Fundamentals of Financial and Cost Accounting PDF

Foundation Fundamentals of Financial and Cost Accounting Paper 2 The Institute of Cost Accountants of India Statutory Body under an Act of Parliament www.icmai.in  About the Institute T...

Foundation Fundamentals of Financial and Cost Accounting Paper 2 The Institute of Cost Accountants of India Statutory Body under an Act of Parliament www.icmai.in  About the Institute T he Institute of Cost Accountants of India is a Statutory Body set up under an Act of Parliament in the year 1959. The Institute as a part of its obligation, regulates the profession of Cost and Management Accountancy, enrols students for its courses, provides coaching facilities to the students, organizes professional development programmes for the members and undertakes research programmes in the ield of Cost and Management Accountancy. The Institute pursues the vision of cost competitiveness, cost management, ef icient use of resources and structured approach to cost accounting as the key drivers of the profession. With the current emphasis on management of resources, the specialized knowledge of evaluating operating ef iciency and strategic management the professionals are known as ''Cost and Management Accountants (CMAs)''. The Institute is the 2ⁿ largest Cost & Management Accounting body in the world and the largest in Asia, having more than 5,00,000 students and 90,000 members all over the globe. The Institute operates through four regional councils at Kolkata, Delhi, Mumbai and Chennai and 113 Chapters situated at important cities in the country as well as 11 Overseas Centres, headquartered at Kolkata. It is under the administrative control of the Ministry of Corporate Affairs, Government of India. Vision Statement T he Institute of Cost Accountants of India would be the preferred source of resources and professionals for the inancial leadership of enterprises globally.” Mission Statement T he Cost and Management Accountant professionals would ethically drive enterprises globally by creating value to stakeholders in the socio-economic context through competencies drawn from the integration of strategy, management and accounting.” Motto From ignorance, lead me to truth From darkness, lead me to light From death, lead me to immortality Peace, Peace, Peace Cover Image Source: https://www.shutterstock.com/search/cost-accounting Behind Every Successful Business Decision, there is always a CMA  FOUNDATION Paper 2 Fundamentals of Financial and Cost Accounting Study Notes SYLLABUS 2022 The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 www.icmai.in First Edition : August 2022 Published by : Directorate of Studies The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 [email protected] Printed at : M/s. Print Plus Pvt. Ltd. 212, Swastik Chambers S. T. Road, Chembur Mumbai - 400 071 Copyright of these Study Notes is reserved by the Institute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof. Copyright © 2022 by The Institute of Cost Accountants of India  PAPER 2: FUNDAMENTALS OF FINANCIAL AND COST ACCOUNTING Syllabus Structure: The syllabus in this paper comprises the following topics and study weightage: Module No. Module Description Weight Section A: Fundamentals of Financial Accounting 70% 1 Accounting Fundamentals 30% 2 Accounting for Special Transactions 15% 3 Preparation of Final Accounts 25% Section B: Fundamentals of Cost Accounting 30% 4 Fundamentals of Cost Accounting 30% Contents as per Syllabus SECTION A: FUNDAMENTALS OF FINANCIAL ACCOUNTING 01 - 278 Module 1. Accounting Fundamentals 01 - 158 1.1 Understanding of Four Frameworks of Accounting (Conceptual, Legal, Institutional and Regulatory) and Forms of Organisation 1.2 Accounting Principles, Concepts and Conventions 1.3 Capital and Revenue Transactions - Capital and Revenue Expenditures, Capital and Revenue Receipts 1.4 Accounting Cycle – Charts of Accounts and Codification Structure, Analysis of Transaction – Accounting Equation, Double Entry System, Books of Original Entry, Subsidiary Books and Finalisation of Accounts 1.5 Journal (Day Books; Journal Proper – Opening, Transfer, Closing, Adjustment and Rectification Entries), Ledger 1.6 Cash Book, Bank Book, Petty Cash Book, Bank Reconciliation Statment 1.7 Trial Balance 1.8 Adjustment Entries and Rectification of Errors 1.9 Depreciation (Straight Line and Diminishing Balance methods only) 1.10 Accounting Treatment of Bad Debts and Provision for Doubtful Debts Module 2. Accounting for Special Transactions 159 - 228 2.1 Consignment 2.2 Joint Venture 2.3 Bills of Exchange (excluding Accommodation Bill, Insolvency) Module 3. Preparation of Final Accounts 229 - 278 3.1 Preparation of Financial Statements of Sole Proprietorship 3.1.1 Income Statement, Balance Sheet 3.2 Preparation of Financial Statements of a Not-for-Profit Orgnisation 3.2.1 Preparation of Receipts and Payments Account 3.2.2 Preparation of Income and Expenditure Account 3.2.3 Preparation of Balance Sheet  Contents as per Syllabus SECTION B: FUNDAMENTALS OF COST ACCOUNTING 279 - 320 Module 4. Fundamentals of Cost Accounting 281 - 320 4.1 Meaning, Definition, Significance of Cost Accounting, its Relationship with Financial Accounting 4.2 Application of Cost Accounting for Business Decisions 4.3 Definition of Cost, Cost Centre, Cost Unit and Cost Drivers 4.4 Classification of Costs (with reference to Cost Accounting Standard 1) 4.5 Ascertainment of Cost and Preparation of Statement of Cost and Profit (Cost Sheet)  SECTION - A FUNDAMENTALS OF FINANCIAL ACCOUNTING  ACCOUNTING FUNDAMENTALS 1 This Module includes: 1.1 Understanding of Four Frameworks of Accounting (Conceptual, Legal, Institutional and Regulatory) and Forms of Organisation 1.2 Accounting Principles, Concepts and Conventions 1.3 Capital and Revenue Transactions - Capital and Revenue Expenditures, Capital and Revenue Receipts 1.4 Accounting Cycle – Charts of Accounts and Codification Structure, Analysis of Transaction – Accounting Equation, Double Entry System, Books of Original Entry, Subsidiary Books and Finalisation of Accounts 1.5 Journal (Day Books; Journal Proper – Opening, Transfer, Closing, Adjustment and Rectification Entries), Ledger 1.6 Cash Book, Bank Book, Petty Cash Book, Bank Reconciliation Statment 1.7 Trial Balance 1.8 Adjustment Entries and Rectification of Errors 1.9 Depreciation (Straight Line and Diminishing Balance Methods Only) 1.10 Accounting Treatment of Bad Debts and Provision for Doubtful Debts The Institute of Cost Accountants of India 1 undamentals of Financial and Cost Accounting ACCOUNTING FUNDAMENTALS Module Learning Objectives: After studying this Module, the students will be able to –  Understand the four frameworks of accounting and various accounting concepts and conventions  Understand how to distinguish Capital and Revenue Transitions  Develop an idea about the Accounting Cycle and its various stages  Learn about the recording of transactions in Journal and posting them to Ledgers  Learn the preparation of Cash Book, Bank Book and Bank Reconciliation Statement  Understand the use of Trial Balance and its preparation methodology  Learn how adjustments and rectification entries are passed before finalization of accounts  Learn accounting for Depreciation and Provision for Doubtful Debt 2 The Institute of Cost Accountants of India  Accounting Fundamentals Understanding of Four Frameworks of 1.1 Accounting and Forms of Organisation A Introduction to Financial Accounting business is an economic activity undertaken with the objective of earning profits and to maximize the wealth of the owners. A business cannot run in isolation. Largely, the business activities are carried out by people coming together with a purpose to serve a common cause. This team is often referred to as an organization, which could be in different forms such as sole proprietorship, partnership, body corporate etc. The rules of business are based on general principles of trade, social values, and statutory framework encompassing national or international boundaries. While these variables could be different for different businesses, different countries etc., the basic purpose is to add value to a product or service in order to satisfy customer demand. The business activities require resources (which are limited & have multiple uses) primarily in terms of material, labour, machineries, factories and other services. The success of business depends on how efficiently and effectively these resources are managed. Therefore, there is a need to ensure the businessman tracks the use of these resources. The resources are not free and thus one must be careful to keep an eye on cost of acquiring them as well. As the basic purpose of business is to make profit, one must keep an ongoing track of the activities undertaken in course of business. Two basic questions would have to be answered: (a) What is the result of business operations? This will be answered by finding out whether it has made profit or loss. (b) What is the position of the resources acquired and used for business purpose? How are these resources financed? Where the funds come from? The answers to these questions are to be found continuously and the best way to find them is to record all the business activities. However, recording of business activities has to be done in a scientific manner so that they reveal correct outcome. The science of book-keeping and accounting provides an effective solution in this respect. It is basically a branch of social science. Definition of Accounting According to the American Institute of Certified Public Accountants (Year 1961), 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 result thereof”. According to the American Accounting Association (Year 1966), accounting is “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the users of accounting”. The Institute of Cost Accountants of India 3 Fundamentals of Financial and Cost Accounting Objectives of Accounting (i) Providing Information to the Users for Rational Decision-making The primary objective of accounting is to provide useful information for decision-making to stakeholders such as owners, management, creditors, investors, etc. Various outcomes of business activities such as costs, prices, sales volume, value under ownership, return of investment, etc. are measured in the accounting process. All these accounting measurements are used by stakeholders (owners, investors, creditors/bankers, etc.) in course of business operation. Hence, accounting is identified as ‘language of business’. (ii) Systematic Recording of Transactions To ensure reliability and precision for the accounting measurements, it is necessary to keep a systematic record of all financial transactions of a business enterprise which is ensured by bookkeeping. These financial records are classified, summarized and reported in the form of accounting measurements to the users of accounting information i.e., stakeholders. (iii) Ascertainment of Results of above Transactions ‘Profit/loss’ is the core accounting measurement. It is measured by preparing Profit and Loss Account for a particular period. Various other accounting measurements such as different types of revenue expenses and revenue incomes are considered for preparing this Profit and Loss Account. Difference between these revenue incomes and revenue expenses is known as result of business transactions identified as profit/ loss. As this measure is used very frequently by stockholders for rational decision making, it has become the objective of accounting to provide such information. For example, Income Tax Act requires that every business should have an accounting system that can measure taxable income of business and also explain nature and source of every item reported in Income Tax Return. (iv) Ascertainment of Financial Position of Business ‘Financial position’ is another core accounting measurement. Financial position is identified by preparing a statement of ownership i.e., Assets and Owings i.e., liabilities of the business as on a certain date. This statement is popularly known as Balance Sheet. Various other accounting measurements such as different types of assets and different types of liabilities as existed at a particular date are considered for preparing the balance sheet. This statement may be used by various stakeholders for financing and investment decision. Functions of Accounting The functions of accounting are as follows: (a) Identification of monetary transactions and events; (b) Measurement of the identified transactions and events; (c) Recording of such transactions; (d) Classifying and summarizing of the recorded transactions; (e) Obtaining the results of operations and determination of financial state of affairs; (f) Analysing and interpreting the results and position to help in decision-making; (g) Communicating such information to the users (both internal and external). 4 The Institute of Cost Accountants of India  Accounting Fundamentals Book Keeping As defined by Carter, ‘Book-keeping is a science and art of correctly recording in books of accounts all those business transactions that result in transfer of money or money’s worth’. It is an activity concerned with recording and classifying financial data related to business operation in order of its occurrence. Its primary objective is to maintain systematic recording of transactions on a regular basis. It is a concept narrower than accounting. Accountancy Accountancy is the discipline that incorporates certain principles or rules of accounting. It refers to the entire body of the theory and practice of accounting. It is a concept wider than accounting. Thus, while Book-keeping is a subset of accounting, Accounting, in turn, is a part of Accountancy. Accountancy Accounting Book Keeping Figure 1.1: Relation between Book Keeping, Accounting and Accountancy 1.1.1 Understanding of Four Frameworks of Accounting (Conceptual, Legal, Institutional and Regulatory) Framework of Accounting According to Collins Dictionary, the term ‘framework’ refers to ‘a structure that forms a support or frame for something’. In the context of any system, it is ‘a particular set of rules, ideas, or beliefs which you use in order to deal with problems or to decide what to do’. In accounting, ‘framework’ provides a common set of rules and guidelines that is used to measure, recognize, present, and disclose the information appearing in an entity’s financial statements. Four Frameworks of Accounting The framework of accounting has four pillars – Conceptual, Legal, Institutional and Legal. These are discussed below. (a) Conceptual Framework The Conceptual Framework is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that The Institute of Cost Accountants of India 5 Fundamentals of Financial and Cost Accounting help achieve those objectives. Those concepts provide guidance in selecting transactions, events and circumstances to be accounted for, how they should be recognized and measured, and how they should be summarized and reported. It states the objectives of General-Purpose Financial Reporting and the information provided by it. Conceptual Framework also guides on the qualitative characteristics that the financial statements must possess. Conceptual Framework often plays an important role in the development of Institutional Framework and assists preparers to develop consistent accounting policies when no accounting standard applies to a particular transaction or other event, or when a standard allows a choice of accounting policy. (b) Legal Framework Businesses are often controlled by various statutes under which they are formed. For example, in India, partnership organisations are governed by Indian Partnership Act, 1932 or Limited Liability Partnership Act, 2008, co-operatives are controlled by the Co-operative Societies Act, 1912, companies are governed by the Companies Act, 2013. In addition, banks are controlled by Banking Regulation Act, 1949, insurance companies are under the Insurance Act, 1938, electricity companies are also governed by the Central Electricity Act, 2003. All these statutes (including various Rules framed under them) not only govern the administrative set up of these organisations, but also provide important guidelines regarding use of resources, financing and also on the maintenance of books of accounts and treatment of specified transactions. For example, the Companies Act, 2013 and Companies (Accounts) Rules, 2014 provide useful provisions on maintenance of accounting records, accounting for issue and redemption of securities, investments to be done, consolidation and even winding up of the company. Companies (Corporate Social Responsibility) Rules, 2014 provides the guidelines regarding accounting of CSR expenses as well as carry forward and set-off of excess amount spent. Thus, legal framework plays an important role in accounting. The Schedules of this Act also provide important guidelines on the form and contents of financial statements. (c) Institutional Framework Institutional framework refers to the guidelines issued in form of certain pronouncements by institutions entrusted by the sovereign authorities to oversee the development of the respective field. In India, the Institute of Chartered Accountants of India has been entrusted to develop standards in the field of accounting to ensure comparability and consistency in accounting information. The Indian Accounting Standard Board of ICAI thus develops quality accounting standards on different areas of accounting. Currently, there are two sets of accounting standards in India – Accounting Standards as per Companies (Accounting Standards) Rules, 2021 and Ind ASs under Companies (Indian Accounting Standards) Rules, 2015. In addition, the Cost Accounting Standards Board (CASB) of the Institute of Cost Accountants of India has, so far, developed 24 Cost Accounting Standards to facilitate cost accounting and reporting. (d) Regulatory Framework The activities of organisations often come under the regulatory ambit of various regulators. In India, there are different regulatory authorities in different segments of financial market, such as RBI in money market operations, SEBI in capital market operations, IRDAI in insurance sector, PFRDA in pension funds. In addition, there are Telecom Regulatory Authority of India (TRAI), Competition Commission etc. The regulations imposed by these authorities may also have important bearing on accounting of a concerned entity. For example, regulations issued by SEBI largely shape the accounting and, more importantly, reporting by a listed firm in India. Similarly, regulations framed by IRDAI affect the accounting and reporting in insurance companies. In banking, BASEL Norms and other guidelines issued by RBI largely determine the accounting of NPA (Non-Performing Assets). Central Electricity Regulatory Commission 6 The Institute of Cost Accountants of India  Accounting Fundamentals (Terms and Conditions of Tariff) Regulations, 2009 affect the determination of tariff and accounting in an electricity company in India. The above four frameworks provide the foundation on which accounting and more specifically corporate accounting is based in India. They help to streamline the accounting process and help to improve the quality of the reports generated and thereby contribute in the overall development of accounting. 1.1.2 Forms of Organizations Among many other factors, the form of organisations contributes a lot in designing the accounting system and policies. Various business forms are often the result of one or more laws and the provisions stated therein governs the accounting as has been explained in the Legal Framework of Accounting. The form of an organisation determines the books to be kept, mode of maintenance of accounts, the components of financial statements and also the extent of disclosure of various information through financial statements. For example – (a) The sole proprietorship organisations are least regulated in India. They normally do not have any specific legislation to govern accounting requirements. However, in case their annual turnover exceeds a certain limit they may be subject to some other legislation such as the Income Tax Act, 1961. (b) The partnership firms are regulated by the Partnership Act, 1932 and also the Contract Act, 1872. In case, the firm does not have clear provisions in the Partnership Contract, the Partnership Act, 1932 decides on sharing profits and losses, deciding partner’s claims such as remuneration and also on interest on loan. (c) Operations including some aspects of accounting are strictly governed by Limited Liability Partnership Act, 2008 for LLPs. (d) Accounting and reporting are highly regulated by the Companies Act, 2013 for Indian companies. A common example that may be cited in this respect is the components of financial statements in different forms of business (see the following Table). Sole Proprietorship Partnership LLP Company Manufacturing/ Manufacturing/ LLP Profit & Loss A/c Statement of Profit and Loss Trading A/c Trading A/c LLP Balance Sheet Balance Sheet Profit and Loss Profit and Loss A/c Cash Flow Statement A/c Profit and Loss Statement Showing Changes Balance Sheet Appropriation A/c in Other Equity Balance Sheet Table 1.1 Components of Financial Statements as per the business forms Thus, it appears that forms of businesses or more specifically, the legislation forming such organisations plays a vital role in determining the form, contents of accounting reports as well as treatment of certain accounting transactions. The Institute of Cost Accountants of India 7 undamentals of Financial and Cost Accounting Fundamentals of Financial and Cost Accounting Accounting Principles, Concepts and Conventions 1.2 O 1.2.1 Introduction ne of the main objectives of accounting is to help users to take appropriate decisions by providing relevant accounting information. For this purpose, accounting maintains records of the each and every transaction in its books of accounts. The practice of this record keeping, however, may be based on diverse policies at various organisations. As a result, there is limited scope for comparing accounting information across entities over the time. In order to ensure uniformity and consistency in record keeping and produce accounting information which is largely comparable, the accounting profession has developed rules, conventions, standards, and procedures which are generally accepted and universally practiced. This common set of rules, conventions, standards, and procedures is referred to as Generally Accepted Accounting Principles (GAAP). The GAAPs provide the guidelines for reporting economic events and are thus, used by organisations in drafting their financial statements. These are followed by organisations so that the users of accounting information have an optimum level of consistency in the financial statements they use while comparing such information over time and across entities for decision purpose. Such accounting principles have been developed from research, accepted accounting practices, and pronouncements of regulators. In India, financial statements are prepared on the basis of accounting standards issued by the Institute of Chartered Accountants of India (ICAI) and the law laid down in the respective applicable statutes (like, Schedule III to Companies Act, 2013 is required to be followed by all companies). These accounting standards as well as rules prescribed under various statutes have the GGAP at their core. 1.2.2 Accounting Principles – Accounting Concepts and Accounting Conventions Accounting principles refer to those rules of action that are universally adopted by the accountants for recording accounting transactions. They provide the guidelines for recording and reporting transactions and as such provide explanations to the current accounting practices. Accounting principles can be further classified into (A) Accounting Concepts and (B) Accounting Conventions. A. Accounting Concepts: Accounting concepts refer to the assumptions and conditions that define the parameters and constraints within which the accounting operates. They lay down the foundation for accounting principles, and ensure recording of financial facts on sound bases and logical considerations. The common accounting concepts include: (a) Entity concept (b) Going concern concept 8 The Institute of Cost Accountants of India  Accounting Fundamentals (c) Periodicity concept (d) Money measurement concept (e) Accrual concept (f) Dual aspect concept (g) Matching concept (h) Realisation concept (i) Cost concept B. Accounting Conventions: Accounting conventions are customs and traditions associated with the practical application of accounting principles. These are widely accepted, and are the common practices which are used as guidelines when transactions are recorded. These have evolved over time out of different accounting practices. These conventions are also known as doctrine. The different accounting conventions include the following: (a) Convention of Conservatism (b) Convention of Consistency (c) Convention of Materiality (d) Convention of Full disclosure. These accounting concepts and conventions are discussed in the following section. 1.2.2.1 Accounting Concepts (a) Business Entity Concept: This concept assumes that, for accounting purposes, the business enterprise and its owners are two separate independent entities. Thus, the business and personal transactions of its owner are separate. For example, when the owner invests money in the business, it is recorded as liability of the business to the owner. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not treated as business expense. (b) Going Concern Concept: Accounting assumes that business will continue to operate for a longer period of time in future. In other words, it is assumed that neither there is any intention nor necessity to curtail the business operations of entity. It is on this basis that financial statements of a business entity are prepared and referring to which investors agree upon their decision to invest in the business. (c) Periodicity or Accounting Period Concept: Accounting period concepts assumes that the infinite life of an organisation can be split into smaller periods of equal duration (viz. a quarter, half-year or year). Due to this concept, the operating results are ascertained for a specific period, the financial position is reflected (through the balance sheet) at regular intervals. (d) Money Measurement Concept: A business transaction will always be recoded if it can be expressed in terms of money. The advantage of this concept is that different types of transactions could be recorded as homogenous entries with money as common denominator. A business may own `3 Lacs cash, 1500 kg of raw material, 10 vehicles, 3 computers etc. Unless each of these is expressed in terms of money, we cannot find out the assets owned by the business. When expressed in the common measure of money, transactions could be added or subtracted to find out the combined effect. In the above example, we could add values of different assets to find the total assets owned. The Institute of Cost Accountants of India 9 Fundamentals of Financial and Cost Accounting (e) The Accrual Concept: The accrual concept is based on recognition of both cash and credit transactions. In case of a cash transaction, owner’s equity is instantly affected as cash either is received or paid. In a credit transaction, however, a mere obligation towards or by the business is created. When credit transactions exist (which is generally the case), revenues are not the same as cash receipts and expenses are not same as cash paid during the period. (f) Dual Aspect Concept: Dual aspect is the foundation or basic principle of accounting. It provides the very basis of recording business transactions in the books of accounts. This concept assumes that every transaction has a dual effect, i.e., it affects two accounts in their respective opposite sides. Therefore, the transaction should be recorded at two places. It means, both the aspects of the transaction must be recorded in the books of accounts. For example, goods purchased for cash has two aspects which are (i) Giving of cash (ii) Receiving of goods. These two aspects are to be recorded. Thus, the duality concept is commonly expressed in terms of fundamental accounting equation: Assets = Liabilities + Capital (g) Matching Concept: This concept states that the revenues and expenses must be recorded at the same time at which they are incurred. In general, the revenues earned should be with the expenses incurred during the accounting period. For the application of this concept several adjustments are made for prepaid expenses, accrued incomes, etc. The operating result of an accounting period can be measured only when incomes are compared with the related expenses incurred. (h) Realisation Concept: This concept states that revenue from any business transaction should be included in the accounting records only when it is realised. The term realisation means creation of legal right to receive money. Selling goods is realisation, receiving order is not. Accordingly, revenue is said to have been realised when cash has been received or right to receive cash on the sale of goods or services or both has been created. (i) Cost Concept: Accounting cost concept states that all assets are recorded in the books of accounts at their purchase price, which includes cost of acquisition, transportation and installation and not at its market price. It means that fixed assets like building, plant and machinery, furniture, etc are recorded in the books of accounts at a price paid for them. For example, a machine was purchased by XYZ Limited for `5,00,000, for manufacturing shoes. An amount of `1,000 were spent on transporting the machine to the factory site. In addition, `2,000 were spent on its installation. The total amount at which the machine will be recorded in the books of accounts would be the sum of all these items i.e., `5,03,000. This cost is also known as historical cost. The effect of cost concept is that if the business entity does not pay anything for acquiring an asset this item would not appear in the books of accounts. 1.2.2.2 Accounting Conventions (a) Convention of Conservatism: This convention is based on the principle that “Anticipate no profit, but provide for all possible losses”. It provides guidance for recording transactions in the books of accounts. It is based on the policy of playing safe in regard to showing profit. The main objective of this convention is to show minimum profit. Profit should not be overstated. If profit shows more than actual, it may lead to distribution of dividend out of capital. This is not a fair policy and it will lead to the reduction in the capital of the enterprise. (b) Convention of Consistency: The convention of consistency means that same accounting principles should be used for preparing financial statements year after year. A meaningful conclusion can be drawn from financial statements of the same enterprise when there is comparison between them over a period of time. But this can be possible only when accounting policies and practices followed by the enterprise are uniform and consistent over a period of time. If different accounting procedures and practices are used for preparing financial statements of different years, then the result will not be comparable. 10 The Institute of Cost Accountants of India  Accounting Fundamentals (c) Convention of Materiality: The convention of materiality states that, to make financial statements meaningful, only material fact i.e., important and relevant information should be supplied to the users of accounting information. The question that arises here is what is a material fact. The materiality of a fact depends on its nature and the amount involved. Material fact means the information of which will influence the decision of its user. (d) Convention of Full Disclosure: Convention of full disclosure requires that all material and relevant facts concerning financial statements should be fully disclosed. Full disclosure means that there should be full, fair and adequate disclosure of accounting information. Adequate means sufficient set of information to be disclosed. Fair indicates an equitable treatment of users. Full refers to complete and detailed presentation of information. Thus, the convention of full disclosure suggests that every financial statement should fully disclose all relevant information. Accounting principles - concepts and conventions – lie at the core of accounting profession as they bring about the much sought-after uniformity in the process of recording transactions. Such uniformity makes it possible to reliably compare the financial performance, financial position, and cash flows across entities and also across the reporting periods. They contribute a lot in standardising the financial reporting process. The Institute of Cost Accountants of India 11 undamentals of Financial and Cost Accounting Fundamentals of Financial and Cost Accounting Capital and Revenue Transactions 1.3  Concept of Transactions Accounting is all about recording transactions in the books of accounts of an organization in order to determine the financial performance and financial state of affairs at regular periodic interval. A transaction is an event which can be expressed in monetary terms and brings change in the financial position of a business unit. For example, investing capital in the business, purchasing goods for resale, paying remuneration to employees etc. all are transactions as these events lead to change in the financial position of the organization. On the other hand, using a new material in production, appointment of a new manger etc. are only event as they do not change the financial position of the entity.  Capital and Revenue Transactions – Need for Distinction Appropriate distinction between capital and revenue transactions lies at the core of accounting and helps in achieving its objectives as stated above. The very act requires application of the accounting concepts of periodicity, accrual and matching. When transactions are appropriately classified into capital and revenue nature, it serves a number of purposes as follows: (a) The distinction ensures proper accounting of transactions by identifying them as income or liability, and expense or asset; (b) It helps determining the profitability of the operations of the entity through correct identification of income and expenses. (c) It facilitates assessing the financial state of affairs through correct identification of assets and liabilities.  Capital and Revenue Transactions Capital Transactions are transactions having long-term effect while Revenue Transactions are transactions having short term effect. Each of these transactions can again be either a receipt or an expenditure. 1.3.1 Capital and Revenue Expenditure Capital Expenditure refers to that expenditure benefit from which can be enjoyed by an entity over a number of accounting periods. This type of expenditure happens to be non-recurring in nature. A capital expenditure takes place when an asset or service is acquired or improvement of a fixed asset is affected. These assets resulting from such expenditure are not intended for resale in the ordinary course of business. A capital expenditure has the following characteristics: (a) The amount involved in such an expenditure is generally large; (b) The benefit accruing from such an expenditure is consumed over more than one accounting period; 12 The Institute of Cost Accountants of India  Accounting Fundamentals (c) The expenditure is non-recurring in nature; (d) It results in an increase in value of fixed assets. Examples of capital expenditure include purchase of machinery, construction of a plant, significant repairs to a fixed or non-current assets that significantly increases its life etc. Revenue Expenditure refers to that expenditure benefit from which can be enjoyed by an entity in the current accounting period. This type of expenditure happens to be recurring in nature. Revenue expenditures are incurred to carry on the regular course of operations by an organization. A revenue expenditure has the following characteristics: (a) The amount involved in such an expenditure is generally small; (b) The benefit accruing from such an expenditure is consumed within one accounting period; (c) The expenditure is recurring in nature; (d) It is incurred in relation to trading activities (i.e., either for purchase or sale of goods or for providing services). Examples of revenue expenditure include purchase of goods for resale, payment of salaries, rent, regular maintenance of fixed assets etc.  Accounting Treatment of Capital and Revenue Expenditure An expenditure of capital nature is not written off completely (i.e., charged) against income in the accounting period in which it is acquired. Rather, it is capitalized i.e., recorded as an asset. However, over time the amount of capital expenditure is recognized as revenue expenditure i.e., it gets gradually charged against the profit in a systematic manner reflecting the benefits consumed out of it. For example, the acquisition of a machinery is a capital expenditure, but charging regular depreciation on this machinery is a revenue expenditure. An expenditure of revenue nature charged as an expense against profit of the accounting period in which it is incurred or recognised.  Distinction between Capital and Revenue Expenditure Following are the major differences between capital expenditure and revenue expenditure: Capital Expenditure Revenue Expenditure 1. The economic benefits of this expenditure are 1. The economic benefits from revenue expenditure consumed over a number of accounting periods. are consumed within one accounting period. 2. It is non-recurring in nature. 2. It is recurring in nature. 3. The amount involved in such an expenditure is 3. The amount involved in such an expenditure is generally large. generally small. 4. It is reflected in the Balance Sheet. 4. It is debited to Income Statement. 5. Capital expenditures are not matched against 5. Revenue expenditures are not matched against capital receipts. revenue receipts 6. It may be incurred before or after the 6. It is always incurred after the commencement of commencement of operations of an entity. operations of an entity. 7. It tends to increase the earning capacity or, reduce 7. It helps in carrying on the activities in the current the operating expenses of an entity. accounting period. 8. It may be incurred before or after the 8. It is always incurred after the commencement of commencement of operations of an entity. operations of an entity. The Institute of Cost Accountants of India 13 Fundamentals of Financial and Cost Accounting  Rules for Determining Capital Expenditure An expenditure can be recognized as capital if it is incurred for the following purposes: An expenditure incurred for the purpose of acquiring long term assets (useful life is at least more than one accounting period) for use in business to earn profits and not meant for resale, will be treated as a capital expenditure. For example, if a second-hand motor car dealer buys a piece of furniture with a view to use it in business; it will be a capital expenditure. But if he buys second hand motor cars, for re-sale, then it will be a revenue expenditure because he deals in second hand motor cars. When an expenditure is incurred to improve the present condition of a machine or putting an old asset into working condition, it is recognized as a capital expenditure. The expenditure is capitalized and added to the cost of the asset. Likewise, any expenditure incurred to put an asset into working condition is also a capital expenditure. For example, if one buys a machine for ` 5,00,000 and pays ` 20,000 as transportation charges and ` 40,000 as installation charges, the total cost of the machine comes up to ` 5,60,000. Similarly, if a building is purchased for ` 1,00,000 and ` 5,000 is spent on registration and stamp duty, the capital expenditure on the building stands at ` 1,05,000. If an expenditure is incurred to increase earning capacity of a business, it will be considered as capital expenditure. For example, expenditure incurred for shifting the factory for easy supply of raw materials. Here, the cost of such shifting will be a capital expenditure. Preliminary expenses incurred before the commencement of business is considered capital expenditure. For example, legal charges paid for drafting the memorandum and articles of association of a company or brokerage paid to brokers, or commission paid to underwriters for raising capital. Note: One useful way of recognizing expenditure as capital is to see that because of the expenditure, the business will own something which qualifies as an asset at the end of the accounting period. Some examples of capital expenditure: (i) Purchase of land, building, machinery or furniture; (ii) Cost of leasehold land and building; (iii) Cost of purchased goodwill; (iv) Preliminary expenditures; (v) Cost of additions or extensions to existing assets; (vi) Cost of overhauling second-hand machines; (vii) Expenditure on putting an asset into working condition; and (viii) Cost incurred for increasing the earning capacity of a business.  Rules for Determining Revenue Expenditure Any expenditure which cannot be recognized as capital expenditure can be termed as revenue expenditure. A revenue expenditure temporarily influences only the profit earning capacity of the business. An expenditure is recognized as revenue when it is incurred for the following purposes: Expenditure for day-to-day conduct of the business, the benefits of which last less than one year. Examples are wages of workmen, interest on borrowed capital, rent, selling expenses, and so on. 14 The Institute of Cost Accountants of India  Accounting Fundamentals Expenditure on consumable items, on goods and services for resale either in their original or improved form. Examples are purchases of raw materials, office stationery, and the like. At the end of the year, there may be some revenue items (stock, stationery, etc.) still in hand. These are generally passed over to the next year though they were acquired in the previous year. Expenditures incurred for maintaining fixed assets in working order. For example, repairs, renewals and depreciation. Some examples of revenue expenditure: (i) Salaries and wages paid to the employees; (ii) Rent and rates for the factory or office premises; (iii) Depreciation on plant and machinery; (iv) Consumable stores; (v) Inventory of raw materials, work-in-progress and finished goods; (vi) Insurance premium; (vii) Taxes and legal expenses; and (viii) Miscellaneous expenses.  Revenue Expenditure Treated as Capital Expenditure: The following are some of the instances where an item of expenditure which is in the nature of revenue expenditure will be treated as capital expenditure. (a) Repairs: Repairs expenditure is revenue in nature, but huge amount incurred on a second-hand machinery in order to bring it to working condition can be treated as capital expenditure and should be added to the cost of Machinery. (b) Wages: Normally, wages are revenue in nature. But wages paid to the workers for the construction or installation of fixed assets, will be treated as capital expenditure and added to the cost of that asset. (c) Preliminary Expenses: All the expenses paid in the process of formation of a company should be treated as capital expenditure and recorded in the balance sheet on asset side. (d) Brokerage, Government Stamp Duty and Legal Expenses: All the expenses paid on the purchase of a property will be regarded as capital expenditure. (e) Raw Materials and Stores: These are generally revenue in nature, but if raw materials and stores are consumed in the constructing a fixed asset, the same should be treated as capital expenditure. (f) Development Expenditure: All the expenditure incurred for the development of mines and plantations should be treated as capital expenditure.  Deferred Revenue Expenditures Deferred Revenue Expenditure is the expenditure for which payment has been made or a liability has been incurred but which is carried forward on the presumption that will be of benefit over a subsequent period or periods. [Guidance Note on Terms used in Financial Statements issued by Institute of Chartered Accountants of India]. Deferred revenue expenditures are a combination of capital and revenue expenses whose usefulness does not expire in the year of their occurrence, but generally expires in the near future. These types of expenditures are carried forward and are written-off in future accounting periods. A portion of The Institute of Cost Accountants of India 15 Fundamentals of Financial and Cost Accounting such expenditure is capitalised even though it is revenue in nature, and hence is also referred to as Capitalised Revenue Expenditure. Examples of Deferred Revenue Expenditure include heavy advertisement expenditure incurred prior to launching a new product, development expenses of a product etc. Out of the total amount of Deferred Revenue Expenditure, a part (the portion representing benefits consumed during the year) is written-off and recorded in the debit-side of the Income Statement, while the unwritten-off portion appears as an asset in the Balance Sheet. Note: After the issuance of AS-26, the expenditures which were recognised as deferred revenue expenditure has to be treated as simple revenue expense. The accounting standard has specifically mentioned that any expenditure incurred for research, training, advertising and promotional activities should be recognised as an expense of the accounting period in which it has been incurred. Illustration 1. State whether the following are capital, revenue or deferred revenue expenditure. (i) Carriage of ` 7,500 spent on machinery purchased and installed. (ii) Heavy advertising costs of ` 20,000 spent on the launching of a company’s new product. (iii) ` 200 paid for servicing the company vehicle, including ` 50 paid for changing the oil. (iv) Construction of basement costing ` 1,95,000 at the factory premises. Solution: (i) Carriage of ` 7,500 paid for machinery purchased and installed should be treated as a Capital Expenditure. (ii) Advertising expenses for launching a new product of the company should be treated as a Revenue = Expenditure. (As per AS-26) (iii) ` 200 paid for servicing and oil change should be treated as a Revenue Expenditure. (iv) Construction cost of basement should be treated as a Capital Expenditure. Illustration 2. State whether the following are capital or revenue expenditure. (i) Paid a bill of ` 10,000 of Mr. Kumar, who was engaged as the erection engineer to set up a new automatic machine costing ` 20,000 at the new factory site. (ii) Incurred ` 26,000 expenditure on varied advertisement campaigns undertaken yearly, on a regular basis, during the peak festival season. (iii) In accordance with the long-term plan of providing a well- equipped Labour Welfare Centre, spent ` 90,000 being the budgeted allocation for the year. Solution: (i) Expenses incurred for erecting a new machine should be treated as a Capital Expenditure. (ii) Advertisement expenses during peak festival season should be treated as a Revenue Expenditure. (iii) Expenses incurred for Labour Welfare Centre should be treated as a Capital Expenditure. 16 The Institute of Cost Accountants of India  Accounting Fundamentals Illustration 3. Classify the following items as capital or revenue expenditure: (i) An extension of railway tracks in the factory area; (ii) Wages paid to machine operators; (iii) Installation costs of new production machine; (iv) Materials for extension to foremen’s offices in the factory; (v) Rent paid for the factory; (vi) Payment for computer time to operate a new stores control system, (vii) Wages paid to own employees for building the foremen’s offices. Give reasons for your classification. Solution: (i) Expenses incurred for extension of railway tracks in the factory area should be treated as a Capital Expenditure because it will yield benefit for more than one accounting period. (ii) Wages paid to machine operators should be treated as a Revenue Expenditure as it will yield benefit for the current period only. (iii) Installation costs of new production machine should be treated as a Capital Expenditure because it will benefit the business for more than one accounting period. (iv) Materials for extension to foremen’s offices in the factory should be treated as a Capital Expenditure because it will benefit the business for more than one accounting period. (v) Rent paid for the factory should be treated as a Revenue Expenditure because it will benefit the Company only during the current period. (vi) Payment for computer time to operate a new stores control system should be treated as Revenue Expenditure because it has been incurred to carry on the normal business. (vii) Wages paid for building foremen’s offices should be treated as a Capital Expenditure because it will benefit the business for more than one accounting period. Illustration 4. For each of the cases numbered below, indicate whether the income/expenditure is capital or revenue. (i) Payment of wages to one’s own employees for building a new office extension. (ii) Regular hiring of computer time for the preparation of the firm’s accounts. (iii) The purchase of a new computer for use in the business. (iv) The use of motor vehicle, hired for five years, but paid at every six months. Solution: (i) Payment of wages for building a new office extension should be treated as a Capital Expenditure. (ii) Computer hire charges should be treated as a Revenue Expenditure. (iii) Purchase of computer for use in the business should be treated as a Capital Expenditure. (iv) Hire charges of motor vehicle should be treated as a Revenue Expenditure. The Institute of Cost Accountants of India 17 Fundamentals of Financial and Cost Accounting Illustration 5. State with reasons whether the following are capital or revenue expenditure: (i) Freight and cartage on the new machine ` 150, and erection charges ` 500. (ii) Fixtures of the book value of ` 2,500 sold off at ` 1,600 and new fixtures of the value of ` 4,000 were acquired. Cartage on purchase ` 100. (iii) A sum of ` 400 was spent on painting the factory. (iv) ` 8,200 spent on repairs before using a second hand car purchased recently, to put it in usable condition. Solution: (i) Freight and cartage totaling ` 650 should be treated as a Capital Expenditure because it will benefit the business for more than one accounting year. (ii) Loss on sale of fixtures ` (2,500 – 1,600) = ` 900 should be treated as a Capital Loss. The cost of new fixtures and carriage thereon should be treated as a Capital Expenditure because the fixture will be used for a long period. So the cost of new fixture will be ` (4,000+100) ` 4,100. (iii) Painting of the factory should be treated as a Revenue Expenditure because it has been incurred to maintain the factory building. (iv) Repairing cost of second hand car should be treated as a Capital Expenditure because it will benefit the business for more than one accounting year. Illustration 6. State the nature (capital or revenue) of the following expenditure which were incurred by Vedanta & Co. during the year ended 30th June, 2021: (i) ` 350 was spent on repairing a second hand machine which was purchased on 8th May, 2021 and ` 200 was paid on carriage and freight in connection with its acquisition. (ii) A sum of ` 30,000 was paid as compensation to two employees who were retrenched. (iii) ` 150 was paid in connection with carriage on goods purchased. (iv) ` 20,000 customs duty is paid on import of a machinery for modernisation of the factory production during the current year and ` 6,000 is paid on import duty for purchase of raw materials. (v) ` 18,000 interest had accrued during the year on term loan obtained and utilised for the construction of factory building and purchase of machineries; however, the production has not commenced till the last date of the accounting year. Solution: (i) Repairing and carriage totaling ` 550 for second hand machine should be treated as a Capital Expenditure. (ii) Compensation paid to employees shall be treated as a Revenue Expenditure. (iii) Carriage paid for goods purchased should be treated as a Revenue Expenditure. (iv) Customs duty paid on import of machinery to be treated as a Capital Expenditure. However, import duty paid for raw materials should be treated as a Revenue Expenditure. (v) Interest paid during pre-construction period to be treated as a Capital Expenditure. 18 The Institute of Cost Accountants of India  Accounting Fundamentals Illustration 7. State with reasons whether the following items relating to Parvati Sugar Mill Ltd. are capital or revenue: (i) ` 50,000 received from issue of shares including ` 10,000 by way of premium. (ii) Purchased agricultural land for the mill for ` 60,000 and ` 500 was paid for land revenue for period after purchase. (iii) ` 5,000 paid as contribution to PWD for improving roads of sugar producing area. (iv) ` 40,000 paid for excise duty on sugar manufactured. (v) ` 70,000 spent for constructing railway siding. Solution: (i) ` 40,000 (50,000 – ` 10,000) received from issue of shares will be treated as a Capital Receipt. The premium of ` 10,000 should be treated as a Capital Profit. (ii) Cost of land ` 60,000 to be treated as Capital Expenditure and land revenue of ` 500 to be treated as Revenue Expenditure. (iii) Contribution paid to PWD should be treated as a Revenue Expenditure. (iv) Excise duty of ` 40,000 should be treated as a Revenue Expenditure. (v) ` 70,000 spent for constructing railway siding to be treated as a Capital Expenditure. 1.3.2 Capital and Revenue Receipts A receipt of money may be of a capital or revenue nature. A clear distinction, therefore, should be made between capital receipts and revenue receipts in order to determine the correct result of operating performance of the entity. Capital Receipts refer to the receipts which are obtained by an entity from operations other than the regular operations of the entity. Capital receipts do not have any effect on the profits earned or losses incurred during the course of a year. Capital receipts can take one or more of the following forms: (a) Additional capital introduced by the owner; and, (b) Proceeds from sale of long-term assets. A receipt of money is considered as Revenue Receipt when it is obtained by an entity from its regular course of operations. Receipts of money in the revenue nature increase the profits or decrease the losses of a business and must be set against the revenue expenses in order to ascertain the profit for the period. For example, ccollection from customers for goods sold on credit; Fees received for services rendered etc.  Accounting Treatment of Capital and Revenue Receipts Capital receipts are credited to the respective account of capital nature, and gets reflected in the Balance Sheet. On the other hand, revenue receipts are recognised as income and are reflected in the Income Statement. The Institute of Cost Accountants of India 19  Fu Fundamentals of Financial and Cost Accounting  Distinction between Capital and Revenue Receipts Major differences between capital receipts and revenue receipts are as follows: Sr. No. Capital Receipt Revenue Receipt 1. These receipts are obtained by an entity from These receipts are obtained by an entity from operations other than from the regular operations. regular day-to-day operations. 2. It is non-recurring in nature. It is recurring in nature. 3. It is not recognised as an income. It is recognised as an income. 4. It gets reflected in the Balance Sheet. It is credited to Income Statement. 5. It does not affect the operating result of an entity. It affects the operating result of an entity. 6. It may result in creation of liability. It does not create any liability.  Capital and Revenue Profit While ascertaining the operating performance of an entity for a particular period, a proper distinction is to be made between capital and revenue profits. If a profit arises out of an ordinary nature, being the outcome of the ordinary functions and object of the business, it is termed as ‘revenue profit’. But, when a profit arises out of a non-recurring transaction, it is termed as capital profit. Generally, Capital Profits arise out of the sale of assets other than inventory at a price more than its book value or in connection with the raising of capital or at the time of purchasing an existing business. Examples of Capital Profit include Profit prior to incorporation; Premium received on issue of shares; Profit made on re-issue of forfeited shares etc. Similarly, examples of Revenue Profit include profit on sale of goods and providing services. Normally, Capital Profits are transferred to Capital Reserve while Revenue Profits are either distributed to owners or are credited to Reserves for future investments.  Capital and Revenue Losses While ascertaining profit, revenue losses are differentiated from capital losses, just as revenue profits are distinguished from capital profits. Revenue losses arise from the normal course of business by selling the merchandise at a price less than its purchase price or cost of goods sold or where there is a decline in the current value of inventories etc. Examples include discount allowed to customers for prompt payment; Bad debt loss. Capital Loss, on the other hand, refers to a loss which does not arise to an entity in the regular course of its operations. Capital losses may result from the sale of assets, other than inventory for less than written down value or the diminution or elimination of assets other than as the result of use or sale (flood, fire, etc.) or in connection with raising capital of the business (issue of shares at a discount) or on the settlement of liabilities for a consideration more than its book value (debenture issued at par but redeemed at a premium). Treatment of capital losses are same as that of capital profits. Capital losses arising out of sale of fixed assets generally appear in the Income Statement (being deducted from the net profit). But other capital losses are adjusted against reserves of capital in nature. Revenue losses are transferred to the Income Statement. 20 The Institute of Cost Accountants of India undamentals of Financial and Cost Accounting Accounting Fundamentals Accounting Cycle, Analysis of Transaction Etc. 1.4 A 1.4.1 Concept of Accounting Cycle n accountant follows a sequence of activities to record and finally report transactions of an entity during an accounting period. This sequence of activities starts with identifying an event to be a transaction wroth of recording in then books to their presentation in the financial statements after proper process of summarising, classifying and finalising. To keep track of the full accounting cycle from start to finish is one of the main duties of a bookkeeper. Thus, accounting cycle is defined as the holistic process of recording and processing all financial transactions of a company, from when the transaction occurs, to its representation on the financial statements, to closing the accounts. Accounting cycle consists of the following sequential steps. (a) Identifying the Transactions: The first step in the accounting cycle is to analyse the events to determine if they are ‘transactions’. Only events that leads to change in the financial position of the accounting unit is called transactions. (b) Recording transaction in the Journal: The second step in the accounting cycle is to record the transactions in the books of original entry i.e., Journal after identifying the Debit and the Credit element. (c) Posting to Ledger: In the next step, the transaction is posted in a summarised and classified manner to different accounts of the ledger. (d) Drafting of Unadjusted Trial Balance: At the next step, the ledger balances are compiled in the trial balance to check whether there is any error during the recording stage. This stage is, however, not mandatory. (e) Passing of adjustment entries: Identification of necessary adjustments and passing of adjusting entries make up the fifth step in the cycle. (f) Drafting of Adjusted Trial Balance: Once all adjusting entries are completed, an Adjusted Trail Balance can be prepared. This happens to be the last step before the preparation of the financial statements. (g) Closing of books: In this stage of the accounting cycle, the ledger accounts are closed and balanced (also referred to as “zeroed out”) at the end of every accounting period. (h) Drafting the Financial Statements: In the last stage of the accounting cycle, the Income Statement is prepared with the closing balances of the nominal accounts, while the balances of real and personal accounts get reflected in the Balance Sheet. Financial statements are prepared in the following order: Income Statement, Statement of Retained Earnings, Balance Sheet and Statement of Cash Flows. The Institute of Cost Accountants of India 21 Fundamentals of Financial and Cost Accounting Identifying Transactions Drafting Financial Recording in Statements Journal Closing the Books Posting to Ledger Drafting Adjusted Drafting Unadjusted Trial Balance Trial Balance Adjustment Entries Figure 1.2: Accounting Cycle These steps and their related components have been explained in greater detail in the following sections of this module. Charts of Accounts and Codification Structure The primary purpose of financial accounting is to record the transactions entered into by an organisation during an accounting period. To achieve this, various accounts are opened and after the classification exercise the transactions get posted in the ledger (which itself is classified as personal and impersonal). These happen to be the building blocks for developing the financial statements and other management reports of the organisation. However, with the increase in the complexity of business and flow of data, it has become quite a challenge to retrieve the information stored in the accounting records. It is for the purpose of effective management and retrieval of the already recorded accounting information, Chart of Accounts are developed. Concept of Chart of Accounts A Chart of Accounts (COA) is the list of all accounts in the general ledger, each account being accompanied by a reference number. It is a financial organizational tool that provides a complete listing of every account in the general ledger of a company, broken down into subcategories. Specifically, it is an index of all the financial accounts in the general ledger of an organisation. Chart of Accounts is the driving force behind an organisation’s book-keeping and accounting systems, and is considered to be the foundation of financial reporting. 22 The Institute of Cost Accountants of India  Accounting Fundamentals The basic purpose of such charting is to organize the accounts and group similar ones together. This process makes it easier for the accountants and auditors to locate specific accounts. A well-structured chart of accounts is often the single best and most effective way to raise the financial reporting of an organization to the next level. The organization of accounts within the COA varies from company to company. It usually consists of the accounts that a company has identified and made available for recording transactions in its general ledger. This can be done with accounting software. Codification Structure A Chart of Accounts provides the structure for the general ledger accounts of a concern. It lists specific types of accounts, describes each account, and includes account numbers. A chart of accounts typically lists asset accounts first, followed by liability and capital accounts, and then by revenue and expense accounts. (a) Setting up of a Chart of Accounts: To set up a chart of accounts, the first is to define the various accounts to be used by the organisation. Each account should have a number to identify it. Each chart of accounts typically contains a name, brief description, and an identification code. (b) Ordering of Accounts: Balance Sheet Accounts tend to follow a standard that lists the most liquid assets first. Revenue Accounts and Expense Accounts tend to follow the standard of first listing the items most closely related to the operations of the business. For example, Sales would be listed before non-operating income. In some cases, part of all the expense accounts simply may be listed in alphabetical order. (c) Designing of Chart of Accounts: The designing of a detailed chart of accounts would typically begin with an initial design which would reflect the major headings of the accounts. Thereafter, the detailed descriptions of the transaction are added, which may act as future references. Note: While codifying the accounts, an organisation may follow a three-layer approach of providing Division Code followed by Department Code followed by Account Code. Division Code is usually a two-digit code (but may be of three digits as well) that defines the specific company division within an organization. A company with a single division does not require division coding. The department code is usually a two- or three-digit code that defines various departments within a division. A division will usually have various departments such as accounting, production, engineering, and so on. In order to identify the departments in a division, an account manager can use these codes. Account Code is usually a three-digit code that are assigned to the accounts such as assets, supplies, expense, revenue, and so on. For instance, a multi-division company would have the chart accounts numbering in the following manner – zz-aa-123—the zz representing division, aa for the department, and 123 for accounts. Illustration of Account Codification for a small business organisation: For a small business, three digits code may suffice for the account number, although more digits are desirable. However, in order to allow for new accounts to be added as the business grows with more digits, new accounts can be added while maintaining the logical order. Complex businesses may have thousands of accounts, and require longer account reference numbers. As such, it is worthwhile to put thought into assigning the account numbers in a logical way and to follow any specific industry standards. The Institute of Cost Accountants of India 23 Fundamentals of Financial and Cost Accounting The following is an example of some of the accounts that may be included in a chart of accounts and reflecting how the digits might be coded: Account Numbering & Description of Accounts 1000 to 1999: Asset accounts 2000 to 2999: Liability accounts 3000 to 3999: Equity accounts 4000 to 4999: Revenue accounts 5000 to 5999: Cost of goods sold accounts 6000 to 6999: Expense account 7000 to 7999: Other revenue (for example rent received, bad debt recovery etc.) 8000 to 8999: Other expenses (for example depreciation income taxes etc.) An alternative presentation of a typical Chart of Accounts is as follows: Balance Sheet Accounts Income Statement Accounts Assets (1000 – 1999) Operating Revenues (4000 – 4999) Liabilities (2000 – 2999) Operating Expense (5000 – 5999) Owner’s Equity (3000 -3999) Overhead Costs or Expenses (6000 – 6999) Non-operating revenue and gains (7000 – 7999) Non- operating expenses and Losses (8000 – 8999) It is to be noted that by separating each account by several numbers many new accounts can be added between any two while maintaining the logical order. 1.4.2 Analysis of Transactions  Events and Transactions A transaction is an event between two contracting parties, which can be expressed in terms of money and which leads to change in the financial position of a business unit. A transaction may be an exchange in which each party receives as well as sacrifices value. Examples include sale and purchase of goods, purchase of assets etc. An event is an occurrence, happening, change or incident, which may or may not bring any change in the financial position of a business unit. Thus, appointment of a manger, launch of a new product are events but not transactions. Hence, all transactions are events but all events are not transactions. In accounting, transactions are recorded systematically based on some source documents. Source documents include sales order, invoices and credit notes, petty cash vouchers etc. 1.4.2.1 Accounting Equation The accounting equation is a representation of the interrelationship among three important components of accounting namely Assets, Liabilities and Equity. 24 The Institute of Cost Accountants of India  Accounting Fundamentals In the most simplistic form, the accounting equation is presented as: Assets = Liabilities + Equity Assets represent the valuable resources owned and controlled by the company with the purpose of using it for generating future profits, such as cash, accounts receivable, fixed assets, inventory etc. Liabilities represent obligations of an organisation to its external stakeholders to be settled at a future date. It represents amount of money that the business owes to the other parties. Equity represents owners net claim on the assets. The above equation can be further expanded by incorporating the various elements of the Equity component as under: Assets = Liabilities + Equity or, Assets = Liabilities + [Capital + (Revenue – Expenses) – Drawings] or, Assets + Expenses + Drawings = Liabilities + Capital + Revenue Accounting equation lies at the core of the double-entry accounting system. Whatever be the transaction to be recorded, the accounting equation before and after the entry of the transaction always remains in balance. Consider the following illustrations. Transaction Assets + Expenses + Drawings Liabilities + Capital + Revenue Capital introduced by the Cash (Assets) increases Capital increases owner in cash Purchase of goods in credit Inventory (Asset) increases Creditors/ Payables (Liabilities) increases Sale of goods in credit Debtors/ Receivables (Assets) increases; N.A. Inventory (Assets) decreases Wages paid Wages (Expenses) increases; N.A. Cash/ Bank (Assets) decreases Commission received Cash/ Bank (Assets) increases Commission received (Revenue) increases Cash withdrawn by proprietor Cash (Assets) decreases Capital decreases Illustration 8. Prepare an Accounting Equation from the following transactions in the books of Mr. X for January, 2021: 1 Invested Capital in the firm ` 20,000 2 Purchased goods on credit from Das & Co. for ` 2,000 4 Bought plant for cash ` 8,000 8 Purchased goods for cash ` 4,000 12 Sold goods for cash (Cost ` 4,000 + Profit ` 2,000) ` 6,000. 18 Paid to Das & Co. in cash ` 1,000 22 Received from B. Banerjee ` 300 25 Paid salary ` 6,000 The Institute of Cost Accountants of India 25 Fundamentals of Financial and Cost Accounting 30 Received interest ` 5,000 31 Paid wages ` 3,000 Solution: Effect of transaction on Assets, Liabilities and Capital Date Transaction Assets = Liabilities + Capital 2021 Invested Capital in the firm ` 20,000 20,000 - 20,000 Jan.1 2 Purchased goods on credit from Das & Co. ` 2000 +2,000 +2,000 - Revised Equation 22,000= 2,000+ 20,000 4 Bought Plant for cash ` 8,000 +8,000 - - -8,000 Revised Equation 22,000= 2,000+ 20,000 8 Purchased goods for cash ` 4,000 +4,000 -- -- -4,000 Revised Equation 22,000= 2,000+ 20,000 12 Sold Goods for cash (Cost ` 4,000 + Profit ` 2,000) +6,000 +2,000 -4,000 Revised Equation 24,000 2,000+ 22,000 18 Paid to Das & Co. for ` 1,000 -1,000 -1,000 - Revised Equation 23,000= 1,000+ 22,000 22 Received from B. Banerjee for ` 300 +300 -300 Revised Equation 23,000= 1,000+ 22,000 25 Paid salary for ` 6,000 - 6,000 -6,000 Revised Equation 17,000= 1,000+ 16,000 30 Received Interest for ` 5,000 +5,000 +5,000 Revised Equation 22,000= 1,000+ 21,000 31 Paid Wages for ` 3,000 -3,000 -3,000 Revised Equation 19,000= 1,000+ 18,000 1.4.2.2 Double Entry System  Concept of Double Entry System Double entry system of book keeping is an accounting system which recognizes the fact that every transaction has two aspects - ‘Debit’ and ‘Credit’ and both aspects of the transaction are recorded in the books of accounts. The term ‘Debit’ is derived from the Latin word ‘debitum’ which means ‘what is due’. It is abbreviated by ‘Dr.’ The term ‘Credit’ is derived from the Latin word ‘credere’ which means ‘what is trusted. It is abbreviated by ‘Cr.’ 26 The Institute of Cost Accountants of India  Accounting Fundamentals Double entry system records the transactions by understanding them as a Debit item or Credit item. A debit entry in one account gives the opposite effect in another account by credit entry. This means that the sum of all Debit accounts must be equal to the sum of Credit accounts.  Features of Double Entry System (i) Every transaction has two-fold aspects, i.e., one party giving the benefit and the other receiving the benefit. (ii) Every transaction is divided into two aspects, Debit and Credit. One account is to be debited and the other account is to be credited. (iii) Every debit must have its corresponding and equal credit.  Concept of Account An account is defined as a summarized record of transactions related to a person or a thing e.g., when the business deals with customers and suppliers, each of the customers and supplier will be a separate account. The account is also related to inanimate objects – both tangible and intangible. e.g., land, building, equipment, brand value, trademarks etc. are some of the things. When a business transaction occurs, one has to identify the ‘account’ that will be affected by it and then apply the rules to decide the accounting treatment. Only then the transactions can be recorded in accounting. Typically, an account is expressed as a statement in form of English letter ‘T’. It has two sides. The left-hand side is called as “Debit’ side and the right-hand side is called as “Credit’ side. The debit side is indicated by ‘Dr’ and the credit side by ‘Cr’. Accounts are classified as follows: (a) Personal Account: As the name suggests, these are accounts related to persons. Personal Accounts can again be of three types as follows. (i) Natural Personal Account: These represents natural persons like Suresh’s A/c, Anil’s a/c, Rani’s A/c etc. (ii) Artificial Personal Account: The persons could also be artificial persons like companies, bodies corporate or association of persons or partnerships etc. For example, M/s ABC Ltd, M/s PQR Industries etc. (iii) Representative Personal Account: They represent the person collectively. For example, Outstanding Rent A/c, Prepaid Insurance A/c etc. (b) Real Accounts: These are accounts related to assets or properties or possessions. Depending on their physical existence or otherwise, they are further classified as - (i) Tangible Real Account – They represent assets that have physical existence and can be seen, and touched. e.g., Machinery A/c, Stock A/c, Cash A/c, Vehicle A/c, and the like. (ii) Intangible Real Account – These represent possession of properties that have no physical existence but can be measured in terms of money and have value attached to them. e.g. Goodwill A/c, Trade mark A/c, Patents & Copy Rights A/c, Intellectual Property Rights A/c and the like. (c) Nominal Account: These accounts are related to expenses or losses and incomes or gains e.g., Salary and Wages A/c, Rent and Rates A/c, Travelling Expenses A/c, Commission received A/c, Loss by fire A/c etc. The Institute of Cost Accountants of India 27 Fundamentals of Financial and Cost Accounting  Analysing Debit and Credit of a Transaction The double entry system has specific rules for determining the Debit Account and Credit Account in any transaction. The rules can broadly be discussed as follows: A. Golden Rule Approach This method is based on the conventional classification of accounts. Conventionally, accounts are classified into three types – Nominal Account, Real Account and Personal Account. The rules of Debit and Credit under this approach are described below. Nature of Account Rule of Debit and Credit Nominal Account Debit Expenses and Losses Credit Incomes and Gains Real Account Debit What comes in Credit What goes out Personal Account Debit The receiver Credit The giver B. Accounting Equation Approach This method is based on the concept of accounting equation. The rules of debit and credit under this method are presented as follows: Types of Account To be Debited To be Credited Assets Account Increase Decrease Liabilities Account Decrease Increase Capital Account Decrease Increase Revenue Account Decrease Increase Expense Account Increase Decrease Withdrawal Account Increase Decrease Once the transactions are identified into Debit Account and Credit Account, they are recorded in the books of original entry i.e., Journal and therefrom posted to the individual accounts maintained under the Ledger. Consider the following illustrations on analysis of transactions. Illustration 9. Ascertain the debit and credit from the following particulars under Modern Approach. (a) Started business with capital. (b) Bought goods for cash. (c) Sold goods for cash. d) Paid salary. (e) Received Interest on Investment. (f) Bought goods on credit from Mr. Y (g) Paid Rent out of Personal cash. 28 The Institute of Cost Accountants of India  Accounting Fundamentals Solution: Effect of Transaction Account To be debited/Credited (a) Increase in Cash Cash A/c Debit Increase in Capital Capital A/c Credit (b) Increase in Stock Purchase A/c Debit Decrease in Cash Cash A/c Credit (c) Increase in Cash Cash A/c Debit Decrease in Stock Sale A/c Credit (d) Increase in Expense Salary A/c Debit Decrease in Cash Cash A/c Credit (e) Increase in Cash Cash A/c Debit Increase in Income Interest A/c Credit (f) Increase in Stock Purchase A/c Debit Increase in Liability Y A/c Credit (g) Increase in Expense Rent A/c Debit Increase in Liability Capital A/c Credit Illustration 10. Ascertain the Debit Credit under British Approach or Double Entry System. Consider previous illustration. Solution: Step-I Step-II Step-III Step-IV (a) Cash A/c Real Comes in Debit Capital A/c Personal Giver Credit (b) Purchase A/c Nominal Expenses Debit Cash A/c Real Goes out Credit (c) Cash A/c Real Comes in Debit Sales A/c Nominal Incomes Credit (d) Salary A/c Nominal Expenses Debit Cash A/c Real Goes out Credit (e) Cash A/c Real Comes in Debit Interest A/c Nominal Incomes Credit (f) Purchase A/c Nominal Expenses Debit Y’ A/c Personal Giver Credit (g) Rent A/c Nominal Expenses Debit Capital A/c Personal Giver Credit The Institute of Cost Accountants of India 29  Fu Fundamentals of Financial and Cost Accounting  Advantages of Double Entry System (i) It ensures arithmetical accuracy of the books of accounts as, for every debit, there is a corresponding and equal credit. This is ascertained by preparing a trial balance periodically or at the end of the financial year. (ii) It prevents and minimizes frauds. Moreover, frauds can be detected early. (iii) Errors can be checked and rectified easily.  Limitations of Double Entry System (i) The system does not disclose all the errors committed in the books accounts. (ii) The trial balance prepared under this system does not disclose certain types of errors. (iii) It is costly as it involves maintenance of a number of books of accounts. 1.4.3 Books of Original Entry Books of original entry are referred to as the books where a business records all the business transactions initially. It is also known as Journal. These are the primary books of accounts which are used by the accountants for recording the transactions chronologically in the first place. These are also referred to as Books of Primary Entry or Books of First Entry.  Types of Books of Original Entry The books of original entry are broadly classified into two categories as follows: (a) Special Journal/ Subsidiary Books: A Special Journal is a book of primary entry in which transactions of a specific type viz. credit purchases, credit sales, return inwards etc. Some examples include Cash Book, Bank Book, Purchase Day Book, Sales Day Book etc. These are also known as Subsidiary Books. (b) General Journal: It is the book of original entry in which miscellaneous transactions, which do not fit in any other Special Journals (as mentioned above) books, are recorded. Examples are, opening entry, closing entry adjustment entry etc. For detail discussion, please refer to Module 1.5. 1.4.4 Posting in Ledger and Finalization of Accounts After recording each transaction in the books of original entry, they are posted to the Ledger. Ledger contains individual accounts to which the transactions are posted. Ledger is also known as the Book of Final entry. At the end of the accounting period (viz. quarter, half-year or year), the ledger accounts are balanced and closed. The closure of ledger accounts depends on their nature. Specifically, the nominal accounts (viz. accounts representing incomes, expenses, gains and losses) are closed by transfer to the Income Statement (namely, Trading A/c and Profit & Loss A/c for a profit-oriented organisation, and Income & Expenditure A/c for a non-profit organisation). The income statement is prepared to ascertain the operating results (viz. profit/ loss or surplus/ deficit) in relation to a specific accounting period. The balances of the accounts of real and personal nature are carried forward to the next accounting period. Their balances are reflected in a specific financial statement called the Balance Sheet. It shows the financial position of an organisation at the end of a specific accounting period by reflecting the different assets owned, liabilities and equity of the organisation. 30 The Institute