Introduction to Accounting PDF

i. I SEMESTER STUDY MATERIAL Introduction to Accounting Prepared By Chand pasha A Assistant Professor  CHAPTER - I INTRODUCTION TO ACCOUNTING INTRODU...

i. I SEMESTER STUDY MATERIAL Introduction to Accounting Prepared By Chand pasha A Assistant Professor  CHAPTER - I INTRODUCTION TO ACCOUNTING INTRODUCTION In all activities (whether business activities or non-business activities) and in all organizations (whether business organizations like a manufacturing entity or trading entity or non-business organizations like schools, colleges, hospitals, libraries, clubs, temples, political parties)which require money and other economic resources, accounting is required to account for these resources. In other words, wherever money is involved, accounting is required to account for it. Accounting is often called the language of business. The basic function of any language is to serve as a means of communication. Accounting also serves this function. MEANING AND DEFINITION OF BOOK- KEEPING Meaning Book- keeping includes recording of journal, posting in ledgers and balancing of accounts. All the records before the preparation of trail balance is the whole subject matter of book- keeping. It is important to note that only those transactions related to business and which can be expressed in terms of money are recorded. Definition “Book- keeping is the art of recording business transactions in a systematic manner”. A.H.Rosenkamph. “Book- keeping is the science and art of correctly recording in books of account all those business transactions that result in the transfer of money or money’s worth”. R.N.Carter ACCOUNTING Meaning of Accounting Accounting, as an information system is the process of identifying, measuring and communicating the economic information of an organization to its users who need the information for decision making. It identifies transactions and events of a specific entity. An entity means an economic unit that performs economic activities. Business transaction is a transaction in which money or money’s worth is involved. Definition of Accounting American Institute of Certified Public Accountants (AICPA) which defines accounting as “an art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events, which are, in part at least, of a financial character and interpreting the results thereof”. Objective of Accounting Objective of accounting may differ from business to business depending upon their specific requirements. However, the following are the general objectives of accounting. i) To keeping systematic record: It is very difficult to remember all the business transactions that take place. Accounting serves this purpose of record keeping by promptly 1 Recording all the business transactions in the books of account. ii) To ascertain whether the business operations have been profitable or not: Accounting helps in ascertaining result i.e., profit earned or loss suffered in business during a particular period. For this purpose, a business entity prepares either a Trading and Profit and Loss account or an Income and Expenditure account which shows the profit or loss of the business by matching the items of revenue and expenditure of the some period. iii) To ascertain the financial position of the business: In addition to profit, a businessman must know his financial position i.e., availability of cash, position of assets and liabilities etc. This helps the businessman to know his financial strength. Financial statements are barometers of health of a business entity. iv)To portray the liquidity position: Financial reporting should provide information about how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing, about its capital transactions, cash dividends and other distributions of resources by the enterprise to owners and about other factors that may affect an enterprise’s liquidity and solvency. v)To protect business properties: Accounting provides upto date information about the various assets that the firm possesses and the liabilities the firm owes, so that nobody can claim a payment which is not due to him. Users of Accounting Information: i) Owners: The owners provide funds or capital for the organization. They possess curiosity in knowing whether the business is being conducted on sound lines or not and whether the capital is being employed properly or not ii) Management: The management of the business is greatly interested in knowing the position of the firm. The accounts are the basis, the management can study the merits and demerits of the business activity. Thus, the management is interested in financial accounting to find whether the business carried on is profitable or not. iii) Creditors: Creditors are the persons who supply goods on credit, or bankers or lenders of money. It is usual that these groups are interested to know the financial soundness before granting credit. iv) Employees: Employees are interested in the financial position of the concern particularly when payment of bonus depends upon the size of the profits earned. v) Investors: The prospective investors, who want to invest their money in a firm, of course wish to see the progress and prosperity of the firm, before investing their amount, by going through the financial statements of the firm. vi) Government: Government keeps a close watch on the firms which yield good amount of profits. The state and central Governments are interested in the financial statements to know the earnings for the purpose of taxation. vii) Research Scholars: Accounting information, being a mirror of the financial performance of a business organization, is of immense value to the research scholar who wants to make a study into the financial operations of a particular firm. 2  Functions of Accounting 1.Record Keeping Function: The primary function of accounting relates to recording, classification and summary of financial transactions-journalisation, posting, and preparation of final statements. These facilitate to know operating results and financial positions. The purpose of this function is to report regularly to the interested parties by means of financial statements. ii) Managerial Function:Decision making programme is greatly assisted by accounting. The managerial function and decision making programmes, without accounting, may mislead. iii) Legal Requirement function: Auditing is compulsory in ca s e o f registered firms. Auditing is not possible without accounting. Thus accounting becomes compulsory to comply with legal requirements. Accounting is a base and with its help various returns, documents, statements etc., are prepared. iv)Language of Business: Accounting is the language of business. Various transactions are communicated through accounting. Advantages of Accounting The following are the advantages of accounting to a business: i) It helps in having complete record of business transactions. ii) It gives information about the profit or loss made by the business at the close of a year and its financial conditions. iii) It provides useful information for making economic decisions, iv) It facilitates comparative study of current year’s profit, sales, expenses etc., with those of the previous years. v) It supplies information to judge the management’s ability to utilise enterprise resources effectively in achieving primary enterprise goals. vi) It provides users information about transactions and other events which are useful for predicting, comparing and evaluating the enterprise’s earning power. vii) Errors & Frauds can be minimized. Limitations of Accounting 1. Records only monetary transactions. 2. Effect of price level changes are not considered. 3. No Realistic information. 4. Personal bias of Accountant affects the accounting statements. 5. Permits alternative treatments. 6. No real test of managerial performance. 7. Accounting statements do not show the impact of inflation. Methods of Accounting Business transactions are recorded in two different ways. Single Entry System Double Entry System Single Entry System: It is incomplete system of recording business transactions. The business organization maintains only cash book and personal accounts of debtors and creditors. So the complete recording of transactions cannot be made and trail balance cannot 3  be prepared. Double Entry System: It this system every business transaction is having a two fold effect of benefits giving and benefit receiving aspects. The recording is made on the basis of both these aspects. Double Entry is an accounting system that records the effects of transactions and other events in atleast two accounts with equal debits and credits. Types of Accounts The object of book-keeping is to keep a complete record of all the transactions that place in the business. To achieve this object, business transactions have been classified into three categories: (i) Transactions relating to persons. (ii) Transactions relating to properties and assets (iii) Transactions relating to incomes and expenses. The accounts falling under the first heading are known as ‘personal Accounts’. The accounts falling under the second heading are known as ‘Real Accounts’, The accounts falling under the third heading are called ‘Nominal Accounts’ The accounts can also be classified as personal and impersonal. The following chart will show the various types of accounts: 4  The accounts can also be classified as personal and impersonal. The following chart will show the various types of accounts: Accounts Personal Accounts Impersonal Account a. Real Account b. Nominal Account Personal Accounts: Accounts recording transactions with a person or group of persons are known as personal accounts. Example: Sharma’s A/c, Anand’s A/c, Firm’s A/c, Bank A/c, Company A/c When a person starts a business, he is known as proprietor. This proprietor is represented by capital account for all that he invests in business and by drawings account for all his withdrawals from the business for personal use. So, capital accounts and drawings account are also personal accounts. The rule for personal accounts is: Debit the receiver & Credit the giver Real Accounts: Accounts relating to properties or assets are known as ‘Real Accounts’, A separate account is maintained for each asset e.g., Cash Machinery, Building, etc., Real accounts can be further classified into tangible and intangible. a) Tangible Real Accounts: These accounts represent assets and properties which can be seen, touched, felt, measured, purchased and sold. E.g. Machinery account Cash account, Furniture account, stock account etc. b) Intangible Real Accounts: These accounts represent assets and properties which cannot be seen, touched or felt but they can be measured in terms of money. E.g., Goodwill accounts, patents account, Trademarks account, Copyrights account, etc. The rule for Real accounts is: Debit what comes in & Credit what goes out Nominal Accounts: Accounts relating to income, revenue, gain expenses and losses are termed as nominalaccounts. These accounts are also known as fictitious accounts as they do not represent any tangible asset. A separate account is maintained for each head expense or loss and gain or 5 income. Wages account, Rent account Commission account, Interest received account are some examples of nominal account The rule for Nominal accounts is: Debit all expenses and losses & Credit all incomes and gain BRANCHES OF ACCOUNTING The changing business scenario over the centuries gave rise to specialized branches of accounting which could cater to the changing requirements. The branches of accounting are; i) Financial accounting; ii) Cost accounting; and iii) Management accounting. Financial Accounting The accounting system concerned only with the financial state of affairs and financial results of operations is known as Financial Accounting. It is the original from of accounting. It is mainly concerned with the preparation of financial statements Cost Accounting In view of the limitations of financial accounting in respect of information relating to the cost of individual products, cost accounting was developed. It is that branch of accounting which is concerned with the cost ascertainment and cost control. Cost accounting seeks to ascertain the cost of unit produced and sold or the services rendered by the business unit with a view to exercising control over these costs to assess profitability and efficiency of the enterprise. It generally relates to the future and involves an estimation of future costs to be incurred. Management Accounting It is an accounting for the management i.e., accounting which provides necessary information to the management for discharging its functions. According to the Anglo-American Council on productivity, “Management accounting is the presentation of accounting information is such a way as to assist management in the creation of policy and the day-to-day operation of an undertaking.” 6  PRINCIPLES OF ACCOUNTING ACCOUNTING CONCEPTS AND CONVENTIONS Accounting concepts: The term ‘concept’ is used to denote accounting postulates, i.e., basic assumptions or conditions upon which the accounting super-structure is based. The following are the common accounting concepts adopted by many business concerns. 1. Business Entity Concept 2. Money Measurement Concept 4. Dual Aspect Concept 3. Going Concern Concept 5. Accounting Period Concept 6. Cost Concept 7. Matching Concept 8. Realisation Concept 9. Accrual Concept 10. Objective Evidence Concept i) Business Entity Concept: A business unit is an organization of persons established to accomplish an economic goal. Business entity concept implies that the business unit isseparate and distinct from the persons who provide the required capital to it. This concept can be expressed through an accounting equation, viz, Assets = Liabilities + Capital. ii) Money Measurement Concept: In accounting all events and transactions are recorded in terms of money. Money is considered as a common denominator, by means of which various facts, events and transactions are recorded. Those transactions which can be measured in terms of money will be recorded in the books of accounts. iii) Going Concern Concept: Under this concept, the transactions are recorded assuming that the business will exist for a longer period of time, i.e., a business unit is considered to be a going concern and not a liquidated one. Keeping this in view, the suppliers and other companies enter into business transactions with the business unit. This assumption supports the concept of valuing the assets at historical cost or replacement cost. This concept also supports the treatment of prepaid expenses as assets, although they may be practically unsaleable. iv) Dual Aspect Concept: According to this basic concept of accounting, every transaction has a two-fold aspect, Viz., 1.giving certain benefits and 2. Receiving certain benefits. The basic principle of double entry system is that every debit has a corresponding and equal amount of credit. This is the underlying assumption of this concept. The accounting equation viz., Assets = Capital + Liabilities or Capital = Assets – Liabilities, will further clarify this concept, i.e., at any point of time the total assets of the business unit are equal to its total liabilities. Liabilities here relate both to the outsiders and the owners. Liabilities to the owners are considered as capital. V) Accounting Period Concept: Under this concept, the life of the business is segmented into different periods and accordingly the result of each period is ascertained. Though the business is assumed to be continuing in future (as per goingconcern concept), the measurement of income and studying the financial position of the business for a shorter and definite period will help in taking corrective steps at the appropriate time. Each segmented 7 period is called “accounting period” and the same is normally a year. At the end of an accounting period, an Income Statement is prepared to ascertain the profit or loss made during that accounting period and Balance Sheet is prepared which depicts the financial position of the business as on the last day of that period. vi) Cost Concept: According to this concept, the transactions are recorded in the books of account with the respective amounts involved. For example, if an asset is purchased it is entered in the accounting record at the price paid to acquire the same and that cost isconsidered to be the base for all future accounting. vii) Matching Concept: The essence of the matching concept lies in the view that all costs which are associated to a particular period should be compared with the revenues associated to the same period to obtain the net income of the business. Under this concept, the accounting period concept is relevant and it is this concept (matching concept) which necessitated the provisions of different adjustments for recording outstanding expenses, prepaid expenses, outstanding incomes, incomes received in advance, etc., during the course of preparing the financial statements at the end of the accounting period. Accounting Conventions i) Accounting conventions are customs and traditions which act a guidelines to the users in preparation of books of accounts. 8  JOURNAL AND LEDGER INTRODUCTION Journal is a book of original entry where in transactions are first recorded. All transactions are recorded in the journal in the order in which they take place. Thus journal is a simple book of accounts in which all the business transactions are originally recorded in chronological order and from which they are posted to the ledger accounts at any convenient time. Journaling refers to the act of recording each transaction in the journal. The form, in which it is recorded, is known as a journal entry. ADVANTAGES OF JOURNAL The following are the inherent advantages of using journal, though the transactions can also be directly recorded in the respective ledger accounts; 1. As all the transactions are entered in the journal chronologically, a date wise record can easily be maintained; 2. All the necessary information and the required explanations regarding all transactions can be obtained from the journal 3. Errors can be easily located and prevented by the use of journal or book of prime entry. Compound Journal Entry When two or more transactions of the same nature take place on the same date , acompound or combined journal entry may be passed for the same instead of passing separate entry for each transaction. Compound journal entry is one where two or more accounts are debited or two or more accounts are credited. LEDGER Ledger is a main book of account in which various accounts of personal, real and nominal nature, are opened and maintained. It is a summary statement of all transactions relating to a person ,assets, expenses or incomes which have taken place during a particular period of time. when transactions take place, they are first entered in the journal and subsequently posted to the concerned accounts in the ledger. Posting refers to the process of entering in the ledger the information given in the journal. Distinction between journal and ledger 1. Journal is a book of prime entry, whereas ledger is a book of final entry. 2. Transactions are recorded daily in the journal, whereas posting in the ledger is made periodically. 3. In the journal, information about a particular account is not found at one place, whereas in the ledger information about a particular account is found at one place only. 4. Recording of transactions in the journal is called journalising and recording of transactions in the ledger is called posting. 5.A journal entry shows both the aspects debit as well as credit but each entry in the ledger shows only one aspect. 6. Narration is written after each entry in the journal but no narration is given in the ledger. 7.Vouchers, receipts, debit notes, credit notes etc., from the basic documents form journal 9 entry, whereas journal constitutes basic record for ledger entries. 10  TRIAL BALANCE INTRODUCTION According to the dual aspect concept, the total of debit balance must be equal to the credit balance. It is a must that the correctness of posting to the ledger accounts and their balances be verified. This is done by preparing a trail balance. MEANING AND DEFINITION Meaning Trial balance is a statement prepared with the balances or total of debits and credits of all the accounts in the ledger to test the arithmetical accuracy of the ledger accounts. As the name indicates it is prepared to check the ledger balances. If the total of the debit and credit amount columns of the trail balance are equal, it is assumed that the posting to the ledger in terms of debit and credit amounts is accurate. The agreement of a trail balance ensure arithmetical accuracy only, A concern can prepare trail balance at any time, but its preparation as on the closing date of an accounting year is compulsory. Definition According to M.S. Gosav “Trail balance is a statement containing the balances of all ledger accounts, as at any given date, arranged in the form of debit and credit columns placed side by side and prepared with the object of checking the arithmetical accuracy of ledger postings”. OBJECTIVES OF PREPARING A TRAIL BALANCE (i) It gives the balances of all the accounts of the ledger. The balance of any account can be found from a glance from the trail balance without going through the pages of the ledger. (ii) It is a check on the accuracy of posting. If the trail balance agrees, it proves: (a) That both the aspects of each transaction are recorded and (b) That the books are arithmetically accurate. (iii) It facilitates the preparation of profit and loss account and the balance sheet. FEATURES OF TRAIL BALANCES The following are the important features of a trail balances: (i) A trail balance is prepared as on a specified date. (ii) It contains a list of all ledger account including cash account. (iii) It may be prepared with the balances or totals of Ledger accounts. (iv) Total of the debit and credit amount columns of the trail balance must tally. (v) It the debit and credit amounts are equal, we assume that ledger accounts are arithmetically accurate. LIMITATIONS OF TRAIL BALANCE 11  The following are the important limitations of trail balances: (i) The trail balance can be prepared only in those concerns where double entry system of book- keeping is adopted. This system is too costly. (ii) A trail balance is not a conclusive proof of the arithmetical accuracy of the books of account. On the other hand, some errors are not disclosed by the trail balance. (iii) It the trail balance is wrong, the subsequent preparation of Trading, P&L Account and Balance Sheet will not reflect the true picture of the concern. METHODS OF PREPARING TRAIL BALANCE A trail balance refers to a list of the ledger balances as on a particular date. It can be prepared in the following manner: Total Method According to this method, debit total and credit total of each account of ledger are recorded in the trail balance. Balance Method According to this method, only balance of each account of ledger is recorded in trail balance. Some accounts may have debit balance and the other may have credit balance. All these debit and credit balances are recorded in it. This method is widely used. Note: Accounts of all assets, expenses, losses and drawings are debit balances. Accounts of incomes, gains, liabilities and capital are credit balances. Trial balance discloses some of the errors and does not disclose some other errors. This is given below. A) Trial Balance discloses the following Errors i) Wrong totaling of subsidiary books ii) Posting of an amount on the wrong side iii) Omission to post an amount into ledger iv) Double posting or omission of posting v) Posting wrong amount vi) Error in balancing B) Trail Balance does not disclose the following Errors i) Error of principle ii) Error of omission iii) Errors of Commission iv) Recording wrong amount in the books of original entry v) Compensating errors 12