Need for Accounting

A businessman invests capital with the objective of making profit and thereby
increasing his resources. He incurs various expenses like salaries, rent and
stationery to operate his business. He receives income from different sources
like commission, interest and discount. He deals with several persons in the
course of buying and selling of goods, purchasing and selling of assets and
borrowings money for financing the business. He acquires various properties and
assets like building, machinery, furniture to generate revenue.

Effective Management of business requires control over expenses to reduce the

cost of operation and to make the business profitable. Assets must be properly
maintained to increase their productivity. Liabilities of a business have to be
repaid in due time. Dealings with customers and suppliers must be managed
properly to keep them satisfied. In order to maintain property in good condition,
to repay debts in time, to reduce the expenses and to increase sales, the
businessman required complete information about all his business transactions.

In practice, it is impossible for any businessman to memorise and recollect all his
business dealings. Moreover, he will be interested in knowing at the end of each
year (i) What he owns? (ii) What he owes? (iii) How much profit he has earned?
(iv) What his financial position is? To relive businessmen from the burden of
memorising all the business dealings and for providing necessary information,
Accounting was developed.

Businessmen also require accounting records to submit in courts to prove their

claims or to defend in courts against claims made by outsiders. They are
required to produce business records to tax authorities whenever demanded.
Similarly, financiers require accounting records of businessmen to decide about
sanctioning of loans. Thus, transactions relating to business have become so
important that their recording has become a necessity.

Accounting as the Language of Business

Arnold W.Johnson in his book ‘Elementary Accounting says that ‘modern

accounting has often been called ‘the language of business.’ Its responsibility is
applying a thorough knowledge of the theory of accounting i.e., generally
accepted principles of accounting to the practical field of business in order that
income and financial position may be stated fairly”.

The basic function of language is to serve as a means of communication.

Accounting serves the purpose of communicating the results of business
operations to all the interested parties such as proprietors’ managers, creditors
and investors.

Definition of Accounting

According to American Institute of Certified Public Accountants, “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”.
Branches of Accounting

 Financial Accounting

 Cost Accounting

 Management Accounting

FINANCIAL ACCOUNTING

Financial Accounting is concerned with recording all revenues and expenses,

assets and liabilities of a business concern and ends up with the preparation of
Trading and Profit and Loss Account [ to ascertain the profit/loss made ] and a
Balance Sheet [to find out what the business owns and owes to others].

Functions or Process of Financial Accounting

Accounting performs the following functions:

· Recording: As soon as a financial transaction takes place in an organisation,

they are recorded in proper books of accounts [called Journal ] in chronological
order.

· Classification: It is the process of grouping transactions of similar type under

one head, called Accounts. This is done in a separate book called Ledger. Thus,
each ledger account gives a complete picture of all happenings in relation to that
particular account.

· Summarising: It is the process of presenting the classified data in an

organized manner which is understandable and useful to all interested parties.
This takes place in the form of Trial balance, Trading and Profit and Loss Account
and Balance Sheet.

· Interpreting: The financial statements are analysed and interpreted in such a

way that the end-users can judge the performance correctly and make informed
decision regarding future course of action.

Objectives of Financial Accounting

· To maintain accounting records.

· To calculate the result [ Profit or Loss] of operations by preparing income

statement [called Profit and Loss Account].

· To ascertain the financial position by preparing position statement [called

Balance Sheet] which shows the resources owned [called Assets] and the sources
of such resources [called Liabilities].

· To provide information to external and internal users.

External users include investors, creditors, bank and Government. Investors are
mainly interested in finding out the solvency and profitability position of an
organisation. Creditors are interested in knowing the safety of their principal and
receiving interest. Government needs information for tax assessment and
granting subsidy.
Internal users include owners, employees and management. Owners are
interested in knowing how their funds were used. Employees are interested in
financial performance for seeking higher pay and bonus. Management requires
information for Planning and controlling the operations of the enterprise.

Advantages of Financial Accounting

· Maintains systematic record of all business transactions.

· Enable the user to find out whether the organisation has made profit or incurred
loss during a specified period.

· Facilitates assessment of financial position of the concern.

· It provides the needed information to various interested groups.

· It can be used as authenticate evidence in a court of law.

· Provides information for assessment and settlement of taxes like income tax,
sales tax, etc. · Helps the users in judging the financial performances of the
concern correctly.

· Aids in making informed and sound decisions.

Limitations of Financial Accounting

· It records only those transactions which can be expressed in terms of money. It

cannot measure qualitative factors like quality of personnel, soundness of
management policies, quality of product or research and development, morale of
employees, etc.

· It ignores changes in price level.

· Accounting uses estimates and subjective opinions of management and

accountant. For example, amount of depreciation depends upon the estimated
useful life of a machine. Similarly provision for bad debts and market value of
stock in hand is influenced by subjective opinion. Hence, accounting results can
at best be only approximately correct.

COST ACCOUNTING

The limitations of Financial Accounting has led to the emergence of Cost

Accounting. Cost Accounting is concerned with recording, classifying, allocating
and apportioning expenses for determining the cost of products or services, and
presenting data to the management for cost control and decision making.

Definition of Cost Accounting

According to the Chartered Institute of Management Accountants, London, Cost

accounting is “the process of accounting for costs from the point at which the
expenditure is incurred or committed to the establishment of its ultimate
relationship with cost units. In its widest sense, it embraces the preparation of
statistical data, the application of cost control methods and the ascertainment of
the profitability of the activities carried out or planned.
Functions of Cost Accounting

· Determination of cost for a specific product or activity.

· Recording of cost in cost journal and their subsequent posting to ledger.

· Critical evaluation of cost information to assist the management in its planning

and control function.

· Reporting of cost data to all concerned.

Objectives of Cost Accounting

· Ascertaining the cost of the products or services.

· Control cost by (i) establishing standard cost (ii) comparing actual cost against
standard cost and (iii) analyzing the causes for their variation and taking
corrective action.

· Another object of cost accounting is not only to control cost but also reduce
them.

· Facilitate fixing of selling price.

Advantages of Cost Accounting

· Helps management in cost ascertainment, cost control and cost reduction.

· Aids in improving operational efficiency.

· Minimizes wastages.

· Helps in price fixation during depression, facing competition and in exporting

goods.

Limitations of Cost Accounting

· Installing a costing system is quiet expensive.

· They are mainly applicable in manufacturing concerns. Hence, it is not of much

use for a trading organisation.

Management Accounting

Management Accounting is concerned with providing necessary information to

the management in such a way as to enable it to discharge its management
functions efficiently. Definition of Management Accounting

The Chartered Institute of Management Accountants defines Management

Accounting as “the application of professional knowledge and skill in the
preparation of accounting information in such a way as to assist management in
the formation of policies and in the planning and control of the operations of the
undertaking.

Objectives and Functions of Management Accounting

· Helps management in effective decision making and policy formulation.

· Aids in planning and forecasting.

· Facilitates exercising effective control throughout the organisation.

Advantages of Management Accounting

· Ensures effective planning

· Facilitates performance evaluation.

· Exercises effective control over the entire organisation.

· Helps in making sound decisions.

Financial Accounting- Generally Accepted Accounting Principles

Accounting bodies across the world have developed principles, concepts and
conventions over a period of time in order to ensure uniformity in the compilation
and preparation of accounts. They act as “the basic points of agreement “upon
which the entire theory and practice of Financial Accounting are built.

Generally Accepted Accounting Principles:- These are those rules of conduct or

procedure which are adopted by the Accountants universally, while recording
accounting transactions. They act as general guidelines for effective accounting
practical.

Accounting principles are further classified into (a) Accounting concepts and (b)
Accounting conventions. These are different concepts and conventions as given
below.

Accounting Concepts
 These are those basic assumptions or conditions or postulates upon which the
source of accounting is based. Following are the various Accounting concepts:-

1) Business Entity Concept:

According to this concept, an organisation is treated as a separate entity distinct

from its owner. All transactions are recorded from business point of view only.

2) Money Measurement Concept:

This concept states that only those transactions which can be expressed in terms
of money alone will be recorded in the books of accounts. Important matters
which cannot be expressed in monetary units like, quality of management,
morale of employees, etc. cannot be recorded in the books of accounts.

3) Going Concern Concept:

This concept assumes that the business will continue to operate in the
foreseeable future. It constitutes the foundation for spreading the depreciation
over the useful life of the asset and treating outstanding expenses, pre-paid
expenses, income due and income received in advance in the books of accounts.

4) Dual Aspect Concept:

According to this concept, every business transaction will have two aspects-
benefit giving aspect [called credit] and benefit receiving aspect [called debit],
ie. for each transaction there will be a debit and a corresponding equal credit.
This forms the basis for Double Entry System of book keeping, and “Accounting
Equation” developed by American accountants.

5) Accounting Period Concept:

This concepts states that the business is a continuous affair, the life of the
business is divided into suitable accounting periods [say, a period of one year],
for ascertaining and reporting the results of business operations. It helps in
calculating the income generated during a specific period and the expenses
incurred in generating that income. It also forms the basis for segregating
expenses into capital and revenue nature. While revenue expenditure is charged
to Profit and Loss Account, capital expenditure is shown in Balance Sheet.

6) Cost Concept:

According to this concept, assets purchased are recorded in the books at the
cost at which they were acquired. This cost will be the base for all subsequent
accounting periods. Depreciation charges will be made on the basis of the cost at
which the assets were procured.

7) Revenue Recognition Concept:

This concept deals with the recognition of revenue in the Income Statement.
Revenue is said to have been made when the organisation gets the legal right to
receive it. Revenue is the gross inflow of cash or near cash items arising in the
ordinary course of business from sale of goods/ services and from use of
organisation’s resources by others. It excludes the amount collected on behalf of
third parties, such as taxes.

8) Matching Concept:

This concept states that revenue earned during a period should be matched with
the expenses incurred in earning that revenue. Hence, while preparing Final
Accounts, adjustments should be made for outstanding expenses, outstanding
incomes, expenses paid in advance and income received in advance.

9) Accrual Concept:

This concept advocates that revenue and costs should be recognized as and
when they are earned or incurred and not when money is actually received or
paid. Mercantile system of accounting is based on this concept.

10) Objective Evidence Concept:

It states that each and every transaction recorded in the books of accounts
should be supported by adequate physical evidence. This ensures that the
recorded accounting data is definite, verifiable and also free from the personal
bias of the accountant.

Accounting Conventions

These are those customs or traditions followed by accountants worldwide while

preparing accounts. There are four important conventions as given below:

1) Convention of Conservatism:

This convention states that while preparing accounts, accountants should take a
conservative approach, in the sense that they should provide for all anticipated
losses, but should not take into account expected profits. It provides the basis for
valuing stock at ‘cost or market price whichever is less’.

2) Convention of Consistency:

This convention insists that accounting practices should remain unchanged over
a period of time. This will facilitate meaningful comparison of the organisation’s
performance between different accounting periods. In case of any change in the
accounting practice, its impact should be quantified and clearly indicated in the
financial statements.

3) Convention of Full Disclosure:

According to this convention, financial statements should provide all pertinent

information expected of them. It has paved the way for the practice of giving
references and parenthesis in the statements.

4) Convention of materiality:

Accountants, while preparing final accounts, should give all material information
and ignore insignificant details. What constitutes material information depends
upon the circumstances and is left to the discretion of the accountants. An
 information is considered to be material, if its disclosure would influence the
judgment of any interested party.

MEANING OF DEBIT AND CREDIT

DEBIT:

The Benefit receiving aspect or Incoming aspect of a transaction is called Debit.

The abbreviation “Dr.” is used for debit.

CREDIT:

The Benefit giving aspect or Outgoing aspect of a transaction is called Credit.

The abbreviation “Cr.” is used for credit.

By convention, the left hand side of an Account. [An account is one which
summarizes all transactions relating to a particular item under one hand. It is
abbreviated as A/c.] is treated as Debit side and right hand side of an account is
treated as Credit side.

Golden Rule – Rules for Debit and Credit

The rules for debit and credit are commonly referred as Golden Rule. These are
given below:

Type of Accounts Debit Credit

1) Personal A/c The Receiver The Giver

2) Real A/c What comes in What goes out

3) Nominal A/c All expenses and losses All Incomes and Gains

ACCOUNTING CYCLE

Accounting cycle contains a series of steps starting from recording of

transactions and ending with preparation of final accounts.

Steps in the accounting cycle Explanation

 1. Transactions are recorded in the journal as
and when they occur.

2. Transactions recorded in the journal are

posted to their respected accounts
maintained in the Ledger.

3. The difference between the debit total and

credit total for each account is worked out.

4. A list of the balances of each and every

account is prepared to find out whether debit
total equals credit total.

5. Ultimately, the following are prepared:

(a) Trading and Profit and Loss A/c’s to

calculate the profit or loss made.

(b) Balance Sheet to find out the financial

position of the company.

Meaning of Journal and Journalizing

Journal is a book which records the transactions in the same order as they occur.
Since this is the originating point of the accounting cycle, a journal is also known
as a Book of Original Entry.

The art of recording a transaction in the journal is called Journalising.

Following is the format of a journal:

Date Particulars L.F Debit Rs. Credit

Rs.

xxxx “Account to xxxxx

debited”
xxxxx
Dr

To “Account to be
credited”

[Narration or
Explanation]

1. Date : The date of the transaction is entered here

2. Particulars: Accounts to be debited and credited are entered here along with
an explanation called “Narration”.
 3. L.F: Stands for Ledger Folio. Folio mean ‘page’. It indicates the page number
in the ledger where the entry is posted.

4. Debit: The amount to be debited is entered in this column against “Dr.”

account.

5. Credit: The amount to be credited is entered in this column against “Account

to be credited”.

Steps in Journalising

(i) Identify the accounts involved in the given transaction.

(ii) Identify their type, i.e. Personal, Real, Nominal.

(iii) Apply the Golden Rule and find out the accounts to be debited and credited.

(iv) Make entry in the journal.

Note: It is of paramount importance to remember that transactions are recorded

from business point of view.

Illustration 1:

Journalise the following transactions:

1/1/22 Ram started business with cash of Rs.1, 00,000.

2/1/22 Purchased furniture for cash Rs.15, 000.

3/1/22 Purchased goods on credit from John Rs.20,000

4/1/22 Purchased good for cash Rs.30,000

5/1/22 Sold goods to Murali on credit Rs.75,000

6/1/22 Sold goods for cash Rs.80,000

7/1/22 Paid John Rs.12,000 by cash

8/1/22 Received cash from Murali Rs.55,000

8/1/22 Murali returned goods worth Rs.1000

9/1/22 Paid salary by cash Rs.16,000

10/1/22 Withdrew cash for personal use Rs.2000

10/1/22 Returned good to John Rs.1000

11/1/22 Withdrew from bank for personal use Rs.8000

12/1/22 Withdrew from bank for official use Rs.7000

13/1/22 Goods withdrawn for personal use Rs.1000

14/1/22 Received cheque from Murali for Rs.15, 000

15/1/22 Paid John by cheque Rs.3000

Solution:

Date Particulars L.F Debit Credit Rs.

Rs.

1/1/22 Cash 1,
A/c 00,00
1, 00,000.
Dr 0.

To Ram’s Capital A/c

[Being Capital
introduced]

2/1/22 Furniture A/c 15,00

Dr 0
15,000
To Cash A/c

[Being Furniture
Purchased]

3/1/22 Purchases 20,00

A/c Dr 0
20,000
To John A/c

[Being goods purchased

on credit]

4/1/22 Purchases 30,00

A/c Dr 0
30,000
To Cash A/c

[Being goods purchased

for cash]

5/1/22 Murali 75,00

A/c 0
75,000
Dr

To Sales A/c

[Being goods sold on

credit]

6/1/22 Cash 80,00

A/c 0
80,000
Dr

To Sales A/c

[Being goods sold for

 cash]

7/1/22 John 12,00

A/c 0
12,000
Dr

To Cash A/c

[Being cash paid to John]

8/1/22 Cash 55,00

A/c 0
55,000
Dr

To Murali A/c

[Being cash received

from Murali]

8/1/22 Sales Return 1,000

A/c Dr
1,000
To Murali A/c

[Being goods returned

by Murali]

9/1/22 Salary 16,00

A/c 0
16,000
Dr

To Cash A/c

[Being Salary paid in

cash]

10/1/22 Drawings 2,000

A/c Dr
2,000
To Cash A/c

[Being cash drawn for

personal use]

10/1/22 John 1,000

A/c
1,000
Dr

To Purchase Return
A/c

[Being goods returned to

John]

11/1/22 Drawings 8,000

 A/c Dr

To Bank A/c 8,000

[Being cash drawn from
bank for personal use]

12/1/22 Cash 7,000

A/c
7,000
Dr

To Bank A/c

[Being cash drawn from

bank for official use]

13/1/22 Drawings 1,000

A/c
1,000
Dr

To Purchases A/c

[Being goods drawn for

personal use]

14/1/22 Bank 15,00

A/c 0
15,000
Dr

To Murali A/c

[Being cheque received

from Murali]

15/1/22 John A/c 3,000

Dr
3,000
To Bank A/c

[Being Cheque issued to

John]

Illustration 2

Journalise the following transactions in the books of Gery:

1/1/23 Started business with cash of Rs.4,500.

1/1/23 Paid into bank Rs.2,500.

2/1/23 Goods Purchased for cash Rs.1,500

3/1/23 Purchase of Furniture and payment by cheque Rs.500

5/1/23 Sold goods for cash Rs.600

8/1/23 Sold goods to Aravind Rs.400

10/1/23 Goods purchased from Amrit Rs.700

12/1/23 Goods returned to Amrit Rs.100

15/1/23 Sold goods to Ram Swaroop for Cash Rs.250

18/1/23 Cash Received from Aravind Rs.396 and discount allowed to him Rs.4

21/1/23 Withdrew from bank for private use Rs.100

21/1/23 Withdrew from bank for use in the business Rs.500

25/1/23 Paid telephone rent for one year Rs.40

28/1/23 Cash paid to Amrit in full settlement of his account Rs.594

30/1/23 Paid for Stationery Rs. 20, Rent Rs.100, Salaries to staff Rs.250

Solution: Journal of Gery

Date Particulars L.F Debit Credit

Rs. Rs.

1/1/23 Cash 4,500

A/c
4,500
Dr

To Capital A/c

[Being Capital introduced]

1/1/23 Bank A/c 2,500

Dr
2,500
To Cash A/c

[Being Cash paid into bank]

2/1/23 Purchases 1,500

A/c Dr
1,500
To Cash A/c

[Being goods purchased for

cash]

3/1/23 Furniture 500

A/c Dr
500
To Bank A/c

[Being purchase of
furniture]

5/1/23 Cash 600

A/c Dr
 To Sales A/c 600

[Being goods sold for cash]

8/1/23 Aravind 400

A/c Dr
400
To Sales A/c

[Being goods sold for cash]

10/1/23 PurchasesA/c 700

Dr
700
To Amrit A/c

[Being credit purchase]

12/1/23 Amrit 100

A/c
100
Dr

To Return outwards
A/c

[Being goods returned]

15/1/23 Cash A/c 250

Dr
250
To Sales A/c

[Being goods sold for cash]

18/1/23 Cash 396

A/c
4
Dr
400
Discount Allowed
A/C Dr

To Aravind A/c

[Being Rs.396 received

from Aravind]

21/1/23 Drawings 100

A/c Dr
500
Cash
600
A/C
Dr

To Bank A/c
 [Being cash withdrawn from
bank ]

25/1/23 Telephone Rent 40

A/c Dr
40
To Cash A/c

[Being payment of
telephone rent]

28/1/23 Amrit A/c 600

Dr
594
To Cash A/c
6
To Discount Allowed

[Being cash paid to Amrit]

30/1/23 Stationery 20
A/c Dr
100
Rent A/C
250
Dr
370
Salaries
A/C Dr

To Cash A/c

[Being cash paid for

stationer, rent and salaries]