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BASICS OF ACCOUNTING

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Introduction to accounting
Introduction
 The main objective of every business is to earn profit.

 At end of each year, every business wants to know how much profit they have earned or losses
occurred, how much stock they have in their warehouse, how much is business liabilities, how
much is owed to them and by whom, etc.

 So many other such questions which a businessman wants to know on a daily, monthly or annual
basis.

 In order to attain such information, it is essential to keep a complete and systematic record of each
and every business transaction entered into during the year.

Meaning of accounting
Accounting is the process of identifying, recording, classifying, summarising, interpreting and
communicating financial information of business to its users for judgement and decision making.

“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 atleast, of a financial character, and interpreting the
result thereof.” — American Institute of Certified Public Accountants

Functions of accounting

1. Identifying: Identifying the business transactions of a financial character from the

source documents such as invoice, agreements, cash memos etc. and measure them in
terms of money.
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2. Recording: The next function of accounting is to keep a systematic record of all business
transactions, which are identified in chronological order of their occurrence in the journal
or subsidiary books.
3. Classifying: Classification of the recorded business transactions so as to group the transactions
of similar type at one place. i.e., in ledger accounts. In order to verify the arithmetical accuracy
of the accounts, trial balance is prepared.
4. Summarising: The classified information available from the trial balance is used to prepare
profit and loss account and balance sheet in a manner useful to the users of accounting
information.
5. Analysing: It establishes the relationship between the items of the profit and loss account and
the balance sheet. The purpose of analysing is to identify the financial strength and weakness
of the business. It provides the basis for interpretation.
6. Interpreting: It is concerned with explaining the meaning and significance of the relationship
so established by the analysis. Interpretation should be useful to the users, so as to enable
them to take correct decisions.
7. Communicating: The results obtained from the summarised, analysed and interpreted
information are communicated to the interested parties.

Accounting Cycle
The accounting cycle is the holistic process of recording and processing all financial transactions of a
company, from when the transaction occurs, to its representation on the financial statements, to closing
the accounts. One of the main duties of a bookkeeper is to keep track of the full accounting cycle from
start to finish. The cycle goes on continued till the business ends.

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1. Transactions- the first task of accounting is to identify the transactions of financial

character and measure them in terms of money. Transactions may include a debt payoff,
any purchases or acquisition of assets, sales revenue, or any expenses incurred.
2. Journal Entries- With the transactions set in place, the next step is to record these
entries in the company’s journal in chronological order. In debiting one or more
accounts and crediting one or more accounts, the debits and credits must always
balance.
3. Posting to the General Ledger (GL) -The journal entries are then posted to the general
ledger where a summary of all transactions to individual accounts can be seen.
4. Trial Balance - At the end of the accounting period (which may be quarterly, monthly,
or yearly, depending on the company), a total balance is calculated for the accounts.
5. Financial Statements- The balance sheet, income statement, and cash flow statement
can be prepared using the correct balances.

Book-keeping, accounting and accountancy

Book-Keeping – Book-keeping is recording the business transaction of monetary aspects in books of

accounts. It is mainly concerned with record keeping or maintenance of books of accounts. It
includes identifying, measuring, recording and classifying functions of accounting. The book-keeping
function is routine and clerical in nature and can be performed by a person having limited knowledge
of accounting.

Accounting - Accounting is considered as a system which collects and processes financial information
of a business. Accounting starts where bookkeeping ends. It includes summarising, analysing,
interpreting and communicating functions of accounting.

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Accountancy - Accountancy refers to a systematic knowledge of accounting, concerned with the

principles and techniques which are applied in accounting. Accountancy is collection of theory and
practices of accounting.

Basis Book-keeping Accounting

Objective To maintain systematic To ascertain the net results and the
records of transactions of financial position of the business
financial nature
Phase It is the recording phase of It is the summarizing phase of an
an accounting system accounting system
Stage It is a primary stage and It is secondary stage which begins
basis for accounting where the book-keeping process
ends.
Skills required It is routine in nature and It is analytical in nature and require
does not require any special special skill or knowledge
skill or knowledge
Who performs It is done by junior staff It is done by senior staff called
called book keepers accountants

Objectives of accounting
The following are the main objectives or utility of accounting:

1. Keep systematic record of business transaction- The main objective of accounting is to keep
complete record of business transactions according to specified rules. Complete record of business
transactions helps to avoid the possibility of omission and frauds. For this purpose, all the business
transactions are first of all recorded in journal or subsidiary books and then posted into ledger.

2. Calculate profit or loss – The second main objective of accounting is to ascertain the net profit
earned on loss suffered on account of business transactions during a particular period. For this
purpose trading and profit & loss account of the business is prepared at the end of each accounting
period.

3. To ascertain the financial position of the business - After preparing the profit & loss account a
statement called balance sheet is prepared which shows the assets and their values on one hand
and liabilities and capital on the other. A balance sheet is actually a screen picture of financial
position of the business.

4. To provide information to various parties- The objective of the accounting is to communicate the
accounting information to various interested parties like owners, creditors, banks, government
etc.

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Accounting is an art as well as science

Accounting, like science follows a systematic and organized path to understand the economic status of an
entity.

Science is obtaining knowledge by a systematic pattern including observation, study, practice, experiments
and investigation. Like Science, Accounting requires gaining knowledge about the economic status of an
entity by systematic study. An accountant finalizes the economic results by identifying, analyzing,
classifying using the method of double entry book-keeping system.

So, Accounting is a science that comprises of rules, principles, concepts, conventions and standards in science.

Art is the application of techniques and methods. Accounting is an art because it presents the financial
findings by following and implementing universally accepted principles (GAAP).

Art is the study of application of scientific method to practical use. Accounting is an art as the established
rules and principles of accounting are applied to bookkeeping process of an economic entity.

Advantages of accounting

 Protecting business assets

 Facilitates settlement of tax liabilities: A systematic accounting record immensely helps settlement
of taxes as it is good evidence of the correctness of transactions.
 Replaces memory: A systematic and timely recording of transactions obviates the necessity to
remember the transactions. The accounting record provides the necessary information.
 Facilitates comparative study: A systematic record enables a businessman to compare one year’s
results with those of other years and locate significant factors leading to the change, if any.

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 Facilitates loans: Loan is granted by the banks and financial institutions on the basis of growth
potential which is supported by the performance. Accounting makes the information available with
respect to performance.
 Facilitates sale of business: If someone desires to sell his business, the accounts maintained by him
will enable the ascertainment of the proper purchase price.

Disadvantages of accounting

 Accounting ignores the qualitative element: Since accounting is confined to monetary matters
only, qualitative elements like the quality of staff, industrial relations and public relations are
ignored.

 Accounting may lead to window dressing: The term window dressing means manipulation of
accounts in a way so as to conceal vital facts and present the financial statements in a way to show
a better position than what it is actually.
 Accounting is based on historical costs: Accounting often uses historical costs to measure the
values. This fails to take into consideration factors such as inflation, price changes, etc. This skews
the relevance of such accounting records and information. This is one of the major limitations of
accounting.
 Accounting is not fully exact: Although most of the transactions are recorded on the basis of
evidence such as sale or purchase or receipt of cash, yet some estimates are also made for
ascertaining profit or loss. Examples of this are providing depreciation on the basis of the estimated
useful life of an asset, possible bad debts, the probable market price of the stock of goods, etc.

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Types of Accounting Information

Information relating to profit or surplus: The income statement i.e., profit and loss account makes
available the accounting information about the profit earned or loss incurred as a result of business
operations or otherwise during an accounting period.

Information relating to financial position: The position statement, i.e., the balance sheet makes the
information available about the financial position of the entity.
In the case of not-for-profit organisation, the difference between assets and liabilities is termed as ‘General
Fund.’

Information about cash flow: Cash flow statement is a statement that shows flow, both inflow and
outflow, of cash during a specific period. It is of immense use as many decisions such as payment of
liabilities, payment of dividend and expansion of business etc., are based on the availability of cash.

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Basic accounting terms

Capital: refers to the amount invested by the proprietor in a business enterprise.

Capital is also known as – Owner’s Equity /Net Worth/ Net Assets

Assets = Liability + Capital

Drawings: any cash or value of goods withdrawn by the owner for personal use or any private payments
made out of business funds.

Liabilities: It refers to the amount which the firm owes to outsiders.

Example: Unpaid wages, Creditors, etc.

Assets: Assets are valuable resources owned by businesses that are acquired at a measurable money cost.
Example: Cash, Land, Furniture, etc.

Classification of assets

(1) Fixed Assets:

 Held for continued use in business for producing goods and services; and
 Not meant for resale

Eg: Furniture, Land & Building.

Tangible assets - which have a physical existence. (Cash, Computer)

Intangible assets – do not have a physical existence. (Patents, Goodwill)

(2) Current assets (Floating assets/ Circulating assets)

 Meant for sale or

 Converted into cash within 1 year.
Eg: Debtors, Stock, Bills receivables

Expenditure: any disbursement of cash or transfer of property or incurring liability for the purpose of
acquiring assets, goods or services.

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Expense: It is a value that has expired during the accounting period. An expense is charged to profit and
loss account.

Income: Income is the profit earned during a period of time.

Income = Revenue – Expense

Profit: It is the excess of revenue of a business over its costs.

Gain: It is a profit of irregular or non-recurrent nature. For example, profit on the sale of a fixed asset or
investment.

Loss: A loss is excess of expenses of a period over its related revenues which may arise from normal
business activities. It decreases the owner’s equity.

Case: Following transactions were reported during an accounting reported for Mr. B’ s business of
furniture.

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Terms related to trade

Distinction between stock and inventory

Stock refers to the value of goods which are purchased for reselling and which are lying unsold at the end
of the accounting period.

Inventory is a wider term which includes stock also.

Inventory includes:
1. Inventory of raw material
2. Inventory of semi-finished goods
3. Inventory of finished goods
4. Inventory of stock

Bills receivable: An accounting term for bills of exchange drawn on debtors or received by way of
endorsement from them. The amount specified in such a bill is receivable at a future date.

Bills payable: an accounting term for bills of exchange accepted in favour of creditors. The amount
specified in such a bill is payable at a future date.

Debtors: Persons or firms to whom goods have been sold or services rendered on credit and payment has
not been received from them.
They owe some amount to the business.

Creditors: Persons or firms from whom goods have been purchased or services procured on credit and
payment has not been made to them. Some amount is still owing to them.

Bad debts: the amount that has become irrecoverable from a debtor. It is debited to P&L account as an
expense.

Insolvent: a person or an enterprise which is not in a position to pay its debts.

Discount: rebate or allowance given by the seller to the buyer.

It is of 2 types:
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(i) Trade discount: at a fixed percentage on the list or catalogue price of the goods. Not recorded in the
books of accounts (deducted in the invoice from the gross value of goods)

(ii) Cash Discount: for making prompt payment. It is always recorded in the books of accounts.

Accounting principles
BASIC ACCOUNTING PRINCIPLES
Accounting Principles - Financial statements are the product of a 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 conformity with generally accepted accounting principles. These principles
represent the most current consensus about how accounting information should be recorded, what
information should be disclosed, how it should be disclosed, and which financial statement should be
prepared. The general acceptance of an accounting principle usually depends on its usefulness,
objectiveness and feasibility.

Generally Accepted Accounting Principles (GAAP)

Generally Accepted Accounting Principles (GAAP) are basic accounting principles and guidelines which
provide the framework for more detailed and comprehensive accounting rules, standards and other
industry-specific accounting practices.

Separate Business Entity Concept - In accounting we make a distinction between business and the owner.
All the books of accounts records day to day financial transactions from the view point of the business
rather than from that of the owner.
For instance, when a person invests Rs. 1 lakh into a business, it will be treated that the business has
borrowed that much money from the owner and it will be shown as a ‘capital’ in the books of accounts of
business.
Similarly, if the owner withdraws some amount from the business, then it is shown as drawings in the
books of accounts of business.

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Money Measurement Concept - In accounting, only those business transactions are recorded which can be
expressed in terms of money. In other words, a fact or transaction or happening which cannot be
expressed in terms of money is not recorded in the accounting books.
This concept imposes two limitations:

Dual Aspect Concept - Financial accounting records all the transactions and events involving financial
element. Each of such transactions requires two aspects to be recorded. The recognition of these two
aspects of every transaction is known as a dual aspect analysis. According to this concept every business
transaction has dual effect.

Going Concern Concept - The business entity is assumed to be a going concern, i.e., it will continue to
operate for an indefinite amount of time. This assumption is important because if the business entity were
to liquidate in the near future, it would have to restate its assets and liabilities in the accordance with the
actual amount that could be realised or payable as the case may be so as to reflect the true financial
position of the entity.

Accounting Period Concept - This concept requires that the life of the business should be divided into
appropriate segments for studying the financial results shown by the enterprise after each segment. A year
is the most common interval on account of prevailing practice, tradition and government requirements.
Some firms adopt financial year of the government, some other calendar year.

Historical Cost Concept - According to this concept an asset is ordinarily entered on the accounting records
at the price paid to acquire it.

The cost concept does not mean that all assets remain on the accounting records at their original cost for
all times to come. The asset may systematically be reduced in its value by charging ‘depreciation’.

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Matching Concept - This concept requires the revenue for a particular period to be matched with its
corresponding expenditure so as to show the true profit for the period.
This means that if you owned a store and spent money to purchase items for your inventory, you wouldn't
record that expense until you sold the items for revenue.

Accrual Concept - Accrual concept is the most fundamental principle of accounting which requires
recording revenues when they are earned and not when they are received in cash and recording expenses
when they are incurred and not when they are paid.

Materiality Convention – Materiality concept states that items of small significance need not be given
strict theoretically correct treatment.

Conservatism Convention - All anticipated expenses or losses will need to be accounted for but all
potential income or gains should not be recorded until actually earned/received.

Consistency Convention - The convention of consistency requires that once a firm decided on certain
accounting policies and methods and has used these for some time, it should continue to follow the same
methods or procedures for all subsequent similar events and transactions unless it has a sound reason to
do otherwise.

Disclosure Convention: This principle state that the financial statement should be prepared in such a way
that it fairly discloses all the material information to the users, so as to help them in taking a rational
decision.

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Advantages and disadvantages

Cash basis Accrual basis

Advantages
Advantages
1. It is very simple as adjustment
enteries are not required 1. It shows a complete picture of
financial transactions of the business
2. This basis of accounting is suitable
for those enterprises where most of 2. It discloses correct profit or
the transactions are on cash basis loss and also exhibits true
financial
position of an enterprise

Disadvantages
1. It does not give a true and fair Disadvantages
view of the profit or loss abd the
financial 1. It is not as simple as cash basis
position of an enterprise 2. A quick appraisal of the profit/loss
2. It does not follow the is not possible
matching principle of

Accounting equation
Prior to understanding an accounting equation, it is essential to know about a Balance Sheet (in a simple T
format)

Example to understand the basics of accounting equation

Kapil started a business of shoes. He invested Rs.80 lacs of his own and borrowed Rs.20 lacs from Sunil @
7% p.a. From this amount he bought a shop worth Rs40 lacs. He spent on furnishing Rs.10 lacs. He bought
some stock of shoes worth Rs.30 lacs and balance he deposited in bank.
The above position can be expressed as:

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Meaning
Accounting Equation signifies that the assets of a business are always equal to the total of capital and
liabilities.

A business transaction will result in the change in either of the total assets, liabilities or capital of the firm
and even after the change the assets will be again equal to the total of capital and liabilities.

Continuing with the previous examples

Shoes of Rs.5 lacs were sold to a retailer (Ram) on credit.

Assets = Liabilities + Capital

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Rules of debit and credit

Meaning of debit and credit
All accounts are divided into two sides. The left side of an account is called Debit side (Dr.) and the right
side of account is called Credit side (Cr.)

Rules of debit or credit in respect of the various categories of accounts

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Natural persons

Personal accounts Artificial persons

Classification of accounts

Representative
persons

Tangible
Real
Impersonal
Intangible
accounts
Nominal

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Note: When any word (as a prefix or suffix) is added to a Nominal A/c, it becomes a Personal A/C
Example:
Interest A/C: Nominal A/c
Interest Outstanding A/C: Personal A/c

Journal
Meaning

The books in which transactions are recorded for the first time from a source document are called ‘Book of
Original Entry’.

Journal is one of the basic books of original entry in which transactions are originally recorded in a
chronological order according to the principles of double entry system.

After Journal, transactions are entered in Ledger.

The various columns of journal are explained in details below:

Date
This column is used to write the date of the business transaction. Different date formats are used in
different countries. Different formats of date are: 15.03.2001, 03.15.2011, 15 March 2021 etc.

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Particulars or Details Column
In this column the names of the two connected accounts are written in two consecutive lines - in the first
line the name of account debited and in the second line the name of account credited.

The world "Dr." is used at the end of the name of account debited. It is not necessary to place the word
"Cr." after the name of the credited account, because if one account is Dr. It follows that the other account
must be Cr.

Ledger Folio (L.F)

In this column, the number of the ledger page is written to which the amount is posted

Amount
The debit amount is written in the first "amount" column against the name of account debited and the
credit amount in the second "amount" column against the name of account credited.

Rules for Journalizing

How a transaction is recorded in journal, is discussed below:
Suppose the transaction is:
Purchased furniture from Mr. A on 10.01.20 for Rs.16,000, for cash
Here furniture accounting is debited and cash account is credited.

Simple Entry and Compound Entry

Simple entry - Every transaction effect two accounts - one is debited and another account is credited.
Thus, in recording a transaction in a journal one account is debited and another account is credited. This
type of entry is called simple entry.

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Compound entry - The entry in which more than one account is debited or more than one account is
credited, is known as compound entry. Three or more accounts are connected with a compound entry.

Example of Simple Entry

For example, on 10.04.20 we bought furniture from S. The entry is:

Example of Compound Entry

For example, on 16.05.20 we paid Rs. 1,000 on account of salaries and Rs.600 on account of rent. For this
the entry will be:

Here two accounts have been debited and the entry involves three accounts. Hence, it is a compound
entry.

Example: Mr. R started a business with Rs.20,000

Drawings
If the proprietor draws any money or takes goods from his business for his personal use, it will be recorded
in drawings A/C. Drawings A/C is the personal account of the proprietor, so it is classified as the personal
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account. Proprietor receives benefit when he withdraws money or goods from business. So, the
proprietor's account i.e., drawing is debited.
Example:

Entries of some specific transactions

Cash Discount
The manufacturers and whole sellers frequently grant cash discount to their debtors who will pay their
debts before due date for goods purchased by them on credit. The seller regards it a "cash discount"
or "sale discount" or "discount allowed". The buyer calls the discount as "purchase discount" or
"discount received".

Trade Discount
This discount is allowed by wholesaler or manufacturer to the retailer at a fixed percentage on the listed
price of goods. It is allowed when goods are manufactured in bulk. No separate entry is passed for the
trade discount, as it is deducted from the invoice of the goods.

Opening Entry
Business firms close their books of accounts at the end of each year and start a new set of books in the
beginning of each new year. The first entry in journal is to record the closing balances of individual assets
and liabilities of the previous year. These balances become the opening balances of the new year. The
entry passed to record the closing balances of the previous year is called the opening entry.
While passing the opening entry all the assets are debited and capital and liabilities are credited. If capital
is not given, total liabilities are deducted from total assets.

Example of Journal
Journalise the following transactions: 2020
Feb. 3 X commenced business with a capital of Rs.15,000
05 Purchased good Rs.6,000
07 Purchased goods on credit from S & Co. Rs.3,000
10 Purchased furniture Rs.2,400
11 Sold goods Rs.3,900
15 Sold goods on credit to D Rs.2,250

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 20 Paid salaries Rs.960
25 Received commission Rs.75
26 Returned goods to S & Co. Rs.600.
27 Returned goods by D Rs.450
28 Received from D Rs.1,500
Paid to S & Co. Rs.1,800
X withdrew from business Rs.900
Charged depreciation on Rs.240
Borrowed from K Rs.1,500

Solution:

Journal

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 Ledger
The journal provides a complete listing of the daily transactions of a business, but it does not provide
information about a specific account in one place. For example, to know how much cash balance we have,
the accounting clerk would have to check all the journal entries in which cash is involved which is very
difficult. To avoid this difficulty, the debit and credit of journalized transactions are transferred to ledger
accounts. Thus, all the changes for a single account are located in one place - in a ledger account. This
makes it easy to determine the current balance of any account.

Standard Form of Ledger Account:

To understand clearly as to how to write the accounts in ledger, the standard form of an account is given
below with two separate transactions:

Posting Procedure:
Transferring information i.e., entries from journal to ledger accounts is called posting. The procedure of
posting from journal to ledger is as follows:
1. Locate the ledger account from the first debit in the journal entry.
2. Record the date in the date column on the debit side of the account. The date is the date of transaction
rather than the date of the posting.
3. Record the name of the opposite account (account credited in entry) in the particular (also known as
reference column, description column etc.) column.
4. Record the page number of the journal in the journal reference (J.R) column from where the entry
is being posted.
5. Record the amount of the debit in the "amount column"
6. Locate the ledger account for the first credit in the journal and follow the same procedure.

Balancing An Account:
The difference between the two sides of an account is its balance. The balance is written on the lesser side
to make the two sides equal. The process of equalizing the two sides of an account is known as balancing.
The rules for balancing an account are stated as below:
1. Add up the amount columns of both the sides of an account and write the totals in a separate slip of
paper.
2. Find out the difference of the two totals.
3. Write down the difference on the lesser side of the account.
4. Now total up both the sides and write the totals and draw double lines under them.
5. Again write the difference on the opposite side below the double line.

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If the debit side of an account is heavier, its balance is known as debit balance. and if the credit side of an
account is heavier its balance is known as credit balance. If the two sides are equal, that account will show
zero balance. The rules for determining the balance is as follows:

It may be noted that at the time of balancing an account debit balance is placed on the credit side and credit
balance on debit site. This balance is known as closing balance. What is closing balance in this year, is the
opening balance of the next year.

Example:
Enter the following transactions in journal and post them into ledger: 2018

Jan. 1 Mr. Javed started business with cash Rs.100,000

2 He purchased furniture for Rs.20,000
3 He purchased goods for Rs.60,000
5 He sold goods for cash Rs.80,000
Solution:6 He paid salaries Rs.10,000

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DISTINCTION BETWEEN BOOKS OF ORIGINAL ENTRY AND LEDGER

CLOSING OF ACCOUNTS

1. Personal Accounts
If a personal account shows a debit balance, it indicates the amount owing from him.
On the contrary, if a personal account shows a credit balance, it indicates the amount owing to him.
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2. Real Accounts
Method of closing the Cash A/c and the accounts of all other assets is the same as that of personal
accounts. When balanced, these will always show debit balances.

3. Nominal Accounts
These accounts do not require balancing. As the main purpose of opening such accounts is to ascertain
the net profit or loss of the firm, all such accounts are transferred to the trading and profit and loss
account of the firm at the end of the financial period.

Subsidiary books
If the size of business is small, then it is possible to enter every transaction in Journal only, but if the size of
business is large, it is no longer possible to enter every transaction in one book only. Therefore, Journal is
divided into sub-parts, known as Special Journals.
Therefore, following subsidiary books are prepared:

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Petty Cash
It is another Cash Book which is maintained, generally, in large business concerns to reduce the burden of
'Main Cash Book', in which numerous transactions involving petty (small) amounts are recorded. For this
purpose, a Petty Cashier is appointed by the Chief Cashier. The Chief Cashier advances a sum of money to
the Petty Cashier to enable him to meet petty expenses for a fixed period. The Petty Cashier will record
this amount on the Debit Side of the Petty Cash Book while the Chief Cashier will record the same amount
on the Credit Side of the Main Cash Book.

Imprest system of petty cash book

Under this system, a definite sum, say Rs.2,000 is given to the petty cashier at the beginning of a certain
period. This amount is called imprest amount. The petty cashier goes on making all small payments out of
this imprest amount and when he has spent the substantial portion of the imprest amount say Rs.1,780, he
gets reimbursement of the amount spent from the head cashier. Thus, he again has the full imprest
amount in the beginning of the next period. The reimbursement may be made on a weekly, fortnightly or
monthly basis, depending on the frequency of small payments.

The balance of the Petty Cash Book will be shown on the asset side of balance sheet as "Cash in hand" at
the end of the year.

Example

From the following particulars prepare a Petty Cash Book under Imprest System.
2018
Jan. 1. Received from the Chief Cashier as imprest cash Rs.400.
Jan. 2. Paid Taxi hire Rs.20.
Jan. 3. Paid postage Rs.28 and stationery Rs.60.
Jan. 4. Purchased stationery Rs.48.
Jan. 5. Paid telegram charges Rs.28 and bus fare Rs.4.
Jan. 6. Bought postage stamps Rs.96.
Jan. 7. Paid Rs.72 for repairs of typewriter.

Solution:
Petty cash book

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Trial balance and rectification of errors

Meaning of trial balance
A trial balance is a statement showing the balances, or total of debits and credits, of all the accounts in the
ledger with a view to verify the arithmetical accuracy of posting into the ledger accounts.

Format of trial balance

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Trial Balance of …… as on March 31, 2014

Purpose of Trial Balance

1. To check the equality of debits and credits - an arithmetical or mathematical test of accuracy.
2. To help in preparation of final accounts.
3. To locate errors.
4. To obtain a summary of ledger accounts.

If the trial balance agrees we may reasonably assume that the books are correct. On the other hand, if it
does not agree, it indicates that the books are not correct - there are mistakes somewhere. There are
however, a few types of errors which the trial balance cannot detect. In other words, the trial balance will
agree in spite of the existence of those errors.

Methods of Preparing Trial Balance

There are two methods for the preparation of trial balance. These methods are:
1. Total or gross trial balance
2. Balance or net trial balance

Total or Gross Trial Balance

Under this method the two sides of all the ledger accounts are totalled up. The total of debit side and
credit side of each account is then placed on "debit amount" column and "credit amount" column
respectively of a list. Finally, the two columns are added separately to see whether they agree of not.

Balance or Net Trial Balance

Under this method, first of all the balances of all ledger accounts are drawn. Thereafter, the debit
balances and credit balances are recorded in "debit amount" and "credit amount" column respectively
and the two columns are added separately to see whether they agree or not.

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Example
Enter the following transactions in journal and post them into the ledger and also prepare a trial balance.

2018
Jan. 1 Mr. X started business with cash Rs.80,000 and furniture Rs.20,000.
Jan. 2 Purchased goods on credit worth Rs.30,000 from Y.
Jan. 3 Sold goods for cash Rs.16,000.
Jan. 4 Sold goods on credit to S for Rs.10,000
Jan. 8 Cash received from S Rs.9,800 in full settlement of his account.

Solution:

Journal

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Ledger
Cash Account

Furniture Account

Capital Account

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Financial statement of sole proprietorship

Meaning
Financial Statements are the summaries of the accounts of a business enterprise and shows the
profitability and financial position at the end of the accounting period.
It includes at least two basic statements:
A) Trading and & Profit and Loss Account
B) Balance Sheet

Trading Account
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It is prepared for calculating the gross profit or gross loss arising out of the trading activities of a business.

Format of a Trading Account

All expenses which relate to either purchase of raw material or manufacturing of goods are recorded in the
Trading account. All such expenses are called ‘Direct Expenses’.

Examples of direct expenses:

 Carriage or freight inwards
 Manufacturing wages
 Power and fuel
 Factory lighting
 Factory rent and rates
 Royalties
 Consumable stores

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Calculation of Cost of Goods Sold:

Cost of Goods Sold = Opening stock + Net Purchases + Direct Expenses – Closing stock Cost
of Goods Sold = Sales – Gross Profit
Case:
Calculate Net Sales and Gross Profit from the following information:
Cost of Goods Sold Rs.1,00,000
Gross Profit 20% on Sales

Solution: Sales will be 1,00,000 × (100/80) = Rs.1,25,000 Gross

Profit = Sales – Cost of Goods Sold
= Rs.1,25,000 – Rs.1,00,000
= Rs.25,000

Profit and loss account

Trading account only shows gross profit earned as a result of buying and selling goods. However, there are
other expenses also which must be included to get the net profit, for this Profit and Loss Account is
prepared.

All Distribution, office, selling, administrative and miscellaneous expenses like, interest on loan, interest on
capital etc. are included in Profit and Loss Account.

A Profit & Loss A/c is an account into which all gains and losses are collected, in order to ascertain the excess
of gains over the losses or vice-versa.

Name of Business
Profit and Loss Account for the year ended .....

Particulars Amt Particulars Amt

To gross loss b/d XXX By gross profit b/d XXX

To Salaries XXX By rent from tenant XXX

To rent, rates and taxes XXX By discount received XXX

To printing & stationery XXX By dividend on shares XXX

To lighting XXX By interest on investments XXX

To travelling expense XXX By commission received XXX

To insurance XXX By bad debts recovered XXX

To establishment expenses XXX By misc receipts XXX

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To legal charges XXX By profit on sale of assets XXX

To audit fees XXX By net loss (t/f to capital a/c) XXX

To telephone charges XXX

To postage & telegram XXX

To general expenses XXX

To advertisement XXX

To bad-debts XXX

To packing charges XXX

To delivery van expenses XXX

To commission XXX

To depreciation XXX

To bank charges XXX

To loss on sale of assets XXX

To net profit (t/f to capital a/c) XXX

Balance sheet
A Balance Sheet is a statement at a particular date showing on one side the trader’s property and
possessions and on the other hand the liabilities.

Balance sheet contains all the Assets and Liabilities to show the exact financial position of the business. It is
known as Balance Sheet because it shows the balances of ledger accounts which are left open after
transferring all the nominal accounts to Trading & Profit & loss Account. Balances of all the Real and
Personal Accounts are grouped together and shown in Balance Sheet as Assets and Liabilities.

Marshalling of Assets and Liabilities in Balance Sheet

The assets and liabilities must be shown in such a manner that the financial position of the business can be
assessed through it easily and quickly. Thus, an arrangement is made in which assets and liabilities are
shown in the balance sheet. Such an arrangement is called marshalling of assets and liabilities. There are
three methods of marshalling:
1. Permanency Preference Method
2. Liquidity Preference Method

Permanency Preference Method

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Under this method, the assets and liabilities are shown in balance sheet in the order of their permanence.
In other words, the more permanent the assets and liabilities, the earlier they are shown.

Liquidity Preference Method

Under this method, assets and liabilities are shown in order of their liquidity. The more liquid the assets,
the earlier are they shown.

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Classification of Assets
1. Non-current Assets: Acquired for continuous use and last for many years.
Example: Furniture, Motor Vehicles etc.

2. Current Assets: Either in the form of cash or can be easily converted into cash within 1 year of the
date of Balance Sheet.
Example: Accrued Income, Closing stock etc.

Classification of Liabilities
1. Non-Current/ Long-term Liabilities
Liabilities which are to be paid after 1 year or more.
Example: Debentures, Public Deposits, etc.

2. Current or Short-term liabilities

Liabilities which are expected to be paid within 1 year of the date of the Balance Sheet.
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Example: Bank overdraft, Bills Payable etc.

3. Contingent Liabilities
They are liabilities which will become payable only on the happening of some specific event, otherwise not.
Examples:
a. Liabilities for bill discounted
b. Liabilities in respect of a suit pending in a court of law
c. Liability in respect of a guarantee given for another person.

***Contingent liabilities are not shown in the Balance Sheet but as a footnote below the Balance Sheet.

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