Financial Accounting PDF - Indira Gandhi National Open University

BCOC-131 Financial Accounting Indira Gandhi National Open University School of Management Studies Block 1 THEORETICAL FRAMEWORK UNIT 1 Nature and Scope of Accounting 5 UNIT 2 Accounting Process and Rules 23 UNIT 3 Accounti...

BCOC-131 Financial Accounting Indira Gandhi National Open University School of Management Studies Block 1 THEORETICAL FRAMEWORK UNIT 1 Nature and Scope of Accounting 5 UNIT 2 Accounting Process and Rules 23 UNIT 3 Accounting Principles 37 UNIT 4 Accounting Standards 60 Theortical Framework PROGRAMME DESIGN COMMITTEE B.COM (CBCS) Prof. Madhu Tyagi Prof. D.P.S. Verma (Retd.) Faculty Members Director, SOMS, IGNOU Department of Commerce SOMS, IGNOU University of Delhi, Delhi Prof. N V Narasimham Prof. R.P. Hooda Former Vice-Chancellor Prof. K.V. Bhanumurthy (Retd.) Prof. Nawal Kishor MD University, Rohtak Department of Commerce Prof. M.S.S. Raju University of Delhi, Delhi Prof. B. R. Ananthan Dr. Sunil Kumar Former Vice-Chancellor Prof. Kavita Sharma Dr. Subodh Kesharwani Rani Chennamma University Department of Commerce University of Delhi, Delhi Dr. Rashmi Bansal Belgaon, Karnataka Dr. Madhulika P Sarkar Prof. I. V. Trivedi Prof. Khurshid Ahmad Batt Dr. Anupriya Pandey Former Vice-Chancellor Dean, Faculty of Commerce & M. L. Sukhadia University Management Udaipur University of Kashmir, Srinagar Prof. Purushotham Rao (Retd.) Prof. Debabrata Mitra Department of Commerce Department of Commerce Osmania University, Hyderabad University of North Bengal Darjeeling Prof. R. K. Grover (Retd.) School of Management Studies IGNOU COURSE DESIGN COMMITTEE Prof. Madhu Tyagi Faculty Members Director, SOMS, IGNOU SOMS, IGNOU Prof. N. V. Narasimham Prof. A.A. Ansari Prof. Nawal Kishor Jamia Millia Islamia, New Delhi Prof. M.S.S. Raju Dr. Sunil Kumar Ms. Surbhi Gupta Dr. Subodh Kesharwani Vivekananda College Dr. Rashmi Bansal University of Delhi, Delhi Dr. Madhulika P. Sarkar Dr. Anupriya Pandey COURSE PREPARATION TEAM Dr. Sunil Kumar (Unit-4) Prof. M.S.S. Raju (Course Coordinator & Editor) Dr. Sunil Kumar (Course Coordinator & Editor) Preparatory Course in Commerce: PCO-01 (Unit-1, 2 and 3 Revised by Dr. Sunil Kumar) Prof. J. Satyanarayan, Osmania University, Hyderabad Prof. V. Vishwanadham, Osmania University, Hyderabad Dr. D. Obul Reddy, Osmania University, Hyderabad Shri M. Satyanarayana, Badruka College, Hyderabad Print Production Sh. Y. N. Sharma Sh. Sudhir Kumar Assistant Registrar (Pub.) Section Officer (Pub.) MPDD, IGNOU MPDD, IGNOU June, 2019 Indira Gandhi National Open University, 2019 ISBN-978-93-89200-06-5 All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means, without permission in writing from the Indira Gandhi National Open University. Further information on the Indira Gandhi National Open University courses may be obtained from the University’s Office at Maidan Garhi, New Delhi-l10068 or website of INGOU www.ignou.ac.in Printed and published on behalf of the Indira Gandhi National Open University, New Delhi by Registrar, MPDD, IGNOU, New Delhi. Laser Typeset by : Rajshree Computers, V-166A, Bhagwati Vihar, (Near Sec. 2, Dwarka), Uttam Nagar, New Delhi-110059 2 Printed by : BLOCK 1 THEORETICAL FRAMEWORK This block will introduce you to the core area in Commerce. In order to appreciate the need for accounting, You have to practice accounting and require a clear understanding of the nature and scope of accounting, the language used in accounting and the principles that guide the accountant. This block also deals with basic rules of double entry system and accounting standards which provides the basis for accounting policies in order to prepare the financial statements. This block is structured to cover these and other related aspects. It is hoped that this block will provide you the necessary theoretical background to understand and appreciate accounting in the right perspective. It covers four units. Unit 1 explains the nature and scope of accounting and the importance of accounting information to various parties. Unit 2 analyse the basic rules of double entry system and their application. Unit 3 presents some of the terms commonly used in accounting and the basic concepts underlying accounting. Unit 4 deals with Accounting Standards which provides the basis for accounting policies and for preparation of financial statements. 3 Theortical Framework 4 UNIT 1 NATURE AND SCOPE OF ACCOUNTING Structure 1.0 Objectives 1.1 Introduction 1.2 Need for Accounting 1.3 Objectives of Accounting 1.4 Definition and Scope of Accounting 1.5 Book-Keeping, Accounting and Accountancy 1.6 Users of Financial Accounting Information 1.7 Accounting as an Information System 1.8 Branches of Accounting 1.9 Advantages of Accounting 1.10 Limitations of Accounting 1.11 Bases of Accounting 1.11.1 Cash Basis of Accounting 1.11.2 Accrual Basis of Accounting 1.12 Qualitative Characteristics of Accounting Information 1.13 Functions of Accounting 1.14 Let Us Sum Up 1.15 Key Words 1.16 Some Useful Books 1.17 Answers to Check Your Progress 1.18 Terminal Questions 1.0 OBJECTIVES After studying this unit, you should be able to:  explain the need for accounting;  identify the objectives of accounting;  describe accounting as an information system;  outline the scope and bases of accounting;  distinguish between book-keeping, accounting and accountancy;  identify the parties interested in accounting information;  describe the functions and important branches of accounting;  describe the advantages and limitations of accounting; and  state the qualitative characteristics of accounting. 5 Theortical Framework 1.1 INTRODUCTION In this unit, we shall discuss the functions, branches, advantages, limitations, and bases for accounting. In this unit, we also intend to elaborate on the need for accounting and then discuss the nature, scope and importance of accounting. 1.2 NEED FOR ACCOUNTING Let us elaborate on need for accounting. Suppose you are given ten rupees to purchase vegetables and asked to account for the amount. You have purchased the vegetables— 1 kg of tomatoes for Rs. 4, 1 kg of potatoes for Rs. 3, and 1 kg of brinjalsfor Rs. 2. The total amount spent is Rs. 9 and the balance of amount with you is Re 1. Thus, you have rendered the account for Rs. 10. This is one time affair. Therefore, you could remember what you have spent. Suppose, you are given Rs. 2,000 and asked to manage the home for a month and render the account for the money at the end of the month. You will be purchasing groceries, milk, vegetables, paying for electricity, school/college fees, etc. You will be spending almost everyday. In that case, is it possible to remember all the payments you are making everyday and render account at the end of the month? No, it is not possible to remember, especially when the number of payments is more. Not only that, it is not even advisable to depend on memory. Therefore, it is better to write down (or record) whatever payments you have made. Further, it is advisable to obtain receipts or bills for the payments you have made, so that you can render the account, beyond doubt. The above example is a simple one, where you have one receipt of money i.e., Rs. 2,000 and a number of payments. But the case of business is different. In business, you may have to purchase and sell hundreds and thousands of times over a period of time. You will have a number of receipts and a number of payments (known as transactions). Will it be possible for you to remember hundreds and thousands of transactions which have taken place in your business, that too over a period of time, say a year? It is not humanly possible to remember all transactions which have taken place in business over a period of time. Even if you remember all the transactions, you will find it impossible to calculate the net effect of all such transactions i.e., profit. It, therefore, becomes necessary to record all the transactions that have taken place in business. Further, it is not possible for the businessman to sit at the cash counter throughout the day. Sometimes his family members may be asked to sit at the cash counter. As the size of the business grows, it becomes necessary to employ people to assist the businessman. In such cases, theft of goods or cash is possible or all the sale proceeds may not be put into the cash box. Hence, it becomes necessary to maintain accounting records for the purpose of control, especially when outsiders are employed. It can, thus, be seen that there is need for proper accounting records even in case of a sole proprietorship concern. It is all the more important in the case of other forms of business organisation. In case of a partnership firm, all the partners may or may not be actively participating in the day-to-day management of the business. It is, therefore, necessary to record all the transactions in order to satisfy all the partners. In case of a company, it is not possible for the owners (shareholders) who are too large in number to take part in the day-to-day management of the company. Generally, the management of the company is entrusted to paid managers. Hence, there is a need for recording all transactions. 6 Information about the business is required for both internal and external use. Nature and Scope of Accounting For example, the management needs a lot of information (for their internal use) for planning, controlling and evaluating the operations of the business. Information is also needed by some outsiders, banks, creditors, etc. For example, it is required for filing sales tax, income tax, and other tax returns with appropriate tax authorities. When a firm approaches the bank for loan or the creditors for supply of goods on credit, the bank or creditors like to know the firm’s financial position (whether it is financially sound or not) and its profit earning capacity. The question is how to obtain all such information. A systematic accounting record is the only answer. Accounting is necessary in not only business organisations, but also ‘non- business’ organisations like schools, colleges, hospitals, libraries, etc. 1.3 OBJECTIVES OF ACCOUNTING From the above discussion, the objectives of accounting can be stated as follows: i) To keep systematic records: Accounting is done tokeep a systematic record of financial transactions, like purchase of goods, sale of goods, cash receipts and cash payments. Systematic record of various assets and liabilities of the business is also to be maintained. ii) To ascertain the net effect of the business operations i.e., profit or loss of business: Weknow that the primary objective of business is to make profit and the businessman is very much interested in knowing the same. A proper record of income and expenses facilitates the preparation of the profit and loss account (income statement). The profit and loss account reveals the profit earned or loss incurred by the business firm during a particular period. iii) To ascertain the financial position of the business: The businessman is not only interested in knowing the operating results, but also interested in knowing the financial position of his business i.e., where it stands. In other words, he wants to know when the business owes to others and what it owns and what happened to his capital – whether the capital increased or decreased or remained constant. A systematic record of various assets and liabilities facilitates the preparation of a statement known as ‘balance sheet’ (position statement) which answers these questions. iv) To provide accounting information to interested parties: Apart from the owners, there are various other parties who are interested in knowing about the business firm, such as the management, the bank, the creditors, the tax authorities, etc. For this purpose, the accounting system has to furnish the required information. Check Your Progress A 1. Give five points in support of the need for accounting................................................................................................................................................................................................................................................................................................................................................................................................................................................................. 7 Theortical Framework 2. State the main objectives of accounting................................................................................................................................................................................................................................................................................................................................................. 3. What is profit?................................................................................................................................................................................................................................................................................................................................................ 4. What do you understand by ‘Financial Position?................................................................................................................................................................................................................................................................................................................................................ 1.4 DEFINITION AND SCOPE OF ACCOUNTING Accounting has been defined in different ways by different authorities on the subject. Accounting is a comprehensive discipline and it is difficult to explain satisfactorily through any single definition. However, two definitions are given below. This should help you to understand the nature and scope of accounting. The American Accounting Association defines Accounting as the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information. This definition stresses three aspects viz., identifying, measuring and communicating economic information. In the words of the Committee on Terminology appointed by the American Institute of Certified Public Accountants, ‘‘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 financial character and interpreting the results thereof ’’. This is a popular definition of accounting and it outlines the nature and scope of accounting activity. A business is generally started with proprietor’s funds i.e., capital. The proprietor may also acquire additional funds from outsiders like banks and creditors. These funds are utilised to acquire the assets needed for business and also to carry out other business activities. In the process many transactions and events take place. The accountant has to identify all such transactions and events, measure them in terms of money, and record them in appropriate books of account. Then, he has to classify them under separate heads of accounts, summarise periodically in the form of Profit and Loss Account and Balance Sheet; and analyse, interpret and communicate the results thereof to the interested parties. Accounting can thus be broadly defined as follows; Accounting is the process of identifying, measuring, recording, classifying, summarising, analysing. interpreting, and communicating the financial transactions and events in monetary terms. 8 The above definitions clearly bring out the scope of accounting. This can now Nature and Scope of Accounting be outlined as follows: 1. Accounting is concerned with financial transactions and events which bringabout a change in the resources (or wealth) position of the business firm. Such transactions have to be identified first, as and when they occur. It is not difficult because, there will be proof in the form of a bill or receipt (called vouchers). With the help of these bills and receipts, identification of a transaction is easy. For example, when you purchase something you get a bill, when you make payment, you get a receipt. 2. These transactions are to be measured or expressed in terms of money, if not done already. Generally, this problem will not arise, because the statement of proof expresses the transaction in terms of money. For example, if ten books are purchased at the rate of Rs. 20 each, then the bill is prepared for Rs. 200. But, if an event cannot be expressed in monetary terms, it will not come under the scope of accounting. 3. The transactions which are identified and measured are to be recorded in a book called journal or in one of its sub-divisions. 4. The recorded transactions are to be classified with a view to group transactions of similar nature at one place. The work of classification is done in a separate book called ledger. In the ledger, a separate account is opened for each item so that all transactions relating to it can be brought to one place. For example, all payments of salaries are brought to salaries account. 5. The recording and classification of many transactions will result in a mass of financial data. It is, therefore, necessary to summarise such data periodically (at least once a year), in a significant and meaningful form. The summarisation is done in the form of profit and loss account which reveals the profit made or loss incurred, and the balance sheet which reveals the financial position. 6. The summary results will have to be analysed, interpreted (critically explained) and communicated to interested parties. Accounting information is generally communicated in the form of a ‘report’. Big organisations generally present printed reports, called published accounts. 1.5 BOOK-KEEPING, ACCOUNTING AND ACCOUNTANCY Very often you will come across terms like bookkeeping, accounting, and accountancy in the literature on accounting. We propose to explain them in the following paragraphs: You know Accounting involves a series of activities, as listed out in the scope of accounting. These activities are; (1) identifying, (2) measuring. (3) recording, (4) classifying, (5) summarising, (6) analysing, (7) interpreting, and (8) communicating, the financial transactions and events. – Book-keeping is a narrow term, which means record keeping or maintaining books of account. It only covers the first four activities (1 to 4 above) of accounting. 9 Theortical Framework The term ‘Accountancy’ refers to a systemiatised knowledge of accounting and is regarded as an academic subject like economics; statistics, chemistry, etc. It explains ‘why to do’ of various aspects of accounting. In other words, when accounting refers to the actual process of preparing and presenting the accounts, Accountancy tells us why and how to prepare the books of account and how to summarise the accounting information and communicate it to the interested parties. Thus Accountancy is a science, a body of systematised knowledge, whereas Accounting is the art of putting such knowledge intopractice. In general usage, however, Accountancy and Accounting are used as synonyms (meaning the same thing). But, of late, the term accounting is becoming more and more popular. Cheek Your Progress B 1. Define accounting................................................................................................................................................................................................................................................................................................................................................. 2. What do you mean by book-keeping?................................................................................................................................................................................................................................................................................................................................................ 3. What is accountancy?................................................................................................................................................................................................................................................................................................................................................ 4. Accounting involves a series of activities. List them................................................................................................................................................................................................................................................................................................................................................. 1.6 USERS OF FINANCIAL ACCOUNTING INFORMATION You have learnt that many groups of people are interested in accounting information which may help them: i) to understand the present position of the enterprise ii) to compare its present performance with that of its past years iii) to compare its present performance with that of similar enterprises. Now, let us see who such parties are and how accounting information is useful 10 to various parties. Owners: Ownerscontribute capital and assume the risk of business. Naturally, Nature and Scope of Accounting they are interested to know the amount of profit earned by the business and so also its financial position. If however, the management of the business is entrusted to paid managers, the owners also use the accounting information to evaluate the performance of the managers. Managers: Accounting information, supplemented by other information, is of immense use to managers. It helps them to plan, control and evaluate the operations of the business. They also need such information for various decision- making. Lenders : The funds are provided by the owners initially, but if the business requires more funds they are provided by banks and other lenders of money. Before they lend money, they would like to know the solvency (i.e.., capacity to repay debts) of the enterprise, so as to satisfy themselves that their money will be safe and that they can expect repayment on time. Creditors: Those who supply goods and services on credit are called creditors. Like lenders, they too want to know about solvency of the enterprise, so as to decide whether credit can be granted or not. Prospective investors: A person who wants to become a partner in a partnership concern or a person who wants to become a shareholder of a company, would like to know how safe and rewarding the proposed investment would be. Tax authorities: Tax authorities of the Government are interested in the financial statements so as to assess the tax liability of the enterprise. Employees: The employees of the enterprise are also interested in knowing the state of affairs of the organisation in which they are working, so as to know how safe their interests are in that organisation. 1.7 ACCOUNTING AS AN INFORMATION SYSTEM Accounting is part of an organization’s information system, which includes both financial and non-financial data. Accounting is the process of identifying, measuring and communicating economic information to permit judgment and decisions by users of the information. The main objective of accounting is to provide information to the users. Accounting is also required to serve some broad social obligations since the accounting information is used by a large body of people such as customers, employees, investors, creditors and government. Accounting is commonly divided into (1) Financial Accounting, and (2) Managerial Accounting. Financial accounting refers to the preparation of general purpose reports for use by persons outside an organization. Such users include shareholders, creditors, financial analysts, labour unions, government regulations etc. External users are interested primarily in reviewing and evaluating the operations and financial status of the business as a whole. Managerial accounting, on the other hand, refers to providing of information to managers inside the organization. For example a production manager may want a report on the number of units of product manufactured by various workers in order to evaluate their performance. A sales manager might want a report 11 Theortical Framework showing the relative profitability of two products in order to pinpoint selling efforts. The financial reports are available from the libraries or company themselves whereas managerial accounting reports are not widely distributed outside because they often contain confidential information. The following figure shows that accounting is part of an organization system which includes both financial and non financial data: Accounting as an information system Uses of Accounting Information Accounting provides information for the following three general uses:- 1) Managerial decision making: Management is continuously confronted with the need to make decisions. Some of these decisions may have immediate effect while the others have in the long run. Decisions regarding the price of the product like make or buy the product or to drop it, to expand its area of operations etc., are some of the examples of decisions making. Management Accounting provides necessary information to arrive at right conclusions. 2) Managerial planning, control and internal performance evaluation: Managerial accounting plays an important role in the planning and control. By assisting management in the decision making process, information is provided for establishing the standard. Accounting also provides actual results to compare with projections. For example, where a marketing manager is given a target of sales revenues of Rs. 10 crores, the amount of Rs. 10 crores will serve as a standard for evaluating the performance of the marketing manager. If annual sales revenues vary significantly from Rs. 10 crores, steps will be taken to ascertain the causes for the difference. When the factors leading to the variance are not under the control of the marketing manager, then the marketing manager would not be held responsible for it. On the other hand the cause for variance is under the control of marketing manager then he will be held responsible in evaluating the performance of marketing manager. Accounting provides necessary information to measure the variance in the actual performance. 3) External financial reporting: Accounting has always been used to supply information to those who are interested in the affairs of the company. Various laws have been passed under which financial statements should be prepared in such way that required information is supplied to shareholders, 12 creditors, government etc. For example, the investors may be interested in the financial strength of the business, creditors may require information about Nature and Scope of Accounting the liquidity position, government may be interested to collect details about sales, profit, investment, liquidity, dividend policy, prices etc. in deciding social and economic policies. Information is required in accordance with generally accepted accounting principles so that it is useful in taking important decisions. 1.8 BRANCHES OF ACCOUNTING Accounting, as we know it today, has evolved over many centuries in response to the changing economic, social and political conditions. The development of modern accounting was influenced by a number of factors such as industrial revolution, growth of large enterprises like companies, introduction of compulsory audit of companies, legal regulations, establishment of professional organisations like the Institute of Chartered Accountants of India, the Institute of Cost and Works Accountants of India, American Institute of Certified Public Accountants, etc Economic development and technological improvements have resulted in an increase in the scale of business operations and the advent of company form of organisation. This has made management function more and more complex. These factors have increased the importance of accounting and have given rise to special branches of accounting. The important branches of accounting are briefly explained below: Financial Accounting: The purpose of this branch of accounting is to keep a record of financial transactions and events so that: a) the net result of the operations of the business (profit or loss) during an accounting period can be ascertained; b) the financial position (assets, liabilities and capital position) of the business as at the end of the period can be ascertained; and c) relevant financial information can be provided to management and other interested parties. Cost Accounting: The purpose of cost accounting is to analyse the expenditure so as to ascertain the cost of each product, operation, service, etc. The price of an article is nothing but the cost plus a certain amount of profit. Unless cost is known, price cannot be fixed rationally. Cost accounting helps not only in ascertaining the costs but also assists the management in controlling the costs. Management Accounting: The purpose of management accounting is to assist the management in taking rational policy decisionsand to evaluate the impact of its decisions and actions. Examples of such decisions are: pricing decisions, capital expenditure decisions, etc. This branch of accounting is primarily concerned with presenting information that may be needed by management in such decision-making. In this course, we are concerned with financial accounting only. Check Your Progress C 1. Mr. Agarwala started Agarwala Electricals shop with a capital of Rs. 1,00,000. As this amount is insufficient, he has borrowed Rs. 50,000 from Syndicate Bank. As he is not keeping good health, he appointed Mr. Ram Naresh to look after the business on a salary of Rs. 1,000 per month. Pavan Electrical Works supplies electrical goods to Agarwala Electricals 13 Theortical Framework on credit. Mr. Mirchand, Mr. Sabir and Mr. Wilson are the other persons working in Agarwals Electricals, as salesmen. Mr. Agarwals wants to expand the business. He is not in a position to invest more money. Mr. Shyamlal wants to join as a partner. From this, identify the names of the following parties and write the answer in theblank space provided. Name i) Business firm.............................................................. ii) Owner.............................................................. iii) Manager.............................................................. iv) Lender.............................................................. v) Creditor.............................................................. vi) Prospective Investor.............................................................. vii) Employees.............................................................. 2. Complete the following sentences: i) Accounting is the process of identifying, measuring and ……………… economic information to permit informed judgements. ii) Accounting designed to serve external parties to provide information relating to the operating activities of the business is termed as ……………………… iii) Accounting designed for operational needs of business is termed as …………………………………….. iv) ……………………….. Accounting is more or less compulsory for every business. 1.9 ADVANTAGES OF ACCOUNTING The following are the advantages of a properly maintained accounting system: 1) Replaces memory: Since all the financial events are recorded in the books, there is no need to rely on memory. The books of account will serve as historical records. Any information required at any time can be had from these records. 2) Provides control over assets: Accounting provides information regarding balance of cash in hand and at bank, the stock of goods in hand, the amount receivable from various parties, the amount invested in various other assets, etc. Information about these matters help owner(s) and management to make use of the assets in the best possible way. 3) Facilitates the preparation of financial statements: With the help of information contained in the accounting records, financial statements viz., Profit and Loss Account and Balance Sheet can be easily prepared. These statements enable the businessman to know the net result of the business during an accounting period and its financial position. 4) Meets the information requirements: Various interested parties such as owners, management, lenders, creditors, etc. get the necessary information 14 at frequent intervals which help them in their decision-making. 5) Facilitates a comparative study: The financial Statements prepared will Nature and Scope of Accounting enable the enterprise to compare its present position with that of its past, and with that of similar organisations. This helps them to draw useful conclusions and improve its performance. 6) Assists the management in many ways: It is possible to identify reasons for the profit earned or loss suffered. The identification of reasons helps in taking necessary steps to increase profits further, or to avoid losses. Accounting information will also help in planning and controlling the activities of the business. 7) Difficult to conceal fraud or theft: It is difficult to conceal fraud, theft, etc..as there is an automatic check in the form of periodic balancing of books of account. Further, in big organisations, the record keeping work is divided among many persons. so that chances of committing fraud are minimised. 8) Tax matters : The Government levies various taxes such as customs duty, excise duty, sales tax, and income tax. Properly maintained accounting records will help in the settlement of tax matters with the tax authorities. 9) Ascertaining value of business: In the event of sale of a business firm, the accounting records will help in ascertaining the value of business. 1.10 LIMITATIONS OF ACCOUNTING The accounting information is used by various parties who form judgments about the profitability and the financial soundness of a business on the basis of such information. It is, therefore, necessary to know about the limitations of accounting. These are as follows: 1. They do not record transactions and events which are not of a financial character. Hence. They do not reveal a complete picture because facts like quality of human resources, licences possessed, locational advantage, business contacts, etc. do not find any place in books of account. 2. The data is historical in nature. The accountants adopt historical cost as the basis in valuing and reporting all assets and liabilities. They do not reflect current values, it is quite possible that items like land and buildings may have much more value than what is stated in the balance sheet. 3. Facts recorded in financial statements are greatly influenced by accounting conventions and personal judgements. Hence, they do not reveal the true picture. In many cases, estimates may be used to determine the value of various items. For example, debtors are estimated in terms of collectability, inventories are based on marketability, and fixed assets are based on useful working life. All these estimates are materially affected by personal judgements. 4. Data provided in the financial statements is insufficient for proper analysis and decision making. It only provides information about the overall profitability of the business. No information is given about the cost and profitability of different activities. 15 Theortical Framework 1.11 BASES OF ACCOUNTING There are two bases of accounting: (i) cash basis, and (ii) accrual basis. These are explained below: 1.11.1 Cash Basis of Accounting In this system, the accounting entries are made on the basis of cash received or cash paid. In other words, transactions are recorded only when cash is received or paid. The incomes earned but not yet received (accrued income) or the expenses incurred but not yet paid (expenses outstanding) are completely ignored while preparing the final accounts. For example, rent for the month of December, 2017 is paid in January, 2018. This is taken into the Profit and Loss Account of 2018 even though the benefit of that payment (accommodation) is enjoyed in 2017 itself. 1.11.2 Accrual Basis of Accounting This system of accounting attempts to record the financial effects of transactions in the period in which they occur and not in the period in which the amount is received or paid to the enterprise. Accrual accounting is also called ‘Mercantile System of Accounting’. It recognises that buying, selling and all other operations of an enterprise during a period may not coincide with the period during which the related cash receipts and cash payments take place. In other words, all revenues earned in a year may or may not have been received in cash in that year. Similarly, all expenses incurred in a year may or may not have been paid in the same year. Accrual accounting attempts to relate the revenues and expenses to year in which they are actually earned or incurred. For example, rent for the month of December, 2017 is paid in January, 2018. As per the accrual principle, it would be taken to the Profit and Loss Account of the year 2017 and not 2018. This is more logical because the benefit of payment is enjoyed in the year 2017 and not in 2018. The main difference between accrual accounting and cash basis of accounting is the recognition of revenues, gains, expenses and losses. The objective of accrual accounting is to account for the effects of transactions and events to the extent that their financial effects are recognisable and measurable in the periods in which they occur. The adjustments made in the final accounts in respect of prepaid expenses (prepaid insurance, salaries paid in advance, etc.), income received in advance (rent received in advance, interest received in advance, etc.), income earned but not yet received (interest receivable, commission receivable, etc.) are based on accrual accounting. Sometimes, a business adopts a combination of both the above systems. In that case it is called ‘Mixed or Hybrid System’. For example, the business may consider income in cash receipt basis and expenses on accrual basis. This is considered most conservative. In practice, most enterprise adapt the accrual basis of accounting. 16  Nature and Scope of 1.12 QUALITATIVE CHARACTERISTICS OF Accounting ACCOUNTING INFORMATION Business owners can use accounting information to conduct a financial analysis of business operations. Accounting information often has quantitative and qualitative characteristics. Quantitative characteristics refer to the calculation of financial transactions. Qualitative characteristics include the business owner’s perceived importance of financial information. Business owners often require financial information when making business decisions. Incorrect or inappropriate information can hamper decision-making or cause business owners to make incorrect assessments about their companies. Some of the qualitative characteristics of accounting information are as follows: (i) Understandable Accounting information must be understandable. This is an important qualitative characteristic for small business owners. Many small business owners do not have a strong accounting background. Financial information that is too technical or cannot be understood by a layperson can be ineffective for business owners. Small business owners often use professional accountants to complete various accounting functions. Business owners should choose an accountant who can prepare information in an easily understandable manner. (ii) Usefulness Business owners need accounting information that is applicable to the business decision at hand. They can request financial statements, accounting schedules, reconciliations or cost-benefit analysis. For example, cost allocation reports may not provide sufficient information for business owners who must make a decision on hiring employees. Cost allocation usually refers to applying business costs to goods or services produced by the company, which has very little to do with human resources. Business owners should carefully request and review accounting information to ensure that it provides the most useful information for the decision-making process. (iii) Relevance Accounting information should relate to a specific time period or contain information regarding individual business functions. Business owners often conduct a trend analysis when reviewing financial information. The trend analysis compares historical financial information to the company’s current accounting period information. Irrelevant historical information can severely distort the trend analysis process. For example, reviewing the production process for budgets requires relevant information on the cost of materials for budgets. Cost information on the materials to produce COGS would be irrelevant. (iv) Reliability Accounting information must be reliable, so that business owners can be reasonably assured that accounting information presents an accurate picture of the company’s financial health. Business owners often use accounting information to secure external financing for their business. Information that is not reliable or accurate may cause lenders and investors to question the business’s 17 Theortical Framework management ability. Business owners may also struggle to secure external financing with poor accounting information. (v) Comparable Comparability allows business owners to review their company’s accounting information against that of a competitor. Business owners use comparison to gauge how well their companies operate under certain market conditions. Owners often use the leading company of an industry for the comparison process. These companies usually have the most efficient and effective business operations. Non- comparable accounting information can make this a difficult process. For example, business owners should consider preparing financial statements according to standard accounting principles. The statements can then be compared to other company’s financial standard prepared in a similar manner. (vi) Consistent Consistency refers to how business owners and accountants record financial information in a company’s general ledger. Business owners need to ensure that financial transactions are handled the same way. Inventory purchases should be recorded the same way as yesterday, today and tomorrow. This helps companies create accurate historical records and limit the amount of financial accounts or journal entries included in their general ledgers. 1.13 FUNCTIONS OF ACCOUNTING Functions of Accounting involves the creation of financial records of business transactions, flows of finance, the process of creating wealth in an organization, and the financial position of a business at a particular moment in time. The progress and reputation of any business big or small is build up on sound financial footing. There are number of parties who are interested in accounting information relating to a business. Financial Accounting communicates financial information of the business concern to various parties. Financial accounting provides information regarding the status of a business and results of its operation. Here are the functions of accounting: (i) Recording This is the basic function of accounting. It is essentially concerned with not only ensuring that all business transactions of financial character are in fact recorded but also that they are recorded in an orderly manner. Recording is done in the book “Journal”. (ii) Classifying Classification is concerned with the systematic analysis of the recorded data, with a view to group transactions or entries of one nature at one place. The work of classification is done in the book termed as “Ledger”. (iii) Summarizing This involves presenting the classified data in a manner which is understandable and useful to the internal as well as external end-users of accounting statements. This process leads to the preparation of the following statements: (1) Trial Balance, (2) Income statement (3) Balance Sheet. 18 (iv) Analysis and Interprets Nature and Scope of Accounting This is the final function of accounting. The recorded financial data is analyzed and interpreted in a manner that the end-users can make a meaningful judgment about the financial condition and profitability of the business operations. The data is also used for preparing the future plan and framing of policies for executing such plans. (v) Communicate The accounting information after being meaningfully analyzed and interpreted has to be communicated in a proper form and manner to the proper person. This is done through preparation and distribution of accounting reports, which include besides the usual income statement and the balance sheet, additional information in the form of accounting ratios, graphs, diagrams, funds flow statements etc. 1.14 LET US SUM UP 1. Business has a series of transactions. It is not possible to remember all the transactions which have taken place over a period of time, and calculate the net effect of all such transactions i.e., profit or loss. Hence, the need for accounting takes place. 2. Information about the business enterprise is required for both internal and external use. To get the required information, a systematic record is necessary. 3. The objectives of accounting are: to keep systematic records; to ascertain the profit or loss and also the financial position; and to provide accounting information to interested parties for rational decision-making. 4. Accounting is the process of identifying, measuring, recording, classifying, summarising, analysing, interpreting and communicating the financial transactions and events. 5. The series of activities mentioned above, explain the nature and outline the scope of accounting. 6. Book-keeping is a part of accounting. It is the record keeping function of accounting and is limited upto the classifying stage. 7. Accountancy is the systematic knowledge, while accounting is the practice of the knowledge i.e., the actual maintenance of books of account and provide accounting information. 8. Many groups of people like owners, management, lenders, creditors, investors, tax authorities, employees, etc., are interested in the accounting information of the enterprise. 9. Changes in economic environment and the increasing complexity of management function have given rise to specialised fields of accounting such as financial accounting, cost accounting and management accounting. 10. There are many advantages of a properly maintained accounting system. 19 Theortical Framework 1.15 KEY WORDS Accountancy: The science of measurement of wealth. It is the systematic knowledge of accounting. Accounting: Process of identifying, measuring, recording, classifying, summarising and communicating business transactions and events in terms of money. Accounting Year : A period of 12 months at the end of which the financial results of the enterprise are generally ascertained. Accrual Basis of Accounting: A basis of accounting which takes into account all incomes, gains, expenses and losses in the year in which they are earned or incurred, and not when they are received or paid. Book-keeping: Systematic recording of business transactions in the books of account. Balance Sheet: A statement prepared for ascertaining the financial position of the business as at the end of the accounting period. Cash Basis of Accounting: A basis of accounting in which accounts are prepared on the basis of cash received or cash paid. No accruals -are considered. Cost Accounting: A branch of accounting concerned with measurement and control of costs. Financial Accounting: It is primarily concerned with record keeping directed towards preparation of financial statements and other accounting reports. Financial Position: Position of assets and liabilities of a business at a given point of time. Financial Statements: Summary of accounting information such as Profit and Loss Account and Balance Sheet. Final Accounts : Financial statements prepared at the end of the accounting period for ascertaining the profit or loss and the financial position of the business. They include Profit and Loss Account and the Balance Sheet. Management: It is used in two senses: i) to mean the process of management or managing the business, for example, the day-to-day management is entrusted to paid managers; and ii) to mean the persons who are incharge of carrying out the business activity i.e., managers, for example, management wants this information. Report has to be submitted to the management. Management Accounting: It is concerned with the supply of information which is useful to the management in planning, controlling and decision-making. Profit: Excess of income over expenses. Profit and Loss Account: A statement showing all incomes and expenses for the accounting period. It is prepared for ascertaining the operational result of the enterprise. 20  Nature and Scope of 1.16 SOME USEFUL BOOKS Accounting Bièrman, Harold & Drebin, Allan R., Financial Accounting: An Introduction (Philadelphia: W.B. Saunders Company, 1998). Briston, R.J., Introduction to Accountancy & Finance (London: The Macmillan Press Ltd., 1991). Maheshwari, S.N., Principles and Practice of Book-Keeping (New Delhi: Arya Book Depot, 2018). Matulich, S. & Heitger, L.E., Financial Accounting (New York: McGraw Hill Book Company, 1990). Patil, V.A. & Korlahalli, Principles and Practice of Book-Keeping (New Delhi: R. Chand & Co., 2018). 1.17 ANSWERS TO CHECK YOUR PROGRESS C 1. i) Agarwala Electricals Shop ii) Mr. Agarwala iii) Mr. Ram Naresh iv) Syndicate Bank v) Pawan Electrical Works vi) Mr. Shyamlal vii) Mr. Mirchand, Mr. Sabir and Mr. Wilson. 2. i) Communicating ii) Financial Accounting iii) Management Accounting iv) Financial 1.18 TERMINAL QUESTIONS 1. Outline the need for accounting and briefly describe the objectives of accounting. 2. Define accounting and explain its scope. 3. Name the different parties interested in accounting information, and explain why do they want it. 4. What are the qualitative characteristics of accounting information? Briefly Explain. 5. Describe the advantages and limitations of accounting. 6. Briefly discuss the functions of accounting. 7. Define accounting. Explain the need for accounting. 21 Theortical Framework 8. Write short notes on the following: a) Book-keeping b) Accountancy c) Accounting 9. Distinguish between cash basis and accrual basis of accounting with examples. Note : These questions will help you to understand the unit better. Try to write answers for them. But, do not submit your answers to the University for assessment. These are for your own practice only. 22 UNIT 2 ACCOUNTING PROCESS AND RULES Structure 2.0 Objectives 2.1 Introduction 2.2 Accounting Process 2.3 What is an Account? 2.4 Classification of Accounts 2.5 Principle of Double Entry 2.6 Accounting Rules 2.7 Let Us Sum Up 2.8 Key Words 2.9 Some Useful Books 2.10 Answers to Check Your Progress 2.11 Terminal Questions/Exercises 2.0 OBJECTIVES After studying this unit, you should be able to:  identify the different stages of accounting;  classify accounts;  analyze the dual effect of each transaction; and  apply the rules of accounting, and determine the account to be debited and the account to be credited. 2.1 INTRODUCTION So far you have learnt the definition of accounting, its objects, advantages, the terms commonly used in accounting, and the basic accounting concepts relevant to record keeping. You know accounting is the art of recording, classifying and summarising the business transactions, and interpreting the results thereof. So, the accounting process starts with recording of transactions and ends with the preparation of financial statements and their analysis. In this unit, we shall first identify the different stages involved in the accounting process and then discuss different classes of accounts, the principle of double entry, and the rules of debit and credit which you are expected to master. 2.2 ACCOUNTING PROCESS The accounting process consists of the following four steps: 23 Theortical Framework i) Recording the Transactions ii) Classifying the Transactions iii) Summarising the Transactions iv) Interpreting the Results Recording the Transactions The accounting process begins with recording of transactions in the books of original entry. The book used for the original entries is called ‘Journal’. Business transactions are recorded in the journal as and when they occur in the order of dates. You will learn the method of recording a transaction in the journal in Unit 5. Entries in the journal are made on the basis of various vouchers such as cash memos, invoices, receipts, etc. Classifying the Transactions The second step is to group the transactions of similar nature and post them in different accounts in another book called the ‘Ledger’. For example, all transactions relating to cash are brought together and are recorded at one place in Cash Account in the ledger. Similarly, dealings with different persons are recorded separately in the account of each person. The accounts so prepared are totaled and balanced periodically to know the net effect of related transactions. We shall discuss the process of posting into ledger and balancing of accounts in detail in Unit 5. Summarising the Transactions The next step is to prepare a year-end summary known as ‘Final Accounts. But before final accounts are prepared, we prepare a statement called ‘Trial Balance’ to test the arithmetical accuracy of the work done. In other words, the trial balance is prepared to find out whether the Principle of Double Entry has been strictly followed or not, while recording the transaction. Then, with the help of the trial balance and some other relevant information we prepare the final accounts. The objectives of preparing the final accounts are: (i) to know the net result of business activities, and (ii) to know the financial position of the business. The final accounts consist of an income statement called ‘Trading and Profit and Loss Account’, and a position statement called ‘Balance Sheet’. The Trading and Profit and Loss Account is prepared to know whether the business unit has earned profit or incurred loss. The Balance Sheet is prepared to know the financial position of the business, i.e., what the business owns and what it owes. Interpreting the Results The results are then analysed and interpreted with a view to assess the performance of the business, its future profit-earning capacity and its ability to pay short-term and long-term debts. The results and conclusions thus arrived at are reported to the interested parties like investors, management, bankers, creditors, tax authorities, etc. The balances on various accounts shown in the Balance Sheet will then be transferred to the new books of account for the next year. The process of recording transactions for the next year is again started, this continuous process 24 of accounting is referred to as the ‘Accounting Cycle’ because it repeats itself regularly and in the same order. The Accounting Cycle is presented in Chart 2.1. Accounting Process and Rules Chart 2.1 ACCOUNTING CYCLE Ledger Journal Trial Balance Transactions Trading and Profit Balance Sheet and Loss Account 2.3 WHAT IS AN ACCOUNT? We have seen that an account is a summarised record of the effect of all transactions relating to a particular person or an item. Let us now learn more about this term. An account is vertically divided into two halves and resembles the shape of the English alphabet ‘T’ as under: Name of the account Dr. Cr. The left hand side is called the ‘debit side’. It is indicated by writing ‘Dr.’ (abbreviation for debit) on the left hand top corner of the account. The right hand side known as the ‘credit side’ is indicated by writing ‘Cr.’ (abbreviation for credit) on the right hand top corner of the account. The name of the account is written at the top in the centre. The word ‘Account’ or its abbreviation ‘A/ c’ is added to the name of the account. The rules of recording the transactions on the debit and credit sides shall be discussed later in this unit. 2.4 CLASSIFICATION OF ACCOUNTS All business transactions broadly be classified into three categories: (i) those relating to persons, (ii) those relating to property (assets), and (iii) those relating to incomes and expenses. Hence, it becomes necessary to keep an account for each person, each asset, and each item of income and expense. Thus, three classes of accounts are maintained for recording all business transactions. They are: (i) Personal Accounts, (ii) Real Accounts, and (iii) Nominal Accounts. Real and Nominal Accounts taken together are called Impersonal Accounts. 25 Theortical Framework Personal Accounts Accounts which show dealings with persons are called ‘Personal Accounts’. Such dealings may relate to credit purchases of goods or credit sales of goods or loans taken, etc. A separate account is kept in the name of each person for recording the benefits received from, or given to, the person in the course of dealings with him. Examples are: Krishna’s Account, Gopal’s Account, Loan from Ratanlal Account, etc. Personal accounts also include accounts in the names of institutions or companies called artificial persons) such as Indian Bank Account. Nagarjuna Finance Limited Account, the Andhra Pradesh Paper Mills Limited Account, etc. The accounts which represent expenses payable, expenses paid in advance, incomes receivable and incomes received in advance are also personal accounts, though impersonal in name. For example, when salaries are due to the employees, but not paid before closing of the books of account for the year, an account called ‘Salaries Outstanding Account’ will be opened in the books. The Salaries Outstanding Account is regarded as a personal account representing the employees to whom salaries are payable by the business. Such a personal account is called Representative Personal Account’ as it represents a particular person or a group of persons. Other examples of representative personal accounts are: Interest Outstanding Account, Prepaid Insurance Account, Rent Received in Advance Account, Commission Outstanding Account. etc. Capital Account and Drawings Account are also treated as personal accounts as they represent dealings with the owner of the business. Real Accounts Accounts relating to properties or assets are known as ‘Real Accounts’. Every business needs assets such as Machinery, Furniture, etc., for running its activities. In. book-keeping, a separate account is maintained for each asset owned by the business. Dealings relating to purchase or sale of the asset are recorded through this account. Furniture Account, Machinery Account, Building Account, etc., are some examples of real accounts. Cash Account which shows receipts and payments of cash is also a real account. They are known as real accounts because they represent things of value owned by the business. Nominal Accounts Accounts relating to expenses, losses, incomes and gains are known as ‘Nominal Accounts’. Every business unit incurs certain expenses such as payment of salaries to employees, payment of wages to workers, etc., while carrying out its activities. It may also suffer losses such as loss by fire, loss by theft, etc. It may also earn certain incomes and gains such as receipt of commission, receipt of-interest, profit on sale of an asset, etc. A separate account is maintained for recording each item of expense, loss, income or gain. Thus, Wages Account, Salaries Account, Commission Received Account, and Interest Received Account are all nominal accounts. Classification of accounts is presented in Chart 2.2. 26  CHART 2.2 Accounting Process and Rules CLASSIFICATION OF ACCOUNTS Accounts Personal Accounts Impersonal Accounts Real Accounts Nominal Accounts Krishna Furniture Salaries Gopal Buildings Wages Loan from Ratanlal Machinery Interest Salaries Outstanding Vehicles Rent Insurance Prepaid Cash Commission Check Your Progress A 1. State whether each of the following statements is True or False. a) First recording of transactions is done in Journal. b) Summarising of all business transactions is done in Ledger. c) Interpretation of the results is done by preparing Trial Balance. d) Right hand side of an account is called credit side. e) Personal accounts include accounts of persons with whom the business deals. f) Accounts which represent an item of asset is called Representative Personal Accounts. g) Accounts relating to assets held in the name of the firm are called Nominal Accounts. 2. Names of some accounts are given below, classify them into Personal, Real or Nominal. Name of Account Class of Account a) Bank A/c b) Interest A/c c) Interest Outstanding A/c d) Patents A/c e) Loan from Gopal Das A/c f) Loose Tools A/c g) Commission Received in Advance A/c h) Prepaid Salaries A/c i) Stationery A/c j) Electricity Charges A/c 27 Theortical Framework 3. State whether the following classification of accounts is correct or not. Give the correct classification, wherever necessary. Name of Account Class of If correct, put a Account tick mark. If wrong, state the correct class of account a) Fixtures A/c Nominal Account b) Discount Received A/c Personal Account c) Discount Received in advance A/c Nominal Account d Ram & Co. A/c Personal Account e) Goodwill A/c Personal Account f) Office Expenses A/c Real Account g) Office Equipment A/c Nominal Account h) Cash A/c Real Account i) Cartage A/c Real Account j) Import Duty/A/c Real Account 2.5 PRINCIPLE OF DOUBLE ENTRY You have learnt earlier that a transaction results in the transfer of money or money’s worth i.e., goods or services. Hence, every business transaction involves a transfer and as such consists of two aspects: (i) the receiving aspect, and (ii) the giving aspect. It is necessary to note that these two aspects go together, as receiving necessarily implies giving and vice versa. For example, let us consider a transaction where machinery is purchased for cash. In this case, the receiving aspect is machinery (as machinery comes in) and giving aspect is cash (as cash goes out). Similarly, in a transaction where wages are paid to workers, the receiving aspect is the service of the workers and the giving aspect is cash. The receiving and giving take place between two parties or the accounts representing those parties. Thus, in the first example discussed above, from the point of view of the business, Machinery Account is receiving the benefit and Cash Account is giving the benefit. In the second example, Wages Account is receiving the benefit in the form of service and Cash Account is giving the benefit. These two aspects are represented in every account by the terms ‘Dr’. and ‘Cr.’. The ‘Dr.’ represents the receiving aspect and the ‘Cr.’ the giving aspect. The record of any business transaction will be complete only when both of these aspects are recorded. This recording of the two aspects of each transaction is known as ‘Double Entry’ and the system is called ‘Double Entry System’. Thus, every transaction affects two accounts and according to Double Entry system entries will be made in both of them on the debit side (left hand side) in one account and on the credit side (right hand side) in the other. In case of the first example (machinery purchased for cash), entries will be made on the debit side of Machinery Account and the credit side of Cash Account. In the case of second example (wages paid to workers), entries will be made on debit side of Wages Account and the credit side of Cash Account. Hence, 28 for every debit there must be a corresponding credit for an equal amount and vice versa. This is known as the ‘Principle of Double Entry, and all business Nature and Scope of Accounting transactions are recorded in books of account according to this principle. In order to develop a clear understanding of the receiving and giving aspects of various business transactions and the accounts affected thereby study Table 2.1 carefully. Table 2.1: Dual Aspect of Transactions and the Account Affected Transaction First Aspect Second Aspect Receiving Account Giving/Giver Account Receiver affected affected 1. Commenced business with Cash Cash A/c Proprietor Capital A/c Rs. 50,000 as capital. 2. Bought goods for cash Rs. 5,000 Goods Goods A/c Cash Cash A/c 3. Bought goods from Ramesh & Goods Goods A/c Ramesh & Ramesh & Co. on credit Rs. 10,000 Co. Co. A/c 4. Sold goods for cash Rs. 12,000 Cash Cash A/c Goods Goods A/c 5. Sold goods to Ajay on credit Ajay Ajay’s A/c Goods Goods A/c Rs. 2,500 6. Paid cash to Ramesh & Co. Ramesh Ramesh & Cash Cash A/c Rs. 5,000 & Co. Co. A/c 7. Received Cash from Ajay Cash Cash A/c Ajay Ajay’s A/c Rs. 1,000 8. Paid rent Rs. 1,000 Benefit of Rent A/c Cash Cash A/c accommoda tion 9. Purchased Typewriter Rs. 4,500 Typewriter Typewriter A/c Cash Cash A/c 10. Paid interest on loan Rs. 1,200 Benefit of Interest A/c Cash Cash A/c using the loan Check Your Progress B Manohar had the following transactions. Determine the two aspects of each transaction and the accounts affected. Transaction First Aspect Second Aspect Receiving Account Giving/Giver Account Receiver affected affected a) Purchased machinery for Rs. 60,000 b) Purchased goods from Karim & Co. on credit Rs. 10,000 29 Theortical Framework c) Sold goods for cash Rs. 2,400 d) Loan taken from bank Rs. 25,000 e) Travelling expenses paid to salesman Rs. 122 f) Paid electricity charges Rs. 110 g) Received Cash from Shanker Rs 1,200 h) Paid cash to Karim & Co. Rs. 2,000 I) Cash drawn for personal expenses Rs. 500 j) Paid cash into bank Rs. 5,000 2.6 ACCOUNTING RULES We have already seen that every transaction affects two accounts and this effect will have to be entered in both of them, on the debit side in one account and on the credit side in the other account. It is, therefore, necessary to find out which of the two accounts is to be debited and which is to be credited. For this purpose, one has to first identify the class to which these two accounts belong i.e., personal, real or nominal; and then certain rules known as ‘rules of debit and credit’ are applied. These rules are as follows: 1. For Personal Accounts: The account of the person receiving the benefit (receiver) of the transaction (from the business) is debited and the account of the person giving the benefit (giver) of the transaction (to the business) is credited. 2. For Real Accounts: When an asset is coming into the business, the account of that asset is debited. When an asset is going out of the business, the account of that asset is credited. 3. For Nominal Accounts: When an expense is incurred or loss suffered, the account representing the expense or the loss is debited because the business receives the benefit thereof. When any income is earned or gain made, the account representing the income or the gain is credited. This is because the business gives some benefit. The above rules have been shown in Table 2.2 Table 2.2 : Rules of Debit and Credit Class of Account Debit Credit Personal Accounts The Receiver The Giver Real Accounts What comes in What goes out Nominal Accounts Expenses and Losses Income and Gains 30 We shall now see the application of these rules, taking a few transactions. Accounting Process and Rules Example 1: Paid cash to Ramesh & Co. Rs. 5,000. In this case, the two accounts affected are Ramesh & Co.’s Account and Cash Account. Ramesh & Co.’s Account is a personal account and Cash Account is a real account. Ramesh & Co. has received the benefit (cash Rs. 5,000) from the business and, therefore, it has to be debited as per the first part of the rule for personal accounts ‘debit the receiver’. As cash has gone out, Cash Account will be credited according to the second part of the rule for real accounts ‘credit what goes out’. Example 2: Received cash from Ajay Rs. 1,000. In this case, Cash Account and Ajay’s Account are the two accounts affected. Cash Account is a real account and Ajay’s account is a personal account. As cash has come in, Cash Account will have to be debited according to the first part of the rule for real accounts ‘debit what comes in’. Ajay has given the benefit (cash Rs. 1,000) to the business and, therefore, his account will have to be credited as per the second part of the rule for personal accounts ‘credit the giver’. Example 3: Paid rent Rs. 1,000. In this case, the accounts affected are Rent Account and Cash Account. Rent Account is a nominal account and Cash Account is a real account. As per the first part of the rule for nominal accounts, ‘debit expenses and losses’, Rent Account will have to be debited as it is an expense to the business. As cash has gone out, Cash Account will have to be credited according to the second part of the rule for real accounts ‘credit what goes out’. Example 4: Received Rs 400 as commission. In this case, Cash Account and Commission Account are the two accounts affected. Cash Account is a real account and Commission Account is a nominal account. As cash has come in, Cash Account will have to be debited according to the first part of the rule for real accounts ‘debit what comes in’. As per second part of the rule for nominal accounts, ‘credit incomes and gains’, Commission Account will be credited as it is an income to the business. You have seen that the three rules of debit and credit explained above, make it possible to analyse the transaction and identify the account to be debited and the account to be credited. Even though it has been explained that there are three different rules for the three classes of accounts, it is to be noted that these three rules, in reality, are a manifestation of the dual aspect concept. In other words, the account that receives the benefit of the transaction is to be debited and the account that gives the benefit is to be credited, irrespective of the class of account involved. Let us now apply these rules to the transactions given in Table 2.1 and ascertain which account is to be debited and which account is to be credited. This has been analysed in Table 2.3. You may go through it carefully and grasp the application of the Rules of Debit and Credit. 31 Theortical Framework Table 2.3 : Analysis of Accounts Affected Transaction Accounts affected Class of Debit/ Reasons Accounts Credit 1. Commenced business with i) Cash A/c ii) Capital A/c Real Debit Cash comes in Proprietor Rs. 50,000 as capital Personal Credit gives benefit 2. Bought goods for cash i) Goods A/c ii) Cash A/c Real Real Debit Goods come in Cash goes Rs. 5,000 Credit out 3. Bought goods from Sohan i) Goods A/c ii) Sohan A/c Real Debit Goods come in Giver on credit Rs.10000 Personal Credit Giver 4. Sold goods for cash i) Cash A/c ii) Goods A/c Real Real Debit Cash comes in Goods go Rs. 1,500 Credit out 5. Sold goods to Vijay on i) Vijay A/c ii) Goods A/c Personal Debit Receiver Goods go out credit Rs. 2,500 Real Credit 6. Purchased furniture i) Furniture A/c RealReal Debit Furniture comes inCash Rs. 4,000 ii) Cash A/c Credit goes out 7. Sold old typewriter Rs. 500 i) Cash A/c RealReal Debit Cash comes in Typewriter ii) Typewriter A/c Credit goes out 8. Purchased postage i) Postage A/c ii) Cash A/c Nominal Debit Postage is an expenseCash stamps Rs. 50 Real Credit goes out 9. Paid salaries Rs. 6,000 i) Salaries A/c ii) Cash A/c Nominal Debit An expense Cash goes out Real Credit 10. Received interest Rs. 200 i) Cash A/cii) Interest A/c Real Debit Cash comes in An income Nominal Credit 2.7 LET US SUM UP 1. The accounting process starts with recording of transactions in the journal. From the journal, they are posted to ledger accounts. Then, a trial balance is prepared to verify the accuracy of the work done and the final accounts are prepared to know the profit or loss made and the financial position of the business. Finally, the results are analysed and reported to the interested parties. 2. Accounts are classified as Personal, Real, and Nominal Accounts. Accounts showing dealings with persons are called personal accounts. Accounts relating to assets are known as real accounts and those relating to expenses, losses, incomes and gains are known as nominal accounts. 3. Every transaction consists of two aspects: (i) the receiving aspect and ii) the giving aspect. The recording of this two-fold effect of each transaction is called ‘Double Entry’. The principle of double entry is, for every debit there must be an equal and a corresponding credit and vice versa. 4. Certain rules are followed for recording business transactions. In the case of personal accounts, the rule is, ‘Debit the receiver and Credit the giver. For real accounts, the rule is, ‘Debit what comes in and Credit what goes out’, and for nominal accounts the rule is, ‘Debit expenses and losses and 32 Credit incomes and gains’.  Accounting Process 2.8 KEY WORDS and Rules Account: A summarised record which shows the effect of the transactions relating to a particular person or thing. Credit: Credit represents the giving aspect of a transaction. Debit: Debit represents the receiving aspect of a transaction. Double Entry Principle: Principle of recording both the receiving and the giving aspects of each transaction. Nominal Accounts: Accounts relating to expenses, losses, incomes and gains. Personal Accounts: Accounts which relate to persons. Real Accounts: Accounts which relate to assets. 2.9 SOME USEFUL BOOKS Briston, R.J., Introduction to Accountancy and Finance, (London: The Macmillan Press Ltd., 2017). Birman, Harold & Derbin, Allan R., Financial Accounting: An Introduction, (Philadelphia: W.B. Saunders Company, 2008). Grewal, T.S., Double Entry Book-Keeping, (New Delhi: Sultan Chand & Sons, 2018) Maheshwari, S.N., Principles & Practice of Accountancy Part-I, (New Delhi: Arya Book Depot, 2018). Patil V.A. & Korlahalli, J.S., Principles and Practice of Book-Keeping, (New Delhi R. Chand & Co., 2018). 2.10 ANSWERS TO CHECK YOUR PROGRESS A 1. a) True b) False c) False d) True e) True f) False g) False 2. a, c, e, g, h are Personal Accounts. d and f are Real Accounts. b, i, j are Nominal Accounts. 3. a) Real Account b) Nominal Account c) Personal Account d) Correct e) Real Account f) Nominal Account g) Real Account h) Correct i) Nominal Account j) Nominal Account 33 Theortical Framework B Transaction First Aspect Second Aspect Receiving/Receiver Account Giving/Giver Account affected affected a) Machinery Machinery A/c Cash Cash A/c b) Goods Goods A/c Karim & Co. Karim & Co. A/c c) Cash Cash A/c Goods Goods A/c d) Cash Cash A/c Bank Bank Loan A/c e) Benefit of Travelling Cash Cash A/c service (Transport) Expenses A/c f) Benefit of service Electricity Cash Cash A/c (Electricity) Charges A/c g) Cash Cash A/c Shanker Shanker’s A/c h) Karim &Co. Karim & Co. A/c Cash Cash A/c i) Proprietor Drawings A/c Cash Cash A/c j) Bank Bank A/c Cash Cash A/c 2.11 TERMINAL QUESTIONS/EXERCISES Questions 1. Discuss the various stages involved in the accounting process. 2. What is an Account? Describe t