Fundamentals of Accounting Study Notes PDF

FOUNDATION : PAPER - 2 FUNDAMENTALS OF ACCOUNTING FOUNDATION STUDY NOTES The Institute of Cost Accountants of India CMA Bhawan,12, Sudder Street, Kolkata - 700 016 First Edition : January 2013 Revised Edition : April 2013 Second Edition : December 2014 Published by : Directorate of Studies The Institute of Cost Accountants of India (ICAI) CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 www.icmai.in Printed at : Repro India Limited Plot No. 02, T.T.C. MIDC Industrial Area, Mahape, Navi Mumbai 400 709, India. Website : www.reproindialtd.com Copyright of these Study Notes is reserved by the Insitute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof. Syllabus Paper 2: Fundamentals of Accounting (FOA) Syllabus Structure A Fundamentals of Financial Accounting 60% B Fundamentals of Cost & Management Accounting 40% B A 40% 60% ASSESSMENT STRATEGY There will be written examination paper of three hours OBJECTIVES To gain comprehensive understanding of all aspects relating to financial statements, principles, procedures of accounting and their application to different practical situations Learning Aims The Syllabus aims to test the student’s ability to: l Understand and explain the conceptual framework of Accounting l Prepare Accounts for various entities under different situations l Acquire basic concepts of Cost & Management Accounting relevant for managerial decision making Skill sets required Level A: Requiring the skill levels of knowledge and comprehension Section A : Fundamentals of Financial Accounting 60% 1. Accounting Process 2. Reconciliation Statement 3. Accounting for Depreciation 4. Preparation of Final Accounts 5. Accounting for Special Transactions Section B: Fundamentals of Cost & Management Accounting 40% 6. Fundamentals of Cost Accounting 7. Preparation of Cost Statements 8. Fundamentals of Management Accounting – basic knowledge and its application Section A : Fundamentals of Financial Accounting [60 marks] 1. Accounting Process (a) Theoretical Framework ( meaning, scope and usefulness of Accounting; Generally Accepted Accounting Principles, Concepts and Conventions) (b) Capital and Revenue transactions- capital and revenue expenditures, capital and revenue receipts (c) Measurement, Valuation and Accounting estimates (d) Double entry system, Books of prime entry, Subsidiary Books (e) Recording of Cash and Bank transactions (f) Preparation of Ledger Accounts (g) Preparation of Trial Balance- interpretation and usefulness (h) Rectification of Errors (i) Opening entries, Transfer entries, Adjustment entries, Closing entries 2. Reconciliation Statements (a) Bank Reconciliation Statement (b) Receivables / Payables Reconciliation Statement (c) Stock Reconciliation Statement 3. Accounting for Depreciation (a) Depreciation Policy (b) Methods, computation and Accounting treatment 4. Preparation of Final Accounts: (a) Of a Profit making concern (for sole proprietorship concern and partnership firm only) (i) Preparation of Trading Account, Profit & Loss Account and Balance Sheet (ii) Accounting treatment of bad debts, reserve for bad and doubtful debts, provision for discount on debtors and provision for discount on creditors (b) Of a Not-for-Profit making concern (i) Preparation of Receipts and Payments Account; (ii) Preparation of Income and Expenditure Account (iii) Preparation of Balance Sheet (c) Under Single Entry System including conversion of single entry into double entry system (basic level) (i) Concept of Single Entry System and preparation of Statement showing Profit and Loss , Statement of Affairs (ii) Conversion of Single Entry System into Double Entry System of Accounting 5. Accounting for Special Transactions (a) Bills of Exchange (b) Consignment (c) Joint Venture (d) Sale of goods on approval or return basis Section B: Fundamentals of Cost & Management Accounting[40 marks] 6. Fundamentals of Cost Accounting (a) Cost and Management Accounting – Generally Accepted Cost Accounting Principles (b) Accounting for Material cost (including Accounting of Inventory – LIFO, FIFO, Weighted Average Cost) (c) Accounting for Labour costs, Direct Expenses and Overheads 7. Preparation of Cost Statements (a) Cost Data collection, Cost Sheet formats, (b) Preparation of Cost Sheets (historical cost sheets and estimated cost sheets) 8. Fundamentals of Management Accounting (a) Marginal Costing and Break-even analysis – basic knowledge (b) Application of Marginal Costing for decision-making Content FUNDAMENTALS OF ACCOUNTING Study Note 1 : Accounting Process 1.1 Introduction 1.1 1.2 Definitions 1.2 1.3 Book-Keeping 1.4 1.4 Accounting Cycle 1.5 1.5 Basic Accounting Terms 1.6 1.6 Generally Accepted Accounting Principles 1.10 1.7 Accounting Concepts and Conventions 1.10 1.8 Events & Transactions 1.14 1.9 Voucher 1.14 1.10 Double Entry System 1.14 1.11 The Concepts of “Account”, “Debit” & “Credit” 1.15 1.12 Types of Accounts 1.16 1.13 The Accounting Process 1.17 1.14 Accounting Equation 1.19 1.15 Accrual Basis & Cash Basis of Accounting 1.20 1.16 Capital & Revenue Transaction 1.23 1.17 Accounting Standards 1.30 1.18 Double Entry System, Books of Prime Entry, Subsidiary Books 1.33 1.19 Trial Balance 1.52 1.20 Measurement, Valuation & Accounting Estimates 1.60 1.21 Opening entries, Closing entries, Transfer entries and Rectification entries 1.75 Study Note 2 : Reconciliation Statements 2.1 Bank Reconciliation 2.1 2.2 Receivable Reconciliation 2.16 2.3 Payable Reconciliation 2.17 2.4 Stock Reconciliation 2.18 Study Note 3 : Depreciation Accounting 3.1 Introduction 3.1 3.2 Certain Usful Terms 3.1 3.3 Causes of Depreciation 3.2 3.4 Characteristics of Depreciation 3.3 3.5 Objective of and Necessity for providing Depreciation 3.3 3.6 Factors to be Consider for Calculating the Actual Depreciation 3.3 3.7 Methods of Charging Depreciation 3.4 3.8 Provision for Depreciation Account 3.12 3.9 Disposal of an asset 3.13 3.10 Profit or Loss on sale of assets - Method of Depreciation Calculation 3.15 3.11 Change of Method - Prospective and Retrospective 3.16 3.12 Application of AS 6 - Depreciation Accounting 3.21 3.13 Application of AS 10 - Accounting for Fixed Asset 3.23 Study Note 4 : Preparation of Final Accounts 4.1 Introduction 4.1 4.2 Preparation of Financial Statements 4.1 4.3 Bad Debts 4.35 4.4 Preparation of Financial Statement of Non-Trading Concern 4.48 4.5 Preparation of Financial Statement under Single Entry System including Conversion of Single Entry into Double Entry System 4.72 Study Note 5 : Accounting for Special Transactions 5.1 Bill of Exchanges 5.1 5.2 Consignment Accounting 5.26 5.3 Joint Venture Accounts 5.41 5.4 Sales of goods on approval or return basis 5.54 Study Note 6 : Fundamentals of Cost Accounting 6.1 Introduction 6.1 6.2 Generally Accepted Cost Accounting Principles (GACAP) & 6.2 Cost Accounting Standards (CASs) 6.3 Definitions 6.14 6.4 Methods of Costing 6.17 6.5 Cost & Cost Object 6.19 6.6 Cost Organization 6.25 6.7 Costing System 6.26 6.8 Cost Determination 6.26 Study Note 7 : Preparation of Cost Statements 7.1 Cost Statements - Introduction 7.1 7.2 Cost Accumulation 7.1 7.3 Cost Collection 7.2 7.4 Cost Sheet Formats & Preparation 7.3 Study Note 8 : Fundamentals of Management Accounting 8.1 Marginal Costing-Introduction 8.1 8.2 Concept of Contribution, P/V Ratio and Break-Even Point 8.3 8.3 Concept of Margin Of Safety (MOS) 8.4 8.4 Cost - Volume - Profit Relationship (CVP Analysis) 8.5 8.5 Application of Marginal Costing for Decision Making 8.7 Study Note - 1 ACCOUNTING PROCESS This Study Note includes 1.1 Introduction 1.2 Definitions 1.3 Book-Keeping 1.4 Accounting Cycle 1.5 Basic Accounting Terms 1.6 Generally Accepted Accounting Principles 1.7 Accounting Concepts and Conventions 1.8 Events and Transactions 1.9 Voucher 1.10 Double Entry System 1.11 The Concepts of “Account”, “Debit” and “Credit” 1.12 Types of Accounts 1.13 The Accounting Process 1.14 Accounting Equation 1.15 Accrual Basis & Cash Basis of Accounting 1.16 Capital & Revenue Transactions 1.17 Accounting Standards 1.18 Double Entry System, Books of Prime Entry, Subsidiary Books 1.19 Trial Balance 1.20 Measurement, Valuation & Accounting Estimates 1.21 Opening entries, Closing entries, Transfer entries and Rectification entries 1.1 INTRODUCTION Business is an economic activity undertaken with the motive of earning profits and to maximize the wealth for the owners. Business cannot run in isolation. Largely, the business activity is 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 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. 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. It FUNDAMENTALS OF ACCOUNTING I 1.1 Accounting Process is a branch of social science. This study material aims at giving a platform to the students to understand basic principles and concepts, which can be applied to accurately measure performance of business. After studying the various chapters included herein, the student should be able to apply the principles, rules, conventions and practices to different business situations like trading, manufacturing or service. 1.2 DEFINITIONS Definition of Accounting Definition by 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”. Definition by the American Accounting Association (Year 1966): “The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the users of accounting”. (a) 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 book- keeping. These financial records are classified, summarized and reposted in the form of accounting measurements to the users of accounting information i.e., stakeholder. (iii) Ascertainment of Results of above Transactions ‘Profit/loss’ is a 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. 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) Ascertain the 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. 1.2 I FUNDAMENTALS OF ACCOUNTING (v) To Know the Solvency Position Balance sheet and profit and loss account prepared as above give useful information to stockholders regarding concerns potential to meet its obligations in the short run as well as in the long run. Providing Information to the Users for Rational Decision-making Systematic Recording of Transactions Ascertainment of Results of above Transactions Ascertain the Financial Position of Business To Know the Solvency Position Function of Accounting The main functions of accounting are as follows: (a) Measurement: Accounting measures past performance of the business entity and depicts its current financial position. (b) Forecasting: Accounting helps in forecasting future performance and financial position of the enterprise using past data. (c) Decision-making: Accounting provides relevant information to the users of accounts to aid rational decision-making. (d) Comparison & Evaluation: Accounting assesses performance achieved in relation to targets and discloses information regarding accounting policies and contingent liabilities which play an important role in predicting, comparing and evaluating the financial results. (e) Control: Accounting also identifies weaknesses of the operational system and provides feedbacks regarding effectiveness of measures adopted to check such weaknesses. (f) Government Regulation and Taxation: Accounting provides necessary information to the government to exercise control on die entity as well as in collection of tax revenues. Accounting – Classification The various sub-fields of the accounting are: ACCOUNTING Financial Cost Management Accounting Accounting Accounting 1. Financial Accounting Determining the financial results for Stewardship Accounting the period and the state of affairs on the last day the accounting period. 2. Cost Accounting Information generation for Controlling Control Accounting operations with a view to maximizing efficiency and profit. 3. Management Accounting Accounting to assist management in Decision Accounting planning and decision making. FUNDAMENTALS OF ACCOUNTING I 1.3 Accounting Process (a) Financial Accounting It is commonly termed as Accounting. The American Institute of Certified Public Accountants defines Accounting as “an art of recoding, classifying and summarizing in a significant manner and in terms of money, transactions and events which are in part at least of a financial character, and interpreting the results thereof.” (b) Cost Accounting According to the Chartered Institute of Management Accountants (CIMA), Cost Accountancy is defined as “application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability as well as the presentation of information for the purpose of managerial decision-making.” (c) Management Accounting Management Accounting is concerned with the use of Financial and Cost Accounting information to managers within organizations, to provide them with the basis in making informed business decisions that would allow them to be better equipped in their management and control functions. Difference between Management Accounting and Financial Accounting The significant difference between Management Accounting and Financial Accounting are : Management Accounting Financial Accounting 1. Management Accounting is primarily 1. Financial Accounting is based on the based on the data available from Financial monetary transactions of the enterprise. Accounting. 2. It provides necessary information to the 2. Its main focus is on recording and classifying management to assist them in the process monetary transactions in the books of of planning, controlling, performance accounts and preparation of financial evaluation and decision making. statements at the end of every accounting period. 3. Reports prepared in Management 3. Reports as per Financial Accounting are Accounting are meant for management meant for the management as well as for and as per management requirement. shareholders and creditors of the concern. 4. Reports may contain both subjective and 4. Reports should always be supported by objective figures. relevant figures and it emphasizes on the objectivity of data. 5. Reports are not subject to statutory audit. 5. Reports are always subject to statutory audit. 6. It evaluates the sectional as well as the 6. It ascertains , evaluates and exhibits the entire performance of the business. financial strength of the whole business. 1.3 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’. Book-keeping is an activity concerned with recording and classifying financial data related to business operation in order of its occurrence. Book-keeping is a mechanical task which involves: Collection of basic financial information. Identification of events and transactions with financial character i.e., economic transactions. Measurement of economic transactions in terms of money. 1.4 I FUNDAMENTALS OF ACCOUNTING Recording financial effects of economic transactions in order of its occurrence. Classifying effects of economic transactions. Preparing organized statement known as trial balance. The distinction between book-keeping and accounting is given below: Distinction between Book-keeping and Accounting Book-Keeping Accounting 1. Output of book-keeping is an input for 1. Output of accounting permit informed accounting. judgments and decisions by the user of accounting information. 2. Purpose of book-keeping is to keep 2. Purpose of accounting is to find results of systematic record of transactions and operating activity of business and to report events of financial character in order of its financial strength of business. occurrence. 3. Book-keeping is a foundation of 3. Accounting is considered as a language of accounting. business. 4. Book-keeping is carried out by junior staff. 4. Accounting is done by senior staff with skill of analysis and interpretation. 5. Objects of book-keeping is to summarize 5. Object of accounting is not only bookkeeping the cumulative effect of all economic but also analyzing and interpreting reported transactions of business for a given period financial information for informed decisions. by maintaining permanent record of each business transaction with its evidence and financial effects on accounting variable. 1.4 ACCOUNTING CYCLE When complete sequence of accounting procedure is done which happens frequently and repeated in same directions during an accounting period, the same is called an accounting cycle. Steps/Phases of Accounting Cycle The steps or phases of accounting cycle can be developed as under: Recording of Transaction Financial Journal Statement Closing Ledger Entries Adjusted Trial Trial Balance Balance Adjustment Entries ACCOUNTING CYCLE FUNDAMENTALS OF ACCOUNTING I 1.5 Accounting Process (a) Recording of Transaction : As soon as a transaction happens it is at first recorded in subsidiary book. (b) Journal : The transactions are recorded in Journal chronologically. (c) Ledger : All journals are posted into ledger chronologically and in a classified manner. (d) Trial Balance : After taking all the ledger account closing balances, a Trial Balance is prepared at the end of the period for the preparations of financial statements. (e) Adjustment Entries : All the adjustments entries are to be recorded properly and adjusted accordingly before preparing financial statements. (f) Adjusted Trial Balance : An adjusted Trail Balance may also be prepared. (g) Closing Entries : All the nominal accounts are to be closed by the transferring to Trading Account and Profit and Loss Account. (h) Financial Statements : Financial statement can now be easily prepared which will exhibit the true financial position and operating results. 1.5 BASIC ACCOUNTING TERMS In order to understand the subject matter clearly, one must grasp the following common expressions always used in business accounting. The aim here is to enable the student to understand with these often used concepts before we embark on accounting procedures and rules. You may note that these terms can be applied to any business activity with the same connotation. (i) Transaction: It means an event or a business activity which involves exchange of money or money’s worth between parties. The event can be measured in terms of money and changes the financial position of a person e.g. purchase of goods would involve receiving material and making payment or creating an obligation to pay to the supplier at a future date. Transaction could be a cash transaction or credit transaction. When the parties settle the transaction immediately by making payment in cash or by cheque, it is called a cash transaction. In credit transaction, the payment is settled at a future date as per agreement between the parties. (ii) Goods/Services : These are tangible article or commodity in which a business deals. These articles or commodities are either bought and sold or produced and sold. At times, what may be classified as ‘goods’ to one business firm may not be ‘goods’ to the other firm. e.g. for a machine manufacturing company, the machines are ‘goods’ as they are frequently made and sold. But for the buying firm, it is not ‘goods’ as the intention is to use it as a long term resource and not sell it. Services are intangible in nature which are rendered with or without the object of earning profits. (iii) Profit: The excess of Revenue Income over expense is called profit. It could be calculated for each transaction or for business as a whole. (iv) Loss: The excess of expense over income is called loss. It could be calculated for each transaction or for business as a whole. (v) Asset: Asset is a resource owned by the business with the purpose of using it for generating future profits. Assets can be Tangible and Intangible. Tangible Assets are the Capital assets which have some physical existence. They can, therefore, be seen, touched and felt, e.g. Plant and Machinery, Furniture and Fittings, Land and Buildings, Books, Computers, Vehicles, etc. The capital assets which have no physical existence and whose value is limited by the rights and anticipated benefits that possession confers upon the owner are known as lntangible Assets. They cannot be seen or felt although they help to generate revenue in future, e.g. Goodwill, Patents, Trade-marks, Copyrights, Brand Equity, Designs, Intellectual Property, etc. Assets can also be classified into Current Assets and Non-Current Assets. 1.6 I FUNDAMENTALS OF ACCOUNTING Current Assets – An asset shall be classified as Current when it satisfies any of the following : (a) It is expected to be realised in, or is intended for sale or consumption in the Company’s normal Operating Cycle, (b) It is held primarily for the purpose of being traded , (c) It is due to be realised within 12 months after the Reporting Date, or (d) It is Cash or Cash Equivalent unless it is restricted from being exchanged or used to settle a Liability for at least 12 months after the Reporting Date. Non-Current Assets – All other Assets shall be classified as Non-Current Assets. e.g. Machinery held for long term etc. (vi) Liability: It is an obligation of financial nature to be settled at a future date. It represents amount of money that the business owes to the other parties. E.g. when goods are bought on credit, the firm will create an obligation to pay to the supplier the price of goods on an agreed future date or when a loan is taken from bank, an obligation to pay interest and principal amount is created. Depending upon the period of holding, these obligations could be further classified into Long Term on non-current liabilities and Short Term or current liabilities. Current Liabilities – A liability shall be classified as Current when it satisfies any of the following : (a) It is expected to be settled in the Company’s normal Operating Cycle, (b) It is held primarily for the purpose of being traded, (c) It is due to be settled within 12 months after the Reporting Date, or (d) The Company does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date (Terms of a Liability that could, at the option of the counterparty, result in its settlement by the issue of Equity Instruments do not affect its classification) Non-Current Liabilities – All other Liabilities shall be classified as Non-Current Liabilities. E.g. Loan taken for 5 years, Debentures issued etc. (vii) Internal Liability : These represent proprietor’s equity, i.e. all those amount which are entitled to the proprietor, e.g., Capital, Reserves, Undistributed Profits, etc. (viii) Working Capital : In order to maintain flows of revenue from operation, every firm needs certain amount of current assets. For example, cash is required either to pay for expenses or to meet obligation for service received or goods purchased, etc. by a firm. On identical reason, inventories are required to provide the link between production and sale. Similarly, Accounts Receivable generate when goods are sold on credit. Cash, Bank, Debtors, Bills Receivable, Closing Stock, Prepayments etc. represent current assets of firm. The whole of these current assets form the working capital of a firm which is termed as Gross Working Capital. Gross Working capital = Total Current Assets = Long term internal liabilities plus long term debts plus the current liabilities minus the amount blocked in the fixed assets. There is another concept of working capital. Working capital is the excess of current assets over current liabilities. That is the amount of current assets that remain in a firm if all its current liabilities are paid. This concept of working capital is known as Net Working Capital which is a more realistic concept. Working Capital (Net) = Current Assets – Currents Liabilities. (ix) Contingent Liability : It represents a potential obligation that could be created depending on the outcome of an event. E.g. if supplier of the business files a legal suit, it will not be treated as a liability because no obligation is created immediately. If the verdict of the case is given in favour of the FUNDAMENTALS OF ACCOUNTING I 1.7 Accounting Process supplier then only the obligation is created. Till that it is treated as a contingent liability. Please note that contingent liability is not recorded in books of account, but disclosed by way of a note to the financial statements. (x) Capital : It is amount invested in the business by its owners. It may be in the form of cash, goods, or any other asset which the proprietor or partners of business invest in the business activity. From business point of view, capital of owners is a liability which is to be settled only in the event of closure or transfer of the business. Hence, it is not classified as a normal liability. For corporate bodies, capital is normally represented as share capital. (xi) Drawings : It represents an amount of cash, goods or any other assets which the owner withdraws from business for his or her personal use. e.g. if the life insurance premium of proprietor or a partner of business is paid from the business cash, it is called drawings. Drawings will result in reduction in the owners’ capital. The concept of drawing is not applicable to the corporate bodies like limited companies. (xii) Net worth : It represents excess of total assets over total liabilities of the business. Technically, this amount is available to be distributed to owners in the event of closure of the business after payment of all liabilities. That is why it is also termed as Owner’s equity. A profit making business will result in increase in the owner’s equity whereas losses will reduce it. (xiii) Non-current Investments : Non-current Investments are investments which are held beyond the current period as to sale or disposal. e. g. Fixed Deposit for 5 years. (xiv) Current Investments : Current investments are investments that are by their nature readily realizable and are intended to be held for not more than one year from the date on which such investment is made. e. g. 11 months Commercial Paper. (xv) Debtor : The sum total or aggregate of the amounts which the customer owe to the business for purchasing goods on credit or services rendered or in respect of other contractual obligations, is known as Sundry Debtors or Trade Debtors, or Trade Payable, or Book-Debts or Debtors. In other words, Debtors are those persons from whom a business has to recover money on account of goods sold or service rendered on credit. These debtors may again be classified as under: (i) Good debts : The debts which are sure to be realized are called good debts. (ii) Doubtful Debts : The debts which may or may not be realized are called doubtful debts. (iii) Bad debts : The debts which cannot be realized at all are called bad debts. It must be remembered that while ascertaining the debtors balance at the end of the period certain adjustments may have to be made e.g. Bad Debts, Discount Allowed, Returns Inwards, etc. (xvi) Creditor : A creditor is a person to whom the business owes money or money’s worth. e.g. money payable to supplier of goods or provider of service. Creditors are generally classified as Current Liabilities. (xvii) Capital Expenditure : This represents expenditure incurred for the purpose of acquiring a fixed asset which is intended to be used over long term for earning profits there from. e. g. amount paid to buy a computer for office use is a capital expenditure. At times expenditure may be incurred for enhancing the production capacity of the machine. This also will be a capital expenditure. Capital expenditure forms part of the Balance Sheet. (xviii) Revenue expenditure : This represents expenditure incurred to earn revenue of the current period. The benefits of revenue expenses get exhausted in the year of the incurrence. e.g. repairs, insurance, salary & wages to employees, travel etc. The revenue expenditure results in reduction in profit or surplus. It forms part of the Income statement. (xix) Balance Sheet : It is the statement of financial position of the business entity on a particular date. It lists all assets, liabilities and capital. It is important to note that this statement exhibits the state of affairs of the business as on a particular date only. It describes what the business owns and what the business owes to outsiders (this denotes liabilities) and to the owners (this denotes capital). It is prepared after incorporating the resulting profit/losses of Income statement. 1.8 I FUNDAMENTALS OF ACCOUNTING (xx) Profit and Loss Account or Income Statement : This account shows the revenue earned by the business and the expenses incurred by the business to earn that revenue. This is prepared usually for a particular accounting period, which could be a month, quarter, a half year or a year. The net result of the Profit and Loss Account will show profit earned or loss suffered by the business entity. (xxi) Trade Discount : It is the discount usually allowed by the wholesaler to the retailer computed on the list price or invoice price. e.g. the list price of a TV set could be ` 15000. The wholesaler may allow 20% discount thereof to the retailer. This means the retailer will get it for ` 12000 and is expected to sale it to final customer at the list price. Thus the trade discount enables the retailer to make profit by selling at the list price. Trade discount is not recorded in the books of accounts. The transactions are recorded at net values only. In above example, the transaction will be recorded at ` 12000 only. (xxii) Cash Discount : This is allowed to encourage prompt payment by the debtor. This has to be recorded in the books of accounts. This is calculated after deducting the trade discount. e.g. if list price is ` 15000 on which a trade discount of 20% and cash discount of 2% apply, then first trade discount of ` 3000 (20% of ` 15000) will be deducted and the cash discount of 2% will be calculated on ` 12000 (`15000 – ` 3000). Hence the cash discount will be ` 240 (2% of ` 12000) and net payment will be ` 11,760 (`12,000 - ` 240) Illustration 1. Fill in the blanks: (a) The cash discount is allowed by ———— to the —————. (b) Profit means excess of ——— over —————. (c) Debtor is a person who ——— to others. (d) In a credit transaction, the buyer is given a ——— facility. (e) The fixed asset is generally held for —————. (f) The current liabilities are obligations to be settled in ——— period. (g) The withdrawal of money by the owner of business is called ———— (h) The amount invested by owners into business is called —————. (i) Transaction means exchange of money or money’s worth for ————. (j) The net result of an income statement is ———— or ————. (k) The ——————— shows financial position of the business as on a particular date. (l) The ————— discount is never entered in the books of accounts. (m) Vehicles represent ———— expenditure while repairs to vehicle would mean ————— expenditure. (n) Net worth is excess of —— ——— over ——— ———. Solution: (a) creditor, debtor (b) income, expenditure (c) Owes (d) Credit (e) Longer period (f) Short (g) Drawings (h) Capital (i) Value FUNDAMENTALS OF ACCOUNTING I 1.9 Accounting Process (j) Profit, loss (k) Balance sheet (l) Trade (m) Capital, revenue (n) Total assets, total liabilities Illustration 2. Give one word or a term used to describe the following:- (a) An exchange of benefit for value (b) A transaction without immediate cash settlement. (c) Commodities in which a business deals. (d) Excess of expenditure over income. (e) Things of value owned by business to earn future profits. (f) Amount owed by business to others. (g) An obligation which may or may not materialise. (h) An allowance by a creditor to debtor for prompt payment. (i) Assets like brand value, copy rights, goodwill Solution: (a) Transaction, (b) credit transaction, (c) goods, (d) loss, (e) Assets, (f) liability, (g) contingent liability, (h) cash discount, (i) intangible assets 1.6. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES A widely accepted set of rules, conventions, standards, and procedures for reporting financial information, as established by the Financial Accounting Standards Board are called Generally Accepted Accounting Principles (GAAP). These are the common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information. GAAP is to be followed by companies so that investors have a optimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover such aspects like revenue recognition, balance sheet item classification and outstanding share measurements. 1.7 ACCOUNTING CONCEPTS AND CONVENTIONS As seen earlier, the accounting information is published in the form of financial statements. The three basic financial statements are (i) The Profit & Loss Account that shows net business result i.e. profit or loss for a certain periods (ii) The Balance Sheet that exhibits the financial strength of the business as on a particular dates (iii) The Cash Flow Statement that describes the movement of cash from one date to the other. As these statements are meant to be used by different stakeholders, it is necessary that the information contained therein is based on definite principles, concrete concepts and well accepted convention. Accounting principles are basic guidelines that provide standards for scientific accounting practices and procedures. They guide as to how the transactions are to be recorded and reported. They assure uniformity and understandability. Accounting concepts lay down the foundation for accounting principles. They are ideas essentially at mental level and are self-evident. These concepts ensure 1.10 I FUNDAMENTALS OF ACCOUNTING recording of financial facts on sound bases and logical considerations. Accounting conventions are methods or procedures that are widely accepted. When transactions are recorded or interpreted, they follow the conventions. Many times, however, the terms-principles, concepts and conventions are used interchangeably. Professional Accounting Bodies have published statements of these concepts. Over years, many of these concepts are being challenged as outlived. Yet, no major deviations have been made as yet. Path breaking ideas have emerged and the accounting standards of modern days do require companies to record and report transactions which may not be necessarily based on concepts that are in vogue for long. It is essential to study accounting from the basic levels and understand these concepts in entirety. Theory Base of Accounting Modifying Basic Assumptions Basic Principles Principles (a) Basic Principles (a) Revenue Realization Concept (a) Materiality Concept (b) Going Concern Concept (b) Matching Concept (b) Consistency Concept (c) Money Measurement Concept (c) Full Disclosure Concept (c) Conservatism Concept (d) Accounting Period Concept (d) Dual Aspect Concept (d) Timeliness Concept (e) Accrual Concept (e) Verifiable Objective Evidence Concept (e) Industry Practice Concept (f) Historical Cost Concept (g) Balance Sheet Equation Concept A. BASIC ASSUMPTIONS (a) Business Entity Concept This concept explains that the business is distinct from the proprietor. Thus, the transactions of business only are to be recorded in the books of business. (b) Going Concern Concept This concept assumes that the business has a perpetual succession or continued existence. (c) Money Measurement Concept According to this concept only those transactions which are expressed in money terms are to be recorded in accounting books. (d) The Accounting Period Concept Businesses are living, continuous organisms. The splitting of the continuous stream of business events into time periods is thus somewhat arbitrary. There is no significant change just because one accounting period ends and a new one begins. This results into the most difficult problem of accounting of how to measure the net income for an accounting period. One has to be careful in recognizing revenue and expenses for a particular accounting period. Subsequent section on accounting procedures will explain how one goes about it in practice. (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. Today’s accounting systems based on accrual concept are called as Accrual system or mercantile system of accounting. FUNDAMENTALS OF ACCOUNTING I 1.11 Accounting Process B. BASIC PRINCIPLES (a) Realization Concept This concept speaks about recording of only those transactions which are actually realized. For example Sale or Profit on sales will be taken into account only when money is realized i.e. either cash is received or legal ownership is transferred. (b) Matching Concept It is referred to as matching of expenses against incomes. It means that all incomes and expenses relating to the financial period to which the accounts relate should be taken in to account without regard to the date of receipts or payment. (c) Full Disclosure Concept As per this concept, all significant information must be disclosed. Accounting data should properly be clarified, summarized, aggregated and explained for the purpose of presenting the financial statements which are useful for the users of accounting information. Practically, this principle emphasizes on the materiality, objectivity and consistency of accounting data which should disclose the true and fair view of the state of affairs of a firm. (d) Duality Concept According to this concept every transaction has two aspects i.e. the benefit receiving aspect and benefit giving aspect. These two aspects are to be recorded in the books of accounts. (e) Verifiable Objective Evidence Concept Under this principle, accounting data must be verified. In other words, documentary evidence of transactions must be made which are capable of verification by an independent respect. In the absence of such verification, the data which will be available will neither be reliable nor be dependable, i.e., these should be biased data. Verifiability and objectivity express dependability, reliability and trustworthiness that are very useful for the purpose of displaying the accounting data and information to the users. (f) Historical Cost Concept Business transactions are always recorded at the actual cost at which they are actually undertaken. The basic advantage is that it avoids an arbitrary value being attached to the transactions. Whenever an asset is bought, it is recorded at its actual cost and the same is used as the basis for all subsequent accounting purposes such as charging depreciation on the use of asset, e.g. if a production equipment is bought for ` 1.50 crores, the asset will be shown at the same value in all future periods when disclosing the original cost. It will obviously be reduced by the amount of depreciation, which will be calculated with reference to the actual cost. The actual value of the equipment may rise or fall subsequent to the purchase, but that is considered irrelevant for accounting purpose as per the historical cost concept. The limitation of this concept is that the balance sheet does not show the market value of the assets owned by the business and accordingly the owner’s equity will not reflect the real value. However, on an ongoing basis, the assets are shown at their historical costs as reduced by depreciation. (g) Balance Sheet Equation Concept Under this principle, all which has been received by us must be equal to that has been given by us and needless to say that receipts are clarified as debits and giving is clarified as credits. The basic equation, appears as :- Debit = Credit Naturally every debit must have a corresponding credit and vice-e-versa. So, we can write the above in the following form – Expenses + Losses + Assets = Revenues + Gains + Liabilities 1.12 I FUNDAMENTALS OF ACCOUNTING And if expenses and losses, and incomes and gains are set off, the equation takes the following form – Asset = Liabilities or, Asset = Equity + External Liabilities i.e., the Accounting Equation. C. MODIFYING PRINCIPLES (a) The Concept of Materiality The materiality could be related to information, amount, procedure and nature. Error in description of an asset or wrong classification between capital and revenue would lead to materiality of information. Say, If postal stamps of ` 500 remain unused at the end of accounting period, the same may not be considered for recognizing as inventory on account of materiality of amount. Certain accounting treatments depend upon procedures laid down by accounting standards. Some transactions are by nature material irrespective of the amount involved. e.g. audit fees, loan to directors. (b) Consistency Concept This Concept says that the Accounting practices should not change or must remain unchanged over a period of several years. (c) Conservatism Concept Conservatism concept states that when alternative valuations are possible, One should select the alternative which fairly represents economic substance of transactions but when such choice is not clear select the alternative that is least likely to overstate net assets and net income. It provides for all known expenses and losses by best estimates if amount is not known with certainty, but does not recognizes revenues and gains on the basis of anticipation. (d) Timeliness Concept Under this principle, every transaction must be recorded in proper time. Normally, when the transaction is made, the same must be recorded in the proper books of accounts. In short, transaction should be recorded date-wise in the books. Delay in recording such transaction may lead to manipulation, misplacement of vouchers, misappropriation etc. of cash and goods. This principle is followed particularly while verifying day to day cash balance. Principle of timeliness is also followed by banks, i.e. every bank verifies the cash balance with their cash book and within the day, the same must be completed. (e) Industry Practice As that are different types of industries, each industry has its own characteristics and features. There may be seasonal industries also. Every industry follows the principles and assumption of accounting to perform their own activities. Some of them follow the principles, concepts and conventions in a modified way. The accounting practice which has always prevailed in the industry is followed by it. e.g Electric supply companies, Insurance companies maintain their accounts in a specific manner. Insurance companies prepare Revenue Account just to ascertain the profit/loss of the company and not Profit and Loss Account. Similarly, non trading organizations prepare Income and Expenditure Account to find out Surplus or Deficit. FUNDAMENTALS OF ACCOUNTING I 1.13 Accounting Process 1.8 EVENTS AND TRANSACTIONS Transaction: Transaction is exchange of an asset and discharge of liabilities with consideration of monetary value. Events: While event is anything in general purpose which occur at specific time and particular place. We can also say that all transactions are events and but all events are not transactions. This is because in order events to be called transaction an event must involve exchange of values. 1.9 VOUCHER Voucher: It is a written instrument that serves to confirm or witness (vouch) for some fact such as a transaction. A voucher is a document that shows goods have bought or services have been rendered, authorizes payment, and indicates the ledger account(s) in which these transactions have to be recorded. Types of Voucher Receipt Payment Non-Cash or Transfer Supporting Voucher Voucher Voucher Voucher (i) Receipt Voucher Receipt voucher is used to record cash or bank receipt. Receipt vouchers are of two types. i-e. (a) Cash receipt voucher – it denotes receipt of cash (b) Bank receipt voucher – it indicates receipt of cheque or demand draft (ii) Payment Voucher Payment voucher is used to record a payment of cash or cheque. Payment vouchers are of two types. i.e. (a) Cash Payment voucher – it denotes payment of cash (b) Bank Payment voucher – it indicates payment by cheque or demand draft. (iii) Non Cash Or Transfer Voucher These vouchers are used for non-cash transactions as documentary evidence. e.g., Goods sent on credit. (iv) Supporting Vouchers These vouchers are the documentary evidence of transactions that have happened. 1.10 DOUBLE ENTRY SYSTEM Double Entry System It was in 1494 that Luca Pacioli the Italian mathematician, first published his comprehensive treatise on the principles of Double Entry System. The use of principles of double entry system made it possible to record not only cash but also all sorts of Mercantile transactions. It had created a profound impact on auditing too, because it enhanced the duties of an auditor to a considerable extent. 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. 1.14 I FUNDAMENTALS OF ACCOUNTING (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. Advantages of Double Entry System (i) Since personal and impersonal accounts are maintained under the double entry system, both the effects of the transactions are recorded. (ii) It ensures arithmetical accuracy of the books of accounts, 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. (iii) It prevents and minimizes frauds. Moreover frauds can be detected early. (iv) Errors can be checked and rectified easily. (v) The balances of receivables and payables are determined easily, since the personal accounts are maintained. (vi) The businessman can compare the financial position of the current year with that of the past year/s. (vii) The businessman can justify the standing of his business in comparison with the previous years purchase, sales, and stocks, incomes and expenses with that of the current year figures. (viii) Helps in decision making. (ix) The net operating results can be calculated by preparing the Trading and Profit and Loss A/c for the year ended and the financial position can be ascertained by the preparation of the Balance Sheet. (x) It becomes easy for the Government to decide the tax. (xi) It helps the Government to decide sickness of business units and extend help accordingly. (xii) The other stakeholders like suppliers, banks, etc take a proper decision regarding grant of credit or loans. 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. (ii) It is costly as it involves maintenance of numbers of books of accounts. 1.11 THE CONCEPTS OF ‘ACCOUNT’, ‘DEBIT’ AND ‘CREDIT’ The 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 things – both tangible and intangible. e.g. land, building, equipment, brand value, trademarks etc are some of the things. When a business transaction happens, one has to identify the ‘account’ that will be affected by it and then apply the rules to decide the accounting treatment. 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 is denoted as ‘Dr’ and the credit by ‘Cr’. The convention is to write the Dr and Cr labels on both sides as shown below. Please see the following example: Dr. Cash Account Cr. Debit side Credit side FUNDAMENTALS OF ACCOUNTING I 1.15 Accounting Process 1.12 TYPES OF ACCOUNTS Let us see what each type of account means. (1) Personal Account : As the name suggests these are accounts related to persons. (a) These persons could be natural persons like Suresh’s A/c, Anil’s a/c, Rani’s A/c etc. (b) The persons could also be artificial persons like companies, bodies corporate or association of persons or partnerships etc. Accordingly, we could have Videocon Industries A/c, Infosys Technologies A/c, Charitable Trust A/c, Ali and Sons trading A/c, ABC Bank A/c, etc. (c) There could be representative personal accounts as well. Although the individual identity of persons related to these is known, the convention is to reflect them as collective accounts. e.g. when salary is payable to employees, we know how much is payable to each of them, but collectively the account is called as ‘Salary Payable A/c’. Similar examples are rent payable, Insurance prepaid, commission pre-received etc. The students should be careful to have clarity on this type and the chances of error are more here. (2) Real Accounts : These are accounts related to assets or properties or possessions. Depending on their physical existence or otherwise, they are further classified as follows:- (a) Tangible Real Account – 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. (b) 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. (3) Nominal Account : These accounts are related to expenses or losses and incomes or gains e.g. Salary and Wages A/c, Rent of Rates A/c, Travelling Expenses A/c, Commission received A/c, Loss by fire A/c etc. The concept of Debit and Credit In double entry book-keeping, debits and credits (abbreviated Dr and Cr, respectively) are entries made in account ledgers to record changes in value due to business transactions. Debit is derived from the latin word “debitum”, which means ‘what we will receive’. It is the destination, who enjoys the benefit. Credit is derived from the latin word “credre” which means ‘what we will have to pay’. It is the source, who sacrifices for the benefit. The source account for the transaction is credited (an entry is made on the right side of the account’s ledger) and the destination account is debited (an entry is made on the left). 1.16 I FUNDAMENTALS OF ACCOUNTING Each transaction’s debit entries must equal its credit entries. The difference between the total debits and total credits in a single account is the account’s balance. If debits exceed credits, the account has a debit balance; if credits exceed debits, the account has a credit balance. 1.13 THE ACCOUNITNG PROCESS There are two approaches for deciding an account is debited or credit. 1. American Approach 2. British Approach or or Modern Approach Accounting Proces Traditional Approach Mostly followed the British Rule. A. American approach : In order to understand the rules of debit and credit according to this approach transactions are divided into the following five categories: (i) Transactions relating to owner, e.g., Capital – These are personal accounts (ii) Transactions relating to other liabilities, e.g., suppliers of goods – These are mostly personal accounts (iii) Transactions relating to assets, e.g., land, building, cash, bank, stock-in-trade, bills receivable – These are basically all real accounts (iv) Transactions relating to expenses, e.g., rent, salary, commission, wages, cartage – These are nominal accounts (v) Transactions relating to revenues, e.g., interest received, dividend received, sale of goods – These are nominal accounts To Sum Up For Assets Increase in Assets Dr. Decrease in Assets Cr. For Liabilities Decrease in Liabilities Dr. Increase in Liabilities Cr. For Capital Decrease in Capital Dr. Increase in Capital Cr. For Incomes Decrease in Income Dr. Increase in Income Cr. For Expense Increase in Expense Dr. Decrease in Expense Cr. For Stock Increase in Stock Dr. Decrease in Stock Cr. B. British Approach or Double Entry System : When one identifies the account that is getting affected by a transaction and type of that account, the next step is to apply the rules to decide whether the accounting treatment is to debit or credit that account. The Golden Rules will guide us whether the account is to be debited or credited. FUNDAMENTALS OF ACCOUNTING I 1.17 Accounting Process These rules are shown below: Personal Account Debit the receiver or who owes to business Credit the giver or to whom business owes Real Account Debit what comes into business Credit what goes out of business Debit all expenses or losses Nominal Account Credit all income or gains Illustration 3. 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. 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 1.18 I FUNDAMENTALS OF ACCOUNTING Illustration 4. Ascertain the Debit Credit under British Approach or Double Entry System. Take 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 1.14 ACCOUNTING EQUATION The whole Financial Accounting dependes on Accounting Equation which is also known as Balance Sheet Equation. The basic Accounting Equation is: Assets = Liabilities + Owner’s equity or A = L + P or P = A - L or L = A - P } Where A = Assets, L = Liabilities, P = Capital While trying to do this correlation, please note that incomes or gains will increase owner’s equity and expenses or losses will reduce it. Students are advised to go through the following illustration to understand this equation properly. Illustration 5. Prepare an Accounting Equation from the following transactions in the books of Mr. X for January, 2012 :- 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 30 Received interest ` 5,000 31 Paid wages ` 3,000 FUNDAMENTALS OF ACCOUNTING I 1.19 Accounting Process Solution: Effect of transaction on Assets, Liabilities and Capital Date Transaction Assets = Liabilities + Capital January, 2013 Invested Capital in the firm ` 20,000 20,000 - 20,000 1 2 Purchased goods on credit from Das & Co. ` 2,000 +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 +6,000 ` 2,000) -4,000 +2,000 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 1.15 ACCRUAL BASIS AND CASH BASIS OF ACCOUNTING Accounting Accrual Cash Basis Basis Accounting 1.20 I FUNDAMENTALS OF ACCOUNTING (i) Accrual Basis of Accounting Accrual Basis of Accounting is a method of recording transactions by which revenue, costs, assets and liabilities are reflected in the accounts for the period in which they accrue. This basis includes consideration relating to deferrals, allocations, depreciation and amortization. This basis is also referred to as mercantile basis of accounting. (ii) Cash Basis of Accounting Cash Basis of Accounting is a method of recording transactions by which revenues, costs, assets and liabilities are reflected in the accounts for the period in which actual receipts or actual payments are made. Distinction between Accrual Basis of Accounting and Cash Basis of Accounting Basis of Distinction Accrual Basis of Accounting Cash Basis of Accounting 1. Prepaid/Outstanding Expenses/ Under this, there may be Under this, there is no accrued/unaccrued Income in prepaid/outstanding expenses prepaid/outstanding Balance Sheet. and accrued/unaccrued expenses or accrued/ incomes in the Balance Sheet. unaccrued incomes. 2. Higher/lower Income in case of Income Statement will show a Income Statement will prepaid expenses and accrued relatively higher income show lower income. income 3. Higher/lower income incase Income Statement will show a Income Statement will of outstanding expenses and relatively lower income. show higher income. unaccrued income 4. Availability of options to an Under this, an accountant has Under this an accountant accountant to manipulate the options. has no option to make a accounts by way of choosing the choice as such. most suitable method out of several alternative methods of accounting e.g. FIFO/LIFO/SLM/WDV Hybrid or Mixed Basis Under the hybrid system of accounting, incomes are recognised as in Cash Basis Accounting i.e. when they are received in cash and expenses are recognised on accrual basis i.e. during the accounting period in which they arise irrespective of when they are paid. Illustration 6. Mr. Anil Roy, a junior lawyer, provides the following particulars for the year ended 31st December, 2013: ` Fees received in cash in 2013 60,000 Salary paid to Staff in 2013 8,000 Rent of office in 2013 14,000 Magazine and Journal for 2013 1,000 Travelling and Conveyance paid in 2013 3,000 Membership Fees paid in 2013 1,600 Office Expenses paid in 2013 10,000 Additional Information:- Fees include ` 3,000 in respect of 2012and fees not yet received is ` 7,000. Office rent includes ` 4,000 for previous year and rent of ` 2,000 not yet paid. Membership fees is paid for 2 years. Compute his net income for the year 2013, under – (a) Cash Basis, (b) Accrual Basis and (c) Mixed or Hybrid Basis. FUNDAMENTALS OF ACCOUNTING I 1.21 Accounting Process Solution: (i) Mr. Anil Roy Statement of Income (Cash Basis) For the year ended 31st December, 2013 Particulars Amount (`) Amount (`) Fees received 60,000 Less : Salary 8,000 Office Rent 14,000 Magazine & Journal 1,000 Travelling & Conveyance 3,000 Membership Fees 1,600 Office Expenses 10,000 37,600 Net Income 22,400 (ii) Mr. Anil Roy Statement of Income (Accrual Basis) For the year ended 31st December, 2013 Particulars Amount (`) Amount (`) Fees received 60,000 Add: Accrued fees for 2013 7,000 67,000 Less: Fees for 2012 received in 2013 3,000 64,000 Less : Salary 8,000 Office Rent 14,000 Add: Outstanding rent 2,000 16,000 Less: Rent for 2012 paid in 2013 4,000 12,000 Magazine & Journal 1,000 Travelling & Conveyance 3,000 Membership Fees 1,600 Less: Advance fee paid for 2014 ( ½ x 1600) 800 800 Office Expenses 10,000 34,800 Net Income 29,200 1.22 I FUNDAMENTALS OF ACCOUNTING (iii) Mr. Anil Roy Statement of Income (Mixed or Hybrid Basis) For the year ended 31st December, 2013 Particulars Amount (`) Amount (`) Amount (`) Fees received 60,000 Less : Salary 8,000 Office Rent 14,000 Add: Outstanding rent 2,000 16,000 Less: Fees for 2012 4,000 12,000 Magazine & Journal 1,000 Travelling & Conveyance 3,000 Membership Fees 1,600 Less: Advance 800 800 Office Expenses 10,000 34,800 Net Income 25,200 1.16 CAPITAL AND REVENUE TRANSACTIONS There are 2 types of Transaction 1. Capital 2. Revenue The concepts of capital and revenue are of fundamental importance to the correct determination of accounting profit for a period and recognition of business assets at the end of that period. Capital Transactions: Transactions having long-term effect are known as capital transactions. Revenue Transactions: Transactions having short-term effect are known as revenue transactions. Capital Expenditure Capital expenditure can be defined as expenditure incurred on the purchase, alteration or improvement of fixed assets. For example, the purchase of a car to be use to deliver goods is capital expenditure. Included in capital expenditure are such costs as: Delivery of fixed assets; Installation of fixed assets; Improvement (but not repair) of fixed assets; Legal costs of buying property; Demolition costs; Architects fees; FUNDAMENTALS OF ACCOUNTING I 1.23 Accounting Process Revenue Expenditures Revenue expenditure is expenditure incurred in the running / management of the business. For example, the cost of petrol or diesel for cars is revenue expenditure. Other revenue expenditure: Maintenance of Fixed Assets; Administration of the business; Selling and distribution expenses. Capitalized Expenditure Expenditure connected with the purchase of fixed asset are called capitalized expenditure e.g. wages paid for the installation of machinery. The Treatments of Capital and Revenue Expenditures Capital expenditures are shown in the Balance Sheet Assets Side while Revenue Expenditures are shown in the Trading and Profit And Loss Account debit side. Revenue Receipts Amount received against revenue income are called revenue receipt. Capital Receipts Amount received against capital income are called capital receipts. Capital Profits Capital profit which is earned on the sale of the fixed assets. Revenue Profit The profit which is earned during the ordinary course of business is called revenue profit. Capital Loss The loss suffered by a company on the sale of fixed assets. Revenue Loss The loss suffered by the business in the ordinary course of business is called revenue loss. Rules for Determining Capital Expenditure An expenditure can be recognised 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 recognised as a capital expenditure. The expenditure is capitalised 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 upto ` 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 will be considered as of capital nature. 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. 1.24 I FUNDAMENTALS OF ACCOUNTING 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. Thus, one useful way of recognising an expenditure as capital is to see that 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 recognised 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 recognised 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. 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. Deferred Revenue Expenditures Deferred revenue expenditures represent certain types of assets whose usefulness does not expire in the year of their occurrence but generally expires in the near future. These type of expenditures are carried forward and are written off in future accounting periods. Sometimes, we make some revenue expenditure but it eventually becomes a capital asset (generally of an intangible nature). If one undertake substantial repairs to the existing building, the deterioration of the premises may be avoided. We may engage our own employees to do that work and pay them at prevailing wage-rate, which is of a revenue nature. If this expenditure is treated as a revenue expenditure and the current year’s-profit is charged with these expenses, we are making the current year to absorb the entire expenses, though the benefit of which will be enjoyed for a number of accounting years. To overcome this difficulty, the entire expenditure is capitalised and is added to the asset account. Another example is an insurance policy. A business can pay insurance premium in advance, say, for a 3 year period. The right does not expire in the accounting period in which it is paid but will expire within a fairly short period of time (3 years). Only a portion of FUNDAMENTALS OF ACCOUNTING I 1.25 Accounting Process the total premium paid should be treated as a revenue expenditure (portion pertaining to the current period) and the balance should be carried forward as an asset to be written off in subsequent years. AS 26 - Intangible Asset does not accept this view. Para 56 states, “Expenditure incurred to provide future economic benefit to an enterprise that can be recognized as an expense when it is incurred. e.g. expenditure incurred on Scientific Research is recognized as an expense when it is incurred”. In short, the whole amount of expenditure is treated as expense for the current year only and will not proportionately be transferred as deferred charge. Illustration 8. 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 9. 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 under taken 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. Illustration 10. 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. 1.26 I FUNDAMENTALS OF ACCOUNTING 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 only 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 11. 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. Illustration 12. 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 ` (4,000+1,000)the cost of new fixture will be ` 4,100. (iii) Painting of the factory should be treated as a Revenue Expenditure because it has been incurred to maintain the factory building. FUNDAMENTALS OF ACCOUNTING I 1.27 Accounting Process (iii) 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 13. State the nature (capital or revenue) of the following expenditure which were incurred by Vedanta & Co. during the year ended 30th June, 2013 : (i) ` 350 was spent on repairing a second hand machine which was purchased on 8th May, 2013 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

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