UNIT 1 ACCOUNTING AND ITS FUNCTIONS
Objectives After studying this unit, you should be able to appreciate the: • • • nature and role of accounting; activities of an accountant; and roles of accounting personnel and the accounting function in an organization.

Accounting and its Functions

Structure 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 Introduction Scope of Accounting Emerging Role of Accounting Accounting as an Information System Role and Activities of an Accountant Accounting Personnel Nature of Accounting Function Organisation for Accounting and Finance Summary Key Words Self-assessment Questions/Exercises Further Readings

1.1

INTRODUCTION

Accounting is often called the language of business. The basic function of any language is to serve as a means of communication. In this context, the purpose of accounting is to communicate or report the results of business operations and its various aspects. Though accounting has been defined in various ways. According to one commonly accepted definition. "Accounting is the art of recording, classifying and summarising 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'. Another definition which is less restrictive interprets accounting as "The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of information"

1.2

SCOPE OF ACCOUNTING

The scope of accounting can be presented in a diagrammatic form as shown in Figure 1.1. Data creationr and collection is the area which provides raw material for accounting. The data collected is `historic' in the sense that it refers to events which have already taken place. Earlier, accounting was largely concerned with what had happened, rather than making any attempt to predict and prepare for future. After the historic data has been collected, it is recorded in accordance with generally accepted accounting theory. A large number of transactions or events have to be entered in the books of original entry (journals) and ledgers in accordance with the classification scheme already decided upon. The recording and processing of information usually accounts for a substantial part of total accounting work. This type of

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Accounting Framework

Source: Adapted from R.J. Bull, Accounting in Business, Butterworths, London, 1969,p.2.

activity of accounting may be called recordative. The processing method employed for recording may be manual, mechanical or electronic. Computers are also used widely in modern business for doing this job. Data evaluation is regarded as the most important activity in accounting these days. Evaluation of data includes controlling the activities of business with the help of budgets and standard costs (budgetary control), evaluating the performance of business, analysing the flow of funds, and analysing the accounting information for decision-making purposes by choosing among alternative courses of action. The analytical and interpretative work of counting may be for internal or external uses and may range from snap answers to elaborate reports produced by extensive research. Capital project analysis, financial forecasts, budgetary projections and analysis for reorganisation, takeover or merger often lead to research-based reports. Data evaluation has another dimension and this can be known as the auditive work which focuses on verification of transactions as entered in the books of account and authentication of financial statements. This work is done by public professional accountants. However, it has become common these days for even medium-sized organisations to engage internal auditors to keep a continuous watch over financial flows and review the operation of the financial system. Data reporting consists of two parts-external and internal. External reporting refers to the communication of financial information (viz., earnings, financial and funds position) about the business to outside parties, e.g., shareholders, government agencies and regulatory bodies of the government. Internal reporting is concerned with the communication of results of financial analysis and evaluation to management for decision-making purposes. You will note that accounting theory has been shown in the centre of the diagram. We will turn to the role of accounting theory in the next unit. The central purpose of accounting is to make possible the periodic matching of costs (efforts) and revenues (accomplishments). This concept is the nucleus of accounting theory. However, accounting is moving away from its traditional procedure-based record-keeping function to the adoption of a role which emphasises its social importance.

Activity 1.1
List the various accounting activities that your organisation is undertaking. Can you ascribe any particular reason as to why your organisation is undertaking these accounting activities?

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Accounting Activity 1……………………………… 2……………………………… 3……………………………… 4……………………………… 5……………………………… 6……………………………… 7……………………………… 8………………………………

Reason 1…………………………… 2…………………………… 3…………………………… 4…………………………… 5…………………………… 6…………………………… 7…………………………… 8……………………………

Accounting and its Functions

1.3

EMERGING ROLE OF ACCOUNTING

The history of accounting indicates the evolutionary pattern which reflects changing socio-ecoiom conditions and the enlarged purposes to which accounting is applied. In the present context four phases in the evolution of accounting can be distinguished.

Stewardship Accounting
In earlier times in history, wealthy people employed `stewards' to manage their property. These stewards rendered an account of their stewardship to their owners periodically. This notion lies at the root of financial reporting even today which essentially involves the orderly recording of business transactions, commonly known as 'book-keeping'. Indeed the accounting concepts and procedures, in use today for systematic recording of business transactions have their origin in the practices employed by merchants in Italy during the 15th century. The Italian method which specifically began to be known as `double entry book-keeping' was adopted by other European countries during the 19th century. Stewardship accounting, in a sense, is associated with the need of business owners to keep records of their transactions, the property and tools they owned, debts they owed, and the debts others owed them.

Financial Accounting
Financial accounting dates from the development of large-scale business and the advent of Joint Stock Company (a form of business which enables the public to participate in providing capital in return for `shares' in the assets and the profits of the company). This form of business organisation permits a limit to the liability of their members to the nominal value of their shares. This means that the liability of a shareholder for the financial debts of the company is limited to the amount he had agreed to pay on the shares he bought. He is into liable to make any further contribution in the event of the company's failure or liquidation. As a matter of fact, the law governing the operations (or functioning) of a company in any country (for instance the Companies Act in India) gives a legal form to the doctrine of stewardship which requires that information be disclosed to the shareholders in the form of annual income statement and balance sheet. Briefly speaking, the income statement is a statement of profit and loss made during the year of the report; and the balance sheet indicates the assets held by the firm and the monetary claims against the firm. The general unwillingness of the company directors to disclose more than the minimum information required by law and the growing public awareness have forced the governments in various countries of the• world to extend the disclosure (of information) requirements.

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Accounting Framework

The importance attached to financial accounting statements can be traced to the need of the society to mobilise the savings and channel them into profitable investments. Investors, whether they are large or small, must be provided with reliable and sufficient information in order to be able to make efficient investment decisions. This is the most significant social purpose of financial accounting.

Cost Accounting
The industrial revolution in England presented a challenge to the development of accounting as a tool of industrial management. Costing techniques were developed as guides to management actions. The increasing awareness on the part of entrepreneurs and industrial managers for using scientific principles of management in the wake of scientific management movement led to the development of cost accounting. Cost accounting is concerned with the application of costing principles, methods and techniques for ascertaining the costs with a view to controlling them and assessing the profitability and efficiency of the enterprise.

Management Accounting
The advent of management accounting was the next logical step in the developmental process.-The practice of using accounting information as a direct aid to management is a phenomenon of the 20th century, particularly the last 30-40 years. The genesis of modern management with its emphasis on detailed information for decision-making provide a tremendous impetus to the development of management accounting. Management accounting is concerned with the preparation and presentation of accounting and controlling information in a form which assists management in the 'formulation of policies and in decision-making on various matters connected. with routine or non-routine operations of business enterprise. It is through the techniques of management accounting that the managers are supplied with information which they need for achieving objectives for which they are accountable. Management accounting has thus shifted the focus of accounting from recording and analysing financial; transactions to using information for decisions affecting the future. In this sense, management accounting has a vital role to play in extending the horizons of modern business. While the reports emanating from financial accounting are subject to the conceptual framework of accounting, internal reports-routine or non-routine are free from such constraints.

Social Responsibility Accounting
Social responsibility accounting is a new phase in the development of accounting and owes its birth to increasing social awareness which has been particularly noticeable over the last two decades or so. Social responsibility accounting widens the scope of accounting by considering the social effects of business decisions; in addition to the economic effects. Several social scientists, statesmen and social workers all over the world have been drawing the attention of their governments and the people in their countries to the dangers posed to environment and ecology by the unbridled industrial growth. The role of business in society is increasingly coming under greater scrutiny\ The management is being held responsible not only for efficient conduct of business as expressed in profitability, but also for what it contributes to social well being and progress. There is a growing feeling that the concepts of growth and profit as measuredin traditional balance sheets and income statements are too narrow to reflect the social responsibility aspects of a business.

Human Resource Accounting
Way back in 1964 the first attempt to include figures on human capital in the balance sheet was made by Hermansson which later. came to be known as Human Resource

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Accounting. However there had been a great socio-economic shift in the 1990's with the emergence of "Knowledge economy", a distinctive shift towards recognition of human and intellectual capital in contrast to physical capital. Human Resource Accounting is a branch of accounting which seeks to report and emphasis the importance of human resources (knowledgeable, trained, loyal and committed employees) in a company's earning process and total assets. It is concerned with "the process of identifying and measuring data about human resources and communicating this information to interested parties". In simple words it involves accounting for investment in people and replacement costs as well as accounting for the economic values of people to an organisation. Generally the methods used for valuing and accounting of human resources are either based on costs or on economic value of human resources., However providing adequate and valid information on human assets (capital), which are outside the concept of ownership, in figures is very difficult. Nevertheless HRA is a managerial tool providing valuable information to the top management to take decisions regarding adequacy of human resources and thus encouraging managers to consider investment in manpower in a more positive way.

Accounting and its Functions

Inflation Accounting
Inflation Accounting is concerned with the adjustment in the value of assets (current and fixed) and of profit in the light of changes in the price level. In a way, it is concerned with the overcoming of limitations that arise in financial statements on account of the cost assumption (that is recording of the assets at their historical or original cost) and the assumption of stable monetary unit (these are discussed in detail in the next unit). It thus aims at correcting the distortions in the reported results caused by price level changes. Generally, rising prices during inflation have the distorting influence of overstating the profit. Various approaches have been suggested to deal with this problem. If this little introduction of HRA and Inflation accounting provokes you to know more about them, we suggest that you listen to the audio programme "Emerging Horizons in Accounting and Finance-Part II and III" which deal with these two topics. You may also read "Money Measurement Concept" explained in the next unit which has a bearing on inflation accounting. Activity 1.2 In the context of your organisation, describe some of the cost and management accounting related activities. Please also identify any particular accounting practice in the area of social responsibility. …………………………………………………………………………………………. …………………………………………………………………………………………. …………………………………………………………………………………………. …………………………………………………………………………………………. …………………………………………………………………………………………. ………………………………………………………………………………………….

1.4

ACCOUNTING AS AN INFORMATION SYSTEM

While discussing the scope of accounting you must have observed that accounting involves a series of activities linked with each other, beginning with the collecting, recording, analysing and evaluating the data, and finally communicating information to its users. Information has no meaning unless it is linked with a certain purpose.

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Accounting Framework

Accounting as a social science can be viewed as an information system since it has all the features of a system. It has its inputs (raw data), processes (men and equipment), and outputs (reports and information). If we consider accounting as an information system, then we are in a position to make some important observations. First, the goal of the system is to provide information which meets the needs of its users. If we can correctly identify the needs of the users, we are then able to specify the nature and character of the outputs of the system. Secondly, it is the output requirements that . determine the type of data which would be selected as the inputs for processing into information output. There are several groups of people who have a stake in a business organisationmanagers, shareholders, creditors, employees, customers, etc. Additionally, the community at large has economic and social interest in the activities of such organisations. This interest is expressed at the national level by the concern of government in various aspects of the firms' activities, such as their economic wellbeing, their contribution to welfare, their part in the growth of the national product, to mention only a few examples. We shall now briefly discuss what the information needs of various users are. Shareholders and Investors: Since shareholders and other investors have invested their wealth in a business enterprise, they are interested in knowing periodically about the profitability of the enterprise, the soundness of their investment and the growth prospects of the enterprise. Historically, business accounting was developed to supply information to those who had invested their funds in business enterprises. Creditors: Creditors may be short-term or long-term lenders. Short-term creditors include suppliers of materials, goods or services. They are normally known as trade creditors. Long-term creditors are those who' have lent money for a long period, usually in the form of secured loans. The main concern of the creditors is focused on the credit worthiness of the firms and its ability to meet its financial obligations. They are therefore concerned with the liquidity of the firms, its profitability and financial soundness. In other words, it can also be stated that creditors are interested mainly in information which deals with solvency, liquidity and profitability so that they could assess the financial standing of the firms. Employees: The view that business organisations exist to maximise the return to shareholders has been undergoing change as a result of social changes. A broader view is taken today of economic and social role of management. The importance of harmonious industrial relations between management and employees cannot be overemphasised. That the employees have a stake in the outcomes of several managerial decisions is recognised. Greater emphasis on industrial democracy through employee participation in management decisions has important implications for the supply of information to employees. Matters like settlement of wages, bonus, and profit sharing rest on adequate disclosure of relevant facts. Government: In a mixed economy it is considered to be the responsibility of the Government to direct the operation of the economic system in such a manner that it subserves the common good. Controls and regulations on the operations of private sector enterprises are the hallmark of mixed economy. Several government agencies collect information about various aspects of the activities of business organisations. Much of this information is a direct output of the accounting system, for example, levels of outputs, profits, investments, costs, and taxes, etc. All this information is very important in evolving policies for managing the economy. The task of the Government in managing the industrial economy of the country is facilitated if accounting information is presented, as far as possible, in a uniform manner. It is clear that if accounting information is distorted due to manipulations and window-dressing in the

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presentation of annual accounts, it will have ill-effects on the measures the government intends to take and the policies it wishes to adopt. Management: Organisations may or may not exist for the sole purpose of profit. However, information needs of the managers of both kinds of organisations are almost the same, because the managerial process i.e., planning, organising and controlling is the same. All these functions have one thing in common and it is that they are all concerned with making decisions which have their own specific information requirements. The emphasis on efficient and effective management of organisations has considerably extended the demand for accounting information. The role of accounting as far as management is concerned was highlighted earlier when we discussed about management accounting. Consumers and others: Consumers' organisations, media, welfare organisations and public at large are also interested in condensed accounting information in order to appraise the efficiency and social role of the enterprises in different sectors of the economy, that is, what levels of profits and outputs are being achieved, in what way the social responsibility is being discharged and in what manner the growth is being planned by the enterprises in-accordance with the national priorities etc. The above discussion perhaps has indicated to you that the information needs of the various users may not necessarily be the same. Sometimes, they may even conflict and compete with each other. In any case, the objective of accounting information is to enable information users to make optimum decisions.

Accounting and its Functions

1.5

ROLE AND ACTIVITIES OF AN ACCOUNTANT

Having discussed the scope of accounting and its emerging role, we are now in a position to describe as to who is an accountant. In an attempt to answer this question we reproduce below some statements in this regard: a) b) c) d) e) f) An accountant is one who is engaged in accounts-keeping. An accountant is a functionary who aids control. An accountant keeps the conscience of an organisation. An accountant is a professional whose primary duties are concerned with information management for internal and external use. An accountant is a fiscal adviser. An accountant produces an income statement and a balance sheet for an accounting period and maintains all supporting evidence and classified facts that lead to the final accounting statements. An accountant verifies, authenticates, and certifies the accounts of an entity.

g)

Tell us about your reactions. Perhaps you do have your own ideas but our thinking is that each of the foregoing statements contain some truth in it as it highlights some aspects of the functions of an accountant, except one statement which presents a somewhat comprehensive view. Can you identify this statement? We will help you in doing this. Statement (a) defines a person who maintains accounts. Statement (f) echoes almost a similar notion but extends his role to the production of financial statements. The work implied in these statements is that of score-keeping and the person performing such activity is known as a financial accountant (or maintenance accountant). Statement (b) is about the role which an accountant can play in the management control process. It is concerned with attention-directing and problem-solving. The functionary may be designated as management accountant (or a controller as in the United States).

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Accounting Framework

Statement (e) underlines a narrow, specific role of an accountant, though of critical significance. In view of high incidence of taxes on business in India, tax planning assumes a vital role in fiscal management. By planning the operations of the enterprise in a particular manner, the tax adviser attempts to minimise the liability of the firm by availing the concessions and incentives provided for in the applicable tax laws. Statement (g) stresses the `audit', `watchdog', or `certification role' of the accountant who is not an employee of a business but who performs an external verification of accounts. Such a functionary is a trained and qualified professional who, like any other professional, has an educational status and a prescribed code of conduct. Chartered Accountants in India, England-Wales, and Certified Public Accountants in USA belong to this category of accountants. Statement (c) presents the accountant as a conscience-keeper. He is seen as a person whose mission is to protect and promote the interest of the employer in a positive manner. He is there to see to it that none of the staff of the organisation carries on this work in an unethical way or in a manner prejudicial to the long-term legitimate interests of the firm. We are now left with statement (d) which defines an accountant as a professional and underlines his pre-occupation withi management of information for internal use (management accounting function) and for external use (financial accounting function). We are sure, our discussion of accounting as an information system has made it easier for you to comprehend this role of the accountant. We may clarify that information management is not necessarily associated with sophisticated (or hi-tech) area of computers. Small firms may `manage' information without a substantial degree of mechanisation or automation. Often the role of accounting in small businessis not properly recognised. It is widely known that a large number of small businesses fail and do not survive beyond a few years. One of the main reasons for their failure is that they do not have an adequate information system to help their managers to control costs, to forecast cash needs and to plan for growth. Organisations which have poor accounting system often find it considerably difficult to obtain finance from banks and outside investors.

1.6

ACCOUNTING PERSONNEL

There is hardly any organisation which does not have an accountant. His role is all pervasive and he is involved in a wide range of activities, particularly in a large and complex organisation. The exact duties of an accountant might differ in different organisations. However, a broad spectrum of responsibilities can be identified. The accountants can be broadly divided into two categories, those who are in public practice and those who are in private employment. The accountants in public practice offer their services for conducting financial and or cost audit. As such, they are known as auditors. The auditor examines the books of account and reports on the balance sheet and profit and loss account of the company as to whether they give a true and fair view of the state of affairs of the company and its profit respectively. The auditor in a company is appointed by the shareholders to whom he reports. Public accountants are generally members of professional bodies like the Institute of Chartered Accountants of India or the Institute of Cost and Works Accountants of India. In addition to conducting financial or cost audit (in accordance with the requirements of the Companies Act), as the case may be, they may also provide consultancy services for design Qing or improving accounting and management control systems. Accountants in employment may be in various business or non-business organisations to perform a variety of accounting and management control functions. Accountants at higher levels generally belong to professional accounting bodies but those who are at

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lower levels need not be so. Accounting chiefs in different organisations, depending upon their nature of work, are variously designated as finance officers or internal auditors or chiefs accounts officers, etc. The term `controller' as the head of the accounting and finance function is not very popular in India but of late it has been catching up. Several large organisations, both in the public and private sectors, have now controllers. Let us have an idea of who these people are and what they do. Internal Auditor: Internal Auditor is an employee of the organisation in contrast to an external auditor who is paid a fee for his services. The internal auditor is responsible for performing monitoring activities and other services, including designing and operating the system of internal control, auditingthe data reported to the directors ofthe company, and assisting external auditors. The head ofthe internal audit function reports directly either to the ch iefexecutive or to the audit committee of the Board of Directors. Internal audit includes continuous verification of entries appearing in the books of account with the original vouchers and proper accounting of assets. Further, it attempts to ensure that the policies and procedures regarding financial matters are being complied with. Internal auditing is also concerned with administering the system of internal check so that mistakes, innocent or intentional, are prevented from taking place. We should distinguish an internal auditor from an external auditor. While an internal auditor devotes his entire time and energy to the needs ofone company (i.e, his employer), an external auditor serves many clients. The primary function ofthe external auditor, as pointed out earlier, is to safeguard the interests ofthe shareholders (by whom he is appointed ) by an independent and impartial appraisal ofthe financial transactions ofthe company so that he could report on the net profit earned by the company and its financial position. His role is that ofan objective outsider, expressing expert opinions tothefinancial condition and operating results ofthe client's business. A part from shareholders, other parties such as banks, lending institutions, government agencies, etc. reply on the fairness of such financial reports in making certain decision about a given company. An auditor is bound by a set of professional regulations which include an examination on technical competence and adherence to a code of ethical conduct. Controller : Controller- the other name for Chief Accountant- is usually the head of the whole area of accounting, including internal audit. He is overall in - charge of all the activities comprising financial accounting, cost accounting, management accounting, tax accounting etc. He exercises authority both for accounting within the organisation and for external reporting. The external reports include reports to government revenue collecting and regulatory bodies, such as Company Law Board and Income Tax . Department He may also supervise the company's internal audit and control systems. In addition to processing historical data, he is expected to supply a good deal of accounting information to top management concerning future operations, in line with the management's planning and control needs. Besides, he is also expected to supply detailed information to managers in different functional areas ( like production, marketing, etc.) and at different levels of the organisation. We may enumerate the functions of the controller as follows: a) b) c) d) e) f) g) Designing and operating the accounting system Preparing financial statements and reports Establishing and maintaining systems and procedures Supervising internal auditing and arranging for external audit Supervising computer applications Overseeing cost control Preparing budgets

Accounting and its Functions

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Accounting Framework

h) i) j)

Making forecasts and analytical reports Reporting financial information to top management Handling tax matters.

Treasurer : He is the custodian arid manager of all the cash and near-cash resources of the firm. The treasurer handles credit reviews and sets policy for collecting receivables (debtors of the firm to whom the firm has sold goods or services) He also handles relationships with banks and other lending or financial institutions. The Financial Executive Institute (of United States of America) makes the following distinction between controllership and treasurership functions: Controllership Planning and Control Reporting and Interpreting Evaluating and Consulting Tax Administration Government Reporting Protection of Assets Economic Appraisal Treasurership Provision of Capital Investor Relations Short-term Financing Banking and Custody Credit and Collections Investments Insurance

Finance Officer: Finance is the life blood of business. Procuring financial resources and their judicious utilisation are the two important activities of financial management. Financial management, includes three major decisions: investment decision, financing decision and dividend decision. Investment decision is perhaps the most important decision because it involves allocation of resources . It is concerned with future which being uncertain involves risk. How the firm is allocating its scarce resources and is planning growth will largely determine its value in the market place. Financing decision is concerned with determining the optimum financing mix or capital structure. It examines the various methods by which a firm obtains short-term and long -term finances through various alternative sources. The dividend decision is concerned with question like how much of the profit is to be retained and how much is to be distributed as dividends. The finance manager has to strike a balance between the current needs of the enterprise for cash and the needs of the shareholders for a adequate return. The financial management of a large company is usually the responsibility of the finance director who may be in place of, or in addition to the controller. Often finance manager and controller are inter-changeable terms and only one of these two positions may be found in a company. The finance manager when there is a controller also in the organisation, is concerned with implementing the financial policy of the board of directors, managing liquidity, preparation of budgets and administration of budgetary control system, managing profitability, etc. Though financial management is regarded as a separate area, this function is performed in several countries, including India, by the Accountant( or the Financial Controller) Several large organisations however have a financial executive besides the ch ief accountant. Often, finance and accountingfunctions are clubbed together in one persons in small organisations.

Activity 1.3
Please meet one or more of the following personnel in any organisation and talk to them about their respective roles within the organisation. Accountant 1…………………………………………………………………………………… 2…………………………………………………………………………………… 3……………………………………………………………………………………

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4…………………………………………………………………………………… 5…………………………………………………………………………………… Chief Accountant 1…………………………………………………………………………………… 2…………………………………………………………………………………… 3…………………………………………………………………………………… 4…………………………………………………………………………………… 5…………………………………………………………………………………… Controller 1…………………………………………………………………………………… 2…………………………………………………………………………………… 3…………………………………………………………………………………… 4…………………………………………………………………………………… 5…………………………………………………………………………………… Finance Manager 1…………………………………………………………………………………… 2…………………………………………………………………………………… 3…………………………………………………………………………………… 4…………………………………………………………………………………… 5…………………………………………………………………………………… Internal Auditor 1…………………………………………………………………………………… 2…………………………………………………………………………………… 3…………………………………………………………………………………… 4…………………………………………………………………………………… 5……………………………………………………………………………………

Accounting and its Functions

1.7

NATURE OF ACCOUNTING FUNCTION

Accounting is a service function. The chief accounting executive (by whatever name he is called) holds a staff position except within his own department where he exerts. authority. This is in contradistinction to the roles played by production or marketing executives who hold line authority: The role of the accountant is advisory in character. He works through the authority of the chief executive. The accounts and or finance department(s) do`not exercise direct authority over line departments. In decentralised structure with a number of units and divisions, the accounting executive however exercises what is known as the functional authority over all the accounting staff deployed in different segments. There are two facets to the role of the accountant. For the top managers he works as a watchdog and for middle and lower level managers he acts as `helper'. The watchdog role is usually performed through `score-keeping' task of accounting and reporting to

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Accounting Framework

all levels of management. The `helper' role is usually performed through the task of directing managers' attention to problems and assisting them in solving problems. Mutual understanding and rapport between the accountant and the manager, in the tasks of attention-directing and problem-solving can be enhanced if accountant and his staff frequently interact with the line managers and guide them in matters concerned with preparation of budgets and control documents with which they might not be conversant. This will instill confidence among line managers regarding the reliability of reports.

1.8

ORGANISATION FOR ACCOUNTING AND FINANCE

A typical organisation chart for accounting and finance function is presented in Figure 1.2. You will note that the person at the helm of affairs the Director (Finance) who is a member of the Board of Directors. Reporting to him may be one or more general managers. If there is only one General Manager, he may be designated as General Manager (Finance), or General Manager (Finance and Accounts), or Controller or Financial Controller. In a large company four or five (as shown in Figure 1.2) Deputy General Managers incharge of different areas like systems and data processing, accounts, finance, internal auditing may report to him. Following the American pattern, a tendency has recently been observed among large companies, especially in the private sector, to designate General Manager (Finance) as President (Finance, or Finance and Accounts) and a Deputy General Manager as Vicepresident. Each of these Deputy General Managers is assisted by a number of senior managers who look after different components of similar activities, e.g., financial accounting, tax planning and administration, management auditing, etc. Management audit is a comprehensive review of the various sub-systems of the organisation like objectives and goals, structure, technical system, personnel policies, (including succession planning), control and coordination policies and procedures, adequacy and effectiveness of communication system, etc. This type of audit is usually done by a team of people comprising the internal resource persons drawn from various functional areas and external management consultant. Figure 1.2: Organisation Chart for Accounting and Finance

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We hope you now have a reasonably good idea of what accounting is, what its scope is, and what are the different types of activities which are generally included in accounting. While basic functions of accounting and finance are performed in all types of organisations, their relative emphases or relevance might differ in different types of organisations. Keeping this in view we have prepared an audio programme "Accounting and Finance Function in Different Types of Organisations" and we suggest that you listen to this tape. This will not only augment your familiarity with the basic aspects and functions of accounting but will also develop your appreciation for relative divergencies.

Accounting and its Functions

1.9

SUMMARY

Accounting is an important service activity in business and is concerned with collecting, recording, evaluating and communicating the results of past events. The history of accounting development reflects its changing role in response to the changing business and social needs. With the emergence of management accounting, the focus of ac-counting has been shifting from mere recording of transactions to that of aiding the management in decisions. Accounting can be perceived as an information system which has its inputs, processing methods and outputs. The usefulness of accounting lies in its capacity to provide information to various stakeholders in business so that they could arrive at the correct decisions. The top accounting personnel are designated with various nomenclature. The practice in this regard djffers in different companies. The organisational setting for accounting and finance function may also vary in different organisations, depending upon their peculiarities, nature and size of business, technology and structural form. At the helm of affairs is usually the Director of Accounts and Finance who is a member of the Board of Directors. Fle is assisted by a General Manager who in turn is helped by Deputy General Managers incharge of various sub-functions like, accounts, finance, internal audit, and data processing, etc. Each of the sub-functions is further subdivided into activities which are the responsibility of a subordinate manager.

1.10 KEY WORDS
Accountant is a professional who is responsible for the processing of financial data for score-keeping, attention-directing and problem-solving purposes. Controller of the management accountant is a staff-functionary who uses accounting information for management planning and control. Auditive work of an accountant comprises authentication of accounting statements. Recordative work extends to routine recording and classified posting of financial transactions and events. Score-keeping is the process of data accumulation or record-keeping which enables interested parties (internal and external) to ascertain how the organisation is performing. Attention-directing role of accounting consists of directing managerial attention to situations where corrective action is needed in the case of unfavourable (or even favourable) differences in operations, outputs or inputs. Information system is a system, sometimes formal and sometimes informal, for collecting, processing, and communicating data at the most relevant time to all levels of management. The data flowing through the system is helpful to managers for

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Accounting Framework

decision-making in the areas of planning and control, or is otherwise needed for financial reporting required under the laws. An essential requirement of information system is feedback, i.e. communicating the results of performance to operating managers for needed modifications. External reporting is the production of financial statements for the use by external interest groups like, shareholders and government. Planning is goal identification and decision-making. Control is the action that implements the planning decision and evaluates performance. Feedback comprises the performance reports which managers can use for improving their decision-making. Staff function is performed in an advisory capacity and without line or decisionmaking authority.

1.11 SELF-ASSESSMENT QUESTIONS/EXERCISES
1 2 3 4 5 6 7 8 9 "Financial Accounting is an extension of Stewardship Accounting". Comment. What new developments in Accounting have taken place over the past 20-25 years? Examine the main factors which have affected such developments. State the group of persons having an interest in a business organisation and examine the nature of their information needs. Discuss the role of accountants in modern business organisations. Differentiate between recordative, interpretative and auditive functions of Accounting. How can accounting reports, prepared on a historical basis after the close of a period, be useful to managers in directing the activities of a business? Distinguish management accounting from financial accounting. How does the accountant help in the planning and control process of a large commercial organisation? State whether the following statements are true or false: a) b) c) To have an accountant is the privilege ofa joint stock company only. A controller is entrusted with the responsibilities of raising funds Management control differs from engineering control since the latter is fully automatic and the former is highly complex. An accountant is the custodian of the properties and financial interests of a business enterprise. True/False True/False True/False

d)

True/False

Answers to Self-assessment Questions/Exercises

18

9 (a) False, (b) False, (c) True, (d) True,

1.12 FURTHER READINGS
Anthony, Robert N. and James S. Reece, 1987. Accounting Principles, All India Traveller Book Seller: New Delhi (Chapter I). Bhattacharya S.K. and John Dearden, 1987. Accounting for Management: Text and Cases, Vikas Publishing 1-louse: New Delhi. (Chapter I). Paul Collier, May 09.2003. Accounting for Managers : Interpreting Accounting Infornration.for Decision Making. Wiley Publishers : Canada. (Chapter I),

Accounting and its Functions

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UNIT 2 ACCOUNTING CONCEPTS AND STANDARDS
Structure
2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 Introduction Objectives The Accounting Framework Accounting Concepts Accounting Standards The Changing Nature of Generally Accepted Accounting Principles Attempts towards Standardisation Accounting Standards in India Summary Key Words Self-Assessment Questions/Exercises Further Readings

Page Nos.
20 20 20 21 30 31 31 32 33 33 34 36

2.0 INTRODUCTION
Any activity that you perform is facilitated if you have a set of rules to guide your efforts. Further, you find that these rules are of more value to you if they are standardised. When you are driving your vehicle, you keep to the left. You are in fact following a standard traffic rule. Without the drivers of vehicles adhering to this rule, there would be much chaos on the road. A similar principle applies to accounting which has evolved over a period of several hundred years, and during this time certain rules and conventions have come to be accepted as useful. If you are to understand and use accounting reports which is the end product of an accounting system then you must be familiar with the rules and conventions behind these reports.

2.1 OBJECTIVES
After going through this unit, you should be able to: l l

l

appreciate the need for a conceptual framework of accounting; understand and appreciate the Generally Accepted Accounting Principles (GAAP), and develop an understanding of the importance and necessity for uniformity in accounting practices.

2.2 THE ACCOUNTING FRAMEWORK
The rules and conventions of accounting are commonly referred to as the conceptual framework of accounting. As with any discipline or body of knowledge, some underlying theoretical structure is required if a logical and useful set of practices and procedures are to be developed for reaching the goals of the profession, and for expanding knowledge in that field. Such a body of principles is needed to help answer new questions that arise. No profession can thrive in the absence of a theoretical framework. According to Hendriksen (1977), accounting theory may be defined as logical reasoning in the form of a set of broad principles that (i) provide a general frame of reference by which accounting practice can be evaluated, and (ii) guide the development of new practices and procedures. Accounting theory may also be used to explain existing practices to obtain a better understanding of them. But the
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Accounting Concepts and Accounting and its Standards Functions

most important goal of accounting theory should be to provide a coherent set of logical principles that form the general frame of reference for the evaluation and development of sound accounting practices. The American Institute of Certified Public Accountants (AICPA) discusses financial accounting theory and generally accepted accounting principles as follows: Financial statements are the product of process in which a large volume of data about aspects of the economic activities of an enterprise are accumulated, analysed, and reported. This process should be carried out in accordance with generally accepted accounting principles. Generally accepted accounting principles incorporate the consensus at a particular time as to which economic resources and obligations should be recorded as assets and liabilities by financial accounting, which changes in assets and liabilities should be recorded, when these changes should be recorded, how the assets and liabilities and changes in them should be measured, what information should be disclosed and how it should be disclosed, and which financial statements should be prepared. Generally Accepted Accounting Principles (GAAP) encompass the conventions, rules and procedures necessary to define accepted accounting practice at a particular time........generally accepted accounting principles include not only broad guidelines of general application, but also detailed practices and procedures. (Source: AICPA. Statements of the Accounting Principles Board No.4 “Basic Concept and Accounting Principles Underlying Financial Statement of Business Enterprises”, October, 1970, pp.54-55). The word ‘principles’ is used to mean a “general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice”. You will note that this definition describes a principle as a general law or rule that is to be used as a guide to action. This implies that accounting principles do not prescribe exactly how each detailed event occurring in business should be recorded. Consequently, there are several matters in accounting practice that may differ from one company to another. Accounting principles are man-made. They are accepted because they are believed to be useful. The general acceptance of an accounting principle (or for that matter, any principle) usually depends on how well it meets the three criteria of relevance, objectivity, and feasibility. A principle is relevant to the extent that it results in meaningful or useful information to those who need to know about a certain business. A principle is objective to the extent that the information is not influenced by the personal bias or judgement of those who furnished it. Objectivity connotes reliability or trustworthiness which also means that the correctness of the information reported can be verified. A principle is feasible to the extent that it can be implemented without undue complexity or cost.

2.3 ACCOUNTING CONCEPTS
Earlier, in unit 1, we had described accounting as the language of business. As with language, accounting has many dialects. There are differences in terminology. In dealing with the framework of accounting theory, one is confronted with a serious problem arising from differences in terminology. A number of words and terms have been used by different writes to express and explain the same idea or notion. Thus, confusion abounds in the literature insofar as the theoretical framework is concerned. The various terms used for describing the basic ideas are: concepts, postulates, propositions, basic assumptions, underlying principles, fundamentals, conventions, doctrines, rules, etc. Although each of these terms is capable of precise definition, general usage by the profession of accounting has served to give them loose and overlapping meanings. The same idea has been described by one author as a concept and by another as a convention. To take another instance, the idea implied in
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conservatism has been labelled by one author as a (modifying) convention, by another as a principle, and by yet another as a doctrine. The wide diversity in terminology to express the basic framework can only serve to confuse the learner. Without falling into the trap of this terminological maze, we will explain below, some widely recognised ideas and we call all of these concepts. We do feel, however, that some of these ideas have a better claim to be called concepts, while the rest should be called conventions. Fundamental accounting concepts are broad, general assumptions that underlie the periodic financial accounts of business enterprises. The reason why some of these ideas should be called concepts is that they are basic assumptions and have a direct bearing on the quality of financial accounting information. The alteration of any of the basic concepts (or postulates) would change the entire nature of financial accounting. Business Entity Concept In accounting we make a distinction between business and the owner. All the records are kept from the viewpoint of the business, rather than from that of the owner. An enterprise is an economic unit, separate and apart from the owner, or owners. As such, transactions of the business and those of the owners should be accounted for, and reported separately. In recording a transaction, the important question is how does it affect the business? For example, if the owner of a shop were to take cash from the cash box for meeting certain personal expenditure, the accounts would show that cash had been reduced even though it does not make any difference to the owner himself. Similarly, if the owner puts cash into the business, he has a claim against the business for capital brought in. This distinction can be easily maintained in the case of a limited company because a company has a legal entity (or personality) of its own. Like a human being, it can engage itself in economic activities of producing, owning, managing, storing, transferring, lending, borrowing and consuming commodities and services. Distinction, however, is difficult in the case of partnership, and even more so in the case of a one-man business. Nevertheless, accounting still maintains separation of business and owner. This implies that, owner’s personal and household expenses or obligations (e.g., expenditure on food, clothing, housing, entertainment, debts, mortgages, etc.) will not appear in the books of account. It may be clarified that it is only for accounting purposes that partnerships and sole proprietorships are treated as separate and apart from the owners though the law does not make such a distinction. A creditor would be justified in looking to both the business assets and the private estate of the owner for satisfaction of his claim. One reason for this distinction is to make it possible for the owners to have an account of the performance from those who manage the enterprise. The managers are entrusted with funds supplied by owners, banks, and others; they are responsible for the proper use of the funds. The financial accounting reports are designed to show how well this responsibility has been discharged.

Check Your Progress 1
Apart from the reason mentioned above, can you think of any other reason for the justification of the Business Entity Concept? ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... ......................................................................................................................................... .
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Check Your Progress 2
The proprietor of a firm withdrew Rs. 50,000 for his personal use. This was shown as an expense of the firm and hence, profits were reduced thereby. Is this right from an accounting point of view? ......................................................................................................................................... ......................................................................................................................................... . ......................................................................................................................................... .............................................................................................…………………………… .

Check Your Progress 3
The proprietor of a firm contributed Rs. 10 lakhs towards the capital of the firm. Does it means, from an accounting point of view, that the firm had a corresponding liability towards the proprietor? ......................................................................................................................................... ......................................................................................................................................... . ......................................................................................................................................... .............................................................................................…………………………… . Money Measurement Concept In accounting, only those facts which can be expressed in terms of money are recorded. As money is accepted not only as a medium of exchange but also as a measuring rod of value, it has a very important advantage since a number of widely different assets and equities can be expressed in terms of a common denominator. Without this adding heterogeneous factors like five buildings, ten machines, six trucks will not have much meaning. While money is probably the only practical common denominator and a yardstick, we must realise that this concept imposes two sever limitations. In the first place, there are several facts which, though vital to the business, cannot be recorded in the books of account because they cannot be expressed in money terms. For example, the state of health of the Managing Director of a company, who has been the key contributor to the success of business, is not recorded in the books. Similarly, the fact that the Production Manager and the Chief Internal Auditor are not on speaking terms, or that a strike is about to begin because labour is dissatisfied with the poor working conditions in the factory, or that a competitor has recently taken over the best customer, or that it has developed a better product, and so on will not be recorded even though all these events are of great concern to the business. From this standpoint, one could say that accounting does not give a complete account of the happenings in the business. You will appreciate that all these have a bearing on the future profitability of the company. Second, the use of money implies that a rupee today is of equal value to a rupee ten years back or ten years later. In other words, we assume that there is a stable or constant value of the rupee. In the accounts, money is expressed in terms of its value at the time an event is recorded. Subsequent changes in the purchasing power of
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money do not affect this amount. You are, perhaps, aware that most economies today are in inflationary conditions with rising prices. The value of a rupee in the 80s has depreciated to an unbelievably low level in the 90s. Most accountants know fully well that the purchasing power of a rupee does change, but very few recognise this fact in accounting books and make an allowance for changing price level. This is so, despite the fact that the accounting profession has devoted considerable attention to this problem, and numerous suggestions have been made to account for the effects of changes in the purchasing power of money. In fact, one of the major problem of accounting today is to find means of solving the measurement problem, that is, how to extend the quality and the coverage of meaningful information. It will be desirable to present, in a supplementary analysis, the effect of price level changes on the reported income of the business and the financial position.

Check Your Progress 4
Suppose the Managing Director of a company is killed in a plane crash. To the extent that “an organisation is the lengthened shadow of a man”, the real value of the company will change immediately, and this will be reflected in the market price of the company shares. Will this have any effect as far as the accounts of the company are concerned? ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . Continuity Concept Accounting assumes that the business (an accounting entity) will continue to operate for a long time in the future, unless there is good evidence to the contrary. The enterprise is viewed as a going concern, that is, as continuing in operation, at least in the foreseeable future. The owners have no intention, nor have they the necessity to wind up or liquidate its operations. This assumption is of considerable importance, for it means that the business is viewed as a mechanism for adding value to the resources it uses. The success of the business can be measured by the difference between output values (sales or revenues) and input values (expenses). Therefore, all unused resources can be reported at cost rather than at market values as, according to the continuity concept, the future instead of selling them out rightly in the market. The assumption that the business is not expected to be liquidated in the foreseeable future, in fact, establishes the basis for many of the valuations and allocations in accounting. For example, depreciation (or amortisation) procedures rest upon this concept. It is this assumption which underlies the decision of investors to commit capital to enterprise. The concept holds that continuity of business activity is the reasonable expectation for the business unit for which the accounting function is being performed. Only on the basis of this assumption can the accounting process remain stable and achieve the objective of correctly recording and reporting on the
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Accounting Concepts and Accounting and its Standards Functions

capital invested, the efficiency of management, and the position of the enterprise as a going concern. Under this assumption neither higher current market values nor liquidation values are of particular importance in accounting. This assumption provides a basis for the application of cost in accounting for assets. However, if the accountant has good reasons to believe that the business, or some part of it, is going to be liquidated, or that it will cease to operate (say within a year or two), then the resources could be reported at their current values (or liquidation values).

Check Your Progress 5
A company bought a building in 2004 at a cost of Rs.50 lakhs. At the end of the Accounting Year 2004-05, its market value is Rs.70 lakhs. The company revalues the building at Rs.70 lakhs for the year 2004-05. Is this practice right? ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . Cost Concept The resources (land, buildings, machinery, property rights, etc.) that a business owns are called assets. The money values assigned to assets are derived from the cost concept. This concept states that an asset is worth the price paid for, or cost incurred to acquire it. Thus, assets are recorded at their original purchase price and this cost is the basis for all subsequent accounting for the assets. The assets shown on the financial statements do not necessarily indicate their present market worth (or market values). This is contrary to what is often believed by an uninformed person reading the statement or report. The term ‘book value’ is used for the amount shown in the accounting records. In the case of certain assets, the accounting values and market values may be similar; cash is an obvious example. In general, the longer an asset has been owned by the company the less, are the chances that the accounting value will correspond to the market value. The cost concept does not mean that all assets remain on the accounting records at their original cost for all time to come. The cost of an asset that has a long but limited life, is systematically reduced during its life by a process called ‘depreciation’ which will be discussed at some length in a subsequent unit. Suffice it to say that depreciation is a process by which the cost of the asset is gradually reduced (or written off) by allocating a part of it to expense in each accounting period. This will have the effect of reducing the profit of each period. In charging depreciation the intention is not to change depreciation equal to the fall in the market value of the asset. As such, there is no relationship between depreciation and changes in market value of the assets. The purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost so as to bring it closer to the market value.

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You must be wondering why assets are shown at cost, even when there are wide differences between their costs and market values. The main argument is that the cost concept meets all the three basic criteria of relevance, objectivity and feasibility.

Check Your Progress 6
A company buys machinery availing heavy discount at Rs. 40,000, but its actual market price is Rs. 60,000. Should the company show the value of machinery in their records at Rs. 40,000 or Rs. 60,000? ......................................................................................................................................... ......................................................................................................................................... . ......................................................................................................................................... ......................................................................................................................................... . ......................................................................................................................................... . Accrual Concept The accrual concept makes a distinction between the receipt of cash, and the right to receive it, and the payment of cash and the legal obligation to pay it. In actual business operations, the obligation to pay and the actual movement of cash may not coincide. The accrual concept recognises this distinction. In connection with the sale of goods, revenue may be received (i)before the right to receive arises, or (ii) after the right to receive has been created. The accrual concept provides a guideline to the accountant as to how s/he should treat the cash receipt and the rights related thereto. In the former case the receipt will not be recognised as the revenue of the period for the reason that the right to receive the same has not yet arisen. In the latter case the revenue will be recognised even though the amount is received in the subsequent period. Similar treatment would be given to expenses incurred by the firm. Cash payments for expenses may be made before or after they are due for payment. Only those sums which are due and payable would be treated as expenses. If a payment is made in advance (i.e., it does not belong to the accounting period in question) it will not be treated as an expense, and the person who received the cash will be treated as a debtor until his right to receive the cash has matured. Where an expense has been incurred during the accounting period, but no payment has been made, the expense must be recorded and the person to whom the payment should have been made is shown as a creditor.

Check Your Progress 7
The accounting year of a firm closes on 31st December each year. The rent for business premises of Rs. 50,000 for the last quarter could not be paid to the owner on account of his being away in a foreign country. Should the rent payable be taken into account for computing the firm’s income for the accounting year? ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... .
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Accounting Concepts and Accounting and its Standards Functions

......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... .

Check Your Progress 8
A government contractor supplies stationery to various government offices. Some bills amounting to Rs.10,000 were still pending with various offices at the close of the accounting year on 31st March. Should the businessman take the revenue of Rs.10,000 into account for computing the net profit of the period? ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . The Concept of Conservatism The concept of conservatism, also known as the concept of prudence, is often stated as “anticipate no profit, provide for all possible losses”. This means an accountant should follow a cautious approach. Facing a choice, he should record the lowest possible value for assets and revenues, and the highest possible value for liabilities and expenses. According to this concept, revenues or gains should be recognised only when they are realised in the form of cash or assets (usually legally enforceable debts) the ultimate cash realisation of which can be assessed with reasonable certainty. Further, provision must be made for all known liabilities, expenses, and losses whether the amount of these is known with certainty, or is at best an estimate in the light of the information available. Probable losses in respect of all contingencies should also be provided for. A contingency is a condition, or a situation, the ultimate outcome of which−gain or loss−cannot be determined accurately at present. It will be known only after the event has occurred (or has not occurred). For example, a customer has filed a suit for damage against the company in a court of law. Whether the judgement will be favourable or unfavourable to the company cannot be determined for sure. Hence, it will be prudent to provide for likely loss in the financial statements. As a consequence of the application of this concept, net assets and incomes are more likely to be understated than overstated.
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Based on this concept is the widely advocated practice of valuing inventory (stock of goods left unsold) at cost or market price, whichever is lower. You will note that this convention, in a way, modifies the earlier cost concept. It should be stated that the logic of this convention has been under stress recently; it has been challenged by many writers on the ground that it stands in the way of fair determination of profit, and the disclosure of true and fair financial position of the business enterprise. The concept is not applied as strongly today as it used to be in the past. In any case, conservatism must be applied rationally as over-conservatism may result in misrepresentation.

Check Your Progress 9
A company is negotiating to get an order for Rs.5 lakhs from XYZ company. It is confident to get an order and as a result, it shows this order as a part of its sales revenue. Will you approve such an accounting treatment of probable order to be obtained in future? ......................................................................................................................................... ......................................................................................................................................... . ......................................................................................................................................... .............................................................................................…………………………… . …………………………………………………………………………………………. . Materiality Concept There are many events in business which are trivial or insignificant in nature. The cost of recording and reporting such events will not be justified by the usefulness of the information derived. The materiality concept holds that items of small significance need not be given strict theoretically correct treatment. For example, a paper stapler costing Rs. 30 may last for three years. However, the effort involved in allocating its cost over the three-year period is not worth the benefit than can be derived from this operation. Since the item obviously is immaterial when related to overall operations, the cost incurred on it may be treated as the expense of the period in which it is acquired. Some of the stationery purchased for office use in any accounting period may remain unused at the end of that period. In accounting, the amount spent on the entire stationery would be treated as an expense of the period in which the stationery was purchased, notwithstanding the fact that a small part of it still lies in stock. The value (or cost) of the stationery lying in stock would not be treated as an asset and carried forward as a resource to the next period. The accountant would regard the stock lying unused as immaterial. Hence, the entire amount spent on stationery would be taken as the expense of the period in which such expense was incurred. Where to draw the line between material and immaterial events is a matter of judgement and common sense. There are no hard and fast rules in this respect. Whether a particular item or occurrence is material or not, should be determined by considering its relationship to other items and the surrounding circumstances. It is desirable to establish and follow uniform policies governing such matters.

Check Your Progress 10
A firm buys an office table for Rs. 800. Though it is, theoretically speaking, an asset having a life, of more than one year, the firm shows it as an expense of the year, and reduces the profit for the year. Is this accounting practice justifiable? Give reasons.
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Accounting Concepts and Accounting and its Standards Functions

......................................................................................................................................... ......................................................................................................................................... . ......................................................................................................................................... Consistency Concept In practice, there are several ways to record an event or a transaction in the books of account. For example, the trade discount on raw material purchased may be deducted from the cost of goods and net amount entered in the books, or alternatively trade discount may be shown as the income with full cost of raw material purchased entered in the books. Similarly, there are several methods to charge depreciation (which is a decrease in the value of assets caused by wear and tear, and passage of time) on an asset, or of valuing inventory. The consistency concept requires that once a company has decided on one method and has used it for some time, it should continue to follow the same method or procedure for all subsequent events of the same character unless it has a sound reason to do otherwise. If for valid reasons the company makes any departure from the method it has been following so far, then the effect of the change must be clearly stated in the financial statements in the year of change. You will appreciate that much of the utility of accounting information lies in the fact that one could draw valid conclusions from the comparison of data drawn from financial statements of one year with data from another year. Comparability is essential so that trends or differences may be identified and evaluated. Inconsistency in the application of accounting methods might significantly affect the reported profit and the financial position. Further, inconsistency also opens the door for manipulation of reported income and assets. The comparability of financial information depends largely upon the consistency with which a given class of events are handled in accounting records year after year.

Check Your Progress 11
A company had been charging depreciation on a machine at Rs. 10,000 per year for the first 3 years. Then it began charging Rs. 9,000 for 4th year and Rs. 7,800 for 5th year and so on. Is this practice justified? Give reasons for your answer. ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ......................................................................................................................................... . ........................................................................................................................…............. . Periodicity Concept Although the results of the operations of a specific enterprise can be known precisely only after the business has ceased to operate, its assets have been sold off and liabilities paid off, the knowledge of the results periodically is also necessary. Those who are interested in the operating results of a business obviously cannot wait till the end. The requirements of these parties, therefore, force the accountant to report the
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changes in the wealth of a firm for some time periods. These time periods in actual practice vary, though a year is the most common interval as a result of established business practice, tradition, and government requirements. Some firms adopt the calendar year, and some others the financial year of the government. But more and more firms are changing to the ‘natural’ business year, the end of which is marked by relatively lower or lowest volume of business activity in the twelve-month period. The custom of using twelve-month period is applied only for external reporting. The firms usually adopt a shorter span of interval, say one month or three months, for internal reporting purposes. The allocation of long-term costs and the difficulties associated with this process directly stem from this concept. While matching the earnings and the cost of those earnings for any accounting period, all the revenues and all the costs relating to the year in question have to be taken into account irrespective of whether or not they have been received in cash, or paid in cash. Despite the difficulties that arise in allocations and adjustments, short-term reports (i.e., yearly reports) are of such importance to owners, management, creditors, and other interested parties that the accountant has no option but to resolve such difficulties. Obviously, the utility of the periodic financial statements outweighs the difficulties. Some other concepts, e.g., the Matching concept, the Realisation concept and the Dual Aspect concept are discussed in units 4 and 5, and as such, they have not been taken up here. While going through all these concepts, probably you may have developed a feeling that they sometimes conflict with each other. You are right. We illustrate this by considering some of these concepts in the context of valuation of business properties. Suppose a firm acquired a piece of land in 1985 for a price of Rs. 6,00,000. Factory premises were constructed in 1986, and operations commenced in 1987. The firm has been successful in achieving the desired profit for the past year. The Balance Sheet (a statement of assets and liabilities) for the year 2005 is being prepared and ‘Land’ is required to be valued. The estimated current market price of this land is Rs. 60,00,000. Should you recommend that the land be valued at Rs. 60 lakhs? The answer is ‘no’, obviously. Land would be carried on the Balance Sheet at its original cost of Rs. 6,00,000 only. This decision is supported by several of the concepts discussed in this section. In the first place, the stability of purchasing power of money implied in the money measurement concept prevents us from recognising accretion in values as a result of changing price levels. Then, the realisation concept will not allow unrealised profits to be included as long as land is held by the company and not sold away. You may note that the continuity, or going concern concept, makes any possible market value of land irrelevant for the balance sheet because the firm has to continue in business, and land will be needed by it for its own use. In this connection, it could be argued that if land were shown on the balance sheet at its estimated current market value, the owner might decide to discontinue the business, sell the land and retire. The principle of objectivity is now introduced into the argument. It can be easily seen that in a situation like this the cost of acquisition of land at Rs. 6,00,000 in 1985 is the objective fact because it is based on a transaction that actually took place and this objective evidence is capable of being verified. In contrast, the estimate of current market value figure may be suspect. It raises many questions. Do you have a market quotation for an identical plot of land? Has a similar plot of land been sold recently, and can we pick it up as verifiable evidence of the current market price? It may be said that even if market price for an identical plot of land is not available, estimates by an accredited valuer may be accepted as verifiable evidence of the market price. Further complications may be noticed if buildings and facilities have been erected on the plot of land. Is it possible to estimate the value of land without factory buildings and other facilities constructed on it? The answer is a flat ‘no’, and the conservatism concept will then deter you from accepting an estimate of market value since it cannot be ascertained with reasonable accuracy.
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2.4 ACCOUNTING STANDARDS
The basic concepts, discussed in the foregoing paragraphs, are the core elements in the theory of accounting. These concepts (postulates or conventions), however, permit a variety of alternative practices to co-exist. As a result, the financial results of different companies cannot be compared and evaluated unless full information is available about the accounting methods which have been used. The variety of accounting practices have made it difficult to compare the financial results of different companies. Further, the alternative accounting methods have also enabled, the reporting of different results, even by the same company. Need for Standards: The information contained in published financial statements is of particular importance to external users, such as shareholders and investors. Without such information they would not be able to take the right decisions about their investments. As in several other countries, Parliament in India specified in the Companies Act, the type and minimum level of information which companies should disclose in financial statements. It is the responsibility of the accounting profession to ensure that the required information is properly presented. It is evident that there should not be too much discretion to companies and their accountants to present financial information the way they like. In other words, the information contained in financial statements should conform to carefully considered standards. Public confidence in accounting information contained in financial statements will grow if they are satisfied as to the logic, consistency and fairness of the figures shown therein. For instance, a company could incur a loss and still pay dividends by manipulating the loss into a profit. In the long run, this course may have a disastrous effect on the company and its investors. You would be better able to appreciate the function of accounting standards by relating them to the basic purpose of financial statements, which is the communication of information affecting the allocation of resources. Ideally, such information should make it possible for investors to evaluate the investment opportunities offered by different firms and to allocate scarce resource to the most efficient ones. In theory, this process should result in the capital distribution of resources within the economy, and should maximise the potential benefit to society. In this context, unless there are reasonably appropriate standards, neither the purpose of the individual investor, nor that of the nation as a whole, can be served. The purpose is likely to be served if the accounting methods used by different firms for presenting information to investors allow correct comparisons to be made. For example, they should not permit a company to report profits which result simply from a change in accounting methods rather than from increase in efficiency. If companies were free to choose their accounting methods in this way, the consequences might be that deliberate distortions are introduced, leading eventually to misapplication of resources in the economy. The relatively less efficient companies will be able to report fictitious profits, and as a result scarce capital of society will be diverted away from the more efficient companies which have adopted more strict and consistent accounting methods.

2.5 THE CHANGING NATURE OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
Generally accepted accounting principles are usually developed by professional accounting bodies like American Institute of Certified Public Accountants (AICPA) and Institute of Chartered Accountants of India (ICAI). In developing such principles, however, the accounting profession has to reflect the realities of social, economic, legal and political environment in which it operates. Besides academic research,
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Accounting System

regulatory and tax laws of the government, e.g., Companies Act, 1956, income Tax Act, 1961, etc., in a large measure, influence the formulation of acceptable accounting principles. Stock exchanges and other regulatory agencies like the Securities and Exchange Board of India (SEBI) have laid down rules for disclosure and the extent of accounting information. Since the environment, in which business operates, undergoes constant changes as a result of changes in economic and financial policies of the Government and changes in the structure of business, continued evaluation of the relevance of generally accepted accounting principles is required. In this sense, the principles of accounting are not ever-lasting truths. You will appreciate that it is the development of relevant accounting principles in tune with the present day needs of the society that would make it possible for the business enterprises to develop financial statements which would be acceptable and of value to the end users. Now, we give you a brief account of the development of standards in the United Kingdom, the United States of America, India, and other countries.

2.6 ATTEMPTS TOWARDS STANDARDISATION
Standardisation in UK and USA: Though the Institute of Chartered Accountants in England and Wales began making recommendations since 1942, real progress started with the establishment of the Accounting Statements Committee (ASC) by the Institute in 1969 in the wake of public criticism of financial reporting methods which permitted diverse practices. As a result of diversity in practices some big investors had suffered heavy losses on their investments in well-known companies. The main objective of the ASC has been to narrow areas of difference and in the variety in accounting practices. The procedure used for standardisation is initiated by the issue of an “Exposure Draft” on a specific topic for discussion by accountants, and the public at large. Comments made on exposure draft are taken into consideration when drawing up a formal statement of the accounting methods for dealing with that specific topic. The statement is known as a Statement of Standard Accounting Practice (SSAP). Once the statement of standard accounting practice is adopted by the accounting profession (the fact that a statement has been issued by the Institute in itself signifies the acceptance by the profession), any material departure by any company from the standard practice in presenting its financial reports is to be disclosed in that report. So far, nineteen statements of standard accounting practice, in addition to some exposure drafts under consideration, have been issued by the ASC. The need for evolving standards in the USA was felt with the establishment of Securities Exchange Commission (SEC) in 1933. The SEC is the Government agency that regulates and controls the issuance of, and dealings in, securities of the companies. A research-oriented organisation called the Accounting Principles Boards (APB) was formed in 1957 to spell out the fundamental accounting postulates. The Financial Accounting Standards Board (FASB) was formed in 1973. The FASB issues statements from time to time, articulating the generally accepted accounting principles. The constant support given by SEC to FASB pronouncements has given considerable credibility to its accounting policy statement. The FASB, till 1985, has issued five statements of concepts and eighty-eight statements of financial accounting standards. Standards at International Level: In view of the growth of international trade and multinational enterprises, the need for standardisation at the international level was felt. An International Congress of Accountants was organised in Sydney. Australia in 1972 to ensure the desired level of uniformity in accounting practices. Keeping this in view, the International Accounting Standards Committee (IASC) was formed and was entrusted with the responsibility of formulating international standards. All the member countries of IASC resolved to conform to the standards developed by IASC,
32

Accounting Concepts and Accounting and its Standards Functions

or at least to disclose variations from recommended standards. After its formation in 1973, the IASC has issued 40 international accounting statement to date. Another professional body, the International Federation of Accountants (IFAC) was established in 1978. Attempts have also been made in countries in the European Economic Community (EEC), and in Canada for standardisation of accounting practices regarding disclosure and consistency of procedures.

2.7 ACCOUNTING STANDARDS IN INDIA
With a view to harmonise varying accounting policies and practices currently in use in India, the Institute of Chartered Accountants of India (ICAI) formed the Accounting Standards Board (ASB) in April 1977 which includes representatives from industry and government. In line with the procedure followed in other countries, the preliminary drafts prepared by the study groups and approved by ASB are circulated amongst various external agencies, including the representative bodies of trade, commerce, and industry. So far, twenty eight standards have been issued by ASB, a brief description of which is provided in Appendix I to this unit. The standards are recommendatory in nature in the initial years. They are recommended for use by companies listed on a recognised stock exchange and other large commercial, industrial, and business enterprises in the public and private sectors. We advise that you read all or at least some of these standards in order to get a feel of what these standards are all about. What are the policies and procedures of accounting that these standards aim to standardise and why? Do not worry if you are unable to understand some of the ideas or expressions contained in the standards. You may like to come back to these standards after you have been through all the blocks of this course, in order to have a better grasp of them. Regarding the position in India, it has been stated that the standards have been developed without first establishing the essential theoretical framework. Without such a framework, it has been contended, any accounting standards and principles developed are likely to lack direction and coherence. This type of shortcoming also existed in the UK and USA, but then it was recognised and remedied a long time ago. In the United States, the first task which the FASB undertook was to develop a conceptual framework project which aimed at defining the objectives of financial reporting (a sample of which is presented in Appendix II). This was to be followed by the spelling out of concepts and standards establishing what have been frequently referred to as generally accepted accounting principles (GAAP). Any attempt to develop a conceptual framework regarding the objectives of reporting will have to take into consideration the answers to the following questions: i) Who are the users of financial reports? ii) What decisions do these user groups have to take? iii) What information can be provided that would assist them to take such decisions? The objectives, as you have already noted, depend upon the economic, social, legal and political environment of the country. At this point it will be useful for you to watch the video programme: Understanding Financial Statement-Part I.

2.8 SUMMARY

33

Accounting System

Accounting as a field of study in its developmental process has evolved a theoretical framework consisting of principles or concepts over period of time. These concepts enjoy a wide measure of support from the accounting profession. That is why they are known as Generally Accepted Accounting Principles (GAAP) . Several concepts, and their implications for business and information users, were discussed in this unit. Since the accounting principles are broad guidelines for general application, they permit a wide variety of methods and practices. The lack of uniformity in accounting practice makes it difficult to compare the financial reports of different companies. Moreover, the multiplicity of accounting practices makes it possible for management to conceal economic realities by selecting those alternative presentations of financial result which allow earnings to be manipulated. The financial statements prepared under such conditions, therefore, may have limited usefulness for several users of information. This problem has been recognised all over the world and various professional bodies are engaged in the task of standardising accounting practices. There is a movement towards consensus building even at the international level. Such professional bodies, in fact, first look at the practices used by practising accountants They then try to obtain a refinement of those practices by a process of consensus. It is in this manner that the theory of accounting is built. In India also, some headway has been made by establishing twenty eight standards for accounting practice.

2.9 KEY WORDS
Accounting framework includes generally accepted accounting principles (GAAP) on the basis of which accounting data is processed, analysed, and reported. Accounting theory is a set of inter-related principles and propositions, which provide a general framework for accounting practice, and deal with new developments in the area. Accrual concept says that an accountant should recognise incomes and expenses when they have actually accrued, irrespective of whether cash is received or paid. Consistency concept envisages that accounting information should be prepared on a consistent basis from period to period, and within periods there should be consistent treatment of similar items. Conservatism concept forbids the inclusion of unrealised gains but advocates provision for possible losses. Cost Concept states that an asset is to be recorded in books of accounts at a price for, or at a cost incurred to acquire it. Entity concept separates the business from owner(s), from the standpoint of accounting. Going concern concept refers to the expectation that the organisation will have an indefinite life. This assumption has an important bearing on how the assets are to be valued. Materiality concept admonishes that events of relatively small importance need not be given a detailed or theoretically correct treatment. They may be ignored for recording purpose. Money measurement concept states that all transactions are to be recorded only in monetary terms and record only those transactions, which can be measured in money terms. It ignores intangibles like employee loyalty and customer satisfaction, as they cannot be expressed in money terms. It also assumes records on the basis of a stable monetary unit.

34

Accounting Concepts and Accounting and its Standards Functions

Objectivity principle requires that only the information based on definite and verifiable facts are to be recorded. Periodicity concept divides the life of a business into smaller time periods which are generally one year, and the accountant is supposed to prepare necessary financial statements for each time period.

2.10 SELF ASSESSMENT QUESTIONS/EXERCISES
1. Examine the role of the Entity accounting concepts in the preparation of financial statements. Is it possible to give a true or a fair view of a company’s position using accounting information? Do you find any of the accounting concepts conflicting with each other? Give examples. In what way can accounting information help in the proper allocation of resources? Why should accounting practices be standardised? Explain. What progress has been made in India regarding the standardisation of accounting practices? Answer whether the following statement are True or False: a) b) c) d) e) 8. The materiality concept refers to the state of ignoring small items from and values accounts. The generally accepted accounting principles ensure a uniform accounting practice. The conservatism concept leads to the exclusion of all unrealised profits. Statements of Standard Accounting Practice were formulated by the Financial Accounting standards Board of USA. The Securities Exchange Commission of USA has played an important role in evolving the conceptual framework for accounting

2.

3. 4. 5. 6. 7.

Conceptual framework of accounting implies: i) ii) iii) iv) v) Making entries in the books of accounts A code of conduct for the accounting profession General principles for the preparation of accounting information Planning and control of enterprise operations None of the above.

9.

Accounting Standards are statements prescribed by: i) ii) iii) iv) v) Law Government regulatory bodies Bodies of shareholders Professional accounting bodies None of the above.

10. Accounting concepts are: i) ii) Broad assumptions Methods of presenting financial accounts
35

Accounting System

iii) Bases selected to prepare a specific set of accounts iv) None of the above. 11. Name the accounting concept violated, in any of the following situations: a) b) The Rs, 1,00,000 figure for inventory on a Balance Sheet is the amount for which it could be sold on the balance sheet date. The Balance Sheet of a retail store which has experienced a gross profit of 40% on sales contains an item of merchandise inventory of Rs. 1,15,00,000: Merchandise inventory (at cost) Rs. 69,00,000. Company M does not charge annual depreciation, preferring instead to show the entire difference between original cost and proceeds of sale as a gain or loss in the period when the asset is sold. It has followed this practice for many years.

c)

Answers to Activities
1. If the ‘separate entity concept’ is not observed, it becomes difficult to calculate the profitability of business and ascertain its financial position. It would be particularly difficult if the owner has several distinct businesses. Proprietary withdrawals reduce the capital of the enterprise unless they are in lieu of anticipated profits. It is not proper to show them as operating expense. They are also not admissible as deductions from profits for tax purposes. Yes, because as per the entity concept the business and the proprietor are two separate entities. If the proprietor contributes some amount towards capital, it means that the business has a liability to return it to the proprietor. No, the money measurement concept does not permit the recording of such events. What effect this event will have on the business cannot be objectively determined. Revaluation violates several concepts like, cost concept, conservatism concept, and continuity concept. To take credit for an extraordinary gain like this is normally not considered justified. However, were a substantial gap exists between the historical cost of a fixed asset and its market value, it has been observed that the accounting profession has been supporting such revaluations so that the balance sheet could show a realistic position of the enterprise. As per the cost concept, the company should show the value of machinery in books of accounts at Rs. 40,000 the price, which is being actually paid. It should be taken into account, otherwise profit will be overstated. It should be taken into account, otherwise profit will be understated. No. Since the order is not actually obtained, the probable sales revenue could not be recognised as per the conservatism concept.

2.

3.

4.

5.

6.

7. 8. 9.

10. Though the table has a long-term life and as such can be shown as an asset, yet the materiality concept requires it to be treated as an expense. 11. It violates the consistency concept, unless there is a solid reason for departing from the earlier practice. Answer to Self-assessment Questions Exercises 7.
36

a) True b) True c) True d) False e) True.

Accounting Concepts and Accounting and its Standards Functions

8. 9.

(iii) (iv)

10. (i) 11. (a) Conservatism concept, (b) Cost concept, (c) Periodicity concept.

2.11 FURTHER READINGS
Financial Accounting, Maheshwari, S.N. and S.K. Maheshwari, 2000, Vikas Publishing House: New Delhi (Chapter 2). Accounting Principles, Anthony, Robert, N. and James Reece, 1987, All India Traveller Book Seller: New Delhi ( Chapters 1-3). Accounting, The Basis for Business Decisions, Meigs, Walter, B.and Robert F. Meigs, 1987, McGraw Hill: New York (Chapter 1). Accounting Theory, Hendriksen, E. S., 1984, Khosla Publishing House, Delhi (Chapters 2,3 and 6).

37

Accounting System

Appendix I Accounting Standards Board The Institute of Chartered Accountants of India (ICAI) has, so far, issued twenty eight standards: Framework for the Preparation and Presentation of Financial Statements (AS 1) Disclosure of Accounting Policies (AS 2) Valuation of Inventories (AS 3) Cash Flow Statements (AS 4) Contingencies and Events Occurring after the Balance Sheet Date (AS 5) Net Profit or Loss for the period, Prior Period, and Extraordinary Items and Changes in Accounting Policies Announcement — Limited Revision to Accounting Standards (AS) 5 (AS 6) Depreciation Accounting (AS 7) Accounting for Construction Contracts Revised Accounting Standard (AS) 7, Construction Contracts, 28-05-2002 (AS 8) Accounting for Research and Development (AS 9) Revenue Recognition (AS 10) Accounting for Fixed Assets Announcement — Status of certain provisions of AS 10, Accounting for Fixed Assets, pursuant to the issuance of AS 19, Leases and As 16, Borrowing Costs (AS 11) Accounting for the Effects and Changes in Foreign Exchange Rates (AS 11) (Revised 2003). The Effects of Changes in Foreign Exchange Rate 21-02-2003 (AS 12) Accounting for Government Grants (AS 13) Accounting for Investments (AS 14) Accounting for Amalgamations (AS 15) Accounting for Retirement Benefits in the Financial Statement of Employers (AS 16) On Borrowing Costs (AS 17) Segment Reporting Disclosure of corresponding previous year figures in the first year of application of Accounting Standards (AS) 17, Segment Reporting Accounting Standard 18, Related Party Disclosures Applicability of Accounting Standards (AS) 18, Related Party Disclosures (AS 19) Leases
38

Accounting Concepts and Accounting and its Standards Functions

(AS 20) Earnings Per Share (AS 21) Consolidated Financial Statements (AS 22) Accounting for Taxes on Income Clarification on Accounting Standards (AS) 22, Accounting for Taxes on Income (AS 23) Accounting for Investments in Associates in Consolidated Financial Statements (AS 24) Discontinuing Operations Announcement — Accounting Standards (AS) 24, Discontinuing Operations (AS 25) Interim Financial Reporting (AS 26) Intangible Assets (AS 27) Financial Reporting of Interests in Joint Ventures (AS 28) Impairment of Assets 30-05-2002 For further details, please visit: http://www.icai.org/resource/o_ac_standard.html

39

Accounting System

Appendix II Financial Accounting Standards Board (FASB) Concepts No. 1: ‘ Objectives of financial reporting by business enterprises’. The three objectives which are included in concept No. 1 are reproduced below: 1) Financial reporting should provide information that is useful to the present and potential investors and creditors and other users in making rational investment, credit and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Since investors’ and creditors’ cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors and others, assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise. Financial reporting should provide information about the economic resources of an enterprise, the claim to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and the effects of transaction, events, and circumstances that change its resources and claims to those resources.

2)

3)

40

1

DefineAccounting and explain its scope.

.

! '

2
3

What are the objectives of Accounting? Name the different parties inte~sted in accounting information ahd state why they want it. Write notes on :

.
,

a) Advantages of Accounting

b) Branches of Accounting c) Accounting Process
'df Types of Accounts

4

Brjefly explain the accounting concepts which guide the accountant at the recording stage. I

5 +Whatdo you understand by Dual Aspect Concept? Explain its accounting implications.

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. These are for your practice only. - --

UNIT 2 THE ACCOUNTING PROCESS
2.0
2.1 2.2

Objectives Introduction Journal
2.2.1 Tv~sactionsReIating to Goods 2.2.2 Receipts and Payments by Chaqucs 2.2.3 'Transactions with the Proprietor 2.2.4 Transactions Relating to Cash Discount 2.2.5 Compound Journal Entry 2.2.6 'Transactions Relating to Bad Dehas

2.3

I~dger

,

2.3.1 Posting into Ledger 2.3.2 Balancing Ledger Accounts 2.3.3 Significnncc. of Balances

2.4 2.5 2.6 2.7 2.8 2.9 2.10

Trial Balance Openidg Entry Let Us Sum Up Key Words Some Useful Books Answers to Check Your Progress Terminal Questions/Exercises

'

After studying this unit you should be able to:
8

a
I

explain what a journal is describe how differen: types of transactions will be recorded in rhe journal post joumal entries in the concemed ledger accounts balance a ledger account and cxplain the significance of balances in different types of accounts prepare a trial balance to test the arithmetical accuracy of recording in the books of account explain what an opening enby is and how it is posted into ledger

2.1 INTRODUCTION
In Unit 1 you learnt that the accounting process involves four stages: (i) recording the the transactions, (ii) classifying-the transactions, (iii) su~nmarising transactions, and (iv) interpreting the results. Thus, you are aware that all transactions are recorded first in the books of original entry viz,, Journal, and then posted into the concerned accounts in the ledger. You have also learnt the basic accounting concepts to be observed at the recording "stage and the rules of debit and credit. With the help of these rules we shall discuss in this unit how various transactions are recorded in the Journal and how they will be posted into the concemed ledger accounts, We shall also explain how to balance different accounts and prepare a Trial Balance in order to test the arithmetical accuracy of the books of account.
I

2.2 JOURNAL
.Journal is a daily record of business transactions,It is also called a 'Day Book' and is used for recording all day today transactrons in the order in which they occur. It is a B&k of prime entry (also called book of original entry) because all transactions are recorded first in. this book. h e process of recordjnga (ransaction in the journal is called 'Joumalising' and I the entries made in this book-are. called '~&bhd Eiirries'. The proforma of Journal is given * in Figure 2.1.

*

.

I

..I

Accounting Fundomentols Date Particulars

Flgure 2.1: Journal

L. F.
Agunt

-

1

Azunt

The Journal is divided into five columns. The first column is used for writing the date of the transaction. It is customary to write the year at the top of the column only once and then in the next line the month and date are written. The second column called 'Particulars' column, The names of the two accounts affected by the transaction are to be recorded in this'column. The name of the account to be debited is written first. The abbreviation 'Dr,' for debit is also written against the name of the account to be debited. It is written on the same line very close to the L. F. column. In the next line, the name of the account to be credited is written. It is always preceded by the word 'To'. It is not necessary to write 'Cr.' against the name of the account to be credited. In the next line, a brief description of the transaction is also given within brackets. It is called 'Narration'. After writing the narration a line is drawn in the particulars column to separate one entry from the other.
.

.

The third column L. F. (Ledger Folio) is meant for writing the page number of the ledger where the concerned account appears. This column is filled at the time of posting into the ledger. The fourth and the fifth columns are meant for recording the amounts with which the two accounts have been affected, The amount to be debited is entered in the debit amount column against the name of the account debited, and the amount to be credited is entered in the credit amount column against the name of the account credited. Both the amounts will always beequal. Let us take a transaction and see how it will be recorded in the Journal.
'

Purchased Machinery for Rs.10,000 on May 1,1988 In this transaction, the two accounts affected are Machinery Account and Cash Account. You know both are real accounts. According to rules relating to real accounts, the , Machinery Account is to be debited and the Cash Account is to be credited. The entry will . be made in the Journal as follows
Date
1988 May I

/ '

Particulars

L.F.

Dr. Amount Rs.

Cr. Amount Rs.
10,000

Machinery Account To Cash Account (Being machinery purchased)

Dr.

22*

10,000

Glmaginary figure.

2.2.1 Transactions Relating to Goods
The term goods refer to articles which are traded by the firm i.e., articles bought for resale. For example, for a book-seller books are goods, for an electrical store fans and other electrical items are goods, for a furniture dealer table and chairs are goods. Articles bought for using them in business are not to be treated as goods. They may be fixed assets or consumables and are to be treated as such in books of account. The transactions relating to goods include purchases, sales, purchases returns and sales returns. Normally, as per rules, when gaods are bought you will debit the Goods Account and when they are sold you will credit the Goods Account. Similarly, when goods are returned by your customer you will debit the Goods Account and when you return goods to the suppliers, you yill credit the Goods Account. In other words, for all transaction relating to goods you will maiotain only one account viz., Goods Account. But, in practice, five separate account are maintained, as shown below:

,

. .
24.
'

'

i) Purchases Account-for recording all purchases of goods .- ii)+ Sales Account-for recording all sales of goods I '

'

-

'#'

.

iii) Keturns Onwards Accourii or Purchases Returns k~count-for recording goods returned to suppliers . iv) Returns Inwards Account or Sales Returns Account-For recording goods returned by customers v) Stock Account-for goods in stock (unsold goods) as at the end of the year
I .

The Accounting Proces

Thus, when goods are purchased you will debit the Purchases Account and when they are sold y ~ will credit the Sales Account. Similarly, when goods are returned by your u customers you will debit the Returns Inwards Account (or Sales Returns Account) and when you return goods to the suppliers you will credit Returns Outwards Acwunt (or Purchases Returns Account). There will be no Goods Account at all. This helps in ascertaining the amount of purchases and sales more quickly and correctly.

2.2.2 Receipts and Payments by Cheque
You must be aware that most of the.payments in business are made by cheques these days. This involves the bank where the firm has opened its account. Hence, when payment is made by cheque, you will credit the Bank Account because bank is the giver. Similarljl, when payment is received by cheque, the amount will be debited to the Bank Account because cheque is deposited in the bank who is the receiver.

2.2.3 Transactions with the Proprietor
You have learnt that the business and its proprietor are treated as separate entities. This implies that separate accounts must be maintained in the ledger for recording transactions between the proprietor and the business. Usually, two accounts viz., Capital Account and Drawings Account are maintained for this purpose. Whatever the proprietor brings into the business is treated as his capital and credited to his Capital Account. Similarly, when he withdraws cash from the business for his personal use, he is to be debited with the amount withdrawn by him. Such a debit is given to his Drawings Account. Drawings Account is also debited when the proprietor takes goods from business for domestic use. Note that the proprietor can be charged only by the cost of goods taken and not its selling price. In pr'actice, the cost of such goods are credited to the Purchases Account because it is assumed that it was purchased for him and should therefore be excluded from the purchases for the business. Look at Illustration 1 and study how various transactions are recorded in the Journal.

Illustration1
Journalise the following transactions in the journal of Krishna. 1988 Jan. 1 Commenced business with cash Paid into Canara'Bank Goods purchased for cash Bought furniture and paid by cheque Bought goods from Anand Sold gbods for cash Sold goods to Sunil Sold goods for cash to Anil Drew cash for private expenses. Paid salaries
JOURNAL

Rs.

+;Solution:

ate' . (
1988

Partiiulars

LF . .

D. r
Amount

I
I

Cr.
Amount

'"
"
2

(
-

Cash Account To Capital Account (Being c'apital brought in)

Dr.

Rs . 1 0 , ~
1

Rs.
10,000

,

Bank Account
To Cash Accouot (Being cash deposited into' bank) -

Dr.
----I

Acco~intingFundamentals
.

Date
1988

Particulars 4

Dr. Amount
Rs.
2,000

Jan,

Purchases Account To Cash Account (Being purchases of goods for cash)

Dr.
,

-

Furniture Account To Bank Account (Being furniture purchased nnd paid by cheque)
-

Dr.

Purchascll) Account To AZ~nd's Account (Being goods bought on credit) Cash Accourit To Sales Account (Being goods sold for cash) Sunil's Account To Sales Accou~~t (Being goods sold on credit) Cash Account To Seles Account (Being goods sold for cash) Drawings Account To Cash Account (Being cash withdrawn for personal use) S;~luies Account To Cash Account (Beiny payment of snlarics)

Dr.

Dr.

Dr.

Dr.

Dr.

Note: The following explanations with regard to some transactions will help you to understand their journal entries, Jnn, I: The credit has been given to Capital Account because Krishna, the proprietor of the business, brought cash into the business.
Jan. 2: Cash deposited in Canata Rank implies that a bank accounl has been opened for the business. Any money deposited in the bank is debited to Bank Account and any withdrawal frotn the bank is to be credited to Bank Account.

Jan. 4: When goods are purchased you would normally debit Goods Account as goods come in. But as explained, purchases of goods are debited lo Purchases Account since no Goods Account is to be maintained. Jan. 5 : Furniture is not goods for this business. It is a fixed asset and hedce debited to Furniture Account and not the Purchases Account. Since the payment has been tilade by cheque which leads to withdrawal from the bank, the anlount has been credited to Bank Account.

Jan, 10: When goods are sold you would nonllally credit the Goods Account as goods go out. But, as explained earlier, sales of goods are credited to Sales Account since no Boods Account is to be maintained. Jan. 29: Any amount withdrawn by the proprietor for personal use is treated as drawings by the proprietor and hence debited to Drawings Account.
4

2.2.4 Transactions Relating to Cash Discount
There ate two types of discout~ts allowed to customers: (i) trade discount, and (ii) cash di~cbunt, Trade discount is a reduction in selling price allowed at the time of sale. ne i buyer pays only the net price and the recording in books is made for the net amount only. No entry is made in books for the trade discount. Cash discount, on the other hand, is a reduction in the net amount due. It is allowed only if the customer makes payment before the due date. Cash discount must be recorded in the books of account. This is because when goods were sold to the customer his account was debited with the net amount due. Later, when he makes the payment and is allowed some cash discount, it must be adjusted in his personal account so that his account stands cleared.

When cash discount is allowed to the debtor, it is a loss to the business. So, it is debited to the Discount Allowed Account and credited to the personal account of the debtor. Similarly, when cash is paid to the creditor (the party from whom goods had been purchased on credit) he may also allow some cash discount to the business. Such discount will be a gain to the business. So, it is credited to the Discount Received Account and debited to the personal ' account of the creditor. The entries relating to cash discount will be illustrated under : Compound Journal Entry (Section 2.2.5).

The Accounting Process

2.2.5 Compound Journal Entry
2)

Someti,mes, two or more transactiuns of the same nature may occur on the same day. In such

a situation instead of passing a separate entry forteach transaction we may pass a single

journal entry, known as Compound Journal Entry. For example, on May 5, 1988 you sold goods on credit to Ram for Rs. 600 and to Shyam for Rs. 800.Both of these transactions took place on the same day (May 5, 1988) and are of the same nature (credit sale of goods). You can ppss compound entry for both the transactions as follows: Rs. Ram's Account Shyam's Account To Sales Account (Being goads sold on credit to them) A compound Journal entry can also be passed for a transaction which involves more than two accounts. For example, paid cash to Rarnesh Rs, 950 and he allowed Rs. 50 as discount, This transaction involves three accounts : (i) Ramesh's Account, (ii) Cash Account, and (iii) Discount Received Account. As per rules, Ramesh's Account is to be debited with Rs. 1,000 (Rs. 950 for cash and Rs. 50 for discount), Cash Account is to be credited with Rs. 950, and Discount Received Account is to be credited with Rs. 50. You can pass the following compound journal entry for this transaction : Ramesh's Account To Cash Account To Discount Received Account (Being cash paid to him, discount received RS.50) In practice, a compound journal entry is recorded when i) one account is to be debited and two or more accounts are to be credited, or ii) two or more accounts are to be debited and one account is to be credited, or iii) two or more accounts are to be debited and two or more accounts are to be credited. Dr. Rs. 1,000 Rs. 950 50 Dr. Dr. 500 800 1,300 Rs.

2.2.6 Transactions Relating to Bad Debts
When a debtor becomes insolvent, the business shall not be able to realise the full amount due from him. A parf.of it remains unrealized. The unrealised amount is called 'bad debts'. For example, Rs, 2,000 was due from Kaushal for the goods sold to him on credit. I-Ie became insolvent and only Rs. 1,200 could be realised from him. The remaining amount of Rs. 800 will be treated as bad debts. It is a loss to the business and so debited to Bad Debts Account and credited to the personal account of the debtor. The journal entry for the above transaction will be: Rs. Rs.

,

Cash Account Bad Debts Account To Kaushal's Account (Being Kaushal became insolvent and only Rs. 1,200 , could be recovered)
,

Dr. Dr.

1,200 800

2,000

Accouritlng Fundamentals

If any amount treated as bad debts is recovered late; on, it shall be a gain to.the business. Hence, it shall be credited to Bad Debts Recovered Account and debited to Cash Account. Note that the bad debts so recovered shall not be credited to the personal account of the , debtor because his account had already been closed. In the example.given above, suppose Rs. 800 is recovered from Kaushal later on, the journal entry will be: Rs. :ash Account Dr. 800 800

Rs.

To Bad Debts Recovered ~ c c o u n t (Being bad debts recovered)

Look at illustration 2 and note how journal entries for transaciions of February 18,25,27 and 29 have been made.

Record the following transactions in the Journal of Sunil Kumar. 1988 Feb. 1 ,* 2 ' 4 " 5
"

Rs.
Commenced business with cash Paid into Bank Furniture purchased from Keshav Goods purchased for cash Sold gmds to Santosh Bought goods from Harish Paid for cartage Paid for postage Goods returned by Santosh Goods returned to Harish Goods sold for cash Paid to Keshgv He alIowed discount Sold goods t i ~ k a s h Received from Santosh . Allowed hiin discount Cash drawn for personal use Paid to Harish by cheque He,allowed us discount Paid rent by cheque Paid salaries Gkash becomes insolvent and only Rs. 1500 could be realised from him An old debt written off as bad in 1987 is recovered

6
9
10 12
'

'

" " "
"

"
"

13 15 17 18

Solution:
Journal -rticmlars
1988 Feb.
'

L.F.

~ r . Arnau~~t Amount -

T--G-Rs.
70.000.

Rs.
1

Cash A/c To Capital A/c (Being business commenced with cash)

Dr.

70,OoQ

.

'

"

2

Bank Alc To Cash Alc (Being cash paid into bank)'

. -

--

I

40,000

~urnitureA/c To Keshav (Being furniture bought on credit) Purchases A/c To Cnsli A/c (Being goods purcliased for cash) Stuitosh To Sales A/c (Being goods sold on credit) Purchases A/c To I-Iarish (Being goods purchased on credit) Cartage A/c To Cash A/c (Bcing cartage paid) Postage A/c To Cash A/c (Being postage paid) Retun~s Inwards A/c To Santosh (Being goods returned by Santosh) Harish To Returns Outwards A/c (Being goods returned to Hnrish)
Casli A/c To Sales A/c (Being goods sold for cash)

Dr.

The Accounting Profess

Dr.

Dr.

Dr.

Dr.

Dr.

Dr.

Dr.

Dr.

Kcshav To Cnsh A/c To Discount A/c (Being cash paid and discount received) Akush To Sales A/c (Being goods.sold on credit) Cash A/c Discount A/c , To Santosh (Being cash received and discount allowed) Drawings A/c To Cash A/c (Being cash withdrawn for personal use) Harish To Bank A/c TO Discount A/c (Being payment made by cheque and discount received) Rent A/c To Bank A/c (Being rent paid by cheque) Salaries A/c To Cnsh A/c (Being salaries paid) Cash A/c Bad Debts A/c To Akash (Being Akash became insolvent and only Rs. 1,500 could be recovered) Cash A/c To Bad Debts Recovered A/c (Being the amount treated as bad debts in 1987, now recovered) .---+---. --.

Dr.

.

Dr.

Dr. Dr.

Dr.

. Dr.

Dr,

Dr.

Dr. Dr.

Dr.

.

---

Accounting Fundamentals

Note: In this illustration you will notice that
,

'

a) Instead of writing full word '~ccount'its abbreviation 'A/cl has been used againgt the names of the accounts debited and credited. This is a common practice. In fact the latest trend is not to write anything, just the name of the account is enough. b) The word Account or its abbreviation 'Alc' has not been written against personal names. This again is a common practice. Writing 'A/cl is confined to the real and nominal account\ only.

Check Your Progress A 1 What is Journal?

..L ... ... *. .

............

,

2

What is the purpose of writing narration?

............................
3

...

i......iiii,.ii....,i.....ii..iiii..ii.i.i.i.ii...ii.i..........i.i.i...ii.......i....i...i.ii*....i.i.i..i..ii.

Name the five accounts which are maintained in lied of Goods Account. ii) iii) iv) v) 4

.................................................................................................................................. ................................................................................................................................. ...................... . ................................................................................................. . . .................................... ............................................................................................... .
-.!

Distinguish between trade discount and cash discount..

............................................................................................................................................
5 Indicate the correct alternative in the followingcases by putting a tick at the number: a) Sale of goods to Rakesh for cash should be debited to
i) Rakesh's Account ii) Cash Account iii) Sales Account

.

b) Purchase of machinery should be debited to i) Machinery Account ii) Goods Account

iii) Equipment Account

c) , Goods returned by Mahesh shopld be debited to i) Goods Account ii) Mahesh's Account iii) Returns Inwards Account

.

d) Wages paid to Ral~im should be debited to i) ii) The Accnunting Process

Rahim's Account Wages Account

iii) Repairs Account e) Loan taken from Vikas should be credited to i) ii) Vikas's Account Cash Account

iii) Loan from Vikas Account

f) Cash discount allowed by a creditor should be credited to i) Creditors Account ii) Discount Received Account iii) Allowance Account
g) The amount of bad debts should be debited to

i) ii)

Debtor's Account Bad Debts Account

iii) Discount Account h) Rupees 500 received from Gopal whose account was previously written off as bad debts should be credited to i) ii) Gopal's Account Bad Debts Account

iii) Bad Debts Recovered Account

2 3 LEDGER .
You know that the Journal is just a chronological record of all business transactions. It does not provide all information regarding a particular item at one place. This makes it difficult to know the net effect of various transactions affecting a particular item. For example, if you want to know the amount due to a particular supplier or the amount due from a particular customer, you will have to go through the whole journal. To overcome lhis difficulty, we maintain another book called 'Ledger'. In this book we open separate accounts for each item and all transactions related to a particular item as recorded in journal are posted in the concerned account. For example, all transactions related to a particular supplier, say Mohan, are posted to Mohan's Account. Similarly, all cash payments and cash receipts can be posted to Cash Account. Thus, you will have no problem in knowing the amount due to Mohan or the balance in Cash Account, and so on.
,

Thus, ledger is a book where all accounts relating to different items are maintained and into which all journal entries must be posted. In fact, ledger is the principal book of entry which provides complete information about various transactions relating to all parties and all items of asset, incomes and expenses. Some persons have even suggested that we should record all transactions directly into ledger and do away with Journal. But, it is not advisable because in that case we will not have any date-wise record of the transactions and the details thereof. Such record is considered necessary for future reference. You learnt about the 'T' form of an account which divides it into two parts. The left hand side is called the debit side and the right hand side the credit side. The proper f o m of a ledger account is g i v e n h Figure 2.2.

t\ccout11kt?;: Fundamentals

Figure 2.2 : LEDGER Name of the Accopnt

'

You will notice that both sides of the account have date, particulars, folio and amount columns. Now, let us see how postings are made into the ledger accounts.
'

231 Posting into Ledger ..
The journal entries form the basis for recording in the ledger accounts, and the process of entering transaction in the ledger is called 'Posting'. When a journal entry has to be posted in the concerned ledger accounts, the following procedure is adopted. j 1 ~ v ejournal entry will have to be posted into all those accounts which have been debited and credited in the journal entry. For example, for cash sales, Cash Account is debited and Sales Account is credited in the joumal. When this entry is posted in the ledger, it must be posted in Cash Account as well as in Sales Account.
2 Posting will be made on the debit side of the account which has been debited in the journal, and the credit side of the account which has been credit@in the journal. In case of the above example of cash sales, posting will be made on the debit side of Cash Account, as it has been debited in journal and the credit side of Sales Account, as it had been credited in the journal.
'

3 Whether the posting is made on the debit side or the credit side, first of all the date of the transaction (as given in the journal) will be entered in the date column. The method of recording the date in the ledger account is the same as in the joumal.

4 While posting on the debit side of an account in the particulars column, we shall write the name of the account which had been credited in the journal and add the word 'To' before the name.?irnilarly, while posting on the credit side of an account, we shall write the name of the account which has been debited in the journal and add the word 'By' before the name. In case of the above example, we shall write 'To Sales A/c' in the particulars column on the debit side of Cash Account, and 'By Cash A/c' in the Particulars Column on the credit side of the Sales Account.

5 The journal entries contain 'narration'. But it is not required in the ledger accounts. Similarly, there is no need to draw a line between the two entries in an account as is done in the journal. Note that posting in the ledger account is considered complete only when both the debit and the credit aspects of all journal entries have been posted. 6 In the folio column, we shall mention the page number of the journal where concerned journal entry appears. At the same time, the page number of the ledger accounts will be entered in the 'L, F.' column in the journal so as to complete the cross reference. 7 The amount involved in the journal entry shall be entered in amount columns of both the accounts.
Now let us take a transaction, joumalise it, and then show how the posting is done in the .. ledger.

.

Purchased machinery for.cash, Rs. 50,000 on April 4,1988: This transaction will appear in the joumal and the -ledger as undet-: - ..*

f OUHNAL

The Accounting Process
I

Date
1988

Pnrtlculars

L.F

Dr. Amount Rs.

Cr. Amount Rs.
50,000

April 4

Machinery Alc To Cash A/c (Being machinery phrchased)

Dr.

50,000

LEDGER Machinery Account
- -

Dr.

Dtlts

1 Particulars

- -

-

IF I
-

Amount

I

Date

(

Particulars

I

Cr.

F

I

Amount

Cash Account Date Particulars

(

F

I

Amount

1

Date
1988

( Pnrticulva
By Machinery A/c

I

P

I

Amount

Rb.
50.000

Apr, 4

2.3,2 Balancing Ledger Accounts
Whenever one wants to know the net effect of various transactions in a particular account, wc have to work out its balance, Balance is the difference between the totals of the debit and the credit side of an account. The process of finding out the balance is known as balnncing, The procedure for balancing is as follows:

i) Total the two sides of an account.
. ii)

Find out the difference between the totals of the,two sides.

iii) Put the difference in the amount column of the side showing less total. iv) If the difference is entered on the debit side, write against it in the particulars column 'To Balance c/d' (c/d stands for carried down). In case the difference is entered on the credit side, write against it in the particulars column 'By Balance cld'.
v) Now, total both the sides and you will find that both the totals are equal,

vi) The closing balance (balance c/d) is going to be the opening balance for the subsequent period, The opening balance is shown on the next date in the account by writing 'To Balance b/d' (b/d stands for brought down) or 'By Balance b/d' as the case may be. Note that if the closing balance was on the debit sides, the opening balance would be shown on the credit side and if the closing balance was shown on the credit side, the opening balance would be shown on the debit side. In fact, an account is said to have a debit balwce if its debit side total is bigger and a credit balance if its credit side total is bigger. Thus, the opening balance is shown according to the nature of the balance i.e., the debit balance on the debit side and the credit balance on the credit side. vii) soittimes the totals of the debit side and the credit side of an account are equal. It implies that the account has nil balance. In such a situation the account is said to have closed having no closing and opening balances, h o k at fllustration 3 and study how various transactions have been recorded in the Journal, posted into various accounts in the ledger, and how ledger accoun@are halnnced.

Accounting Fundamentals

Illustration 3 Journalise the following transactions, post them into ledger and balance the accouhts.
1987

Rs.
1

Dec.

Anil commenced business with cash Purchased goods from Prakash Purchased furniture for cash Goods sold to Prem Sold goods to Ramlal Goods purchased from Ramesh for Cash Paid wages Sold goods to Ashok Ashok returned goods Received from Ram La1 in full settlement Stationery purchased for cash Goods sold to Arun for cash Withdrew for personal use Paid to Prakash Sold goods to Prem Received from Prem . Cash sales Paid for interest Received from Ashok Paid rent Paid salaries for the month Prem becomes insolvent and a dividend of 50 paise in the rupee is received.

.

Solution:
JOURNAL

Date
1987 Ilec. 1

Pnrtlculars

I
Dr.

L..

I
1

~9;u.t

I

~i!knt

Rs.
1 ,M),oOo

Cash A/c To Capital A/c (Being capital brought in)
Putcheses A/c To Prakash (Being goods purchased on credit)
To Cash Alc

"

3

To Sales A/c (Being goods sold on cmdit) To Sales A/c
,

"

5

- (Being goods sold on credit) Purchases A/c + To Cash A/c (Being goods purchased for cash) WagesA/c To Cash A/c (Being wages paid)
Dr.

"

7

Dr.

Ashok To Sales Alc (Being goods sold on credit) Returns Inwards AR To Ashok (Being goods returned by him)
-

D. r
&oc'o
Dr.

The Accounting Process

,

Cash Alc Discount A/c ,To Ram La1 (Being cash received in full settlement of his account) Stationery Alc To Cash A/c (Being stationery purchased) Cash A/c To Sales Alc (Being goods sold for cash) Drawings A/c To Cash A/c (Being cash withdrawn for personal use) Pfakash To Cash A/c (Being cash paid to Pmkash)

Dr.

D. r

Dr.

Dr.

Dr.

Dr.

23

Prem To Sales Alc (Being goods sold on credit) Cash A/c To Prenl (Being cash received from Prem) Cash Alc To Sales A/c (Being goods sold for cash)

D. r

.

Dr.

27

Interest A/c To Cash A/c (Being interest pnid) Cash A/c To Ashok (Being cash received) Rent A/c To Cash A/c (Being rent paid)

28

D. r

29

,

Dr.

30

1

Salaries AIc To Cash Alc (Being salaries paid)
Cash Account Bad Debts Account To Prem (Being a dividend of 50 paise in a rupee received from Prern)

Dr.

Dr. Dr.

Notes: 1 Transaction on December 14: Ram La1 paid Rs, 4,950 in full settlement of Rs, 5,000 due from him on account of the goods sold to him on December 4. It implies that Rs. 50 @s. 5000- Rs. 4,950) was allowed to him as cash discount, 2 Transaction on December 30 : Prem becomes insolvent. The f r could recover only im 50 paise in a rupee i.e., 50% of the amount due, Goods worth Rs. 8,000 were sold to him (Rs. 6,000 on December 3 and Rs. 2,000 on December 23). He paid Rs. 5,000 on December 25 leaving a balance of Rs, 3,000. Of this, the firm could recover Rs. 1,500 (50% of Rs, 3,000). The remaining amount of Rs. 1,500-has k e n treated as bad debts.

'

35

Dr.

To capitnl Alc To Ram Lal To S l s N c ae To Prem To Salcs Alc To Ashok

1987 Dec. 2 " 5

I
By Furniture A k By Purchases A/c By Wages A/c by Stationery A/c By Drn\vitlp A/c By Prukash By tn1eres.t AIL'

Rs.
7,000 5,000 100 400
1,1100

"
" "

7
15

20

"
"

22 27
29

"
"

Ry Rent A/c
By Salaries N c By Bolarice c/d

30
31

"

20,000 500 2,000 3,000 9 1,450

Jun. I

1

To Balance bld

1

(rPurchabes Account Dec. 31
30,000
1988 Jan. l

By Balance cld

I

I
To Balnncc bld

Furniture Account

lu~ 1

1

To Bvlrnce bld

I

I iWl

I by Balance c/d

I

I

Returns Idwards Account 1987

bet, 13
1988 Jan. 1

To Ashok
To Balance bld

5w ,
31

By Cash N c
By Bad Debts N c

Sales Account 1987 Dec. 3 1

The Accounting Process

Rs.

By Balancc cld

33,000

1987 Dec. 3 " 4
"

Rs.
By 'Prem By Ram La1

"
"

"
33,000

I1 1 7 23 26

By Ashok By Cash A/C
By Prem By Cash A/c

6,000 5,000 8,000 4,000 2,000 8,000 33,000

-

1988 Jnn. 1

By Balance bld

Capital Account

1;oo,ooo 1918 Jnn. 1

By Bnlwcc bld

1987. Dec. 22 TO Cash A/c " '31 To Balance cld

Prakash's Account

Ks.
20,000 10,000 30,000 ' 1987 Dec. 2

By Purchases A/c

Rs, 30,000

- --

1988 Jan. I

B y Balance bld

10,000

Ram Lal's Account
* T -5,000 R

Dec. 14 T B y Cash A/c T " By Discount

4,950

Ashok's Account 1987 Pec. I I

Rs.
To Sales A/c 8,000

1987 Dec. 13

Rs, By Returns Inwards A/c By Cash A/c By Balance C/d
500

" "
8,000 1988

28 3 1

7,000 500

W"J0

Jan. I

To Balance b/d

500

Discount Allowed Account

" h r
Slation~ry Account Dec. I5 To Cash A/c By Balance cld 1988 Jan. I To Balance bld Drawings Account

1
By Balance cld

Dec. 20
Jan, I

To Cash A/c To Balance b/d

1,000
1,000

Dec. 31

Interest Account 1987 Dec. 27 1988 Jan. 1 Rs. 500
500

i
Rs. By Balance c/d
500

To Cash A/c To Balance b/d

1987 Dec. 31

Rent Account 1987 Dec. 29 1988 Jan. I Rs. 2,000 1987 Dec. 31 Rs.

1
By Balance c/d

To Cash A/c To Balance bld

-

- 2-

2,000

Salaries Account 1987 Dee. 30 To Cash A/c 1988 Jan. 1 To Balance bld

1- 1
"31

By Balance ~ / d

-

Rs. 3,000

31

Bad Debts Account

Dec. 30 To Prem 1987 1988 Jan. I To Balance b/d

I

By Balance c/d

1-

Rs.
1. !E 5

Note:

Nominal accounts like Wages Account, Discount Account, Stationery Account, etc. and the accounts relating to purchases, sales and returns of goods are not to be balanced. As per rules, they are simply closed by transfer to the Trading and Profit and Loss Account at the time of preparing the final accounts. In the above illustration, however, they have been balanced for the purpose of preparing the Trial Balance which is being discussed in the next section,

233 Significance of Balances ..
You have learnt that the 'balance' in an account signifies the net effect of all transactions related to it during a given period. It may be a debit balance or a credit balance or a nil balance depending upon whether the debit or the credit total is higher. Let us now understand the significance of a balance in respect of the various types of accounts in the ledger. Personal Accounts: Personal accounts are more frequently balanced as compared to any other class of accounts. Balance in a personal account indicates whether the party concerned

owes to thk business or the business is owing to him. When it shows a debit balance, it means that the party owes that amount to the business and he is a debtor to the business. Similarly, when it shows a credit balance, it would mean that the business owes that amount to him and he is a creditor of the business. If, however, the account shows a nil balance, it means that the account has been cleared, nothing is due to him or due from him.
Real Accounts: Real accounts are normally balanced at the end of the accounting period

The Accounting Process

primarily for the purpose of preparing the final accounts. The Cash Account, however, is balanced everyday because the actual cash is to be verified and confirmed with the closing balance shown by Cash Account. All real accounts show a debit balance as these are assets (property) accounts. Nominal Accounts: Nominal accounts are not to be balanced. They are simply closed by transfer to the Trading and Profit aid Loss Accounts, at the time of preparing the final accounts. However, for the purpose of understanding the procedure involved, nominal accounts have also been balanced. Even otherwise, the difference between the debit side and credit side totals have to be worked out for preparing the Trial Balance. Note that the accounts which relate to expenses or losses will show a debit balance; whereas those reiating to incomes and gains will have a credit balance. This is because all expenses and losses are debited and all incomes and gains are credited. Check Your Progress B 1 State whether each of the following statements is True or False. i) Ledger is the principal book of entry. ii) Process of joumalising is called posting. iii) Posting will be made on the debit side of the account that had been debited in the Journal iv) The word 'By' is written before the name of an account in the particulars column while posting on the credit side of an account v) Writing narration is necessary while posting into ledger accounts vi) Real accounts always show debit balances 2 Why do you balance an account?

.............. ..............

..............

..............
.............. . , . . , . . . . . . , ,.

.

.

.

.

.

.

.

.

I

............................................................................................................................................ ............................................................................................................................................ ..........,......................................................*.............................,..*...............,..,,,................... .
What do you mean by a debit balance of an account?

2.4 TRIAL BALANCE
After posting the journal entries into the ledger and balancing all accounts, we prepare a statement called Trial Balance. This statement shows the balances of all the accounts which appear in the ledger. The debit balances are shown in one column and the credit balances in the other. It is usually prepared just before preparing the final accounts. m e purpose is to check the arithmetical accuracy of the books of account. You know that under the Double Entry System for every debit'there is an equal and corresponding credit. So, the total of debits given to different accounts must be equal to the

Accounting Fundamentals

total of credits given to different accounts. Similarly, the total of debit balances in different accounts must be equal to the total of credit balances in different accounts. Now if the Trid ~aiance tallies i.e., the total of its debit balances column is equal to the total of its credit balances column, it would mean that both the aspects of each transaction have been correctly &corded in the ledger. If, however, the two totals do not tally it implies that some errors have been committed while posting the transactions into ledger. There are two methods of preparing the Trial Balance: (i)Totals Method, and (ii) Balances Method. Under the first method we show the totals of each side of an account in the Trial Balance. The debit side total of an account is shown h the debit column of the Trial Balance and the credit side total of the account in the credit column. Under the second method we show only the balances of each account in the Trial Balance. The second method is more convenient and commonly used because it eliminates all those accounts which have nil balance.

Now, let us prepare the Trial Balance from the ledger accounts prepared. Under Illustration 3 you will notice that all the accounts which appear i t 1 the ledger have been included and their balances entered in the appropriate column. The total of debit balances column in the Trial Balance is equal to the credit balances column. This means that all postings have been correctly made in different ledger accounts.
Trial Balance as on December 31,1987
S. No.

Name of Account

L.F.

Dr. Balance
Rs.

Cr.
Balance

Rs.
1, ~ , W

Cash Account Capital Account Furniture Account Purchases Account Sales Account Prakash's Account Wages Account Returns Inwards Account Ashok's Account Discount Account Stationery Account Drawings Account Interest Account Rent Account Salaries Account
16

91,450

7,000 35,000
33,000
10,000

100
500 500

50
400

1,000 500

2,000

1

3,000
1,500

Bad Debts Account Total

1,43,OOa

1,43,W

-

2.5, OPENING ENTRY
When an accounting year begins. the previous year's balances in different accounts are brought forward lo the new books of account. This is done by means of a journal entry-dl assets accounts are debited and all liabilities accounts (including the proprietor's capital account) are credited. In case the Capital Account balance is not given, it can be calculated by deducting the other liabilities from the total assets. This will be clear from
Illustration 4.

Illustration 4 Ashok has the following balances on December 31, 1987: Cash in hand Rs.5,000, Debtors Rs,7,200 (Ramesh Rs.6,000, Lalwani Rs. 1,200); Stock of goods Rs. 18,800; Machinery Rs. 8,000, Furniture Rs. 3,000;Creditors Rs. 1,500 (Ravi & Co.) ; Ba* Loan Rs. 3,000.

Pass the opening entry on January 1,1988.

-.

Solution :
JOURNAL Date Particulars

'

The Accounting ~rqce$s

LF ..

Dr. Amount

Cr. Amount Rs.

1988 Jan. 1

Cash Account Ramesl~ Lalwani Stock Account Machinery Account Furniture Account To Ravi & Co. To Bank Loan Account To Capital Account (For the balance brought forward from the previous year)

Dr. Dr. Dr. Dr. Dr. Dr.

wJc'
6,000

Rs.

Posting the Opening Entry into Ledger: The posting of an Opening entry into ledger is slightly different from the posting of other journal entries. We have to open the accounts for all items that appear in the opening entry. Then, in the accounts which have.been debited in opening entry, we shall write 'To Balancb b If' on their debit side, and in the account which have been credited in the opening entry, we shall write 'By Balance b/f' on their credit side. The date, folio and amount columns are completed in the usual manner. As a matter of fact, the accopnts which have been debited and credited through the opening entry merely represent the closing balances of various personal and real accounts from the previous year. The k s d n g of the opening entry as given in Illustration 4 will be made as follows: i Cash Account

, Dr.

Cr.

1988 Jan. 1

Rs.
To Balance b/f
5 ,OOO

Ramesh'e Account

Jan. 1 lgS8

I

ToBalance b/f

,

1988 Jan. 1

To Balance b/f

Rs. 1,200

-

.

Stock Account
I

1988 Jan. 1 .

To BalanCC b/f

Rs. 18,800

1988
Jm:l

Rs.
ToBalana b/f
,

,

8,000
4

..

Acmunting Fundamentals
1988

L
% .

Furniture Accaunl

1

Rs.
TO 'Balance b/f
3,000

I

i

Jan. I

Ravl & CO.'s Account
1988 Jan. 1

Rs.
By Balance b/f
1,500

I

1

Bank Loan Account 1988
Jan. 1

* ,
Rs.

By Balance b/f

3.000

Capital Account
1988
Jan. 1

1
Rs. By Balance b/f
37,500

26 LET US SUM UP .
Journal is a book of original entry wherein all business transactions are recorded in n chronological order. he journd shows the accounts to be debited and those to be credited in respect of each transaction. The journal does hot provide all information regarding a particular item at one place. Hence, we maintain another book called Ledger. In ~his book we open separate accounts for each item. An account has two sides, the debit side and the credit side. When an account is balanced, it shows the net effect of all transactions relating to that account during a given period, Before preparing a summary in the form of final accounts, a statement called Trial Balance is prepared to check the arithmetical accuracy of posting into Ledger. This statement shows the balances of a11 the accounts and if the totaI of debit