Icai accounting basics
- 1. Accounting Package CHAPTER 1 PRINCIPLES OF ACCOUNTING 1.1 INTRODUCTION TO ACCOUNTING 1.1.1 What is Accounting ? Accounting, in simplest terms, is keeping track of our Income, Expenses, Assets and Liabilities. This is true for a business, for a household or for an individual. In the case of a business Accounting can be defined as: “... the art of systematic recording, classifying, summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.” From the above definition, we note the following features of accounting : Only financial aspects are considered in Accounting. A financial transaction is one which brings some change in the financial position of a business. For example, we buy raw material or sell our goods. Thereby, we spend money and earn money. These are financial transactions. But when we place an order to a supplier for a particular machinery, it does not alter the financial position of the business. Thus, it is not a financial transaction and cannot be included in Accounts Books. The transactions are to be recorded primarily in some documents. Later they are to be grouped and summarised. This leads to different steps in Accounts Compilation. The process at different steps in the Compilation of Accounts should be performed on some basic rules, which are common for all business organisations, be it Manufacturing, Trading or the Service Industry. The entire organised, grouped and summarised data should reveal some information for executives at different levels in the organisation. We prepare reports of standard formats for interpretation purposes. 1.1.2 Process of Financial Accounting System The basic documents used in the Financial Accounting System are : Voucher where transactions are entered first Journal where transactions are entered chronologically and denote which accounts will be affected. Ledger where the transactions of particular account are segregated and balanced for each account. 250 INFORMATION TECHNOLOGY TRAINING © The Institute of Chartered Accountants of India
- 2. Principles of Accounting Using the above documents, the main reports prepared in the Financial Accounting System are as stated below: (a) Trial Balance : It gives the consolidated list of various Accounts and their balances. Brings out any error, procedural or arithmetical, in Journalising or Posting of transactions. This is the source point for preparing other reports. (b) Profit & Loss Report : This statement is prepared to find the operating profit in the business for a given period. The net profit is the basis of calculating the tax. The final net profit will be transferred to the Balance Sheet. The P & L statement shows the efficiency of performing operations in the business for a given period. (c) Balance Sheet : The Balance Sheet shows the financial status of the business as at a particular date. The effectiveness of managing the business is depicted here. The P & L Account and the Balance Sheet together form the basis for different analysis. The results of such analysis will be used by different groups of people such as the Income Tax Department, Banks for providing Working Capital Loans, existing and potential investors for investing in the business, and so on. 1.2 DOUBLE ENTRY SYSTEM OF ACCOUNTING 1.2.1 What is Double Entry System of Book-keeping ? Every financial transaction in an organisation has two aspects. There will always be inflow of cash or kind on one side and outflow on the other. For example, purchase material from the supplier on credit. Our stocks of material increase. At the same time our liability towards the supplier (which is outflow of cash) also increases. The double entry system of Book-keeping allows us to keep track of both these aspects. Thus, as per this system, at least two accounts are affected when a transaction is recorded. In the example above, the accounts affected are the Material Purchase account and the supplier account. 1.2.2 DEBIT AND CREDIT ENTRIES IN THE DOUBLE ENTRY SYSTEM How do we account for the two sides of a transaction ? The respective accounts, which get changed by a transaction, get any of the two entries - Debit or Credit. In other words, one account will be debited and the other account will be credited. Passing of the Debit and Credit entries is the basic, but crucial process in Accounting. Any error in this process will have a ripple effect and will affect the final reports. 1.3 ACCOUNTS AND RULES FOR ACCOUNTING 1.3.1 Account Type: Accounts can be any of four types : Asset What the business owns and what is due to the business Liability What the business owes to others Expense A source of expenditure for running the business pertaining to a period Income A source of earning money in the business pertaining to a period. Exercise : Identify the following types of Accounts : Debentures Bank of India Factory Shed Furniture and Fittings Taxes Payable Interest Received Sales Electricity Charges INFORMATION TECHNOLOGY TRAINING 251 © The Institute of Chartered Accountants of India
- 3. Accounting Package 1.3.2 Rules for Recording Transactions Classification of Accounts by the Nature of Account and the Golden Rules of Accounting : (i) Personal Account All accounts which are in the name of any Individual, Firm or Company such as Ram & Co., Shyam Gupta, Metro Transport, and so on. Rule : Debit the Receiver and Credit the Giver (ii) Real Accounts Accounts which relate to the Assets or Liabilities of the Business, Such as Cash A/c, Goods A/c, Furniture A/c, and so on. Rule : Debit what comes in and Credit what goes out (iii) Revenue or Nominal Accounts Accounts which relate to Income or Expense, such as Purchase, Sales, Interest Received, Salary & Wages, and so on. Rule : Debit all Expenses and Credit all Income Let us suppose we have a transaction “Purchase of goods worth Rs. 7000/- on Credit from Mahesh Traders” What accounts will be affected by this transaction ? Which account will be Debited and which will be credited ? To find answers for the above questions, take the help of some basic rules of recording transactions. The rules are given below. Account Type Debit Credit Personal Receiver Giver Asset/liability/Capital (Real) What comes in What goes out (in cash or kind) (in cash or kind) Revenue (Income and Expenses) Expenses and Losses Income or Gains Table 1.3.1 Also known as Nominal Let us understand the rules with some examples. Consider the same transaction : (a) Purchase of goods worth Rs. 7000/- on Credit from Mahesh Traders Accounts affected Purchase Mahesh Traders Type Expense Personal Status Money paid/to be paid Giver Rule Debit Expenses Credit the Giver Entry Debit Purchase A/c Credit Mahesh Traders A/c Amount 7000/- 7000/- ∴ Purchase A/c Dr. 7000/- (Debit all Expenses) To Mahesh Traders A/c Cr. 7000/- (Credit the Giver) Table 1.3.2 252 INFORMATION TECHNOLOGY TRAINING © The Institute of Chartered Accountants of India
- 4. Principles of Accounting (b) Cash drawn from United Bank Rs. 5500/- Accounts affected Cash United Bank Type Asset Asset Status Money comes in Money goes out Rule Debit what comes in Credit what goes out Entry Debit Cash A/c Credit United Bank A/c Amount 5500/- 5500/- ∴ Cash A/c Dr. 5500/- (Debit what comes in) To United Bank A/c Cr. 5500/- (Debit what goes out) Table 1.3.3 1.4 ACCOUNTS COMPILATION & REPORTS 1.4.1 Basic steps in Accounts Compilations, documents used and report In this section, let us learn how to go through the different steps of Accounts compilation and see what document is used and created/updated at each stage. The steps are as indicated below : Step 1 Recording Step 2 Classifying Step 3 Summarising Step 4 Interpreting (by preparing reports) The sequence is best represented in the flow diagram below: Recording Classifying Transaction Voucher Journal Entry Posting Consolidating Trial Balance Ledger Accounts Report Generation Profit & Loss Account Balance Sheet Fig. 1.4.1: Basic Steps in Accounting Let us start with a payment transaction for example : Paid cash Rs. 700 for Local Conveyance (i) Voucher or Entry Document: The first document where the transaction is entered is called a Voucher. A voucher can exist in the form of an Expense Bill, Sales Bill, Receipt, Payment, and so on. INFORMATION TECHNOLOGY TRAINING 253 © The Institute of Chartered Accountants of India
- 5. Accounting Package (ii) Journal Entry: The second step is the stage where we classify the transaction that is, to find out which are the accounts to be debited or credited. The transaction is now entered in the form of a journal entry in a book called a Journal Proper. A paper journal entry has a typical format. Given below is the journal entry for the Cash payment transaction above : 25.04.02 Electricity Charges Dr. 1000 To Cash A/c 1000 The process of passing a journal entry such as the one above is based on the rules for recording transactions, discussed in the earlier section. (iii) Ledger Posting and Balancing: Ledger posting and balancing is done to findout the payments receipt, income or expense through any Account. For example, in the above case the Electricity Charges are posted to the Debit side of Electricity Charges ledger and the Cash A/c is Credited. Thus the process of Posting is transfer of individual transaction amounts from the journal to the debit or credit side in a given Account. A sample Cash Account is shown in next page with posting entries. CASH ACCOUNT RECEIPTS PAYMENTS DATE PARTICULARS AMOUNT DATE PARTICULARS AMOUNT 01.03.02 To Bal B/d 2500 02.03.02 By Electricity Charges 50 05.03.02 To Bank A/c 500 04.03.02 By Printing A/c 35 26.03.02 To Tour Advance A/c 1500 06.03.02 By Stationery A/c 55 (Amount Refunded) 07.03.02 By Tour Advance A/c 460 05.03.02 By Other Expenses A/c 100 31.03.02 By Bal C/F 4400 31.03.02 Total 5000 31.03.02 Total 5000 Table 1.4.1 From the above we see that the total of payments (credit total, omitting the last entry) is different from the total of receipts on the left side. But in the manual system the total of both sides are matched. To get them matched, a new entry is passed on the right side (if the Debit Total is more than the credit total) or on the debit side (if the debit total is less than the credit side). This new entry is known as balancing entry and it will have the difference between the totals in the amount column. In the above cash account, the balancing entry is “By Balance Carried Forward” and the balance amount is 4400. This is the actual cash availability as at the end of March 2002. In other words, it is the closing balance as on March 31, 2002. The ledger accounts are usually posted every month. (iv) Consolidating in Trial Balance: Once we get the closing balance of all accounts for the last month of the fiscal year (March), we are ready to prepare the reports. But first we get the consolidated list of such balances. The list is called the Trial Balance. The Trial Balance has three columns, namely Account Name, Debit Column and Credit Column. When an account has debit Balance (that is Debit Total more than Credit Total in Ledger), the amount appears in the debit column, otherwise in the credit column. A sample Trial Balance is shown below: 254 INFORMATION TECHNOLOGY TRAINING © The Institute of Chartered Accountants of India
- 6. Principles of Accounting ACCOUNT NAME DR CR Type of Account Capital 500000 Liability General Reserve 150000 Liability Surplus in P&L Account 132500 Liability Tax Deducted at source 21000 Liability Expenses Payable 49000 Liability Sales Tax Payable 10000 Liability Furniture 227500 Asset Land & Building 242500 Asset Plant & Machinery 355000 Asset State Bank of India 413000 Asset Cash in Hand 3500 Asset Fixed Deposits 250000 Asset Opening Stock 140000 Expense Material Purchased 382500 Expense Stores Consumed 55500 Expense Labour Charges 6300 Expense Factory Electricity 11750 Expense Salary & Wages 55000 Expense Travelling Expenses 131500 Expense Other Expenses 211500 Expense Sales 1417500 Income Interest Received 43000 Income Other Income 126000 Income Accounts Payable 322050 Liability Accounts Receivable 285500 Asset Total 2771050 2771050 Table 1.4.2 The Trial Balance is a source for preparing the reports. As per double entry system, every transaction has debit and credit entries of equal sum in different accounts. Hence, the total of debit balances and credit balances should be equal in the trial balance. Preparation of this consolidated report reveals any manual or procedural errors in the earlier steps of accounts compilation. There is one more input required before we go for preparing the P&L report and the balance sheet. That is the closing entry. Closing entry is given for stock value at the end of the year. Closing stock is the value of stock available at the end of the year. The closing stock can be valued by any method such as LIFO, FIFO, Weighted Average and Moving Average. The value of stock is shown as a current asset in the Balance Sheet. The closing stock of finished goods is treated as an income in the Profit & Loss (P & L) statement. INFORMATION TECHNOLOGY TRAINING 255 © The Institute of Chartered Accountants of India
- 7. Accounting Package 1.5 PREPARING FINAL REPORTS 1.5.1 Profit & Loss Statement This report depicts the operating profit/loss for a given period. In many organisations, this report is prepared in two steps - Trading Account and P & L Account. The trading account is a list of all direct production-related expenses on one side and the direct source of income (usually income through sales and services) on the other side. The difference between their total is the Gross Profit or Gross Loss. Given below is a sample Trading Account showing the balances in the Trial balance above. The closing stock of Finished goods is assumed as Rs. 25000 and the depreciation for the year is assumed as Rs. 37000. Trading Account of ABC Company for the year ending 31 March, 2001 Expenses Income Opening Stock 140000 Sales Turnover 1417500 Add Material Purchased 382500 Closing Stock 25000 1045000 Labour charges 6300 Factory Power 11750 Gross profit transferred to P & L Account 901950 Total 1442500 Total 1442500 Table 1.5.1 The P & L Account is prepared by listing all other expenses, which were not included in the Trading Account, on one side and all other incomes on the other. Additionally, the Depreciation is included in the expense list. The first entry on the income side is the Gross profit taken from the Trading Account. The Profit & Loss Account using the balances from the Trial Balance and the Closing Entries above is given below. Profit & Loss Statement for ABC Co. For the year ending 31 March, 2001 Expenses AMOUNT Income AMOUNT Stores Consumed 55500 Gross Profit from trading A/c 901950 Salary & wages 55000 Interest earned of fixed Deposits 43000 Travelling Expenses 131500 Other Income 126000 Other Expenses 211500 Depreciation for the year 37000 Net Operating Profit 580450 Total 1070950 Total 1070950 Table 1.5.2 1.5.2 Balance Sheet The P & L statement depicts the operating profit earned or loss suffered by doing the business for the last one year. But the Balance sheet provides information about the financial status of the company as on a particular date. The balance sheet is prepared taking the asset and liability type accounts from the Trial Balance. 256 INFORMATION TECHNOLOGY TRAINING © The Institute of Chartered Accountants of India
- 8. Principles of Accounting The balance Sheet of ABC Co. as at March 31, 2002 is given in next page. The values are taken from the Trial Balance and the Closing entries for Depreciation and Closing Stock. Liabilities Assets Share Capital 500000 Furniture 227500 General Reserve 150000 Land & Building 242500 Surplus in P&L Account 132500 Plant & Machinery 355000 Tax Deducted at Source 21000 Expenses payable 49000 Sales Tax Payable 10000 Less Depreciation 37000 Accounts Payable 322050 Net profit from P&L A/c 580450 Net Fixed Assets 788000 Bank Balance 413000 Cash in Hand 3500 Fixed Deposits 250000 Accounts Receivable 285500 Closing Stock 25000 Total Liabilities 1765000 Total Assets 1765000 Table 1.5.3 1.6 USE OF DAY BOOKS IN ACCOUNTING We learnt that all the transactions are entered from vouchers to the Journal in a chronological order. Using this method, the Journal becomes a voluminous book and extracting entries for posting in Ledgers becomes a time-consuming job. Moreover, the debit and credit entries are written in the Journal and Ledger. This is a duplication of effort. To avoid these disadvantages, the day books are used. Day books are specialised books, where transactions relating to a particular type, say Sales or Purchase, are entered directly from the voucher. They are not written into the journal. At intervals, say every month, the totals from these books are carried forward and used for posting in the Ledger. When the ledger is posted from the day books, there is only one entry written. Thereby, we can get the details such as total sales or total purchase at a glance from the Ledger. If we want to know the details, we have to refer to the Day books using a reference number usually the folio number of the respective Day book. These books are also called Books of Original Entry. 1.7 ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE Accounts Receivable, also known as Bills Receivable, gives the details of the dues from the Customers. The details are maintained in a sub-ledger (called Debtors Ledger or Sundry Debtors). As the sum due from customers is our money blocked, we have to monitor the receivable closely. This also helps us keep a watch on our customers’ credit worthiness and reliability. Many statements are prepared to monitor the Accounts receivable. Some of them are Analysis Statement, Ageing analysis Statement, Business Summary (month-wise or item-wise) and so on. Account Payable, also known as Bills Payable, gives details of your dues to suppliers. The details are maintained in a sub ledger (called Creditors Ledger or Sundry Creditors). A close monitoring of Accounts Payable is also essential, because it helps us in our cash flow planning and knowing the Cash requirement at any time. Further, our credit worthiness toward our suppliers is also enhanced, which is again important. INFORMATION TECHNOLOGY TRAINING 257 © The Institute of Chartered Accountants of India
- 9. Accounting Package 1.8 BANK RECONCILIATION STATEMENT When we maintain a bank account, we prepare a bank book. The bank gives us one book, which is called the pass book. The entries in the bank book are made by us. The Pass book entries are made by the bank authorities. At any point of time, the final balance shown as per the Bank book and the Pass book should be the same. But most of the times it will not be so. This happens because of the following reasons : When we make a cheque payment, we make the Bank book posting immediately, whereas our account will be adjusted only when the cheque is presented and honoured. When we deposit a cheque from the customer, we post the same in our bank book. But our account with the bank is actually adjusted only when the amount is realised. For any outstation cheque receipts or for overdrafts, the bank will deduct the service charges. This will be automatically debited to our account. But we will get the statement only after some time. But to be sure that everything goes fine and no errors are committed, a statement is regularly prepared. This statement is called the Bank Reconciliation Statement. Suppose we have the following entries in our Bank Book and Pass Book for one month ending 30.9.02. Bank Book Dr. Cr. Pass Book Dr. Cr. Opening balance 20000 Opening balance 20000 Payment By Cheque Withdrawal as per No. 489882 1500 Cheque No.2482 1500 Cheque deposited Cheque presented and No. 2345 3500 realised Cheque No. 48945 3500 Arvind by Cheque Purchase of Demand No. 22328 3200 Draft by Cheque No. 22343 3200 Cheque Deposited No. 2434 3000 Service Charges 100 Total 26500 4700 Total 23500 Balance as on 30.9.02 21800 Balance as on 30.9.02 18700 4800 Table 1.8.1 Now comparing the entries in both of the books, we prepare a Bank Reconciliation Statement which looks like the one below : Bank Reconciliation Statement as on 30.9.02 Dr. Cr. Balance as per Bank Book 21800 Add Cheques issued but not presented 0 Less Cheques Deposited but not presented Cheque No. 2434. Amount - Rs.3000 3000 Service Charges 100 Total 21800 3100 Balance as per pass Book (Bank Statement) 18700 Dr. Table 1.8.2 258 INFORMATION TECHNOLOGY TRAINING © The Institute of Chartered Accountants of India