Basics of accounting

Basics of accounting

What Is Accounting?

Accounting is the process of recording, classifying, summarizing, analyzing and interpreting financial transactions and events pertaining to a business and communicating them to the interested parties through the financial statements such as profit and loss account and balance sheet.

 What Is Book-Keeping?

Book-keeping is a part of accounting and is concerned with recording of financial transactions of a business on a day-to-day basis as they occur. The main purpose of book-keeping is to maintain systematic record of all financial transactions of a business.

 Difference Between Book-Keeping And Accounting:-

Book-Keeping Accounting
Book-keeping is a primary stage. Accounting is a secondary stage. It starts where book-keeping ends.
Book-keeping work is performed by junior staff. Accounting work is performed by senior staff.
The main activity of book-keeping is to systematically record all the financial transactions of business in journal and prepare ledger accounts and ascertain the balance of each ledger account. The main activity of accounting is to prepare trial balance, profit and loss account and balance sheet and communicate such financial information to interested parties.
 A book-keeper cannot do the work of an accountant. An accountant can do the work of a book-keeper.
 Book-keeper is not required to have a higher level of knowledge as accountant.  Accountant is required to have a higher level of knowledge than a book-keeper.
The job of book-keeper is often routine and clerical in nature and does not require analytical skill. The job of accountant is analytical in nature and hence analytical skill is required.

What Is Double Entry System Of Book-Keeping?

Double entry system of book-keeping refers to a system of accounting under which two aspects of a financial transaction are recorded. The two aspects are debit and credit. Every debit has an equal amount of credit and every credit has an equal amount of debit. So total of all debits is equal to the total of all credits.
Every financial transaction involves at least two accounts. One account is debited and the other account is credited by the same amount. If a transaction involves more than two accounts, the sum of debit accounts and sum of credit accounts must be equal.

What Is Accounting Equation?

The accounting equation is the foundation of double entry book-keeping system. The equation is:-
Assets=Liabilities+Shareholders capital
                                or
Shareholders capital=Assets-Liabilities
                               or
Liabilities=Assets-Shareholders capital
According to the accounting equation, the total assets of a company are equal to the total liabilities and shareholders capital. The accounting equation displays that assets of a company are either financed by borrowing money or paying with the money of company’s shareholders. The balance sheet reports a company’s assets, liabilities and shareholders capital. It shows that a company’s total amount of assets equals the total amount of liabilities plus shareholders capital.
The accounting equation can also be expanded like this:-
Assets=Liabilities+Shareholders capital+Retained earnings
Retained earnings=Net profit-Dividends

Basis Of Accounting:-

Basis of accounting is the method by which a company’s financial transactions are recorded in the books of accounts. There are two basis or methods of accounting which can be used to record the financial transactions:-

Cash Basis Of Accounting:-

Cash basis of accounting is the method of recording transactions in which revenues and expenses are reflected in the books of accounts for the period in which actual receipts and actual payments are made. Cash basis of accounting recognizes revenues when cash is actually received in business and expenses when cash is actually paid. For e.g if cash is received from the sale of goods, it is recorded as revenue on the date of receipt of cash no matter when the sale was made. Similarly if cash is paid for the purchase of goods, it is recorded as expense on the date of payment of cash no matter when the purchase was made. Sole proprietors and small companies which are not incorporated generally use cash basis of accounting.

Accrual Basis Of Accounting:-

Accrual basis of accounting is the method of recording transactions in which revenues and expenses are reflected in the books of accounts for the period in which they accrue. Accrual basis of accounting recognizes revenues when they are earned and not when cash is actually received and expenses when they are incurred and not when cash is actually paid. For e.g if sale of goods is made today and the cash is received after one week, then it is recorded as revenue today. Similarly if purchase of goods is made today and the cash is paid after two weeks, then it is recorded as expense today. Accrual method allows the revenues to match the expenses which gives more meaningful financial reports. Big incorporated companies all over the world are generally required to compulsorily use accrual basis of accounting. Even in India all the incorporated companies are required to compulsorily maintain the books of accounts according to the accrual basis of accounting. Accrual basis of accounting is also called as mercantile basis of accounting.

Accounting Principles, Concepts And Conventions:-

There are certain rules to be followed in accounting for which a number of principles, concepts and conventions are developed which guide how the financial transactions should be recorded and how the financial statements should be reported. Following are the main ones:-

Money measurement:-

Only those transactions and events which are capable of being expressed in terms of money should be included in the books of accounts. In other words, information which cannot be expressed in terms of money should not be  included in books of accounts. For e.g quality of after sales service of a company or skills of employees of a company do not have any monetary value so they are not to be included in accounting books.

Going concern:-

It is assumed that the company is a going concern and it will continue to operate its business for unspecified long period in the future. It is assumed that the company has neither the intention nor the necessity to liquidate or significantly curtail its operations in near future. Companies that are expected to continue operating for a long period of time are called as going concern.

Accrual:-

Financial statements should be prepared according to the accrual basis of accounting which recognizes all revenues and expenses when they are earned or incurred and not when money is received or paid.

Dual aspect:-

Entry made for each financial transaction is composed of two parts- debit and credit. Every debit has a corresponding credit and every credit has a corresponding debit. Total of all debits must be equal to total of all credits. The two-fold aspect of a transaction is called duality of a transaction.

Business entity :-

A business is treated as a separate entity that is distinct from its owner and all other business entities and hence a distinction is made between (a) personal transactions of the owner and his business transactions and (b) transactions of one business entity and those of other business entities. Personal transactions and business transactions of owner should be accounted separately and transactions of all business entities should be accounted separately. In sole proprietorship, the business entity and the sole proprietor are the same but for the purpose of accounting, they are treated separately.

Historical cost:-

Historical cost is the cost at the time of acquisition of an asset. It is the original cost of the asset at the time of its purchase. The assets must be reported in the financial statements at their historical costs and not their current market value. For e.g. if land was purchased few years back at Rs 500000 and its current market value has become Rs 800000, it should be shown in the balance sheet as Rs 500000 which is its original cost at the time of purchase.

Periodicity:-

A company divides its business activities into artificial time periods which are known as accounting periods. After the end of each accounting period, financial statements such as profit and loss account and balance sheet are prepared and presented to the interested parties or users.

Objectivity:-

A company’s accounting information should be based on verifiable data and must be free from the personal bias of the accountant. Every financial transaction and event recorded in the books of accounts should have adequate evidence to support it and must be not based on the personal opinion or feeling of the accountant. The financial statements so prepared are based on facts and not on opinions.

Substance over form:-

The financial transactions and events should be recorded and presented in accordance with their economic substance and reality rather than just their legal form.

Cost-benefit:-

The cost of providing accounting information in the financial statements should not be more than the benefit from that information to users. It costs the company lot of money to gather all the accounting and other financial information and present it through financial statements and hence the benefit derived from this information should be more than the cost of providing it.

Full disclosure:-

The company should disclose all the relevant and required information to the users in the financial statements so that the users of the financial statements can make a correct assessment about the financial performance and financial position of the company and take informed decisions. The companies provide notes at the end of the financial statements because of the requirement of full disclosure.

Conservatism:-

In the situation of uncertainty and doubt, there should be a conservative approach which means expenses and losses which are uncertain should be recorded even if they are not incurred yet and incomes and gains which are uncertain should not be recorded till the time they are actually earned. The conservatism approach ensures that the profit is not overstated and loss is not understated.

Consistency:-

The company should follow same accounting method or policy for a given category of transactions and events for each accounting period. The company should change the accounting method or policy only if the new method or policy is better than the earlier one and it should disclose such change to the users by   giving a note about it at the end of financial statements.  For e.g a company uses straight line method of depreciation for its particular asset, then it should use that same method for depreciating that asset every accounting period. It ensures consistency and comparability of the financial statements.

Parties Interested In Or Users Of Accounting Information:-

There are various category of people who are interested in the accounting information of a company and use this information to satisfy their respective needs for information. Some of the users of accounting information are:-

Shareholders:-

Shareholders of the company need information to judge the prospects of their investment in the company so that they can decide whether to hold or sell their shares or buy more shares.

Potential shareholders:-

Potential investors need information to judge the prospects of the company so that they can decide whether they should buy the shares of the company or not.

Lenders:-

Lenders need information so that they can know whether the company can return the money lent to them along with the interest when due and on this basis the lenders decide whether to give credit to the company or not.

Suppliers:-

Suppliers need information so that they can know whether the company can pay them in time for the goods sold to them on credit and on this basis the suppliers decide whether to sell raw materials to the company on credit and on what payment terms.

Government and tax authorities:-

Government and tax authorities need information for regulatory purpose and for assessing the tax liabilities of the company.

Management:-

Management of a company need information to review the company’s performance and to take various kinds of decisions.

Employees:-

Employees of a company are interested in information about the profitability and stability of the company. They need information so that they can decide the ability of the company to pay salaries and provide various kinds of employee benefits to them.

Accounting Cycle:-

Accounting cycle consists of the steps or stages that are involved in the accounting process. Accounting cycle starts with the recording of financial transactions and events of a business and ends with the preparation of financial statements. Following are the main steps in the accounting cycle:-

 Recording financial transactions:-

Identifying and recording the financial transactions of the business in the journal. The process of recording the transactions in journal is called as journalizing and the transactions recorded in journal are called as journal entries.

Transferring financial transactions to ledger:-

Opening ledger accounts and transferring the transactions recorded in journal to the respective ledger accounts. The process of transferring the transactions to the ledger accounts is called as posting.

Balancing the ledger accounts:-

Ascertaining the difference between the total of debit amount column and total of credit amount column of all the ledger accounts. This process is called as balancing.

Preparing trial balance:-

preparing trial balance which contains a list showing the balances of each and every ledger account opened. Trial balance helps to verify whether the sum of debit balances and sum of credit balances are equal.

Preparing financial statements:-

preparing financial statements such as trading and profit and loss account, balance sheet. Profit and loss account is prepared to ascertain the profit or loss of the company for the accounting period and balance sheet is prepared to ascertain the position of assets and liabilities of the company at the end of the accounting period.

All the above steps are repeated again for each accounting period.

What Is An Account?

An account is a summary of the relevant financial transactions of a business that took place under a particular head during a particular period of time. Every account has two sides- debit side and credit side.

Classification Or Types Of Accounts:-

Accounts can be classified according to the traditional method of classification or modern method of classification which is also called as accounting equation based method of classification.

 Traditional Method Of Classification Of Accounts:-

Under the traditional method of classification, accounts are classified into three types which are as under:-

 Personal accounts:-

Personal accounts are the accounts of persons and firms that the company deals with. Personal accounts can be of three types:-
(1) Natural persons account:- These are the accounts of real persons that the company deals with. For e.g raj’s account, jai’s account, etc.
(2) Artificial persons account:- These are the accounts of firms and organizations that the company deals with. For e.g ABC company Ltd’s account, IBS bank’s account, etc.
(3) Representative persons account:- These are the accounts which indirectly represent a group of persons. When accounts are of similar nature and their number is large, they are grouped under one head and a representative personal account is opened. For e.g if salary is due to many employees, then outstanding salary account is opened, if rent is paid in advance, then rent paid in advance account is opened, if interest is received in advance, then interest received in advance account is opened and so on.

 Real accounts:-

Real accounts are the accounts of assets, properties and possessions of the company. Real accounts can be of two types:-
(1) Tangible real account:- These are the accounts of tangible assets. Tangible assets are the assets which can be seen, touched, felt and measured. For e.g land, building, machinery, furniture, cash, etc.
(2) Intangible real account:- These are the accounts of intangible assets. Intangible assets are the assets which cannot be seen, touched, felt but can be measured in value. For e.g goodwill, trademark, copyright, patent, etc.

 Nominal accounts:-

Nominal accounts are the accounts which are used in measuring the income and expenses of the company so that the net profit or net loss for the accounting period can be can be calculated. Nominal accounts relate to expenses, losses, income and gains. For e.g purchases account, sales account, salary account, rent account, loss by fire account, discount received or allowed account, etc.

personal and real accounts form part of the balance sheet and nominal accounts form part of the trading and profit and loss account of the company.

Traditional classification of accounts

Rules For Debit And Credit When Accounts Are Classified According To The Traditional Method:-

According to the double entry system of book-keeping and accounting, every financial transaction affects at least two accounts. One account has to be debited and the other account has to be credited. Certain rule has to be followed for each account to decide which account has to be debited and which account has to be credited. These rules are also called as Golden rules of accounting.

Rule for personal accounts:-
Debit the receiver and credit the giver.

Rule for real accounts:-
Debit what comes in and credit what goes out.

Rule for nominal accounts:-
Debit all expenses and losses and credit all income and gains.

Let us look at some examples to understand how to apply the debit and credit rules for financial transactions:-

Example 1
Paid cash to Mr DK
In this transaction the two accounts affected are- cash account which is a real account and Mr DK account which is a personal account. As per the rule of personal accounts, we have to debit the account of benefit receiver which in this transaction is Mr DK and as per the rule of real accounts, we have to credit what goes out which in this transaction is cash.

Example 2
Purchased goods on credit from ACK company Ltd
In this transaction the two accounts affected are- purchases account which is a nominal account and ACK company Ltd account which is a personal account. As per the rule of personal accounts, we have to credit the account of benefit giver which in this case is ACK company Ltd as it is giving goods to the company on credit and as per the rule of nominal accounts, we have to debit all expenses which in this transaction are purchases.

Example 3
Paid salary to employees
In this transaction the two accounts affected are- cash account which is a real account and salary account which is a nominal account. As per the rule of nominal accounts, we have to debit all expenses which in this transaction is salary and as per the rule of real accounts, we have to credit what goes out which in this case is cash.

Example 4
Sold goods for cash
In this transaction the two accounts affected are- sales account which is a nominal account and cash account which is a real account. As per the rule of nominal accounts, we have credit all income which in this case is sales and as per the rule of real accounts, we have to debit what comes in which in this case is cash.

Modern Method Of Classification Of Accounts:-

Under the modern method of classification, accounts are classified into five types which are as under:-

 Income accounts:-

These are the accounts of all the revenues earned by the company such as sale of goods or rendering of services, interest received, discount received, profit from sale of investments, etc. Income accounts appear on the credit side of trading and profit and loss account of the company.

Expenses accounts:-

These are the accounts of all the costs and losses incurred by the company to earn the income such as purchase of raw materials, rent paid, advertising expenses, salaries paid, loss by fire, etc. Expenses accounts appear on the debit side of trading and profit and loss account of the company.

Assets accounts:-

These are the accounts of tangible and intangible assets of the company such as plant, machinery, land, building, goodwill, patents, copyright, etc. Assets accounts appear on the balance sheet of the company.

Liabilities accounts:-

These are the accounts of debts and obligations of the company such as loans, trade creditors, outstanding expenses, etc. Liabilities accounts appear on the balance sheet of the company.

Capital accounts:-

These are the accounts of the owners of the company such as equity share capital, drawings, etc. Capital accounts appear on the liabilities side of balance sheet of the company.

Modern classification of accounts

Rules For Debit And Credit When Accounts Are Classified According To The Modern Method:-

Rule for income accounts:-
Debit the decrease and credit the increase.

Rule for expenses accounts:-
Debit the increase and credit the decrease.

Rule for assets accounts:-
Debit the increase and credit the decrease.

Rule for liabilities accounts:-
Debit the decrease and credit the increase.

Rule for capital accounts:-
Debit the decrease and credit the increase.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One thought on “Basics of accounting”

  1. Such a wonderful explanation am really impressed please do more effort on this website am really impressed.

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