basic accounting concepts.docx
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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 owner’s 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.
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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 AccountFormat for Receipts and Payments Account
Receipt and Payments Account
for the year ended 31 December 2010
Dr. Cr.
Receipts Amount Payments Amount
Balance b/d (Opening
balance)
All Cash receipts
XXXX
XXXX
All cash payments xxxxx
XXXX
Balance c/f (closing
balance)
xxxxx
XXXXX XXXXX
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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 Accountfor the year ended 31 December 2010
Dr. Cr.
Expendi ture Amount Income Amoun t
Revenue expenses only XXXX Trading Profit (if any)
Revenue Incomes only
XXXX
XXXX
Surplus
(when income is more than expenditure)
XXXX Deficit
(when expenditure is more thanincome)
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.
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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 (Non-
trading 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 2009Total subscription received 1000
Less Subscription in arrears, at the starting of the year 200
Add Subscription received in advance for 2009, in previous years. 100
Add Subscription in arrears, at the end of 2009 300
Less Subscription received in advance (for next year), at the end of the year 100
Subs cript io n revenue for Year 2010 1100
You can also make a separate Subscription
Account and then post the finalsubscription amount in the Income and
Expenditure AccountDr. Subscription Account Cr .
Amount Amount
Subscription in arrears (b/d)
(not collected during the previous year)
XXXX Subscription received in advance b/d
(collected during previous year)
XXXX
Subscription received during current
year (from Income & ExpenditureXXXX Total Cash received as subscription during
the current year
XXXX
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Account)
Subscription in advance c/d
(collected for subsequent year)
XXXX Subscription in arrears c/d
(not yet collected for current year)
XXXX
XXXX XXXX
Subscription in arrears b/d XXXX Subscription in advance b/d 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 trader’s 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 Trader’s 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 trader’s 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.
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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 Source
Total Opening Balance Trial Balance at close of previous period
Total Sales Sales Journal
Dishonoured Cheques Cash Book
Discount allowed withdrawn General Journal
Any charges to debtors General Journal
Total cash and cheques received from debtors Cash book
Discount allowed Cash Book
Returns inwards and allowances Returns Inwards journal
Bad Debts 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 Sources
Total cash and cheques paid to creditors Cash Book
Discount received Cash Book
Returns outwards and allowances Returns Outwards Journals
Total opening balances Trial Balance at close of previous period
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Total purchases Purchases Journal
Any charges by creditors Journal
Minority balances in Control AcccountsNormally, 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 BalanceTrial Balance is a statement prepared with the debit and credit balances of ledger accounts toverify 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
Accounts to be
placed on credit
side
Assets
Expenses
Drawings
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 entryIf by mistake only one entry is made for a transaction, Trial Balance will not balance.
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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)
LiabilitiesThese 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
Owner’s equity The funds of a business provided for by its owners.
Owner’s equity = Assets – Liabilities
Owner’s equity increases by Owner’s equity decreases by
Profits Losses
Additional investment into the business Drawings
Double entry SystemLook 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 AccountEach account is shown on a different page.
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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 SystemThis system classifies accounts into five categories:
Assets accountDebit the increase in assets; Credit the decrease in assets
Liabilities accountDebit the decrease in liabilities; Credit the increase in liabilities
Capital accountDebit the decrease in Capital; Credit the increase in Capital
Revenue accountDebit the decrease in income; Credit the increase in income
English systemClassification of Accounts
Personal AccountsPersonal accounts are those which are opened under the NAME of individuals, firms, company, institution etc.
For example John’s account, dinesh’s 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
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Intangible real accountsThose accounts which cannot be touched or seen. Examples include
Goodwill account
Patent accounts
Rule
Debit what comes inCredit what goes out
Nominal AccountsThese 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 Salary paid account
Interest received account Commission paid account
Dividends received 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