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Basic Accounting Concepts

Business Entity Concept/Accounting Entity Concept According to this concept, the business is considered as a separate business entity from its owner(s). Thus the financial information of the business will be recorded and reported separately from its owners personal financial information. Going Concern For accounting purposes, it is assumed that the business will operate for an indefinite period of time and thus considered as going concern. For this reason, the realizable value of the property owned by business will not be relevant. Money Measurement Only those transactions will be recorded in the financial books which can be measured in terms of money. Anything which cannot be measured in monetary terms will not be considered as a part of the accounting data. Historical Cost All assets will be recorded at their cost price. This means that machinery purchased years ago will be recorded at its original cost of purchase even though its value is lower now. The reason for doing so is because the business is considered as a going concern and we need not be worried about the saleable value of the asset. Accounting Period The life a business is considered to be indefinite. But for accounting purposes, the life of the business is divided into specified periods of time. The period may be a month, a half year, a full year or any length of time. Accrual Concept Accrual concept states that revenue is recognized when it is earned and expenses when they are incurred. Any income or revenue generated must be recorded in the books of accounts whether the payment for it is received or not. Similarly, any expense done by the business should be recorded irrespective of the fact that the business has paid for it or not. Objectivity Any transaction which is recorded in the accounting books should be verifiable. In other words, the transaction should backed by some proof in the form of a receipt, invoice, cheque, voucher etc. Consistency According to this concept, the same accounting method should be applied in each accounting period when preparing financial reports. This makes it easy to compare results of one period with another period and the stakeholders can get a more realistic idea about the performance of the business. Prudence It involves being cautious while reporting accounting information. The assets should not be overstated and the liabilities should not be understated. This is why closing stock is always valued at the lower of cost or market value so that the profits are not overstated.

Matching Principle This principle is based on accrual concept of accounting. It states that revenue earned during a specific period has to be matched with the expenses incurred with earning that revenue. The following point should be considered: If an item of revenue is shown in the Profit and Loss account, all expenses incurred on it, whether paid or not, should be shown as expenses in the Profit and Loss account. An expense will be recorded in the books of accounts if the revenue associated with it has not been realized. Incomes received in advance should not be shown in Profit and Loss account. All the cost and expenses incurred on good remaining unsold at end of the year must be carried forward to next year as these goods will be sold in the next accounting period. What are Non Profit Organizations? Sole trader, Partnership and Limited companies have Profit as their main objective. However, Clubs, societies and associations does not only exist to make profit. They may be formed to promote cultural and recreational interest. Thus their final accounts are different from those organizations which solely exist to earn profit. The final accounts of a non-profit organization includes of Trading Accounts (only if there is a restaurant or canteen) Receipts and Payments Accounts Income and Expenditure Account Balance Sheet

Receipts and Payments Account


Format for Receipts and Payments Account Receipt and Payments Account for the year ended 31 December 2010 Dr. Receipts Balance b/d (Opening balance) Amount Payments Cr. Amount xxxxx

XXXX All cash payments

All Cash receipts

XXXX Balance c/f (closing balance) XXXXX

XXXX

xxxxx

XXXXX

Cash (beginning) + all cash receipts (revenue receipts and capital receipts) - All Cash payments (revenue expenditure and capital expenditure) Cash (end)

Features
Similar to Cash Book Cash receipts are on Debit side and Cash payments are on Credit side All cash receipts and payments are recorded irrespective of their relation to current year. There is an opening balance and a closing balance

Income and Expenditure Account


Income and Expenditure Account
for the year ended 31 December 2010 Dr. Expenditure Revenue expenses only Amount XXXX Income Trading Profit (if any) Revenue Incomes only Cr. Amount XXXX XXXX

Surplus (when income is more than expenditure)

XXXX

Deficit (when expenditure is more than income)

xxxxx

XXXXX

XXXXX

Step in constructing a Income and Expenditure Account


1. If there is a Trading Profit put it on the Credit side. 2. Put all the revenue incomes on the Credit side. 3. Put all the revenue expenses on Debit side. 4. Balance both the sides.

5. If the Income side is more than the expenditure side then we get a SURPLUS. 6. If the Expenditure side is more than the income side we get a DEFICIT.

Note
Only revenue receipts and expense are posted in this account Only incomes and expenses pertaining that particular year are recorded. Incomes and expenses pertaining to previous year or future year are adjusted for.

Adjustments in Final Accounts (Nontrading concerns)


Subscription Account
Subscriptions are paid by members as charges for using the facilities of a club or society for a particular period of time. Usually it is on a yearly basis. Receipt and Payment account records the actual subscription received. It may pertain to any year. However, In order to post it to the Income and Expenditure Account adjustments have to be made to the subscription as only subscription pertaining to that particular year is recorded in I/E account.

How to calculate e.g. for Year 2009


Total subscription received Less Subscription in arrears, at the starting of the year Add Subscription received in advance for 2009, in previous years. Add Subscription in arrears, at the end of 2009 Less Subscription received in advance (for next year), at the end of the year Subscription revenue for Year 2010 1000 200 100 300 100 1100

You can also make a separate Subscription Account and then post the final subscription amount in the Income and Expenditure Account
Subscription Account Amount Cr. Amount Subscription received in advance b/d (collected during previous year) Total Cash received as subscription during the current year XXXX

Dr.

Subscription in arrears (b/d) (not collected during the previous year) Subscription received during current year (from Income & Expenditure

XXXX

XXXX

XXXX

Account) Subscription in advance c/d (collected for subsequent year) XXXX Subscription in arrears b/d XXXX Subscription in advance b/d XXXX Subscription in arrears c/d (not yet collected for current year) XXXX XXXX XXXX

What are the reasons for difference in Bank Statement and Cash Book? These can be summarized as follows: Cheque issued by the trader but the customer has not yet presented it to the bank for encashment. This will show a less bank balance in the traders Cash book as he has already issued the cheque, but the bank will not reduce the amount till the cheque is presented to it. Cheque received by the trader was deposited into the bank for collection but the bank did not realize the funds and did not credit the Traders account. Trader deposited a cheque into bank but it was dishonored by the bank. The reason may be the customer does not have sufficient cash in his bank account. Bank pays interest to the trader on his deposit but the trader will not come to know this till he receives the Bank statement and thus his cash book will show less balance as compared to bank statement. Bank might receive direct payment of interest or dividends on behalf of the trader for any investments made by the trader. The trader will not come to know the details till he gets a bank statement and thus his Cash book will be understated. Bank might charge transaction fees or Bank charges or interest on any overdraft which the trader will only know when he receives the bank statement. A customer or debtor might directly pay into the traders bank account and the trader might not be aware of this. A Bank may pay bills, insurance premiums or some payment based on the standing instruction of the trader. The details of these transactions will only be available to the trader once he receives the bank statement. A bank reconciliation statement can be prepared by taking the balance either as per cash book or as per pass book as a starting point. If the statement is started with the balance as per bank column of the cash book, the answer arrived at the end will be balance as per pass book. Alternatively, if the statement is started with the balance as per pass book, the answer arrived at in the end will be the balance as per cash book. A debit balance as per cash book shows the amount of the money in the bank, whereas, a credit balance means that the business has taken an overdraft. In the same way, a credit balance as per pass book shows a positive bank balance whereas debit balance as per pass book shows an Overdraft.

How to make Debtors Control Account


Sales transaction takes place It is recorded in the Sales Journal From the Sales Journal entry is posted to the Sales Ledger.

From where do you get information to draw Debtors Control Accounts?


Information
Total Opening Balance Total Sales Dishonoured Cheques Discount allowed withdrawn Any charges to debtors Total cash and cheques received from debtors Discount allowed Returns inwards and allowances Bad Debts

Source
Trial Balance at close of previous period Sales Journal Cash Book General Journal General Journal Cash book Cash Book Returns Inwards journal General Journal

How do we prepare Creditors Control Account?


Also known as Purchases Ledger Control Account It accounts for all Creditors appearing in the Purchases Ledger.

From where do you get information to draw Creditors Control Accounts?


Information
Total cash and cheques paid to creditors Discount received Returns outwards and allowances Total opening balances Cash Book Cash Book Returns Outwards Journals Trial Balance at close of previous period

Sources

Total purchases Any charges by creditors

Purchases Journal Journal

Minority balances in Control Acccounts


Normally, debtors accounts have debit balances Creditors accounts contain credit balances. There may instances when debtors might return some goods after their accounts have been settled and this may lead them to have a credit balance.

What to do?
The Debtors control Account will have both the debit and credit balances brought down. Same procedure will take place for Creditors Control Account. Through this the true financial position is shown i.e. the exact amount owing by debtors as well as the amount owing to them.

Trial Balance
Trial Balance is a statement prepared with the debit and credit balances of ledger accounts to verify the arithmetical accuracy of the book.
The Trial Balance checks the equality of debits and credits in the ledger by listing each account along with its ending balance.

Accounts to be placed on debit side


Assets Expenses Drawings

Accounts to be placed on credit side


Liabilities Capital Revenue

Errors revealed by Trial Balance


Errors in calculation
Any calculation mistake, especially totaling mistake or balancing mistake will be revealed by Trial Balance as both the side will not match.

Errors of omission of one entry


If by mistake only one entry is made for a transaction, Trial Balance will not balance.

Posting to the wrong side of an account


In case any entry is made on the wrong side of the account, it will be revealed by the Trial Balance. For example Credit sale of $100 was debited to Sales account.

Posting of wrong amount


When two different amounts are entered for the same entry, both the sides of the Trial balance will not match. For example, Credit sales of $123 to James. James was debited with $123 but Sales was wrongly credited as $132.

Limitation of Trial Balance


Though Trial Balance is prepared to check the arithmetical accuracy of double entries, there are still some mistakes which cannot be identified by Trial Balance. These are:

Errors of omission
These are errors where the transactions are totally omitted. They are neither recorded in the Journal or Ledge and thus do not appear in the Trial Balance.

Errors of commission
This means that a wrong amount is entered from the very starting in the Journal or Ledger and thus a Trial Balance based on this amount may not show any mistake at all.

Errors of principle
These errors occur when the classification of accounts is wrongly done. For example revenue expenditure may be considered as capital expenditure. Repairs of machinery $200 was debited to Machinery account whereas it should have been debited to Repairs of machinery account.

Complete reversal of entries


Complete reversal of entries cannot be revealed by Trial Balance. This is when entries have been made to both the sides and thus there is no arithmetical mistake. Good sold to Raman were entered as Sales debited and Raman Credited, whereas, it should have been vice versa.

Compensating errors
These errors are those which cancel themselves because the same error is committed on both sides. For example, Purchases were debited by $100 more and at the same time Sales were also credited by $100. This will neutralize the effect of both the entries.

Accounting equation
Assets = Owners Equity + Liabilities
The above accounting equation expresses the fact that everything the business owns has been supplied by the owner (owners equity) and by external source (liabilities).

Elements of Accounting Equation

Assets
Assets are items of value owned by the business. Examples include Building Machinery Motor vehicle Cash at bank Cash in hand Stock Debtors (people who own money to the business)

Liabilities
These denote the amounts which the business owes to others. Examples include Creditors (people to whom the business owes money) Bills payable Bank overdraft Bank loan

Owners equity
The funds of a business provided for by its owners. Owners equity = Assets Liabilities

Owners equity increases by Profits Additional investment into the business

Owners equity decreases by Losses Drawings

Double entry System


Look at an example: You own a business, for example, selling shoes. When you buy shoes from manufacturer: Transaction is your stock increase because new stock comes in. You pay for that stock and thus your cash reduces. What does it mean? Two entries Stock increases Cash decreases This system is known as Double entry system of book-keeping because for every transaction there are two entries. In this system all transactions are entered in a set of accounts. An account is a place where all the information referring to a particular asset or liability or to capital is entered. Thus there is an account for everything in the business e.g. machinery, furniture, creditors, debtors and even capital.

What is an Account
Each account is shown on a different page.

Page is divided vertically into two halves. Left side is Debit side; right side is Credit side

Rules of Debit and Credit


There are two systems or practices of putting the accounts.

American System
This system classifies accounts into five categories:

Assets account
Debit the increase in assets; Credit the decrease in assets

Liabilities account
Debit the decrease in liabilities; Credit the increase in liabilities

Capital account
Debit the decrease in Capital; Credit the increase in Capital

Revenue account
Debit the decrease in income; Credit the increase in income

English system
Classification of Accounts

Personal Accounts
Personal accounts are those which are opened under the NAME of individuals, firms, company, institution etc. For example Johns account, dineshs account, Coca-Cola ltd account, bank account etc. Rule Debit the Receiver Credit the Giver

Real Accounts
All the assets owned by the business can be classified in this account. These can be categorized as Tangible real accounts All those which can be seen, touched and measured such as Building Land Cash account Stock account Furniture account

Intangible real accounts


Those accounts which cannot be touched or seen. Examples include Goodwill account Patent accounts Rule Debit what comes in Credit what goes out

Nominal Accounts
These include all those accounts which are related with incomes/gains and expenses/losses of the business. Incomes/gains Expenses/losses

Commission received account Rent paid account Discount received account Interest received account Dividends received account Salary paid account Commission paid account Discount allowed account Loss due to theft account Loss due to fire account

Rule Debit all expense and losses Credit all incomes and gains

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