,000
Cash + Furniture + Stock = Creditors + Capital Rs. 27,000 + 3,000 + 7,000 = Rs. 7,000 + 30,000 4.Goods sold for cash for Rs. 6,000 Cash + Furniture + Stock = Creditors + Capital Rs. 33,000 + 3,000 + 1,000 = Rs. 7,000 + 30,000 5.Creditors paid Rs. 3,000 Cash + Furniture + Stock = Creditors + Capital Rs. 30,000 + 3,000 + 1,000 = Rs. 4,000 + 30,000 6.Assume rent paid Rs. 2,000. Rent being an expense reduces Cash & Capital Cash + Furniture + Stock = Creditors + Capital Rs. 28,000 + 3,000 + 1,000 = Rs. 4,000 + 28,000
7.Furniture depreciated by Rs. 5,00 Cash + Furniture + Stock = Creditors + Capital Rs. 28,000 + 2,500 + 1,000 = Rs. 4,000 + 27,500 8.Salary Rs. 2,000 remains outstanding Cash + Furniture + Stock = Creditors + O/S Liability + Capital Rs. 28,000 + 2,500 + 1,000 = Rs. 4,000 + 2,000 + 25,500 9.Goods costing Rs. 1,000 are sold for Rs. 1,500 Profit increases the Capital, Loss reduces it Cash + Furniture = Creditors + O/S Liability + Capital Rs. 29,500 + 2,500 = Rs. 4,000 + 2,000 + 26,000 10.Cash Withdrawn for personal use: Rs. 5,000 Cash + Furniture = Creditors + O/S Liability + Capital Rs. 24,500 + 2,500 = Rs. 4,000 + 2,000 + 21,000 Thus after every transactions assets are equal to Liability and Capital.
Accounting Process Origination of the Transaction Recording of the Transaction in the Journal Posting to the Ledger Preparation of Trial Balance Preparation of Financial Statements
Accounting Data ± Base System Each transaction is first recorded in a book of original entry (also known as book of prime entry) and later it is posted to the general ledger. These books constitute the accounting data-base. 1. Journal 2. Cash Book 3. Special Form Journals (a) Sales Day Book (b) Purchase Day Book 4. General Ledger
The journal is the book of prime or original entry in which all transactions are first recorded in a chronological order as and when they take place. It is also called subsidiary book of account. From Journal, transactions are transferred (posted) to Ledger. The Journal is defined as a book that records all transactions. However, in view of recording of transactions in special books like cash book, Sales day book and purchases day book, the majority of transactions are taken care of. Thus journal records only residual transactions of a nonrepetitive nature such as credit purchase of machinery. Since it is not a cash transaction, nor is it a revenue purchase, it is recorded in journal proper. It also serves some important purposes: i) It provides a connecting link between two accounting periods (opening and closing entries). ii) It rectifies errors in books of accounts. iii) It records adjustment entries, at the end of each year.
Since most of the transactions are in the form of cash receipts and cash payments, a cash book is maintained to record such receipts and payments. On the debit (left) side of the cash book, we record all receipts and on the credit (right) side all payments. Cash book is both a journal and a ledger. It is a journal since all transactions are recorded chronologically, and a ledger since it also serves the purpose of a T account by providing cash balance. Special Form Journals Since purchases and sales constitute a large number of repetitive transactions, we keep special journals to record these transactions. For sales transactions, there is sales day book or µsales journal¶ and for purchase transactions, there is µpurchase day book¶ or µpurchase journal¶. These books record credit sales and credit purchases only (as cash sales and cash purchases are recorded in the cash book). And these are recorded by single entries that are totalled & posted to a µControl account¶ in the Ledger.
Thus the total of the sales day book is credited to sales account and debited to accounts receivable. A separate A/cs Rec. Ledger is kept for separate accounts of individual customers. Similarly, all credit purchases are posted in the purchase day book, and the creditors ledger contains the same information supplier-wise. The total of purchase day book is debited to purchase a/c and credited to A/cs Payable. Control Account: shows in a summary form the debits and credits that are shown in detail in subsidiary ledgers. Thus Sales A/c, Purchase A/c, A/cs Rec. and A/cs payable constitute the control accounts as their details can be seen in sales day book, debtors ledger, purchase day book and creditors ledger.
General Ledger: The next stage in the accounting process after recording the transactions in any one of the above books, is posting of the transactions to the debit and credit sides of the respective accounts in the ledger. General Ledger contains T accounts of: 1.Owner¶s equity 2. Assets like buildings, furniture, stationery, plant and machinery, sundry Drs., prepaid expenses, inventory etc. 3. Liabilities like Long-term Loans, Short-term Loans, bank overdraft, Crs., outstanding expenses, bills payable etc. 4. Revenue items like sales, interest earned, discount and commissions recd. 5. Expense like depn., salaries, wages, insurance, rent, income tax etc.
Each folio in the Ledger is serially numbered and is devoted to one specific account only. Whenever a number of accounts of similar nature are required, a special ledger is opened. For example, a Sundry Drs. Ledger may be maintained which will contain the individual A/cs of all credit customers. Then only total Drs. a/c will appear in the General Ledger representing all credit customers. A creditors ledger can also be maintained likewise.
Journal Proper : Misc. & residual transactions and opening & closing entries Cash Book : Cash transactions including those involving Bank A/c. Purchase Day Book : Credit-purchases of revenue nature Sales Day Book General Ledger : Credit Sales Transactions : Owner¶s equity, Assets & Liability A/c, Rev.& Expense A/cs Creditors Ledger : A/cs of individual creditors Debtors Ledger: : Individual A/cs of customers to whom credit had been granted
Rules of Debit and Credit Business transactions are classified into three categories: i) Transactions relating to persons ii) Transactions relating to properties and assets iii) Transactions relating to incomes and expenses. On this basis, it becomes necessary for the business to keep an account of: i) Each person with whom it deals: Personal Accounts ii) Each property or asset which the business owns. Real Accounts iii) Each item of income or expense. Nominal Accounts Personal Accounts: Three categories i. Natural Personal Accounts: Mohan¶s or Asha¶s A/c ii. Artificial Personal Accounts: Accounts of corporate bodies or institutions which are recognized as persons in business dealings e.g. a Ltd. Co., the A/c of a Coop. Society or that of a club, Govt. or a PSU.
iii. Representative Personal A/c: These are accounts which represent a certain person or group of persons e.g. outstanding rent A/c or outstanding salaries A/c. These A/cs represent the A/cs of the persons to whom rent, salaries etc. have to be paid. The rule is DEBIT the Receiver CREDIT the Giver
For example, if cash has been paid to Ram,the account of Ram will have to be debited. If cash has been received from Keshav, the A/c of Keshav will have to be credited.
Real Accounts: i. Tangible Real A/cs are those which relate to such things which can be touched felt, measured etc., e.g. Cash A/c, building A/c, furniture A/c, Stock A/c etc. But, Bank A/c is a personal A/c. since it represents the banking co-an artificial person. ii. Intangible Real A/cs. These cannot be touched but can be measured, e.g. goodwill A/c, Patent A/c etc. The rule is DEBIT what comes in CREDIT what goes out
If building has been purchased for cash, building a/c should be debited (since it is coming in the business) while Cash A/c should be credited since cash is going out of the business. Similarly, when furniture is purchased for cash, furniture A/c should be debited and cash A/c should be credited.
Nominal Accounts: These include A/cs of all Expenses, Losses, Incomes and Gains; examples are A/c for rent, rates, lighting, insurance, dividends, loss by fire etc. The rule is DEBIT All Expenses and Losses CREDIT All Gains and Incomes Note: When some prefix or suffix is added to a nominal A/c, it becomes a personal A/c. The table below explains: Nominal A/c Rent A/c Interest A/c Salary A/c Personal A/c Rent Pre-paid A/c, Outstanding rent A/c Outstanding Interest A/c, Prepaid Interest A/c, Interest recd. in advance A/c Outstanding Salaries A/c, Prepaid Salaries A/c, etc.
Rules of Debit and Credit:ACCOUNTING EQUATION The rules of debit and credit are based on the nature of an account derived from the Accounting Equation. For this purpose, accounts are classified as follows: i) Assets ii) Liabilities iii) Owner¶s Equity iv) Revenues v) Expenses
The rules are: i. When ±there is an increase in the amount of an asset, its account is debited and when there is a decrease, its account is credited. An asset may increase due to purchase of new asset and decrease due to sale or depreciation. ii). When there is an increase in the amount of Liability, its account is credited and when there is a decrease, its account is debited. iii) When there is an increase in the owner¶s equity its account (capital account) is credited; the account is debited when there is a reduction in the amount of owner¶s equity. iv) When there is an increase in revenues, the concerned revenues account is credited e.g. Sales A/c, Rent Recd. etc. v) When there is an increase in expenses or expense is incurred, the concerned expenses A/c is debited and when there is decrease, the same A/c is credited. Salaries paid to employees are debited to salaries A/c.
Illustration: From the following transactions, find out the nature of account and also state which account should be debited and which A/c credited. a. Rent paid b. Salaries paid c. Interest recd. d. Dividends recd. e. Furniture purchased for cash f. Machinery sold g. Outstanding for salaries h. Telephone charges paid i. Paid to Suresh j. Recd. From Mohan (the proprietor) k. Lighting
Transaction Rent Paid
Accounts involved Rent A/c Cash A/c
Nature of A/cs DEBIT/ CREDIT Nominal A/c Real A/c Nominal A/c Real A/c Real A/c Nominal A/c Real A/c Nominal A/c Real A/c Real A/c Real A/c Real A/c Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Salaries A/c Cash A/c
Cash A/c Interest A/c
Cash A/c Dividend A/c
Furniture A/c Cash A/c
Cash A/c Machinery A/c
Transaction Outstanding Salaries
Accounts involved Salaries A/c Outstanding Salaries A/c
Nature of A/cs Nominal A/c Personal A/c
DEBIT/ CREDIT Debit Credit
Telephone charges paid
Telephone Charges A/c Cash A/c
Real A/c Personal A/c Real A/c Real A/c Personal A/c Nominal A/c Real A/c
Credit Debit Credit Debit Credit Debit Credit
Paid to Suresh
Suresh Cash A/c
Recd. from Mohan (the proprietor) Lighting
Cash A/c Capital A/c
Lighting A/c Cash A/c
Illustration: Lal starts a business with capital of Rs. 20,000 on January 1, 1995. In this case, there are two A/cs involved. These are: i) The A/c of Lal ii) Cash A/c Lal is a natural person and, therefore, his A/cs is a personal A/c. Cash A/c is a tangible asset and therefore, it is a Real A/c. As per the rules of Debit and Credit applicable to personal A/c, Lal is the giver and therefore, his A/c, the capital A/c. should be credited. Cash is coming in the business, and, therefore, as per the rule, it should be debited. The transaction will now be entered in the journal as follows:
Date Particulars Dr. L.F. Debit Rs. 20,000 20,000 Credit Rs.
1995 Cash A/c Jan, 1 To Capital A/c
*(Being commencement of business)
* These words constitute narration for the entry passed, since these narrated the transaction.
2. He purchased furniture for cash for Rs. 5,000 on Jan 5, 1995. Both the furniture A/c & Cash A/c are Real A/cs. Furniture is coming in & should be debited. Cash is going out and it should be credited.
Date Particulars Dr. L.F. Debit Rs. 5,000 5,000 Credit Rs.
1995 Furniture A/c Jan, 5 To Cash A/c
*(Being purchase of furniture)
3. He paid rent for business premises Rs. 2,000 on Jan 10, 1995 The A/cs involved are Rent A/c & Cash A/c. Rent A/c is a nominal A/c. It is an expense and, therefore, it should be debited. Cash A/c is a Real A/c. Since cash is going out, it should be credited.
Date 1995 Jan, 10 Rent A/c To Cash A/c *(Being Rent for premises) Particulars Dr. L.F. Debit Rs. 2,000 2,000 Credit Rs.
4. He purchased goods on credit of Rs. 2,000 from Suresh on January 20, 1995 The A/c of Suresh is a personal A/c, while that of goods is a real A/c. Suresh is the giver of goods and, therefore, his A/c should be credited while goods are coming in the business and, therefore, Goods A/c should be debited.
Date 1995 Jan, 20 Goods A/c To Suresh *(Being purchase of goods on credit) Particulars Dr. L.F. Debit Rs. 2,000 2,000 Credit Rs.
Purchases Account: records all purchases of goods. Goods ³come in´ on purchasing of goods and therefore, the Purchases A/c is debited on purchase of goods. Sales Account: records goods sold. The goods ³go out´ on selling of goods, and, therefore, the Sales A/c is credited. Purchase Return Account: The goods ³go out´ on returning of goods to the suppliers and, therefore, the A/c should be credited on the return of goods purchased. Sales Return Account: The goods ³come in´ and, therefore, the sales Returns A/c should be debited on return of goods.
Purchases Account (Goods Come in «««...Dr.) Sales Account (Goods go out «««.«..Cr.) Purchases Return A/c (Goods go out ««««..Cr.) Sales Return A/c (Goods Come in ««««..Dr.)
Ledger Accounts Business transactions of a financial nature are recorded in the books of original record. These books are cash book, purchases book, sales book, purchase return book, sales return book, bills receivable book, bills payable book, journal. The proprietor may, however, like to know the position of individual debtors and creditors. Or, the value of assets and liabilities separately. Collection of requisite information concerning a particular account and presenting them under one head is known as ledger posting. We may sell goods to Ram or purchase goods from him. We may return goods to Ram or Ram may return goods. Payments may be made to him or may be received from him. All these transactions regarding dealings with Ram must have been recorded in different books such as purchases book or sales book or returns books or cash book. Recording transactions in different books concerning Ram does not present the picture of Ram¶s account. We are not in a position to know if Ram is a debtor or a creditor and to what extent.
In order to show Ram¶s A/c under one heading at one glance, only a ledger account will show the collective picture. Information from different books is collected and presented under one heading known as a Ledger A/c Dr Date Particulars (1) (2) To-------A/c Format of Ledger Account Folio Amount (3) (4) Date Particulars (5) (6) By-------A/c Cr Folio Amount (7) (8)
The left hand side is the debit side and the right hand side is credit side. Preparation of Assets Account Assets have a debit balance. Asset accounts are debited for increases and credited for decreases. The debit side of an asset account records purchases and the credit side records the sale and depreciation of the asset.
Illustration: Prepare Furniture A/c with the following information.: 1998 Jan 1 Furniture in hand Jan 1 Purchased furniture June 30 Sold furniture Dec 31 Depreciate furniture including addition @10% 290 Rs. 1,000 2,000 200
Solution: Depn. on furniture calculated @ 10% on 1000 + 2000 = 3000 for six months and on 3000 ± 200 = 2800 at the same rate for another six months. Depn. will amount to Rs. 150 + 140 = 290
1998 Jan 1 Jan 1 To cash A/c
Furniture Account Particulars
To Balance b/d
By Cash A/c By Depn. A/c By Balance c/d
1998 Jun 30
200 290 2510 3000
1999 Jan 1
To Balance b/d
Explanation: Furniture as an asset shows debit balance, so its opening balance has been shown as µTo Balance b/d .¶ Purchase of furniture on 1st January will increase furniture, so it will be shown on the debit side of Furniture A/C. As a general principle pf accounting, we do not show the name of the same account either at the debit side or the credit side of the account being prepared, so we shall be writing µTo Cash A/c¶ for the purchase of furniture. In the same way, sale and depreciation of furniture will decrease the value of furniture and will be posted at the credit side of the furniture A/c and will be shown as µBy Cash A/c¶ for sales and by depreciation A/c for depreciation on furniture. While balancing furniture A/C we find that the total of the debit side i.e, Rs.3000 is more than the credit side, so the total of the debit and credit side must be made equal, Rs.3000 and posted parallel to each other. The total of the credit side is short by Rs.2510. This difference of Rs.2510 will be written as µBy Balance c/d¶ on the closing date of the account period. The closing balance will be carried forward to the first day of the next accounting period and will be written as Balance b/d on the debit side.
Ledger Posting & Trial Balance The term µPosting¶ means transferring the debit and credit items from the Journal to their respective accounts in the Ledger. Exact names of accounts used in the Journal should be carried to the Ledger. The Ledger Folio (LF) column in the Journal is used at the time when debits and credits are posted to the Ledger. The page no. of the Ledger on which the posting has been done is mentioned in the LF column of the Journal. i) The transactions are recorded first of all in the Journal and then they are posted to the Ledger. Thus, the Journal is the book of first or original entry, while the Ledger is the book of second entry. Ii) Journal records transactions in a chronological order, while the Ledger records transactions in an analytical order. Iii) Journals is more reliable as compared to the Ledger since it is the book in which the entry is passed first of all. Iv) The process of recording transactions is termed ³Journalizing´ while for Ledger It is called posting.
Rules Regarding Posting: i) Separate accounts should be opened in the Ledger for posting transactions relating to different accounts recorded in the Journal. For example, separate accounts may be opened for sales, purchases, sales returns, purchase returns, salaries, rent, cash etc. Ii) The concerned account which has been debited in the journal should also be debited in the Ledger. However, a reference should be made of the other account which has been credited in the Journal. For example, for salaries paid, the salaries A/c should be debited in the Ledger, but reference should be given of the cash A/c which has been credited in the journal. Iii) The concerned A/c, which has been credited in the Journal should also be credited in the Ledger, but reference should be given of the A/c, which has been debited in the Journal. For example, for salaries paid, cash A/c has been credited in the Journal. It would be credited in the Ledger also, but reference will be given of the Salaries A/c in the Ledger.
Suppose, salaries of Rs 10,000 have been paid in cash, the following entry will be passed in the Journal: Salaries A/c To Cash A/c Dr 10,000 10,000
In the Ledger two A/cs will be opened (i) Salaries A/c and (ii) Cash A/c. Since salaries A/c has been debited in the Journal. It will also be debited in the Ledger Salaries A/c Dr. Cash A/c Rs. 10,000 Cash A/c Dr. Particulars Rs. Particular Salaries A/c Cr. 10,000 Particular Cr.
The use of words To (e.g. To Cash A/c) and By (e.g. By Salaries A/c) is merely conventional and has no meaning. Modern accountants ignore these words, To & By. Journalize the following transactions and post them in to the Ledger: 1. Ram started business with a capital of Rs. 10,000 2. He purchased furniture for cash Rs. 4,000 3. He purchased goods from Mohan on credit Rs. 2000 4. He paid cash to Mohan Rs. 1000.
Date Particular Cash A/c To Capital A/c Furniture A/c To Cash A/c Purchase A/c To Mohan A/c Mohan To Cash A/c LF Debit (Rs.) 10,000 10,000 4,000 4,000 2,000 2,000 1,000 1,000 Credit (Rs.)
Dr. To Capital A/c
Ledger Cash A/c 10,000 By Furniture A/c By Mohan Capital A/c By Cash A/c
Cr. 4,000 1,000 Cr. 10,000 Cr.
Dr. To Cash A/c Dr. To Mohan A/c Dr. To Cash A/c 1,000 2,000 4,000
Mohan A/c By Purchases A/c
Balancing of Accounts: At the end of each month or year, personal and real accounts are balanced. Balancing means finding the difference between the total debit amounts and the total credit amounts of an account. If the total of the credit side is bigger than the total of the debit side, the difference is known as the credit balance. In the reverse case, it is called debit balance. The credit balance is written on the debit side of the ledger account against the words ³To balance c/d´ and the debit balance is written on the credit side of the Ledger A/c against the words µBy balance c/d¶ in the particulars column. By doing this, the two sides are made equal and the total of the amounts column are written on a parallel line. In the next period, first entry is µTo balance b/d¶ or µBy balance b/d¶ as the case may be. Nominal A/cs are not balanced. They are closed by transfer to the trading and profit and loss a/c. For the purpose of preparing the Trial Balance, nominal accounts are also totalled. In Ledger accounts, the word a/c after the name of the account in the particulars column may be omitted.
TRIAL BALANCE After posting the Ledger, a statement called the trial balance is prepared, It shows separately the debit and credit balances of all the accounts in the ledger, on a particular date i) It provides information about the arithmetical accuracy of posting and provides a basis for preparation of financial statements. If the trial balance agrees, it gives an indication that double entry aspect of every transaction recorded in the books of account is complete and the account books are arithmetically correct. However, inspite of an agreed trial balance, there might he certain errors. For example, if a transaction has been completely omitted from the books of accounts, the two sides of trial balance will still agree, inspite of the books of accounts being wrong. ii) Trial balance forms the basis for preparing financial statements such as the P&L A/c and the balance sheet. iii) The entire Ledger is summarized in the form of a trial balance. The position of a particular A/c can be judged simply by looking at the trial balance
The format of the trial balance is similar to the Journal. For preparing the trial balance, the debit balances of A/cs are placed in the debit column and credit balances in the credit columns of the trial balance. It should be noted that a debit balance is either an asset or expense, and credit balance is in respect of an income, or liability or capital Cash and bank columns in the cash book serve the purpose of prime as well as final entries. In the Ledger. Cash and Bank A/cs are not opened separately. Cash A/c never shows a credit balance, since a person cannot spend more than what he has. The Bank a/c may show a credit balance since a bank may permit a customer to overdraw his account (i.e., withdraw more money than what he has in his account). In such a case, the customer has an overdraft with the bank.
Measurement of Business Income One of the basic objectives of maintaining the books of accounts of a business is to ascertain the amount of profit or loss made or suffered during a particular period. This requires proper matching of expenses with revenue. Revenue: It means income of recurring nature from any source, like sale of goods, performance of service, rental of property etc. Expense: It denotes the cost of services and things used for generating revenue. Expenditure: means payment for an asset or an expense. If an asset is acquired or an expense is incurred, an expenditure is said to have been incurred. Every expense is an expenditure while each expr. Is not necessarily an expense.
Matching of an expense with revenue: Expense may be matched with the revenue at the end of year. A period of 12 months is considered an ideal accounting period. First of all, revenue is determined and then the expense incurred for earning that revenue is matched with that revenue for determination of net income or net profit. Measurement of revenue: Revenue is measured according to the Accrual Concept. This means revenue and cash are two different things. Earning of revenue does not mean receipt of cash and vice versa. Revenue earned in a particular year may be received in cash in the next year. Similarly, cash received in a year may be the revenue of the next year. If a firm receives interest in advance for the year 1997 in 1996, the cash has been received but it will be taken as revenue of the year 1997, and not 1996.
Revenue is considered earned on its being realized.Thus according to Realization Concept, revenue is generally taken to have been realized in that period in which goods or services are furnished to the customers; e.g. ± ± ± if order is received in February, goods are delivered in March Payment is received in September
The revenue is considered earned in March when goods are delivered. Thus revenue is recognized when the actual sale takes place and the ownership in goods has been transferred to the customers. There are, however, exceptions to this rule: i) In the case of extractive industries like gold, silver, oil, etc revenue is recognized in the accounting period in which these have been mined or extracted out.
ii) In the case of Long term contracts (e.g.construction) a proportion of the amount of revenue representing part of the contract completed by the end of the year is treated as realized even before the completion of the contract. iii) In the case of hire purchase, or installment sale transactions, revenue is considered realized only to the extent of the installments which have been received in cash in cases where the seller has doubts about the possibility of realizing the full amount of selling price from the buyer.
Cash Basis- Income is equal to cash recd. Expense is equal to cash paid ± Net Income- is the difference between Cash Receipts & Cash Payments ± Application in case of small enterprises doing business only on cash basis, also clubs, societies, other non-profit organizations. ± It credit terms allowed or recd.; cash basis is inappropriate.
Accrual Concept: Income is the difference between revenue & expenses. It is, therefore, profit earned which is reflected by a net increase in Owner¶s Equity ± If losses are incurred, Owner¶s Equity decreases. ± Receipt of Cash is not Income ± Payment of Cash is not Expense.
Capital and Revenue
Capital income: the term capital income means an income which does not grow out of or pertain to the running of the business proper. It is synonymous to the term capital gain. For example if a building costing Rs. 10,000 purchased by a firm for its use is sold for Rs. 15,000, Rs. 5,000 will be taken as a capital profit. However, only the profit realized over and above the cost of the fixed asset should be taken as a capital profit. Any profit over the book value is treated as revenue profit since depreciation against the fixed asset has already been charged to the P & L A/c, of the earlier years and any profit which is now made is simply recovery of excess provision for depreciation made in the earlier years. According to the I.T. rules, a plant originally purchased for Rs. 10,000 standing in the books at Rs. 6000 is sold for Rs. 12000, there is a profit of Rs. 6000 on the sale of this plant. Out of this profit, Rs. 2,000 (i.e., the amount over and above the cost of the asset) should be taken as capital profit while the balance of Rs. 4,000 should be taken as revenue profit. Capital profit is transferred to the Capital Reserve and is shown in the Balance Sheet on the liabilities side while revenue profit is credited.to the P and L A/c.
Revenue Income: means an income which arises out of and in the course of regular business transactions of a concern, e.g. sales, rental of property, dividends recd. etc. Capital Expenditure: means an expenditure which has been incurred for the purpose of obtaining a long term advantage for the business. Such expenditure is either incurred for acquisition of an asset (tangible & intangible) which can later be sold and converted into cash or which results in increasing the earning capacity of the business. Examples: i)Expr. incurred in increasing the quality of fixed assets, e.g. purchase of additional furniture, plant, building for permanent use in the business. ii)Expr. incurred for increasing the useful life or capacity or efficiency of a fixed asset. iii)Expr. for replacement of an asset by a new one.
iv.Expr. incurred for purchase, receipt, erection of a fixed asset, e.g. cartage, erection, wages etc. v.Purchase of patent rights, copy rights, goodwill etc. vi.Expr. for incorporation of a firm, obtaining a license, legal & other expr. Revenue Expenditure: An expr. whose benefit accrues in the current period is known as rev. expr. An expr. would be rev. expr. if i) It is incurred on day to day production or on running day to day business. ii)It provides any benefit of an immediate or/and non-recurring nature; iii)It helps in keeping the assets in good working condition, e.g. replacement of a worn out part etc.
Deferred Revenue Expr. Sometimes, the benefit of a rev. expr. may be available beyond the current period. Such expr. is referred to as deferred rev. expr. It is written off over a period of 3 to 4 years instead of charging it to the P&L A/c of the period in which it is incurred. Examples: Heavy expr. on advertisement and publicity of a new product or the firm, the benefit of which will be derived in future also. The amount representing loss of an exceptional nature, such as fire earthquake etc.
Exercise Name: Indicate the classification of each of the items in the worksheet indicating the items that cannot be classified
Items Income Building Share Capital Cash Debtors Creditors Equipment Land revalued Stock Goodwill developed Furniture Delivery vehicle Prepayment of expenses. Advances recd.
Exercise ± A tallied Balance Sheet?
Assets Owners¶ equity Merchandise Accounts payable Interest payable Liabilities Taxes payable Cash Equipment Loan payable Accounts receivable Vehicles 11.7 4.0 18.0 24.0 8.0 6.3 72.0 (Rs. 0000) 22.1 35.7 14.0 0.2 72.0
Using the data given above, prepare a proper balance sheet
Exercise ± Ranjan Mahapatra prepared the following tallied balance sheet of Balances Ltd. in a five minutes quiz administered in a Management Accounting class. Balance Sheet of Balances Ltd. for the period ending 31.3-93
Owners¶ equity Merchandise Accounts payable Interest payable Liabilities Taxes payable Cash Equipment Loan payable Accounts receivable Vehicles
22.1 35.7 14.0 0.2 72.0 11.7 4.0 18.0 24.0 8.0 6.3 72.0
Using the data given in the ³balance sheet´ prepared by Ranjan Mohapatra, prepare a proper balance sheet