Basic Accounting Unit 2
Course Title: Basic Accounting
Course outcomes:
- The aim of the course is to build knowledge and understanding principles of accounting among the students.
- The course seeks to give detailed knowledge about the subject matter by instilling them basic ideas about Accounting.
- The outcome of the course will be as follows – To Introduce about Accounting Principles and other aspects of accounting.
- To provide knowledge about rectification of errors.
- To make able about valuation of stocks. To make aware with share and Debenture.
BASIS OF ACCOUNTING SYSTEMCash or receipt basis is the method of recording transactions under which revenues and costs and assets and liabilities are reflected in accounts in the period in which actual receipts or actual payments are made. “Receipts and payments account” in case of clubs, societies, hospitals etc., is the example of cash basis of accounting.Accrual or mercantile basis is the method of recording transactions by which revenues, costs, assets and liabilities are reflected in accounts in the period in which they accrue.This basis includes considerations relating to outstanding; prepaid, accrued due and received in advance.Hybrid or mixed basis is the combination of both the basis i.e. cash as well as mercantile basis. Income is recorded on cash basis but expenses are recorded on mercantile basis.
Accounting Equation:
Meaning of Accounting Equation
The accounting equation is a basic principle of accounting that shows the relationship between the assets, liabilities and capital of a business.
It is based on the idea that everything owned by a business is financed either by the owner's capital or by amounts owed to outsiders.
Definition: The accounting equation is an equation that states that total assets of a business are equal to the sum of its liabilities and owner's capital.
Formula of Accounting Equation
Assets = Liabilities + Capital
Meaning of the terms
Assets: Things owned or controlled by the business, such as cash, furniture, machinery, stock and debtors.
Liabilities: Amounts the business owes to outsiders, such as bank loans and creditors.
Capital: The owner's investment in the business, adjusted for profit, losses and drawings.
3. Example of an Accounting Equation
Suppose a businessman starts a business with ₹1,00,000 in cash.
Particulars | Amount |
|---|---|
Assets (Cash) | ₹1,00,000 |
Liabilities | ₹0 |
Capital | ₹1,00,000 |
Applying the equation:
Therefore, the equation is balanced.
Expanded Accounting Equation
The accounting equation can be expanded to show the effects of income, expenses and drawings.
Where:
Income increases owner's equity.
Expenses decrease owner's equity.
Drawings decrease owner's equity.
Advantages of the Accounting Equation
Foundation of accounting: It is the basis of the double-entry system.
Maintains balance: It shows that assets are financed by liabilities and owner's equity.
Helps detect errors: An imbalance may indicate an accounting error.
Shows financial position: It helps explain the relationship between business resources and financing.
Supports financial statements: It forms the basis of the balance sheet.
Improves understanding: It helps students understand debit and credit effects.
Limitations of the Accounting Equation
It does not show every transaction in detail.
It does not directly calculate net profit without additional information.
An equation that balances does not guarantee that all entries are correct.
It does not directly show cash flow.
It does not include many non-financial factors, such as employee skills or customer satisfaction.
CLASSIFICATION OF ACCOUNTS
The classification of accounts and rules of debit and credit based on such classification are given below:
Classification of accounts
Personal Accounts:
Accounts recording transactions relating to individuals or firms or company are known as personal accounts. Personal accounts may further be classified as:
(i) Natural Person’s personal accounts: The accounts recording transactions relating to individual human beings e.g., Anand’s a/c, Ramesh’s a/c, Pankaj a/c are classified as natural persons’ personal accounts.
(ii) Artificial Persons’ Personal accounts: The accounts recording transactions relating to limited companies, bank, firm, institution, club, etc., Delhi Cloth Mill; M/s Sahoo & Sahoo; Hans Raj College; Gymkhana Club are classified as artificial persons’ personal accounts.
(iii) Representative Personal Accounts: The accounts recording transactions relating to the expenses and incomes are classified as nominal accounts. But in certain cases (due to the matching concept of accounting) the amount, on a particular date, is payable to the individuals or recoverable from individuals. Such amount (i) relates to the particular head of expenditure or income and (ii) represent persons to whom it is payable or from whom it is recoverable. Such accounts are classified as representative personal accounts e.g., “wages outstanding account”, pre-paid Insurance account, etc.
Real Accounts: The accounts recording transactions relating to tangible things (which can be touched, purchased and sold) such as goods, cash, building, machinery etc., are classified as tangible real accounts. Whereas the accounts recording transactions relating to intangible things (which do not have physical shape) such as goodwill, patents and copy rights, trade marks etc., are classified as intangible real accounts.
Nominal Accounts: The accounts recording transactions relating to the losses, gains, expenses and incomes e.g. Rent, salaries, wages, commission, interest, bad debts etc., are classified as nominal accounts.
Rules of debit and credit (classification based)
1. Personal accounts : Debit the receiver Credit the giver (supplier)
2. Real accounts : Debit what comes in Credit what goes out
3. Nominal accounts : Debit expenses and losses Credit incomes and gains
Double Entry System of Accounting
The Double Entry System is a system of accounting in which every financial transaction affects at least two accounts, and the total debit amount is always equal to the total credit amount.
In simple words, every transaction has two effects: one debit and one credit.
Example: A businessman starts a business with cash of ₹50,000.
Cash increases by ₹50,000 — Debit
Capital increases by ₹50,000 — Credit
Advantages of the Double-Entry System
Complete records: Both sides of each transaction are recorded.
Accuracy checking: A trial balance can help identify certain recording errors.
Profit and loss calculation: Helps determine business profit or loss.
Financial position: Helps prepare the balance sheet.
Fraud prevention: Provides an audit trail and makes irregularities easier to investigate.
Better decision-making: Provides useful information for planning and control.
Legal and tax support: Helps maintain records required for audits, taxation and compliance.
Comparability: Supports comparisons between accounting periods.
Limitations of the Double-Entry System
Complexity: Requires accounting knowledge and training.
Time-consuming: Recording and classifying transactions takes time.
Costly: Professional accountants and accounting software may involve expenses.
Errors can remain undetected: A trial balance may agree even when transactions are wrongly recorded in the wrong accounts.
Non-financial information is excluded: Employee morale, customer satisfaction and many other qualitative factors are not directly recorded.
Estimates may be subjective: Depreciation, provisions and asset valuations may involve judgment.
Manipulation is possible: Deliberate falsification may still occur despite maintaining double-entry records.
Illustration 1.Business transactions of Mr.A for the month of Jan.1997.
Rs.
1. Mr. A commenced business with cash 70,000
2. Purchased goods on credit from Mr. B 14,000
3. Paid wages 500
4. Paid to Mr. B 10,000
5. Purchased furniture 1,000
6. Goods stolen by the Store-keeper 200
7. Received commission 100
JOURNAL
Journal is a book which lists accounting transactions of a business other than cash, before posting them to ledgers. The journal is currently only used to a limited extent to cover item outside the scope of other accounting books. Let us understand the mechanism of recording business transaction in a journal.
17th January, 1997 Cash received from B Rs.4,000/-
23rd January, 1997 Paid wages Rs.100/-
25th January, 1997 Furniture purchased from R Rs.400/-
28th January, 1997 Paid for interest Rs.200/-
31st January, 1997 Paid salaries Rs.200/-
Solutions:
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