Month: March 2020

Accounting is the process of systematically recording, classifying, summarizing, and reporting financial transactions of a business. It helps measure a company’s financial performance, track assets and liabilities, and provide information for decision-making. Key concepts include the double-entry system, accrual accounting, and the preparation of financial statements like the balance sheet, income statement, and cash flow statement.

Accounting Concepts

1. Business Entity Concept

This concept states that a business is a separate legal entity from its owners or shareholders. The financial transactions of the business are recorded separately from the personal transactions of the owners. This distinction ensures clarity and accuracy in the financial statements, as the business’s financial position and performance are reflected independently.

2. Money Measurement Concept

Only transactions that can be measured in monetary terms are recorded in the financial statements. Non-financial factors such as employee morale or brand reputation are not included, as they cannot be objectively measured in terms of money. This concept ensures that financial statements are quantifiable, making them easier to analyze and compare.

3. Going Concern Concept

The going concern concept assumes that a business will continue its operations indefinitely, unless there is evidence to suggest otherwise (such as bankruptcy or liquidation). This assumption affects how assets and liabilities are valued. For example, assets are recorded at their original cost rather than liquidation value, as they are expected to be used over time.

4. Cost Concept

According to the cost concept, assets are recorded in the books at their purchase cost, not their current market value. This means that the historical cost of an asset remains unchanged over time, even if its market value fluctuates. This concept ensures objectivity in financial statements, as the value of assets is based on verifiable transactions.

5. Dual Aspect Concept

The dual aspect concept is the basis of the double-entry system of accounting, which states that every transaction affects at least two accounts. For example, when a business purchases equipment, it results in an increase in assets (equipment) and a decrease in cash or an increase in liabilities (loan). This ensures that the accounting equation—Assets = Liabilities + Equity—remains balanced.

6. Accounting Period Concept

Financial reporting is done for specific periods, such as monthly, quarterly, or annually. The accounting period concept ensures that businesses prepare financial statements at regular intervals to provide timely information for decision-making. This allows stakeholders to assess the financial performance and position of the business over time.

7. Accrual Concept

The accrual concept states that transactions should be recorded when they occur, not when the cash is actually received or paid. Revenues are recognized when earned, and expenses are recognized when incurred, regardless of cash flow. This concept ensures that financial statements provide an accurate picture of a company’s financial performance during a specific period.

8. Matching Concept

Closely related to the accrual concept, the matching concept states that revenues and expenses should be matched to the same accounting period. In other words, expenses should be recognized in the period in which the related revenues are earned. This helps in determining the true profitability of a business for a specific period.

9. Materiality Concept

The materiality concept implies that only information that would affect the decisions of users should be included in the financial statements. Insignificant or immaterial information can be omitted. This concept ensures that financial statements are not cluttered with irrelevant details, making them easier to interpret.

10. Consistency Concept

Once a business adopts a specific accounting method or principle, it should continue to use it consistently in subsequent accounting periods. The consistency concept ensures that financial statements are comparable over time. However, if a change in accounting method is necessary, it must be disclosed and justified in the financial statements.

11. Prudence (Conservatism) Concept

The prudence concept advises accountants to exercise caution when recording financial transactions. This means recognizing expenses and liabilities as soon as they are known, but only recognizing revenues and assets when they are assured. The goal is to avoid overstating profits or assets, ensuring that financial statements present a conservative and reliable view of the business.

12. Full Disclosure Concept

The full disclosure concept requires that all relevant financial information is disclosed in the financial statements. This ensures that stakeholders have access to all the necessary data to make informed decisions. Important information that may not be included in the financial statements themselves should be disclosed in the notes to the accounts.

Accounting Conventions

Accounting Conventions are widely accepted practices that guide the preparation of financial statements. While they are not legally binding, they provide a framework for consistent, accurate, and transparent accounting practices. These conventions help standardize how financial data is recorded, interpreted, and presented, making it easier for businesses to compare financial statements across time periods and industries. The four primary accounting conventions are consistency, full disclosure, conservatism, and materiality.

1. Consistency Convention

The consistency convention requires businesses to use the same accounting methods and practices from one accounting period to another. For example, if a company adopts the straight-line method for depreciation, it should continue using this method unless there is a justified reason for change. Consistency helps in comparing financial statements over multiple periods, allowing stakeholders to track trends and evaluate performance reliably. However, if a business changes its accounting practices, the change must be disclosed in the financial statements, along with an explanation of how it affects the financial results. This convention promotes transparency and comparability, making it easier for investors, auditors, and regulators to assess the company’s financial data over time.

2. Full Disclosure Convention

The full disclosure convention requires that all relevant and material financial information be fully disclosed in the financial statements. This includes not just the figures presented on the balance sheet, income statement, and cash flow statement, but also any information that may affect the users’ understanding of the financial condition of the business. For example, if a company is involved in a lawsuit that could significantly impact its financial position, this information must be disclosed in the notes to the accounts. Full disclosure ensures that stakeholders, such as investors, creditors, and regulators, have all the necessary information to make informed decisions. This practice fosters transparency and accountability in financial reporting.

3. Conservatism (Prudence) Convention

The conservatism convention, also known as the prudence convention, advises accountants to adopt a cautious approach when recording financial transactions. Under this convention, potential expenses and liabilities should be recorded as soon as they are known, while revenues and assets should only be recognized when they are reasonably certain. This conservative approach ensures that businesses do not overstate their financial performance or position. For example, if there is uncertainty about whether a debtor will repay a loan, the business should create a provision for doubtful debts. The goal of this convention is to present a realistic view of the financial condition, avoiding overly optimistic assessments that could mislead stakeholders.

4. Materiality Convention

The materiality convention dictates that only information that is significant enough to influence the decisions of stakeholders should be included in the financial statements. Immaterial or trivial information that would not affect users’ decisions can be omitted. For example, small office supplies purchased may not be itemized as individual assets but expensed immediately. This convention ensures that financial statements are not cluttered with insignificant details, making them easier to understand and analyze. Materiality is subjective and depends on the size and nature of the business, but it is guided by the principle that financial reporting should focus on information that is useful for decision-making.

Accounting Equation is a fundamental concept in accounting that serves as the foundation for the double-entry bookkeeping system. It reflects the relationship between a company’s assets, liabilities, and equity. The equation is expressed as:

Assets = Liabilities + Equity

This equation must always balance, meaning that the value of a company’s resources (assets) is always equal to the claims against those resources (liabilities and equity). It provides a snapshot of a company’s financial health at a specific point in time and forms the basis for the structure of financial statements, such as the balance sheet.

1. Assets

Assets are the resources owned by a business that are expected to bring future economic benefits. They include both tangible and intangible items that the company controls as a result of past transactions. Examples of assets are:

• Cash: The most liquid asset, representing money available for immediate use.
• Accounts Receivable: Amounts owed to the company by customers for goods or services delivered.
• Inventory: Goods that are held for sale in the normal course of business.
• Equipment and Machinery: Physical assets used in the production or operations of the business.
• Intangible Assets: Non-physical assets such as patents, trademarks, and goodwill.

Assets can be classified as current or non-current based on their liquidity or how soon they can be converted into cash.

2. Liabilities

Liabilities are the obligations or debts that a business owes to outside parties. They represent claims on the company’s assets by creditors, suppliers, and lenders. Liabilities arise from borrowing funds, purchasing goods or services on credit, or other financial commitments. Examples:

• Accounts Payable: Money owed to suppliers for purchases made on credit.
• Loans Payable: Debts that the company must repay, typically to banks or other financial institutions.
• Unearned Revenue: Money received from customers for services or goods to be delivered in the future.

Liabilities are classified as current (due within one year) or long-term (due after one year).

3. Equity

Equity represents the owners’ claims on the company’s assets after all liabilities have been settled. It can be thought of as the residual interest in the assets of the business. Equity is also referred to as owners’ equity or shareholders’ equity in the case of corporations.

• Contributed Capital: The money that shareholders or owners invest in the business.
• Retained Earnings: The accumulated profits that the business has earned over time, minus any distributions (dividends or withdrawals) to the owners.

In a sole proprietorship or partnership, equity is usually referred to as owner’s capital, whereas in a corporation, it includes stock (common or preferred) and retained earnings.

Importance of the Accounting Equation

The accounting equation plays a critical role in maintaining the integrity of a company’s financial records. Every financial transaction that a business undertakes affects at least two accounts, and the equation ensures that these transactions keep the balance intact. For example:

• If a business takes out a loan, assets (cash) increase, but liabilities (loans payable) also increase, keeping the equation balanced.
• If a company purchases inventory with cash, one asset (inventory) increases while another asset (cash) decreases, which also balances the equation.

Double-Entry System

The accounting equation is central to the double-entry accounting system, which requires that every financial transaction affects at least two accounts to keep the equation in balance. For every debit entry made to one account, a corresponding credit entry must be made to another account. This ensures that total debits always equal total credits, maintaining the equality of assets with liabilities and equity.

Relationship with Financial Statements

The accounting equation is directly related to the preparation of the balance sheet, which is structured to reflect the equation. The balance sheet lists a company’s assets on one side and liabilities and equity on the other side. The accounting equation ensures that the balance sheet is always balanced, providing users with a clear view of the financial position of the business at a particular time.

Trial Balance is a summary of all the general ledger accounts of a business at a specific point in time. It lists the balances of each account, separating them into debit and credit columns. The primary purpose of preparing a trial balance is to check the mathematical accuracy of the bookkeeping system, ensuring that total debits equal total credits. If the trial balance is balanced, it indicates that the double-entry accounting system has been followed correctly. However, a balanced trial balance does not guarantee the absence of errors, as some types of mistakes may not affect the overall balance.

Functions of Trial Balance:

• Verification of Mathematical Accuracy

The main function of a trial balance is to ensure that the double-entry accounting system has been followed correctly. In this system, every transaction affects two or more accounts, with debits equaling credits. The trial balance checks the mathematical accuracy of these entries by listing all debit and credit balances. If the total debits equal the total credits, the bookkeeping entries are presumed correct.

• Detecting Errors

The trial balance helps in identifying certain types of errors in the accounting records. For example, if debits and credits do not match, it indicates that there has been a mistake in the recording process. Errors such as omission, reversal of entries, or incorrect postings can be traced and corrected through the trial balance. However, it’s important to note that it won’t detect all types of errors, like compensating errors or incorrect amounts in both debit and credit sides.

• Facilitating the Preparation of Financial Statements

One of the critical functions of the trial balance is to simplify the preparation of financial statements such as the balance sheet and income statement. Once the trial balance is complete and balanced, accountants can use the information to prepare these financial reports, ensuring the financial position and performance of the business are accurately reflected.

• Summarizing Financial Data

The trial balance acts as a summary of all the financial data for a specific period. It compiles the ending balances of all the ledger accounts, providing a snapshot of the company’s financial standing. This summary allows management and auditors to review the overall status of the accounts in one place.

• Checking for Completeness

By listing all the balances from the general ledger, a trial balance helps to check if any accounts have been omitted during the posting process. This function ensures that all financial transactions have been properly accounted for and included in the company’s records.

• Simplifying Adjustments

Trial balances are typically prepared before making adjusting entries at the end of the accounting period. It helps in identifying which accounts require adjustments, such as accruals, depreciation, or prepaid expenses. Once the necessary adjustments are made, a new trial balance, known as the adjusted trial balance, is prepared.

• Monitoring Financial Health

A well-maintained trial balance helps monitor the financial health of a business. By reviewing the balances in various accounts, management can assess liquidity, solvency, profitability, and other key financial metrics. The trial balance also highlights the balances of assets, liabilities, and equity accounts, offering insights into the overall financial condition of the company.

• Supporting Auditing

The trial balance is an important tool for auditors during the auditing process. It provides a basis for auditors to verify the accuracy of financial records, trace transactions back to their original entries, and assess the reliability of the company’s financial statements. It also helps in ensuring that financial statements are prepared according to accounting standards and regulations.

Components of Trial Balance:

Trial Balance consists of several key components that help summarize the financial data of a business at a specific point in time. These components ensure that the double-entry accounting system has been followed correctly, and they aid in the preparation of financial statements.

1. Account Title

• This is the name of each account in the general ledger. It includes all types of accounts such as assets, liabilities, equity, revenues, and expenses.
• Examples of account titles are “Cash,” “Accounts Receivable,” “Inventory,” “Sales Revenue,” and “Salaries Expense.”

2. Debit Column

• The debit column lists all the amounts that have been debited to the various accounts.
• It includes the total debits recorded during the accounting period, and it helps track the value of transactions that increase assets or expenses.
• For example, cash receipts and expenses like rent or utilities are recorded on the debit side.

3. Credit Column

• The credit column contains all the amounts credited to the various accounts.
• It represents the transactions that reduce assets or expenses or increase liabilities, equity, and revenues.
• For example, income from sales and amounts owed to suppliers are typically recorded in the credit column.

4. Account Balances

• The trial balance includes the closing balances of each account from the general ledger.
• Each account will have either a debit or a credit balance depending on its nature (e.g., assets normally have debit balances, while liabilities have credit balances).
• The trial balance displays these balances in the respective debit and credit columns.

5. Total of Debit and Credit Columns

• At the bottom of the trial balance, the total of all debit and credit columns is shown.
• The total debits and total credits should match (be equal), ensuring that the accounting records are mathematically correct and balanced.

6. Date

• The trial balance is usually prepared at the end of an accounting period (monthly, quarterly, or annually).
• The date helps to define the period for which the financial data is summarized, making it clear which transactions are included in the trial balance.

Example of Trial Balance:

Here is an example of a trial balance in table format:

Explanation:

• Debit Column:

This lists all the accounts with debit balances, such as assets (Cash, Accounts Receivable, Inventory, Equipment) and expenses (Salaries Expense, Rent Expense, Utilities Expense).

• Credit Column:

This lists all the accounts with credit balances, such as liabilities (Accounts Payable, Notes Payable), owner’s equity (Capital), and revenues (Sales Revenue).

• Total:

The total of the debit and credit columns must be equal (48,500), confirming that the ledger is balanced.

The reporting information will not be accurate unless we take into consideration the adjustment entries. The treatment of various common adjustments such as closing stock, outstanding expenses, accrued incomes, prepaid expenses, incomes received in advance, bad debts, reserve for bad and doubtful debts, reserve for discount on debtors, reserve for discount on creditors, interest on capital, interest on drawings, depreciation, etc., the knowledge of which should be made use of while preparing final accounts.

Special Items of Adjustments:

1. Goods Distributed as Free Samples

In order to promote a product, free samples are supplied to experts in the field. For example, free samples of books to professors, free samples of medicine to doctors.

Therefore the adjusting entry is as follows:

The transfer entry is as follows:

The net effect would be reduction in purchases and charge to profit and loss account as promotional expense.

2. Goods Sold on Sale or Approval Basis

In order to gain confidence of the customers on quality of the goods, sometimes goods are sold on approval basis. If the customer approves it, then it becomes a sale. If the customer does not approve it, then the sale is not complete and hence cannot be treated as sales. Suppose at the end of the financial year certain goods sent on approval basis are with the customers, then there is a need to pass necessary entries for adjustment.

The adjusting entries are as follows:

The treatment is as follows:

(a) As a deduction from sales at sales price on credit side of trading account and as an addition to closing stock at cost price.

(h) As a deduction from sundry debtors on the assets side and the total stock to be shown at cost price (closing stock at cost + stock with the customers on approval) on the assets side of the balance sheet.

3. Goods Sent on Consignment

Since consignment transaction is not a sale transaction it does not affect the trading and profit and loss accounts directly. A separate consignment account is opened and the goods sent on consignment are debited to consignment account. When the account sale is received, it is treated as consignment sales and credited to consignment account and debited to consignees account.

Any consignment stock remaining with the consignee will be credited to consignment account and profit on consignment is ascertained after charging the expenses on consignment, consignee’s commission, etc. However, closing stock of consignment will be shown on the balance sheet’s assets side and the profit on consignment is credited to profit and loss account (the entry will be reversed if there is loss on consignment).

The transfer entry for profit or loss on consignment is as follows:

• If it is a Profit

• If it is Loss

Note: (i) The above transfer entry becomes necessary only where the consignor is also running a trading business

(ii) The working of consignment account is almost similar to trading account which is not shown here.

4. Loss of Stock by Fire

If the stock is destroyed by fire, then the loss incurred will be treated differently under the following three possible situations:

(a) If the stock is not insured: The entire value of the stock destroyed by fire will be treated as loss, with an entry:

Note: (i) The value of stock destroyed is credited to trading account as “stock destroyed” (had it not been destroyed, it would have appeared as closing stock).

(ii) Entire value of the stock destroyed is treated as loss and charged to profit and loss account.

(b) If stock is fully insured: When the stock which is fully insured is destroyed, the enterprise has a claim on the insurance company for the recovery of loss incurred due to goods being destroyed by fire. Therefore, the claim is preferred with an entry –

In effect, the claim on the insurance company is treated as ‘debtors’ and shown in the balance sheet assets side as due from the insurance company.

If the insurance company settles the dues, then the entry will be as follows:

In effect, the cash/bank balance in the balance sheet will increase to the extent of the claims settled and therefore, insurance company account will not appear in the balance sheet.

(c) If the stock is partly insured: In this case the total value of the stock destroyed is credited to trading account, and that part of the claim to be settled by the insurance company is debited to insurance company account and the difference between stock destroyed and insurance claim accepted is debited to profit and loss account as loss. The entry is as follows:

5. Deferred Revenue Expenditure

Huge expenditure of revenue nature incurred at the initial stages of the business enterprise with the belief of deriving benefit from such expenditure during the subsequent years is regarded as deferred revenue expenditure provided the charging of such expenses is spread over the number of years during which the benefit is expected to be derived.

A part of such expenditure is charged as revenue in each year and the rest is capitalized based on matching concept. For example, huge expenditure on ‘advertisement’ is incurred in the initial years of business to derive the benefit over an estimated term of ten years. Then, each year one-tenth of that expenditure is charged to revenue over the term of ten years. The catch here is that the expenditure that is not charged to revenue is capitalized and shown as fictitious assets on the balance sheet.

Suppose, the advertisement expenditure incurred Rs.2,00,000 is able to yield benefit over five-year term. Then, one-fifth of 2,00,000, i.e., Rs.40,000 is charged to revenue in the first year and the rest Rs.1,60,000 is shown as fictitious assets. In the second year Rs.40,000 is charged to revenue and the balance 1,20,000 is shown as fictitious assets. This process goes on for five years till the complete expenditure is written off. The entries to be passed during the first year are as follows:

6. Creation of a Reserve Fund

To strengthen the financial position of the enterprise, a part of the net profit may be transferred to reserve fund account by means of appropriation. The entry for creating a reserve fund is as follows:

Note: (i) Reserve fund will appear on the liabilities side of the balance sheet.

(ii) In the case of sole trading and partnership organizations, it is customary to change this directly to profit and loss account instead of profit and loss appropriation account.

7. Manager’s Commission

Business enterprises sometimes offer profit incentive to managers in the form of commission to motivate the person to increase the profits of the business. This commission is given as a percentage on the net profits. There are two ways of offering this percentage on net profits.

(a) Percentage of commission on net profits before charging such commission.

(b) Percentage of commission on net profits after charging such commission.