Introduction to Financial Accounting

							Introduction to Financial Accounting & Book Keeping

Basic Concepts

Accounting has been defined as "the art of recording,

classifying and summarizing in a significant manner and in terms of

money, transactions and events which are of financial character, and

interpreting results there of”.

The definition brings out the following as attributes of accounting:

• Events and transactions of a financial nature are recorded while

the events of a non-financial nature cannot be recorded.

• The record should reflect the importance of the transactions so

recorded both individually and collectively, which includes

summarization, thereby making it amenable to analysis.

• The users of the financial statement should be able to obtain

the message encompassed in such financial statement and it

is the knowledge of accountancy which enables the user to

understand the contents OL the financial statement.

Now let us analyze the terms

• Recording: To get accounts, the accounting transactions

must be recorded, in paper or in electronic form.

• Classifying: To give an organized and systematic look,

the transactions are classified into various ledgers,

groups etc. We will explain about them on later. But the

essential point is that they must be classified properly to

get meaningful result out of the recorded transactions.

• Summarizing: The vast records are then summarized to
give an overall picture of the state of affairs of the

business. All transactions are expressed in terms of

money. Where a transaction is in kind or other nature, a

rational and quantified monetary value is attached to it to

reflect it in the accounting records. Book Keeping

Methods of Accounting

Broadly 2 methods of accounting system are in vogue:

1. Single Entry System

2. Double Entry System.

Single Entry System

This system is based purely on cash accounting, i.e. accounted

for when money is received or paid. Only cash transactions are taken

into a/c and all credit transactions, accruals and liabilities are omitted.

Normally, only government accounting is done on this system and

commercial organizations do not follow this system.

Examples- A job is done by a person on 16th March, 2002 and a bill

prepared on that day: The payment was received on 6th April, 2002.

In single entry system, the transaction is recorded on 6th April, 2002

and the accounts of financial year 2001-02 (i.e. April 2001-March

2002) will have no effect for the transaction.

Double Entry System

In the Double Entry System, both cash and credit transactions

are recognized (accrual basis of accounting). All commercial

organization follow this system. A cost incurred i.e. accrued is duly

accounted irrespective of whether it is paid or not during the
accounting period. Additionally, all transactions shall have dual

aspects (Debit and Credit) and that is why it is called double entry

system. In this system for every transaction, Debits and Credits must

be equal. For all practical purposes, Double Entry System is the

accepted method of accounting.

Examples- In the previous example in the books for financial year

2001-02, the related expenses, A/c will be debited and the persons

A/c will be credited to reflect the transaction when the cost incurred.

Again in financial year 2002-03, on 6.4.2002, at the time of payment,

the transaction will be recorded reflecting payment to the person. As double Entry System is the
defective accounting system of

business community in general, everything discussed in this study

material hence forth follows the principles of Double Entry System.

Books of Accounts

Primary Books of Accounts

The primary books of accounts maintained by a business

organization may be conveniently classified into Cash Books,

Journals and General Ledger.

Cash Book

This book records all receipts of and payments in cash and

through Cheque. Normally the deposits into bank account maintained

by the business withdrawals from such accounts and Cheque

payments are also recorded in the cash book.

Example: One cycle is purchased from Cycle Stores and payment is

made by cash or Cheque. The entry is recorded in Cash Book.

Journals
This book records all non-cash transactions (transactions which

are not recorded in Cash Book). For practical convenience, the

journal is divided into several subsidiary books).

General Ledger

The General Ledger contains all the accounts of an

organization. The transactions entered in all primary books i.e. Cash

Books and Journal (including subsidiary books) are posted to General

Ledger. In fact, it is a device for reclassifying and summarizing all

information recorded in the Cash Book and Journal according to

account heads (called Ledger Accounts).

The recording of transactions in the Books of Accounts may be

represented as under:

• Cash Transactions • Non-Cash Transactions

• Recorded in Cash Book

• Recorded in Journals

Secondary Books of Accounts

General Ledger: Classified Summary of all Transactions

Subsidiary books of Journals are the secondary books of accounts.

Following secondary/subsidiary books may constitute the Journal for

an organization:

1. Purchase Books: It is used to record purchase transactions made

in credit.

2. Purchase Return Book: It is used to record when purchase item

is returned to the seller.

Ex. 50 pieces of goods purchased from supplier on credit and
payment will be made later. The entry is recorded in purchase

book in the books of buyer. Out of 50 pieces of goods purchase

from supplier, 10 pieces found defective and returned to

supplier. The entry is recorded in Purchase Returns. Book in

the books of buyer.

3. Sales Book: It records all credit sales transactions.

4. Sales Return Book: It is used to record all sales returns. 50 pens.

of goods sold to customer or sundry debtor on credit for which

payment will be received later. The entry is recorded in sales book in

the books of the Seller. Out of 50 pens, 6 pens, was returned by

debtor. The entry is recorded in sales return book in the books of the

seller.

5. Journal Proper: It is used to record all such transactions that are

not entered in purchase or sales register, or purchase/sales return

register.

Ex. On a loan of Rs. 10,000 taken from Amit Kumar. Interest

amounting Rs. 1800 is payable on 31st March, 2002 but not paid. On

31 st March, 2002 this transaction is recorded through a journal entry. Classification of Accounts

The accounts maintained in the General Ledger may be broadly

classified into:

  Personal Accounts

  Impersonal Accounts

  Real Accounts

  Nominal Accounts

Personal Accounts
Accounts related to any person, firm, companies, banks etc. It

deals with accounts of individuals like creditors, debtors, bank, etc. It

shows the balance due to these individuals or due from them on a

particular date. These accounts appear in Balance sheet.

Real Account

It represents fixed and current assets like plant and machinery,

land & building, vehicle, cash etc. As on a particular date, this

account shows the worth of the asset. These accounts also appear in

Balance Sheet.

Nominal Account

It. consists of different types of expenses or incomes or loss or

profit. These accounts show the amount of income earned or

expenses incurred for a particular period say a month, a year etc.

These accounts appear in Profit and Loss A/ c

General Rules of Debit and Credit

The dual aspect concept requires that when a transaction

occurs both the debit and credit elements should be recorded in the

books of accounts. To ensure a standardized method of recording of

transactions, the rules for debit and credit of accounts were evolved.

The Golden Rules goes with the classification. of accounts and may.

The effects of debits and credits, in general may be represented as

follows: • Assets Debits increase, credits decrease, normally debits

balance.

• Expenses Debits increases, credit decrease normally debit

balance.
• Liabilities Credits Increases, debits decrease, normally credit

balance.

• Capital Credits increase, debits decrease, normally credit

balance.

• Income Credits increase, debits decrease, normally credit

balance.

Trial Balance & Final Accounts

All monetary events are classified under into various Account

Heads which are periodically summarized. This periodical summary is

known .as Trial Balance. In other words, a Trial Balance is a

summary of all General Ledger Balances outstanding as on a

particular date. All the debit balances from the ledger are shown on

one side and all the credit balance in on the other side. If all the debit

and credit balances were recorded on the two sides of the Trial

Balance, it stands to reason that the two sides should be equal, since

in the journal for each item of, debit, there was a credit item. So in

Trial Balance, debit and credit totals are balanced. In other words,

Trial Balance is the closing balance of all accounts (all ledgers

accounts except closing stock) for a specific date. Such statement is

the unadjusted Trial Balance. After passing the adjustment entries at

year end, an adjusted Trial Balance is prepared through which

financial statements are prepared.)

Financial Statements

From the Trial Balance, the following financial statements are made:

• Profit & loss (or income and expenditure statement) for a
specific period consisting of Nominal Accounts.

• Balance sheet (or statement of affairs) as on the last date of the

period consisting of Real & Personal Accounts. Profit & Loss Account

From given Trial Balance we can prepare a trading and profit &

loss account to determine the profit or loss made by a business

organization during a particular period. At the time of preparation of

Profit & Loss A/c the following points may be kept in mind:

• All expenses are debited to Profit & Loss A/c.

• All incomes are credited to Profit & Loss A/c.

• In addition to treating the incomes and expenses found in Trial

Balance. We may have to give special treatment to certain

'adjustments' also.

• The profit is credited to Reserves A/c while the net loss, it is

debited to Reserves A/c in the Balance Sheet, in the case of

companies and in the case of sole trader and partnership firm,

the net profit is credited to capital account and net loss is

debited to capital account.

• Trading account is prepared to ascertain the Gross Profit.

Gross Profit is the difference between sales and cost of goods

sold. Cost of goods sold means (opening stock + Purchase + Direct

Expenses) closing stock Profit and loss account is prepared to

ascertain net profit. Some times it is possible to first determine the

gross profit (arising out of trading operations) and then deducts all

indirect expenses from Gross Profit and to determine the net profit.

Net profit is calculated by deducting other indirect expenses (like
general, administrative or selling and distribution expenses) from

Gross profit. Whether a separate Trading account is prepared to

determine gross profit or not, the net profit remains the same.

It is necessary to emphasize here that Profit & Loss account

(including trading account) is usually prepared on 'Accrual' basis. In

other words, all expenses incurred and due are debited to Profit &

Loss Account whether they are actually paid for or not. Similarly all

incomes earned and due are credited to Profit and loss Account

whether they are actually received or not. Computerized Accounting

When you opt for computerized accounting first time, you have

to create all the ledgers and enter opening balances (in subsequent

years you need not to create the ledgers again or carry forward

previous year's closing balance as opening balance since it would be

carried forward on its own by the software) and classify at this stage.

Thereafter, you enter all transactions in vouchers (different type

of vouchers to record diverse nature of transactions). That's all you

have to do everything else (like posting to ledger, preparation of Trial

Balance, Final Accounts etc.) is done by the software.

In computerized accounting, while creating new ledger, you are

required to classify it suitably under relevant Accounts Group to tell

the software the nature of the ledger and where it will appear. This is

necessary at this stage as all reports are prepared on-line the

moment you enter transactions (vouchers). In case of Manual Book

Keeping, this classification is done at later stage (after preparation of

Trial Balance, Nominal Accounts are transferred to Profit & Loss A/c
through Journal Entry, Real & Personal Accounts are posted to

Balance Sheet under proper heading i.e. groups).

Year End Entries - In manual book-keeping, you are required to

pass Journal entries to transfer closing balance of all nominal account

to prepare Profit & Loss A/c, which you are not required to do in case

of computerized accounting. The software does this job on its own. In

next year, only. Closing balance of Real & Personal accounts are

carried and nominal accounts balance is zeroed by the software (for

which you pass Journal Entries in manual book-keeping). The

advantages are that your accounts are always open and any

modification is instantly reflected.