FUNDAMENTALS OF ACCOUNTING AND MANAGEMENT –I ACCOUNTING: AN OVERVIEW 3. ACCOUNTING CYCLE A business is carried out by a person with some purpose in mind. One or more such purposes may be the earning of profits, growth, generating employment, charity, etc. This person periodically evaluates whether the purpose of the business is being fulfilled or not. Other persons like investors, lenders, government, suppliers, etc. are also interested in knowing the periodical results of the business. The investors are interested in knowing whether the money they have invested is safe and whether they are earning adequate returns on the investment. The government collects tax on the income of the business, etc. This periodical evaluation is done through a process of accounting.
3.0
Objectives Based on the inputs received in this lesson, you will be able to:
• • • • • • • • •
3.1
Understand the core Accounting procedure Classify accounts Record them in the books of accounts following the rules of accounting. Define the ledger and differentiate between Journal and Ledger Understand the process of Posting with the help of an example Understand the process behind trial balance Conceptualize the objectives of trial balance Learn about the method of construction of trial balance Learn about the basic limitations of trial balance as a measure of confirming the arithmetic accuracy
Introduction The result of the business is the outcome of the transactions that take place in the business. This outcome can be known by recording the transactions. The transactions are recorded and classified and the result of the business is known. This recording and classifying of the business transactions over a period is called as an Accounting cycle. This is normally a period of one year or 12 months and this period is called a financial year. This lesson familiarises you with the classification of accounts and their rules of recording in the books of accounts. You will then understand the basics of the accounting process, which include posting and trial balance.
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As this lesson covers the core aspects of accounting, utmost importance should be given to the logic of classifying the accounts and following the rules for recording the transactions in the books of accounts. The Trial balance broadly explains the arithmetical accuracy of the accounting transactions. It also explains that the double entry rules were followed appropriately. The trial balance preparation is an integral step in the formation of financial statements. The Trial balance would help you make a counter check before planning to prepare final accounting statements like Profit and Loss accounts, expense statement and the balance sheet. The Profit and Loss account will give the profit earned during the financial period.
3.2
Classification of Accounts Every business transaction has a two-fold effect. A minimum of two accounts are affected by each business transaction in an equal but opposite way. The first step in the accounting cycle is to classify these minimum two accounts affected into one of the following types of accounts:
•
Personal Accounts: Transactions related to a person or group of persons are called personal accounts. These accounts are necessary to record credit transactions. Personal accounts can be classified as: o Natural persons – related to individual living beings. For eg. Ram’s account, Shyam’s account, etc. o Artificial or legal persons – include accounts related to legal entities created by laws such as Union Bank of India account, Dayalbagh Educational Institute account, Reliance India Limited account etc. o Group / representative account – These are accounts of natural and legal persons grouped together such as debtor’s account, creditors account, share capital account etc.
•
Impersonal Accounts: Accounts which are not personal accounts are termed as impersonal accounts which are of two types Real and Nominal account. o Real Accounts: Real accounts relate to properties of business which can be tangible or intangible in nature. o Tangible Real accounts – Those properties having physical existence like cash, building, stock, furniture etc are tangible real accounts.
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o Intangible Real accounts – Includes account of things which cannot be touched or felt physically but are capable of being measured in monetary terms such as goodwill, patent rights, trademark rights copyrights etc. •
Nominal Accounts: These are the accounts related to income, revenue, gain, expenses and losses. For example salaries, rent, commission, discount, interest received, printing and stationary account etc. The above accounts - personal, real and nominal, follow the rules of double entry book keeping.
3.3
Rules of Double Entry Book Keeping While entering various financial transactions in the records maintained by the organisation, some basic rules for accounting are followed:
3.3.1 In case of Personal Accounts Debit the Receiver, Credit the Giver. Take an example in which Ram has bought goods from Shyam. Ram has received goods and Shyam has given the goods. Ram, therefore, is under an obligation to pay the price of the goods. Shyam is entitled to a credit because he has given up the goods to Ram. In Accounting terminology, Ram will be debited and Shyam will be credited. In the case that Ram does pay the amount to Shyam the entry will be Debit the receiver and Credit the giver. 3.3.2 In case of Real Accounts Debit What Comes In, Credit What Goes Out Take an example in which Mr. Ram pays cash to the firm’s cashier. Mr. Ram has paid and Mr. Cashier has received the account. Therefore according to rule no. 1 Mr. Cashier should be debited and Mr. Ram should be credited. In the same way when Mr. Cashier pays an amount he will be credited. Goods are received by the godown keeper and are issued by him according to the instructions. Hence one can say as per rule no. 1, that when goods are received Mr.Godown keeper should be debited and when goods are issued Mr. Godown keeper should be credited. Such accounts like those of Mr. Cashier and Mr. Godown Keeper cannot work well because these two persons and others like them work only on behalf of the firm and they do not enter into these transactions personally. Therefore, it is not convenient to open accounts in the names of the cashier and the godown keeper. It is more convenient to open accounts in the names of the articles handled. Therefore in place of Mr. Cashier, Cash Account should be debited or credited. When cash is received, cash should be debited. When cash is given, it should be credited. Similarly, in place of the Godown keepers account, there should be goods account. This account should be debited when goods are received and credited when goods are issued. Of course, the person who gives goods or
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pays cash will be credited and those persons who receive goods or receive cash will be debited. From this basis a general rule can be formulated and that is Debit what comes in and Credit what goes out. 3.3.3 In case of Nominal Accounts Debit all the expenses, Credit all the incomes. Following the above two rules, we can for instance, debit the account of the landlord whenever we pay rent to him because the landlord receives the money. The landlord’s account will show all the money which has been paid to him. But if we do this it presents a misleading picture. We will think that the landlord owes us something whereas he owes us nothing. It would be much better if we debit the Rent account and not the landlord’s account. Thus, when expenses are incurred or losses are suffered, the relevant account is debited.
Self-Check Questions Following are a number of accounts. Classify them. (Use P for Personal Accounts, R for Real Accounts and N for Nominal Accounts) 1. 2. 3. 4. 5. 6. 7. 8. 9.
Legal charges Account Land Account Machinery Account Furniture Account Ram’s Account Mohan’s Account Capital Account Bank Loan Account Bank Account
3.4
Journal and Ledger In the Journal, the transactions are placed chronologically according to the date of appearance while in the Ledger the transactions are further transferred into their specific accounts. Ledgers help in easy identification of the detailed profile of specific accounts, dates of transactions, the amount transacted and the remaining balance (Dr or Cr) of the individual accounts in the Ledger.
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Specimen of Ledger account Cash Account as on Date Dr
Cr
Date Year Month , Date Month, Date
Particulars
J.F.
Amount
To opening balance b/F
XXXX
Particulars 2004 By Purchase
To Capital A/c
XXX
By Rent
To Sales A/c To Bank A/c (withdrawls)
To Balance b/d
3.5
Date
J.F.
Amount
By Stationary By Salary Exp By Bank A/c (Deposits) By Ramesh (Cash paid) By Balance c/c XXXXX
XXXXX
Posting Posting is a step-by-step method of allocating each transaction from journal and books of original entry into specific set of accounts in the ledger.
3.5.1 Rules for Posting in Ledger:
• • •
The three basic rules for posting are: Identify the journal transactions and allocate these into respective accounts Check that the transactions of same nature are posted into the same account Rules of debit and credit should be recognized at the time of entry Journal entry (with date, particulars, Dr/Cr, and the amount with description)
Creating individual accounts for both Dr party and the Cr party in the Journal transaction
Cr side particulars and accounts in the Journal will be put into the debit side of the ledger
Dr side particulars and accounts in Journal will be put into the Cr side of the ledger
Posting an entry (with date, particulars, ledger folio number amount
Figure 1: Accounting System-Ledger Posting
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3.5.2 Posting – an example Problem: During January 2004, Hemant Mehta had the following transactions conducted for his business: January 2004 S. No.
PARTICULARS
Amount in Rs.
1 2 3 4 5 6 7 8 9 10
Commenced business in Cash Purchased goods in credit from Gopal Purchased goods in cash Paid Ramesh an advance for goods ordered Paid for Stationery Paid salaries Drew cash for personal use Paid rent Goods sold for cash Bought goods for cash
15000 5000 2000 1500 700 2500 500 200 450 600
After placing the transactions in the chronological order, the next step will be to prepare a Journal. Journal Entries Date
Particulars
Folio No
Amount Debit ( Rs)
Amount Credit P
( Rs)
P
2004 Jan 1
Jan 2
Jan 3 Jan 4
Jan5
Jan 6
Jan 7
6
Cash account Dr. To Capital account (Being the cash bought into business as capital ) Purchase account Dr. To Gopal (Being the goods purchased on cash) Purchase account Dr. To cash account Ramesh Dr. To cash account (Being the cash paid to Ramesh) Stationery account Dr. To cash account (Being the cash paid for stationery) Salaries account Dr. To cash account (Being the cash paid for Salaries) Drawings account Dr. To cash account (Being the cash drawn for personal use)
15000 15000 5000 5000 2000 2000 1500 1500 700 700 2500 2500 500 500
Jan 8
Jan 9
Jan 10
3.6
Rent account Dr. To cash account (Being the cash paid for rent) Cash account Dr. To sales account (Being the goods sold for cash) Purchase account Dr. To cash account (being the goods purchased for cash)
200 200 450 450 600 600
Ledger Accounts The Ledger account is created out of the Journal - the various accounts which are created are:
• • • • • • • • •
Cash account Capital account Purchase account Gopal account Ramesh account Salaries account Rent account Sales account Drawings account One by one, the posting will be done. The transactions in the Journal which were on debit side will go to the credit side of the Ledger account and similarly the transactions appearing on the credit side in the Journal will go to the debit side in the Ledger accounts. Cash Account
Dr Date 2004 Jan 1 Jan 9
Particulars To capital A/c To sales A/c
F no
Amount (Rs.) P 10000 450
10450 Feb 1
To Balance b/d
Particulars Date 2004 Jan 3 Jan 4
By Purchase A/c
Cr F Amount No (Rs.) P 2000
By Ramesh A/c
1500
Jan 5
By Stationary A/c
700
Jan 6
By Salaries A/c
2500
Jan 7
By Drawings A/c
500
Jan 8
By rent A/c
200
Jan 10
By Purchase A/c
600
Jan31
By Balance c/d
2450 10450
2450
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Capital account Dr. Date Jan 31
Particulars
Folio No
To balance c/d
Amount (Rs.) 10000
Date
Particulars
Jan 1
By cash A/c
Feb 1
By balance b/d
Folio No
10000
Cr. Amount (Rs.) 10000 10000 10000
Gopal account Dr. Date Jan 31
Particulars To balance c/d
Folio No
Amount (Rs.) 5000
Date Jan 2
Particulars By Purchases A/c
Feb 1
By balance b/d
Folio No
5000
Cr. Amount (Rs.) 5000 5000 5000
Ramesh account Dr. Date Jan 4
Particulars To cash A/c
Cr.
Feb 1
To balance b/d
Folio No
Amount (Rs.) 1500
Date Jan 31
Particulars By balance c/d
Folio No
1500 1500
Amount (Rs.) 1500 1500
Stationery account Dr. Date
Particulars
Jan 5
To Cash A/c
Feb 1
To balance b/d
J Folio No
Amount (Rs.)
Date
Particulars
700 700 700
Jan 31
By balance c/d
Amount (Rs.)
Date
Particulars
2500 2500 2500
Jan 31
By balance c/d
Amount (Rs.)
Date
Particulars
500 500 500
Jan 31
By balance c/d
Amount (Rs.)
Date
Particulars
200 200 200
Jan 31
By balance c/d
Cr. J Folio No
Amount (Rs.) 700 700
Salaries account Dr. Date
Particulars
Jan 6
To cash A/c
Feb 1
To balance b/d
Folio No
Cr. Folio No
Amount (Rs.) 2500 2500
Drawings account Dr. Date
Particulars
Jan 7
To cash A/c
Feb 1
To balance c/d
Folio No
Cr. Folio No
Amount (Rs.) 500 500
Rent account Dr. Date
Particulars
Jan 8
To cash A/c
Feb 1
To balance b/d
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Folio No
Cr. Folio No
Amount (Rs.) 200 200
Sales account Dr. Date Jan 31
Particulars
Folio No
To balance c/d
Amount (Rs.)
Date
Particulars
450
Jan 9
By cash A/c
Feb 1
By balance c/d
Folio No
450
Cr. Amount (Rs.) 450 450 450
Purchases account Dr. Date
Particulars
Jan 2 Jan 3 Jan 10
To Gopal To cash A/c To cash A/c
Feb 1
To balance b/d
Folio No
Amount (Rs.)
Date
Particulars
5000 2000 600 7600 7600
Jan 31
By balance c/d
Folio No
Cr. Amount (Rs.) 7600 7600
Self-Check Questions Select the correct option 10. Posting is the process which: i. provides the level of money utilized by the businesses ii. provides the amount of loan taken by the organisation iii. helps in putting the transactions into the respective accounts iv. Helps in arranging the journal transactions on the basis of date and amount 11. Journal is also commonly called as : i. Books of accounting entry ii. Books of financial entry iii. Books of original entry iv. Books of correct entry 12. The Dr side of the Journal entry is posted on the : i. Dr side in the Ledger ii. Dr and Cr side both in the ledgers iii. Cr side of the ledger iv. None of the above
3.7
Trial Balance Trial balance is a statement which provides the basis to check whether, during posting of financial transactions in the Journal book or the Journal transactions into the individual accounts (Ledgers), the double accounting
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system has been used properly i.e. both Dr and Cr have been posted. It also checks for any mathematical errors, though at the end of the unit, you will also be able to see that not all the errors in posting can be traced by the Trial balance. However, preparing the Trial balance is an essential step in the overall accounting process. For the sake of understanding, let us utilize the same example as we used in the previous lesson and see whether the transactions done were correct or not. 3.7.1 Trial balance – an example Step 1: Prepare the format of the trial balance, by mentioning the concerned columns like: S. No
Head of Accounts
LF No
Debit balance (Rs.)
Credit balance (Rs.)
Step 2: Start filling the details in each column, for instance, in the above exercise, out of total number of nine accounts, each account balances will be entered in the specific column of the Head of accounts. S. No
Head of Accounts
1 2 3 4 5 6 7 8 9 10
Cash account Capital account Purchase account Gopal account Ramesh account Salaries account Rent account Sales account Drawings account Stationery account Total
LF No
Debit balance (Rs.)
Credit balance (Rs.)
2450 10000 7600 5000 1500 2500 200 450 500 700 15450
15450
If you transfer the details of balances of the individual ledger accounts to the trial balance, you could see the entire picture. For this example, you can see that the Debit balance is equal to the Credit balance and that provide the check that the Journal and the Ledger postings were done correctly. You have understood that after posting, a statement is prepared to check the Dr and Cr balances at any given point of time or at the end of accounting period. If the statement of balances of individual accounts prepared this way agree to, than it assures that double entry system was followed properly.
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3.8 • • •
Objectives of Trial Balance The preparation of the trial balance has the following objectives: It checks for any arithmetical errors that may have been committed during the process of posting. It assists the accountant in preparing the financial statements. It gives a first-hand picture of the financial position of the businesses. However, for further details a ledger may need to be seen. Trial Balance Procedure Journal entry (with date, particulars, Dr/Cr, and the amount with description)
Creating an individual accounts for both Dr party and the Cr party in the Journal transaction
Cr side particulars and accounts in the Journal will be put into the debit side of the ledger
Dr side particulars and accounts in Journal will be put into the Cr side of the ledger
Posting an entry (with date, particulars, ledger folio number amount
After the end of the accounting period, the total of Dr and Cr side of the account is compared
The Dr/Cr balances of the individual accounts in the ledger are arranged
If the totals do not agree
Error Rectification
If the totals agree
OK
Figure 2: Accounting System – Trial balance
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Self-Check Questions Select the correct option 13. The trial balance utilizes picking up the balances of individual ledger accounts a) At the closing date of the ledger b) At the opening date of the ledger c) May be considered at any point in the business d) None of these 14. Tell us about the correct order as it appears in the accounting cycle a) Post, enter, analyze, prepare, close and adjust b) Analyze, enter, post, adjust, prepare, close c) Prepare, enter, adjust, analyze, close d) Enter, post, close, prepare, adjust, analyze 15. If trial balance does not show any mathematical errors, then it confirms a) Mathematical accuracy while putting transactions in the journal b) Mathematical accuracy of all accounting records c) Arithmetical accuracy of posting the entry to the ledger Answer True or False 16. Posting transactions in accounts may be done before or after taking journal entries for the transactions, whichever is more convenient. 17. Ledger means the complete collection of accounts from which the entity’s financial statements are prepared. 18. Trial balance can sometimes provide a base for assessing accounting errors in the books of accounts. 19. Only financial or business transactions are put into the journal. 20. Posting is a process done even before the preparation of the journal.
3.9
Summing Up In this lesson, you have familiarised yourself with the basic accounting procedure, classification of accounts and rules of recording them in the Book of Accounts. You have also familiarised yourself with the fundamental concept behind the creation of the Ledger and also the process of posting in the various accounts that form its part. Lastly the lesson has also provided you with a preliminary understanding of trial balance creation.
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3.10 Answers to Self-Check Questions 1. N 2. R 3. R 4. R 5. P 6. P 7. P 8. P 9. P 10. iii 11. iii 12. i 13. a 14. d 15. c 16. False 17. True 18. True 19. True 20. False
3.11 Terminal Questions 1. Mention how accounts are classified. Give the rules of personal, real and nominal accounts. 2. Following are the accounting details of Manish Gupta, starting April 2005. Manish Gupta had the following transactions conducted for his business. April 2005 S.No. Particulars
Amount in Rs.
1 2 3 4 5 6 7 8 9 10
20000 3400 1200 1300 400 250 550 223 500 600
Commenced business in Cash Purchased goods in credit from Gopal Purchased goods in cash Paid Ramesh an advance for goods ordered Paid for Stationery Paid salaries Drew cash for personal use Paid rent Goods sold for cash Bought goods for cash
Kindly, create the Journal entries and subsequently create the entries in the ledger. For convenience, the empty Journal and Accounts formats are available, fill the right amount inside it and show it to your Course instructor. 13
Journal Entries Date
Particulars
Folio No
Debit ( Rs)
Credit (Rs)
2005
Empty format for individual accounts: _________account as on Date____________ Dr Cr Date Particulars Ledger Amount folio (Rs.) 2005
Date Particulars Ledger Folio 2005
Amount (Rs.)
________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
Particulars
Folio No
Amount (Rs.)
Particulars
Folio No
Amount (Rs.)
Particulars
Folio No
Amount (Rs.)
________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
________ Account Dr. Cr. Date Particulars
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Folio No
Amount (Rs.)
Date
________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
Particulars
Folio No
Amount (Rs.)
Particulars
Folio No
Amount (Rs.)
Particulars
Folio No
Amount (Rs.)
Particulars
Folio No
Amount (Rs.)
Particulars
Folio No
Amount (Rs.)
________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
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________ Account Dr. Cr. Date Particulars
Folio No
Amount (Rs.)
Date
Particulars
Folio No
Amount (Rs.)
For the above question, if all the values in the transactions are dropped by 5% or increased by 5%, then what will be the impact on the Ledger? Draft the Journal and Ledger based on the format mentioned above, Comment on the following issues as well: • •
What will be the change in the balances of the accounts? Will it remain same or change, or if change, then by how many % and why?
3.12 References 1. T.S. Grewal, “Introduction to Accountancy”, New Delhi, S Chand & Company 2. Text book of accountancy by Gujarat State Education Board 3. Lal, J. & Srivastav, S. Financial accounting: Principles and practices. New Delhi: Sultan Chand Publications 4. Shukla S .M. (2004) ‘Financial Accounting’, Sahitya Bhawan, Agra
3.13 Suggested Further Reading 1. Grewal, G.S. & Grewal, H.S. (1991), “Double entry book-keeping”, New Delhi: Sultan Chand & Sons. 2. Narayanaswamy, R. (2001), “Financial Accounting: A managerial perspective”, New Delhi: Prentice Hall of India.
3.14 Glossary • • •
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Accounting Equation - Assets = Liabilities + Capital Account Classification - Personal /Real / Nominal / Accounts Rules of Book keeping o Personal Accounts: Debit Receiver, Credit Giver o Real Accounts: Debit what comes in, Credit What goes out o Nominal Accounts: Debit Expenses & Losses, Credit Incomes & Gains.
• • • •
Journal - A chronological record of business transactions of financial nature arranged on the basis of rules of occurrence. Ledger - An accounting arrangement where by the entries from Journal are separated into respective accounts. Posting - The mechanism in accounting management whereby a transaction noted in Journal is transferred to the ledger following the double entry system. Trial balance - Trial balance is the data sheet where the balances of individual accounts are displayed at the closing date in order to verify the mathematical errors available in it.
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