Intermediate Financial Accounting Study Notes PDF 2022

INTERMEDIATE Paper 6 Financial 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 Reprint :...

INTERMEDIATE Paper 6 Financial 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 Reprint : November 2022 Reprint : January 2023 Reprint : March 2023 Reprint : June 2023 Reprint : August 2023 Reprint : January 2024 Reprint : March 2024 Reprint : May 2024 : July 2024 Price : ₹ 600.00 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. Infinity Advertising Services Pvt. Ltd. Plot No. 171 & 172, Sector-58, Faridabad, Haryana - 121004 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 © 2024 by The Institute of Cost Accountants of India  PAPER 6 : FINANCIAL ACCOUNTING Syllabus Structure: The syllabus comprises the following topics and study weightage: Module No. Module Description Weight Section A: Accounting Fundamentals 15% 1 Accounting Fundamentals 15% Section B: Accounting for Special Transactions 10% 2 Bills of Exchange, Consignment, Joint Venture 10% Section C: Preparation of Financial Statements 20% Preparation of Final Accounts of Commercial Organisations, Not-for-Profit 20% 3 Organisations and from Incomplete Records Section D: Partnership Accounting 20% 4 Partnership Accounting 20% Section E: Lease, Branch and Departmental Accounts etc. 15% 5 Lease Accounting 6 Branch (including Foreign Branch) and Departmental Accounts 15% 7 Insurance Claim for Loss of Stock and Loss of Profit 8 Hire Purchase and Installment Sale Transactions Section F: Accounting Standards 20% 9 Accounting Standards 20% A F 15% 20% B 10% E 15% C 20% D 20%  Learning Environment – Paper 6 Subject Title FINANCIAL ACCOUNTING Subject Code FA Paper No. 6 Course This subject highlights the fundamental concepts of financial accounting, discusses accounting Descriptionof certain special transactions and focuses on the preparation of financial statements of various forms of organisations viz. non-corporate commercial organisations and also not-for-profit organisations. It also focuses on accounting of various aspects of partnership form of business and gives an overview of selected accounting standards. CMA Course 1. Interpret and appreciate emerging national and global concerns affecting organizations and Learning be in a state of readiness for business management. Objectives a. Identify emerging national and global forces responsible for enhanced/varied business (CMLOs) challenges. b. Assess how far these forces pose threats to the status-quo and creating new opportunities. c. Find out ways and means to convert challenges into opportunities 2. Acquire skill sets for critical thinking, analyses and evaluations, comprehension, syntheses, and applications for optimization of sustainable goals. a. Be equipped with the appropriate tools for analyses of business risks and hurdles. b. Learn to apply tools and systems for evaluation of decision alternatives with a 360-degree approach. c. Develop solutions through critical thinking to optimize sustainable goals. 3. Develop an understanding of strategic, financial, cost and risk-enabled performance management in a dynamic business environment. a. Study the impacts of dynamic business environment on existing business strategies. b. Learn to adopt, adapt and innovate financial, cost and operating strategies to cope up with the dynamic business environment. c. Come up with strategies and tactics that create sustainable competitive advantages. 4. Learn to design the optimal approach for management of legal, institutional, regulatory and ESG frameworks, stakeholders’ dynamics; monitoring, control, and reporting with application-oriented knowledge. a. Develop an understanding of the legal, institutional and regulatory and ESG frameworks within which a firm operates. b. Learn to articulate optimal responses to the changes in the above frameworks. c. Appreciate stakeholders’ dynamics and expectations, and develop appropriate reporting mechanisms to address their concerns. 5. Prepare to adopt an integrated cross functional approach for decision management and execution with cost leadership, optimized value creations and deliveries. a. Acquire knowledge of cross functional tools for decision management. b. Take an industry specific approach towards cost optimization, and control to achieve sustainable cost leadership. c. Attain exclusive knowledge of data science and engineering to analyze and create value. Subject 1. To obtain in-depth knowledge on the four frameworks within which accounting operates and Learning the principles on which accounting theories and practices are based. (CMLO 4a, b) Objectives 2. To develop detail application-oriented knowledge on various stages of accounting right from [SLOB(s)] the identification of transactions up to finalisation of accounts. (CMLO 4a, b) 3. To equip oneself with the detail understanding of accounting of certain special transactions to determine surplus, ensure control on resources, for divisional performance evaluation or acquisition of assets through deferred payments. (CMLO 2a, 4c) 4. To develop application-oriented knowledge to prepare financial statements of profit seeking and not-for-profit entities and from incomplete records. (CMLO 3a and 4c) 5. To develop detail understanding of accounting for changes in partnership structure and accounting in an LLP. (CMLO 4a, c) 6. To gain application-oriented knowledge on identifying the impact of various standards on treatment of certain transactions to ensure appropriate reporting. (CMLO 4a, c) Subject SLOC(s) Learning 1. Students will be able to record transactions in a systematic manner in compliance with the Outcome four frameworks of accounting and reporting. (SLOC) and Application 2. They will be able to perform periodical finalization of accounts and prepare financial Skill (APS) statements for reporting to stakeholders. 3. They will guide management on divisional performance evaluation, responsibility accounting and control of resources based on the outcome of accounting records and reports on special transactions. 4. They will be able to handle accounting of various restructuring events in partnership form of business. 5. They will ensure compliance to the standards of accounting with respect to the treatment of certain specified transactions. APS 1. Students will develop appropriate skills to record transactions systematically within the given organisational set-up. 2. They will be able to independently draft mandatory financial statements and other reports of various types of organisations. 3. They will acquire necessary skill sets to prepare customised internal reports on resource utilisation and control, divisional performance evaluation and claim management. Module wise Mapping of SLOB(s) Additional Resources Module Topics (Research articles, books, SLOB Mapped No. case studies, blogs) Section A: Accounting Fundamentals Module wise Mapping of SLOB(s) Additional Resources Module Topics (Research articles, books, SLOB Mapped No. case studies, blogs) 1. Accounting Toward a Science of 1. To obtain in-depth knowledge on the four Fundamentals Accounting – Sterling frameworks within which accounting https://www.tandfonline. operates and the principles on which com/doi/abs/10.2469/faj.v31. accounting theories and practices are based. n5.28?journalCode=ufaj20 2. To develop detail application-oriented knowledge on various stages of accounting right from the identification of transactions up to finalisation of accounts. Section B: Accounting for Special Transactions 2. Accounting The Negotiable Instruments To equip oneself with the detail understanding for Special Act, 1881 of accounting of certain special transactions to Transactions https://legislative.gov.in/sites/ determine surplus, ensure control on resources, default/files/A1881-26.pdf for divisional performance evaluation or acquisition of assets through deferred payments. Section C: Preparation of Financial Statements 3. Preparation Understanding Financial To develop application-oriented knowledge to of Financial Statements – Fraser prepare financial statements of profit seeking Statements and not-for-profit entities and from incomplete records. Section D: Partnership Accounting 4. Partnership The Partnership Act, 1932 To develop detail understanding of accounting Accounting h t t p s : / / w w w. m c a. g o v. i n / for changes in partnership structure and M i n i s t r y / a c t s b i l l s / p d f / accounting in an LLP. Partnership_Act_1932.pdf The LLP Act, 2008 h t t p s : / / w w w. m c a. g o v. i n / content/mca/global/en/acts- rules/llp-act-2008.html Section E: Lease, Branch and Departmental Accounts etc. Module wise Mapping of SLOB(s) Additional Resources Module Topics (Research articles, books, SLOB Mapped No. case studies, blogs) 5. Lease Accounting Lease Accounting: Theory and Practice – Kaur 6. Branch and Financial Accounting – Departmental Tulsian – Person education To equip oneself with the detail understanding Accounting of accounting of certain special transactions to 7. Insurance Claim Financial Accounting – Hanif determine surplus, ensure control on resources, for Loss of stock and Mukherjee – McGraw for divisional performance evaluation or and Loss of profit Hill acquisition of assets through deferred payments. 8. Hire Purchase Financial Accounting – and Installment Tulsian Sale Transactions Section F: Accounting Standards 9. Accounting Accounting Standards To gain application-oriented knowledge on Standards h t t p s : / / w w w. m c a. g o v. i n / identifying the impact of various standards content/mca/global/en/acts- on treatment of certain transactions to ensure rules/ebooks/accounting- appropriate reporting. standards.html  Contents as per Syllabus SECTION A: ACCOUNTING FUNDAMENTALS 01 - 88 Module 1. Accounting Fundamentals 3-88 1.1 Four Frameworks of Accounting (Conceptual, Legal, Institutional and Regulatory) 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 and Journal Proper - Opening Entries, Transfer Entries, Closing Entries, Adjustment Entries, Rectification Entries), Ledger 1.6 Cash Book, Bank Book, Bank Reconciliation Statement 1.7 Trial Balance (Preparation and Scrutiny) 1.8 Adjustments and Rectifications 1.8.1 Depreciation and Amortisation 1.8.2 Adjustment Entries and Rectification of Errors 1.8.3 Accounting Treatment of Bad Debts and Provision for Doubtful Debts, Provision for Discount on Debtors and Provision for Discount on Creditors SECTION B: ACCOUNTING FOR SPECIAL TRANSACTIONS 89-170 Module 2. Bills of Exchange, Consignment, Joint Venture 91-170 SECTION C: PREPARATION OF FINANCIAL STATEMENTS 171-280 Module 3. Preparation of Final Accounts of Commercial Organisations, Not-for-Profit 173-280 Organisations and from Incomplete Records 3.1 Preparation of Financial Statements of Commercial Organisations (other than Corporate Form of Organisation) 3.1.1 Income Statement 3.1.2 Balance Sheet Contents as per Syllabus 3.2 Preparation of Financial Statements of Not-for-Profit Organisation 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 3.3 Preparation of Financial Statements from Incomplete Records SECTION D: PARTNERSHIP ACCOUNTING 281-440 Module 4. Partnership Accounting 283-440 4.1 Admission of Partner 4.2 Retirement of Partner 4.3 Death of Partner 4.4 Treatment of Joint Life Policy 4.5 Dissolution of Partnership Firms including Piecemeal Distribution 4.6 Amalgamation of Partnership Firms 4.7 Conversion of Partnership Firm into a Company and Sale of Partnership Firm to a Company 4.8 Accounting of Limited Liability Partnership SECTION E: LEASE, BRANCH AND DEPARTMENTAL ACCOUNTS ETC. 441-600 Module 5. Lease Accounting 443-458 Module 6. Branch (including Foreign Branch) and Departmental Accounts 459-524 Module 7. Insurance Claim for Loss of Stock and Loss of Profit 525-550 Module 8. Hire Purchase and Installment Sale Transactions 551-600  Contents as per Syllabus SECTION F: ACCOUNTING STANDARDS 601-650 Module 9. Accounting Standards 603-650 9.1 Introduction to Accounting Standards 9.1.1 GAAP 9.1.2 AS 9.1.3 Convergence to Ind AS – Applicability and Scope 9.2 Specified Accounting Standards with Comparative Provisions under Ind AS 9.2.1 Disclosure of Accounting Policies (AS 1) 9.2.2 Property Plant and Equipment (AS 10) 9.2.3 The Effects of Changes in Foreign Exchange Rate (AS 11) 9.2.4 Accounting for Government Grants (AS 12) 9.2.5 Borrowing Costs (AS 16) 9.2.6 Accounting for Taxes on Income (AS 22)  SECTION-A Accounting Fundamentals  Accounting Fundamentals Accounting Fundamentals 1 This Module Includes 1.1 Four Frameworks of Accounting (Conceptual, Legal, Institutional and Regulatory) 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 and Journal Proper - Opening Entries, Transfer Entries, Closing Entries, Adjustment Entries, Rectification Entries), Ledger 1.6 Cash Book, Bank Book, Bank Reconciliation Statement 1.7 Trial Balance (Preparation and Scrutiny) 1.8 Adjustments and Rectifications The Institute of Cost Accountants of India 3 Financial Accounting Accounting Fundamentals SLOB Mapped against the Module To obtain in-depth knowledge on the four frameworks within which accounting operates and the principles on which accounting theories and practices are based. (CMLO 4a, b) To develop detail application-oriented knowledge on various stages of accounting right from the identification of transactions up to finalisation of accounts. (CMLO 4a, b) Module Learning Objectives: After studying this module, the students will be able to: ~ Understand the frameworks of accounting; ~ Know the principles of accounting i.e. Accounting concepts and Accounting conventions; ~ Understand the concept transaction and its different types; ~ Understand the Accounting cycle; ~ Get the knowledge of different books of accounts and related concepts; ~ Learn the preparation and scrutiny of trial balance; ~ Pass adjustment entries and rectification entries; ~ Do accounting for depreciation, amortisation, bad debts and provisions thereof 4 The Institute of Cost Accountants of India  Accounting Fundamentals Four Frameworks of Accounting 1.1 A ccording 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 Regulatory. 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 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- The Institute of Cost Accountants of India 5 Financial Accounting 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 (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. 6 The Institute of Cost Accountants of India  Accounting Fundamentals Accounting Principles, 1.2 Concepts and Conventions T he responsibility of the discipline of accounting is to provide financial information to the users of accounting information. For this purpose, it keeps records of the various transactions in its books of accounts. The practice of record keeping may be practiced differently by different organisations. In order to ensure uniformity and consistency in record keeping, 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 indicate how to report economic events and are thus, used by organisations in drafting their financial statements. They are to be followed by organisations so that the users of accounting information have an optimum level of consistency in the financial statements they use, when analyzing companies for investment purposes. 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). Concept of Accounting Principles, Accounting Concepts, and Accounting Conventions Accounting Principles are the basic rules which act as a primary standard for recording business transactions and maintaining books of accounts. They 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 principles are accepted as such if they happen to be (1) objective (2) usable in practical situations (3) reliable (4) feasible (they can be applied without incurring high costs); and (5) comprehensible to those with a basic knowledge of accounting and finance. The accounting principles can be split into – [A] Accounting Concepts and [B] Accounting Conventions. [A] 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 are: (a) Entity Concept (b) Going Concern Concept (c) Periodicity Concept (d) Money Measurement Concept (e) Accrual Concept The Institute of Cost Accountants of India 7 Financial Accounting (f) Dual Aspect Concept (g) Matching Concept (h) Realisation Concept (i) Cost Concept [B] Accounting Conventions are customs, methods, procedures or guidelines associated with the practical application of accounting principles. These are widely accepted, and are the common practices which are used as a guideline when recording transactions. Accounting conventions are a necessary part of the accounting profession, since they result in transactions being recorded in the same way by multiple organizations. This allows for the reliable comparison of the financial facts and figures. However, accounting conventions may change over a period of time, thus reflecting shifts in the general opinion and/ or practice of dealing with a transaction. The different accounting conventions are: (a) Convention of Conservatism (b) Convention of Consistency (c) Convention of Materiality (d) Convention of Full Disclosure. Accounting Concepts (a) Entity Concept: As per this concept, an organisation is treated as distinct and separate from the persons who own or manage it. In other words, this concept assumes that the organization and business owners are two independent entities. Hence, the personal transaction of its owner is different from the transactions of the organisation. Application of this concept enables recording of transactions between the entity and its owners and/ or other stakeholders. The entity concept requires that all the transactions are to be viewed, interpreted and recorded from organisation’s point of view. For example, if the owner pays his personal expenses from business cash, this transaction can be recorded in the books of business entity. This transaction will take the cash out of business and also reduce the obligation of the business towards the owner. (b) Going Concern Concept: The basic assumption of this concept is that an organisation is assumed to continue to exist for an indefinite period of time. This simply means that every concern has continuity of life. Unless, there is good evidence to the contrary, the accountant assumes that an organisation is a ‘going concern’. This concept enables the accountant to carry forward the values of assets and liabilities from one accounting period to the other without asking the question about usefulness and worth of the assets and recoverability of the receivables. The going concern concept forms the basis for preparation of Balance Sheet of an organisation. (c) 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: Any event which can be expressed in terms of money is always recorded in the books of accounts. 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, the assets owned by the business cannot ascertained. When expressed in the common measure of money, transactions could be added or subtracted to find out the combined effect. However, the limitation of this concept is that only the absolute value of the money is considered, whereas the real value may fluctuate from time to time 8 The Institute of Cost Accountants of India  Accounting Fundamentals due to inflation, exchange rate changes, etc. (e) Accrual Concept: This 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 organisation 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: The dual aspect concept assumes that every transaction recorded in the books of accounts is based on two aspects (technically called ‘Debit’ and ‘Credit’). This concept provides the basis for recording business transactions in the books of accounts. This implies that the transaction that is recorded affects two (or more) accounts on their respective opposite sides. Hence, the transaction should be recorded in at least two accounts. For example, goods purchased in cash have two aspects such as ‘paying cash’ and ‘receiving goods’. Such duality of the transaction is commonly expressed in the terms of an equation as: 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 matched 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: The concept of realisation talks about how much of the revenue should be recognized in the books of accounts. It says, amount should be recognized only to the tune of which it is certainly realizable. Thus, mere getting an order from the customer won’t make it eligible to be recognized as revenue. The reasonable certainty of realizing the money will come only when the goods ordered are actually supplied to the customer and he is billed. This concept ensures that any income which is unearned or unrealized will not be considered as revenue. (i) Cost Concept: The cost concept states all the business assets should be written down in the book of accounts at the costs incurred for their acquisition, including any capital cost incurred in relation to installation. The assets are not to be recorded at their market price. For example, a packing machine was purchased by Bharat Ltd. for ` 40,00,000. An amount of ` 30,000 was spent on transporting the machine to the factory site, and further ` 20,000 was additionally spent on its installation. Hence, the total amount at which the machine will be recorded in the books of accounts would be the aggregate of all these costs i.e. ` 40,50,000. This cost is also termed as ‘Historical Cost’. Accounting Conventions (a) Convention of Conservatism: The convention of conservatism essentially assumes an uncertain future and as such, advocates providing for all possible losses, but never for possible future gains. As such, application of this convention would always result in understatement of incomes, profits and thus, resources. (b) Convention of Consistency: This convention advocates the continuous observation and application of the rules and practices of accounting. The uniformity and consistency of accounting rules is vital to profit and loss calculations as well as comparisons of company performance. Frequent changes in the treatment of accounts would result in inconsistency and hence, make the accounting information less reliable. It would result in making accounting information truthful, accurate and complete. (c) Convention of Materiality: The convention of materiality advocates the recording and reflection of all material facts (i.e. those pieces of information that can potentially influence the decision of informed investor) in the accounting records, and elimination of insignificant information. It should be noted that any item of fact which is considered material by on organisation may be treated as unimportant by another The Institute of Cost Accountants of India 9 Financial Accounting organisation. In the same way, an item that is considered material during a particular time period may be treated as unimportant in subsequent time periods. (d) Convention of Full disclosure: This convention advocates the full disclosure of all material information, whether favourable or otherwise, in the accounting statements of a business enterprise. This convention requires that all accounting statements must be prepared honestly. The convention of disclosure holds greater importance in the case of businesses where the ownership is separate from the management. Conclusion Accounting principle, concepts and conventions are very vital to the accounting profession, since they bring about uniformity in the process of recording transactions. Such uniformity makes it possible to reliably compare the financial results, financial position, and cash flows of different organizations and also over different periods. These, thus go a long way in helping to standardize the financial reporting process. 10 The Institute of Cost Accountants of India  Accounting Fundamentals Capital and Revenue 1.3 Transactions P roper distinction between transactions of capital and revenue nature is one of the fundamental requirements of accounting. It is very significant as without this being done properly, the very objective of accounting gets affected. The application of accounting concepts of periodicity, accrual and matching leads to the identification of a transaction as either capital natured transaction or revenue natured transaction. When transactions get properly classified between capital and revenue nature, it achieves the following purposes: 1. Ensures proper accounting of transactions by identifying them either as income or as liability, and expense or asset; 2. Determination of true operating result by correct identification of incomes and expenses; 3. Proper disclosure of financial position in the balance sheet of the entity by correct disclosure of its assets and liabilities. 1.3.1 Capital and Revenue Expenditures After the incurrence of an expenditure by an entity, that expenditure has to be recognized as either a capital expenditure or a revenue expenditure before being recorded in the books of accounts. 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. Example: Purchase of machinery; Construction of building; Development of website; Heavy repairs of a non- current asset etc. Accounting Treatment: 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 capitalised (i.e. recorded) as an asset and gets reflected in the balance sheet. However, over time the amount of capital expenditure sliced for being recognized as revenue expenditure i.e. it gets gradually charged against the profit. For example, the acquisition of a machinery is a capital expenditure, but charging regular depreciation on this machinery is a revenue expenditure. 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 organisation. Example: Purchase of goods for sale; payment of recurring expenses (like salaries, wages, rent, depreciation, conveyance charges, monthly internet charges etc.); Repairs and maintenance of non-current assets etc. Accounting Treatment: An expenditure of revenue nature charged as an expense against profit of the accounting period in which it is incurred or recognised. The Institute of Cost Accountants of India 11 Financial Accounting The following are the points of distinction between Capital Expenditure and Revenue Expenditure: Capital Expenditure Revenue Expenditure 1. The economic benefits from capital expenditure 1. The economic benefits from revenue expenditure are enjoyed for more than one accounting period. are enjoyed for only one accounting period. 2. It is non-recurring in nature. 2. It is recurring in nature. 3. Normally, it involves heavy cash outlay. 3. Normally, it involves lower cash outlay. 4. It is reflected in the Balance Sheet. 4. It is debited to Income Statement. 5. It may be incurred before or after the 5. It is always incurred after the commencement of commencement of operations of an entity. operations of an entity. 6. It tends to increase the earning capacity or, reduce 6. It helps in carrying on the activities in the current the operating expenses of an entity. accounting period. 7. A portion of capital expenditure may get matched 7. Entire amount of such expenditure is matched against the revenue to determine the operating against the revenue to determine the operating result. result. Certain Rules for Identification of 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 the organisation to carry on its operations (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 acquires 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 coming to ` 5,60,000. Similarly, if a building is purchased for ` 40,00,000 and ` 2,00,000 is spent on registration and stamp duty, the capital expenditure on the building stands at ` 42,00,000. ~ An expenditure incurred for improving the earning capacity of an organisation will be considered to be of capital nature. For example, expenditure incurred for shifting the factory for easy supply of raw materials will be a capital expenditure. ~ Preliminary expenses incurred before the commencement of business is considered capital expenditure. For example, legal charges incurred by a company for drafting the memorandum of association, articles of association of a company or brokerage paid to brokers, or commission paid to underwriters for raising capital etc. 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. Example: Heavy advertisement expenditure incurred prior to launching a new product; Development expenses of a product etc. 12 The Institute of Cost Accountants of India  Accounting Fundamentals Accounting Treatment: A part of such expenditure (the expense portion) is recorded in the debit-side of the Income Statement, while the unwritten-off portion appears as an asset in the Balance Sheet. NB: 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. 1.3.2 Capital and Revenue Receipts A receipt of money may be of a capital or revenue nature depending upon the source of the receipt. A clear distinction should be made between capital receipts and revenue receipts to ensure proper determination of operating results. 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 operating result (i.e. profits earned or losses incurred) during the course of a year. Example: A company issues new shares to raise funds for expansion. Number of share issued: 1000 Issue price per share: 50 Total Capital Raised: - ` (1000 * 50) = ` 50,000. Accounting Treatment: Such receipt is credited to the respective account of capital nature, and gets reflected in the Balance Sheet. Revenue Receipts refer to the receipts which are 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. Example: A company sells 1000 unit @ ` 20 per unit in the normal course of business, in this case Revenue Receipt would be ` (1000 * 20) = ` 20,000. Accounting Treatment: These are recognised as income and should be credited to the Income Statement. The following are the points of difference between capital receipts and revenue receipts: Capital Receipt Revenue Receipt 1. These receipts are obtained by an entity from 1. These receipts are obtained by an entity from operations other than from the regular operations. regular day-to-day operations. 2. It is irregular and hence, non-recurring in nature. 2. It is recurring in nature. 3. It is not recognised as an income. 3. It is recognised as an income. 4. It gets reflected in the Balance Sheet. 4. It is credited to Income Statement. 5. It does not affect the operating result of an entity. 5. It affects the operating result of an entity. 6. It may result in creation of liability. 6. It does not create any liability. The Institute of Cost Accountants of India 13 Financial Accounting The matching of revenues and expenses result in either profit or loss. As such, an extension of the discussion on expenditures and receipts of capital and revenue nature naturally leads to the concepts of ‘Capital and Revenue Profits’ and ‘Capital and Revenue Losses’. 1.3.3 Capital and Revenue Profits While ascertaining the operating result of an entity in relation to an accounting period, proper distinction is to be made between capital profits and revenue profits. Capital Profit refers to a profit which arises out of the non-operating activities of an entity. It is non-recurring in nature. Generally, capital profits arise out of the sale of assets other than inventory, or in connection with the raising of capital or at the time of purchasing an existing business. Examples: Profit prior to incorporation; Premium received on issue of shares; Profit made on re-issue of forfeited shares; Redemption of Debenture at a discount; Profit made on sale or revaluation of a non-current tangible asset etc. Accounting Treatment: Capital profits are generally capitalised i.e. transferred to a Capital Reserve Account. Revenue Profit refers to a profit which arises out of the regular operating activities of an entity. It is recurring in nature. Example: Profit arising out of the sale of the merchandise that the business deals in; Profit made by rendering regular services to clients; Surplus earned by a non-profit organisation etc. Accounting Treatment: Revenue profits, which get determined in the Income Statement, are distributed to the owners of the business or transferred to any Reserve Account. 1.3.4 Capital and Revenue Losses While ascertaining losses, revenue losses are differentiated from capital losses, just as revenue profits are distinguished from capital profits. Capital Loss refers to a loss which does not arise to an entity in the regular course of its operations. Example: Capital losses may result from the sale of assets other than inventory for less than written down value; Diminution/ elimination of assets other than as the result of use or sale i.e. from extra-ordinary activities (viz. loss by flood, fire etc.) or in connection with raising debt capital by a company (issue of debentures 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). Accounting Treatment: It is either charged against the revenue i.e. debit-side of Income Statement or reflected in the asset-side of Balance Sheet (as fictitious assets). Revenue Loss arise to an entity from the normal course of business. Example: Discount allowed to customers for prompt payment; loss due to bad debts etc. Accounting Treatment: Such loss is to be recorded in the debit-side of Income Statement. Example 1 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; 14 The Institute of Cost Accountants of India  Accounting Fundamentals (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 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. Example 2 State with reasons whether the following are Capital Expenditure or Revenue Expenditure: (i) Expenses incurred in connection with obtaining a license for starting the factory were ` 10,000. (ii) ` 1,000 paid for removal of stock to a new site. (iii) Rings and Pistons of an engine were changed at a cost of ` 5,000 to get full efficiency. (iv) ` 2,000 spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the Plaintiff. The suit was not successful. (v) ` 10,000 were spent on advertising the introduction of a new product in the market, the benefit of which will be effective during four years. (vi) A factory shed was constructed at a cost of ` 1,00,000. A sum of ` 5,000 had been incurred for the construction of the temporary huts for storing building materials. Solution: ( i) `10,000 incurred in connection with obtaining a license for starting the factory is a Capital Expenditure. It is incurred for acquiring a right to carry on business for a long period. (ii) `1,000 incurred for removal of stock to a new site is treated as a Revenue Expenditure because it is not enhancing the value of the asset and it is also required for starting the business on the new site. The Institute of Cost Accountants of India 15 Financial Accounting (iii) ` 5,000 incurred for changing Rings and Pistons of an engine is a Revenue Expenditure because, the change of rings and piston will restore the efficiency of the engine only and it will not add anything to the capacity of the engine. (iv) ` 2,000 incurred for defending the title to the firm’s assets is a Revenue Expenditure. (v) ` 10,000 incurred on advertising is to be treated as a Revenue Expenditure. [As per As-26] (vi) Cost of construction of Factory shed of ` 1,00,000 is a Capital Expenditure, similarly cost of construction of small huts for storing building materials is also a Capital Expenditure. 16 The Institute of Cost Accountants of India  Accounting Fundamentals Accounting Cycle, Analysis of 1.4 Transaction etc. T he Accounting Cycle is a sequence of activities performed by an accountant to document and report an organisation’s financial transactions during an accounting period. This cycle follows financial transactions from when they occur to how they affect financial documents. The entire process starting with identification of transactions, their recording and processing all transactions of an organisation, to its representation on the financial statements, and also to closing the accounts, if applicable, is referred to as Accounting Cycle. To keep track of the full accounting cycle from start to finish is one of the main duties of a bookkeeper. Stages of Accounting Cycle The accounting cycle consists of the following sequential steps: 1. Identifying transactions: The first step in the accounting cycle is to analyze events to determine if they are “transactions”. Transactions are the starting point from which the rest of the accounting cycle will follow. 2. Recording transactions in Books of Original Entry: The second step in the accounting cycle is to record the identified transactions in the relevant Books of Original Entry as journal entries. 3. Posting to the ledger: The next step is to record a summary of the activities in relevant account in the ledger (referred to as Posting). 4. Drafting of Unadjusted Trial Balance: At the end of an accounting period, data from the ledger accounts may be taken to draft a trial balance. It is prepared for identifying any errors that may have occurred during the initial stages of the accounting cycle. However, this step is not mandatory. 5. Passing of adjustment entries: Identification of necessary adjustments and passing of adjusting entries make up the fifth step in the cycle. 6. Drafting of Adjusted Trial Balance: Once all adjusting entries are completed, then an Adjusted Trial Balance can be prepared. This happens to be the last step before the preparation of the financial statements. 7. 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. 8. 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 gets 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 17 Financial Accounting Identifying Transactions Drafting Financial Recording in Statements Journal Closing the Books The Accounting Posting to Cycle Ledger Drafting Adjusted Drafting Unadjusted Trial Balance Trial Balance Adjustment Entries Fig: 1.1 Accounting Cycle Events & Transactions The primary purpose of financial accounting is to record the transactions entered into by an organisation during an accounting period. So, transactions are the staring point of the accounting cycle.Transactions are created through events, but all events are not transactions. ~ Events: Everything that is happening in every moment of human life is an event. Simply stated, any happening is an event. As such, events can be financial (like, purchasing a book, paying cab fare, receiving a cheque etc.) and non-financial (like, visiting a book store, going for morning walk etc.). An event may involve any number of parties, and may be complete and may be incomplete. ~ Transactions: An accounting transaction is an event which has a monetary impact on the financial position of the organisation. In order to be considered as a transaction, an event has to satisfy the following conditions: 1. It must be measurable in terms of money. 2. It must involve atleast two parties. 3. It involves a monetary exchange for a goods or service. 4. It must cause a change in the financial position of the entity. Analysis of Transactions An organisation enters into various transactions during the course of its operations. These transactions cause changes in financial position of the organisation. Analysis of transactions implies observing the changes in financial position of the organisation caused by the transactions entered into by it during an accounting period. A change in financial position means change in one or more of the five basic elements of accounting, they being: Assets, Liabilities, Capital/ Equity, Expenses, and Revenue. 18 The Institute of Cost Accountants of India  Accounting Fundamentals In the following example of a trading proprietorship business, various illustrative transactions are used to understand the changes in different elements of accounting: Transaction 1: Mr. Suman De commences his business by investing ` 5,00,000 in cash. Changes brought about by this transaction are: Cash increases in the business by ` 5,00,000; (Element changed: Asset increase) Capital increases by ` 5,00,000 (Element changed: Capital/ Equity increase) Transaction 2: Mr. De opened a current account with the bank by depositing ` 2,00,000. Changes brought about by this transaction are: Cash balance decreases by ` 2,00,000; (Element changed: Asset decrease) Bank balance increases by ` 2,00,000 (Element changed: Asset increase) Transaction 3: He borrows ` 1,20,000 from bank interest @ 10% p.a. Changes brought about by this transaction are: Bank balance increases by ` 1,20,000 (Element changed: Asset increase); Bank loan increases by ` 1,20,000 (Element changed: Liability increase) Transaction 4: Mr. De purchases equipments worth ` 80,000 for cash. Changes brought about by this transaction are: Equipments increase by ` 80,000; (Element changed: Asset increase) Cash decrease by ` 80,000 (Element changed: Asset decrease) Transaction 5: He purchased goods worth ` 1,00,000 for resale, out of which 60% was paid in cash, 30% by cheque and balance was due. Changes brought about by this transaction are: Purchases increases by ` 1,00,000; (Element changed: Expenses increase) Cash balance decreases by ` 60,000 (Element changed: Asset decrease) Bank balance decreases by ` 30,000 (Element changed: Asset decrease) Creditors/ Payables increases by ` 10,000 (Element changed: Liability increase) Transaction 6: Goods sold in cash ` 1,70,000. Changes brought about by this transaction are: Cash increases by ` 1,70,000; (Element changed: Asset increase) Sales increase by ` 1,70,000 (Element changed: Revenue increase) The Institute of Cost Accountants of India 19 Financial Accounting Transaction 7: Goods sold on credit for ` 80,000. Changes brought about by this transaction are: Debtors/ Receivables increases by ` 80,000 (Element changed: Asset increase) Sales increase by ` 80,000 (Element changed: Revenue increase) Transaction 8: Mr. De incurred ` 20,000 as wages. Changes brought about by this transaction are: Wages increases by ` 20,000; (Element changed: Expenses increase) Cash decreases by ` 20,000 (Element changed: Asset decrease) Transaction 9: Interest on bank loan charged ` 3,000. Changes brought about by this transaction are: Bank interest increased by ` 3,000; (Element changed: Expenses increase) Bank balance decreased by ` 3,000 (Element changed: Asset decrease) Transaction 10: He collected cash ` 20,000 from his customer. Changes brought about by this transaction are: Cash increases by ` 20,000; (Element changed: Asset increase) Debtors/ Receivables decreases by ` 20,000 (Element changed: Asset decrease) Transaction 11: Mr. De paid ` 8,000 to his supplier. Changes brought about by this transaction are: Cash decreases by ` 8,000; (Element changed: Asset decrease) Creditors/ Payables decreases by ` 8,000 (Element changed: Liability decrease) Transaction 12: He withdrew cash ` 7,000 for his personal use. Changes brought about by this transaction are: Cash decreases by ` 7,000; (Element changed: Asset decrease) Capital decreases by ` 7,000 (Element changed: Capital/ Equity decrease) Such analysis of the transactions helps in identification of the accounts which would be involved for accounting purposes and also helps in identification of the debit and credit aspects of every transaction. 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. 20 The Institute of Cost Accountants of India  Accounting Fundamentals 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 and they are codified. Charts of Accounts ~ A Chart of Accounts (COA) is a listing of all accounts in the general ledger, each account 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. ~ The basic purpose of such charting is to organize the accounts and group similar ones together. ~ It is used to organize finances and give the stakeholders (viz. investors and shareholders) a clearer insight into a company’s financial health. This process makes it easier for the users 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. 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. ~ 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. ~ 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. ~ 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. 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 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: The Institute of Cost Accountants of India 21 Financial Accounting 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. Accounting Equation The accounting equation is a representation of how the three important components of accounting namely Assets, Liabilities and Equity are associated with each other. In the most simplistic form, the accounting equation is presented as: Assets = Liabilities + Equity. Assets represent the valuable resources controlled by the company such as cash, accounts receivable, fixed assets, inventory etc. Liabilities represent its obligations of an organisation to its external stakeholders, while Equity represents owners net claim on the assets. It is to be noted that, the liabilities and equity represent how the assets of the organisation has been financed. All three components of the accounting equation appear in the balance sheet, which reveals the financial position of an entity at any given point in time. Expanded Accounting Equation: 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 This equation is considered to be the foundation of the double-entry accounting system.At a general level, this means that whenever there is a recordable transaction, the choices for recording it all involve keeping the accounting equation in balance. 22 The Institute of Cost Accountants of India  Accounting Fundamentals Illustrative Accounting Equation Transactions The following table shows a few of the common accounting transactions and their recording within the framework of the accounting equation: Transaction Assets + Expenses + Drawings Liabilities + Capital + Revenue 1. Cash introduced by proprietor Cash (Assets) increases Capital increases 2. Purchase of goods in cash Inventory (Asset) increases; N.A. Cash (Assets) decreases 3. Purchase of goods in credit Inventory (Asset) increases Creditors/ Payables (Liabilities) increases 4. Sale of goods in cash Cash (Assets) increases; N.A. Inventory (Assets) decreases 5. Sale of goods in credit Debtors/ Receivables (Assets) N.A. increases; Inventory (Assets) decreases 6. Salaries paid Salaries (Expenses) increases; N.A. Cash/ Bank (Assets) decreases 7. Rent received Cash/ Bank (Assets) increases Rent received (Revenue) increases 8. Goods withdrawn by proprietor Inventory (Assets) decreases Capital decreases Double Entry System Double Entry System of Bookkeeping is an accounting system which recognizes the fact that every transaction has two aspects and both aspects of the transaction are recorded in the books of accounts.It is a fundamental concept encompassing accounting and book-keeping in present times. 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. This system is based on the accounting equation and requires: 1. Every business transaction to be recorded in at least two accounts. 2. The total debits recorded for each transaction to be equal to the total credits recorded. Rules of Debit and Credit under Double Entry System The double-entry accounting system is based on specific rules of debit and credit for recording transactions in the accounts. The rules of debit and credit can be explained by applying two methods: 1. Golden Rules; and 2. Accounting Equation Successive Processes of the Double Entry System ~ Firstly, transactions are recorded in the Books of Original Entry (i.e. Journal and other Subsidiary Books). The Institute of Cost Accountants of India 23 Financial Accounting ~ Secondly, the transactions are classified in a suitable manner and recorded in another book of account known as Ledger. ~ Thirdly, the arithmetical accuracy of the books of account maychecked by means of drafting a Trial Balance. ~ Finally, the result of the operations of the accounting period is ascertained through the drafting of Income Statementand financial position of the entity at the end of the accounting period is reflected through the Balance Sheet. Books of Original Entry& Subsidiary Books ~ Simply stated, Books of original entry refer to the accounting books (technically called Journals) in which transactions entered into by an organisation are initially recorded. These are the primary books of accounts which are used by the accountants for recording the transactions in the first place. These are also referred to as Books of Primary Entry or Books of First Entry. ~ Whenever an event is recognised as a transaction, it is entered into the accounting system of an entity by first recording it in the journal (with their description and detailed reference to supporting documents). ~ The transactions are recorded in the journals in the form of individual entries (referred to as Journal Entries) as and when they occur in chronological order. As because the transactions are recorded on daily basis, the books of original entry are also referred to as Day Books. ~ The information in these books is thereafter summarized and posted into the ledger accounts. Types of Books of Original Entry The books of original entry are broadly classified into two categories:– Special Journals (Day Books) and General Journal. (Refer to para 1.5- Types of Journal). Posting in Ledger & Finalization of Accounts ~ After the transactions relating to a particular accounting period have been recorded in the journal and/ or subsidiary books, they are posted in respective accounts in the ledger (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 the ledger accounts is based on the nature of the respective accounts. 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. 24 The Institute of Cost Accountants of India  Accounting Fundamentals Journal and Ledger 1.5 The first step in the accounting cycle, after the identification of transactions happens to be recording of transactions in the journal, followed by their posting in respective accounts in the ledger. Journal Journal is the book of original entry in which financial transactions are firstly recorded after their occurrence in chronological order. It is in this book of accounts where the transactions are recorded in the first place. The word ‘Journal means’ a daily record. Journal is derived from French word ‘Jour’ which means a day. This book of account is also referred to as the Book of Prime Entry or Books of First Entry. The process of recording the transactions in a journal is called ‘Journalizing’. This is the first activity that a book-keeper performs after identification of the transactions which has to be recorded in the books of accounts of a concern. The entry made in this book is called a ‘Journal Entry’. Every entry in the journal is followed by a short summary which describes the particular transaction. This short summary is referred to as ‘Narration’. Every entry in the book of original entry must be followed by such a narration. Example of a Transaction and its Journal Entry: As per voucher no. 31 of Roy Brothers, on 09.02.2023 goods of ` 50,000 were purchased. Cash was paid immediately. The folios of the Purchase A/c and Cash A/c in the ledger are 5 and 17 respectively. Journal entry of the above transaction is given below: In the books of Roy Brothers Journal Dr. Cr. Voucher Ledger Date Particulars (`) (`) No. Folio 09.02.2023 Purchase A/c Dr. 31 5 50,000 To Cash A/c 17 50,000 (Being goods purchased for cash) ~ Each journal entry is passed in the books on the basis of some source documents. Some of the common source documents are: purchase invoices (also called inward invoices), sales receipts (also called outward invoices), debit notes, credit notes etc. The process of accounting does not end after recording of transactions in the journal. Rather, with the objective of classification, the transactions are summarized and posted to respective accounts in the ledger(s). The Institute of Cost Accountants of India 25 Financial Accounting ~ A journal entry can be a Simple journal entry or a Compound journal entry. When in a journal entry only two accounts are affected – one account is debited and another account is credited, it is called a Simple journal entry. For example, the journal entry for the transaction ‘Goods worth ` 44,000 sold by Ramesh to Rajesh for cash’ will be a simple journal entry as in this case Cash A/c will be debited with ` 44,000 and Sales A/c will get credited with ` 44,000. ~ While in case of a Compound journal entry at least two debits and at least one credit or at least one debit and two or more credit items are involved. For example, the journal entry for the transaction ‘Goods worth ` 54,000 sold by Ramesh to Rajesh involving cash sale ` 44,000 and balance on credit’ will be a compound journal entry as in this case Cash A/c as-well as Debtors A/c will be debited with ` 44,000 and ` 10,000 respectively, and Sales A/c will get credited with ` 54,000. Types of Journal The books of original entry are broadly classified into two categories: 1. Special Journal: 2. General Journal 1. Special Journal: A Special Journal is a book of primary entry in which transactions of a specific type viz. credit purchases, credit sales, return inwards etc. are first recorded before being posted in the respective ledger account. These are also referred to as Subsidiary Books. During the lifecycle of and organisation, when the volume of transactions increases to an extent that a single journal may no longer be adequate to record the transactions effectively, then special purpose books or subsidiary books are required for more efficient record keeping purposes. The different special journals that are usually maintained by an organisation for primary recording of its transactions are: (a) Cash Journal or Cash Book is a special journal which is maintained for recording all transactions which involve cash, whether cash inflows or cash outflows. (b) Purchase journal is a special journal which is used by an organization to record all the credit purchases made by it during an accounting period. It is also known as Purchase Book or Purchase Daybook. (c) Sales Journal is a type of special journal that is used to record credit sale transactions of an organisation. It is also known as Sales Book or Sales Daybook. (d) Purchase Return Journal is the special journal that is used for recording the goods which have been returned by an organisation to its suppliers, for any reason. It is also known as Purchase Return Book or Purchase Daybook. (e) Sales Return Journal is the special journal that is used for recording the goods which have been returned to an organisation by its customers, for any reason. It is also known as Sales Return Book or Sales Daybook. (f) Bills Receivable Journal is the special journal which is used to record the details of bills of exchange received by an entity from its customers during an accounting period. It is also known as Bills Receivable Book or Bills Receivable Daybook. (g) Bills Payable Journal is the special journal which is used to record the details of bills of exchange accepted by an entity towards its suppliers during an accounting period. It is also known as Bills Payable Book or Bills Payable Daybook. 2. General Journal: This is a book of original entry in which those transactions are recorded for which no specific day book is maintained are recorded. 26 The Institute of Cost Accountants of India  Accounting Fundamentals In the following section, the important subsidiary books have been discussed. 1(a): Cash Journal or Cash Book Cash Journal or Cash Book is a special journal which is maintained for recording all transactions which involve cash, whether cash inflows or cash outflows. In this book of original entry, transactions of every type (whether capital natured transactions or revenue natured transactions) are entered. This journal records the details of each transaction effected in cash by an organisation. Such details include the date, particulars, voucher number, ledger folio and the amount of the transaction. The various aspects of the Cash Book has been discussed in detail in Para 1.6 of the study material. 1(b): Purchase Journal The Purchase Journal is a book of original entry which is meant for recording credit purchase of goods. It is also known as Purchase Day Book or simply, Purchase Book. It is to be noted that cash purchases of goods are not recorded in this day book. Also purchase of other long term assets (like equipment, furniture, machinery etc.) on credit does not find place in purchase day book. The Purchase journal records the details of the credit purchase of goods made by an organisation. Such details include the date of purchase, particulars of items purchased, inward invoice number, ledger folio and the amount of purchase. The format of a purchase journal is as given below: Inward Invoice Ledger Folio Date Particulars (`) No. No. Source document for entry in purchase journal: All entries in this book are made from the Purchase invoices. A purchase invoice is a statement which is issued by the seller of goods to the buyer of goods reflecting the details of the goods like the date of purchase, the quantity of purchase, the rate per unit, the total amount and also the terms of payment, if any. Posting from Purchase Journal to Ledger The Purchase Journal, being a book of original entry, transactions entered here are thereafter required to be posted to the respective ledger accounts in the ledger. The total of the purchases made during a period is posted to Purchases Account in the general ledger, while the individual credit purchase transactions posted in the personal ledger accounts of the respective suppliers (in the suppliers ledger). 1(c): Sales Journal Sales Journal is the book of original entry which records credit sales of goods. It is also known as Sales Day Book or simply, Sales Book. It is to be noted that sale of goods for cash are not recorded in this day book. Also sale of other long term assets (like equipment, furniture, machinery etc.) does not find place in this book of original entry. The Sales journal records the details of the credit sales of goods made by an organisation during a period. Such details include the date of sale, particulars of items sold, outward invoice number, ledger folio and the amount of sales. The Institute of Cost Accountants of India 27 Financial Accounting The format of a typical sales journal is as given below: Outward Ledger Folio Date Particulars (`) Invoice No. No. Source Document for Entry in Sales Journal: All entries in this book are made from the Sales invoices. A sales invoice is a statement which is issued by the seller of goods to the buyer of goods reflecting the details of the goods like the date of sale, the quantity of sale, the rate per unit, the total amount and also the terms of payment, if any. Posting from Sales Journal to Ledger The Sales Journal, being a book of original entry, transactions entered here are thereafter required to be posted to the respective ledger accounts in the ledger. The total amount of sales made during a period is posted to Sales Account in the general ledger, while the individual entries of credit sale are posted in the personal ledger accounts of the respective customers/ debtors (in the debtors ledger). 1(d): Purchase Returns Journal The Purchase Returns Journal is a book of original entry which is meant for recording returns of goods purchased on credit from the suppliers. It is also known as Returns Outward Day Book. It is to be noted that returns arising out of cash purchases of goods, or return of any assets other than merchandising goods on credit does not find place in this day book. The Purchase returns journal records the details of the returns arising out of credit purchase of goods viz. the date of return, particulars of items returned, name of supplier, debit note number, ledger folio and the total amount. The format of a purchase returns journal is as given below: Debit Note Ledger Folio Date Particulars (`) No. No. Source Document for Entry in Purchase Returns Journal: All entries in this book are made from the debit notes issued to respective suppliers or credit notes received from the respective suppliers. Posting from Purchase Returns Journal to Ledger The Purchase Returns Book, being a book of original entry, transactions entered here are thereafter required to be posted to the respective ledger accounts in the ledger. The total of the purchase returns made during a period is posted to Purchase Returns or Return Outwards Account in the general ledger, while the individual purchase return transactions posted in the personal ledger accounts of the respective suppliers (in the Creditors Ledger). 28 The Institute of Cost Accountants of India  Accounting Fundamentals 1(e): Sales Returns Journal Sales Return Journal is the book of original entry which records returns of goods earlier sold on credit basis. It is also known as Sales Returns Day Book or simply, Sales Returns Book. The Sales Returns Book records the details of the goods returned out of credit sales made by an organisation during a period. Such details include the date of return, particulars of items returned, credit note number, ledger folio and the amount of sales returns. The format of the sales return journal is as given below: Ledger Folio Date Particulars Credit Note No. (`) No. Source Document for Entry in Sales Returns Journal: All entries in this day book are made from the Credit Note issued by the seller of goods. A sales invoice is a statement which is issued by the seller of goods to the buyer of goods reflecting the details of the goods like the date of sale, the quantity of sale, the rate per unit, the total amount and also the terms of payment, if any. Posting from Sales Returns Journal to Ledger As the Sales Return Journal is a book of original entry, and so transactions recorded here are thereafter required to be posted to the respective accounts in the ledger. The total amount of sales returns made during a period is posted to Returns Inward (or Sales Returns) Account in the general ledger, while the individual entries of sale returns are posted in the personal ledger accounts of the respective customers/ debtors (in the Debtors ledger). 1(f): Bill Receivable Journal The Bill Receivable Journal is a book of original entry which is meant for recording the bills of exchange received from the customers to whom goods have been sold on credit. This journal records the details like the details of the customer, name of drawer, name of acceptor, date of receipt of the bill, date of drawing of the bill, date of acceptance of the bill, tenure of the bill, date of maturity, ledger folio and the amount of the bill. Source document for entry in purchase journal: All entries in this book are made from the bills of exchanges received from the customers. Posting from Bill Receivable Journal to Ledger The Bill Receivable Journal, being a book of original entry, transactions entered here are thereafter required to be posted to the respective ledger accounts in the ledger. The total of the bill of exchanges received during a period is posted to Bills Receivable Account in the general ledger, while the individual transactions posted in the personal ledger accounts of the respective customers (in the Debtors Ledger). 1(g): Bill Payable Journal The Bill Payable Journal is a book of original entry which is meant for recording the bills of exchange issued to the suppliers from whom goods have been purchased on credit. This journal records the details like the details of the supplier, name of drawer, name of acceptor, date of issue of the bill, date of drawing of the bill, date of acceptance of the bill, tenure of the bill, date of maturity, ledger folio and the amount of the bill. The Institute of Cost Accountants of India 29 Financial Accounting Source document for entry in purchase journal: All entries in this book are made from the bills of exchanges issued to the suppliers. Posting from Bill Payable Journal to Ledger The Bill Payable Journal, being a book of original entry, transactions entered here are thereafter required to be posted to the respective ledger accounts in the ledger. The total of the bill of exchanges issued during a period is posted to Bills Payable Account in the general ledger, while the individual transactions posted in the personal ledger accounts of the respective customers (in the Creditors Ledger). 2. General Journal or Journal Proper General Journal is the book of original entry in which those transactions for which no special journal is maintained are recorded. In other words, transactions like credit purchases, credit sales, purchase returns, sales returns etc. (for which specific subsidiary books are maintained) are recorded in this book of primary entry. This book of original entry is also known as Journal Proper. The