In this session we will explain some common terms and touch upon the basic concepts of Accounting as that may help you to understand the later chapters better. When you talk about Accounting, it will be helpful if you know about Debit and Credits, Assets and Liabilities, Expenses and Incomes, so that you are able to prepare and maintain accounts systematically and correctly.
WHAT IS ACCOUNTING
Accounting is the language of business. American Institute of Certified Public Accounts have defined ‘Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in pat at least, of a financial character and interpreting their result thereof’’.
· Accounting involves
· Recording
· Classifying
· Summarizing
· Interpreting financial transactions
· Analyzing Information
NEED FOR ACCOUNTING
In a business organization, innumerable monetary transaction takes place. Accounting keeps a systematic record of such transactions and summarizes them through entries in various accounts. A clear picture of functioning of the business emerges from ‘Accounting. Accounting revels what the Business own and owes, Profit or Loss.
FUNCTIONS OF ACCOUNTING
Accounting has two distinct but allied functions, Historical and Managerial.
The Historical function is related to recording classifying and summarizing the transactions. The reporting is done at standard periodical interval as per convention and statute (like P/L Statement, Balance Sheet etc)
The managerial function relates to comparing, analyzing, and appraising the performance. For the purpose of compilation, all monetary events are recognized as Transactions and classified into various Account heads. The related account heads are then summarized into significant groups so that interpretation becomes possible. Utility of accounting information is greatly increased when it is computed in systematic manner and financial statements are prepared at periodical intervals.
METHODS OF ACCOUNTING
The two methods of accounting system that is in vogue:
· Single Entry System
· 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 account and all credit transactions and accruals are omitted. Normally, only government accounting is done on this basis and commercial organization does not follow this system.
Ex: A building is constructed by a Contractor, final measurement taken and Bill prepared on 10th Feb 2000; the bill is paid on 20th Apr 2000.
In a single entry system, the transaction is recorded only on 20th April 2000 and the accounts of Financial Year 1999-00 (April’99-March, 2000) will have no effect for the transaction.
DOUBLE ENTRY SYSTEM
In this system, both cash and credit transactions are recognized. All commercial organizations follow this system. A cost incurred is duly accounted irrespective of whether it is paid or not during the accounting period. Additionally, all transactions shall have dual aspects and Debits and Credits must be equal. For all practical purposes, Double Entry System is the accepted method of accounting.
Ex: In the above case, Building Account will be debited and Contractor account will be credited in the books for FY ’99-00, to reflect the transaction when the cost incurred (i.e., on 10.02.2000). Again in FY 2000-01 on 20-04-00, the transaction will recorded reflecting payment to the Contractor.
USERS OF ACCOUNTING INFORMATION
People who have direct or indirect interest in the organization like owners (proprietor, partners or shareholders), intending investors, Creditors, Employees, Financial Institutions, Banks, Lenders, Management and Financial analysts, Government agencies, are eager to know its financial status. Since the same information is shared by different classes of users, standardized by different classes of users standardized Accounting concepts and principles were evolved to ensure that accounting information serves needs of various users.
To add creditability to the results, the financial statements are required to be verified and attested by professional Accountants who perform the tasks of Auditing and express their opinion on the financial statements.
BOOKS OF ACCOUNTS: MANUAL SYSTEM
Before we start looking into a computerized Accounting system, it would be prudent to have a look at the Manual Accounting practice being followed by generations as computerized Accounting is based on Manual Accounting.
The books of accounts maintained by a business may be conveniently classified as follows:
CASH BOOK
The term Cash is used in broader term, it includes Cash and Bank. Cash Book records all receipts of and payments in Cash & though Bank instruments.
(Ex: Cheque, Draft, Pay order etc)
Deposits into bank accounts maintained by the business, withdrawals from such accounts are also recorded in the Cash Book.
A Cashbook, which is used to record both cash and bank transactions, is referred to as a Two-column Cashbook.
JOURNAL BOOK
All non-cash transactions are recorded in Journal. The journal is used as the book of all transactions, which cannot be recorded in the Cash Book. For practical convenience, much Business organization maintains a number of Subsidiary Books for Journal, such as
· Purchase Book – is used to record Purchase transactions in Credit.
· Purchases Return Book (Debit Note Register) - is used to record Purchases return transactions
· Sales Book – records all Credit Sales transactions.
· Sales Returns Book (Credit Note Register) – records all Sales Returns.
· Journal Proper – records all such non-cash transactions that can not be entered in Purchase, Sales, Purchase Return or Sales Return books.
GENERAL LEDGER
Ledger is a device for classifying all information recorded in the Cash Book & Journal, according to account heads (called Ledger Accounts). Each Ledger Account has two sides, namely Debit and Credit side, Account heads debited in the primary books are posted in the debit side of the Ledger and account heads credited in primary books are posted in the credit side of the Ledger. Ledger reveals all transactions related to individual accounts and difference between debit and credit side is the closing balance for the Ledger as on that date.
The recording of transactions in the Books of Accounts and classifying into Ledger may be represented through following diagram.
CLASSIFICATION OF ACCOUNTS
The accounts maintained in the General Ledger of any organization may be broadly classified as under:
TYPES OF ACCOUNTS
Personal Accounts | Accounts related to an Individual, Body Corporate or Institution, which are recognized as a person. Ex: Owner’s Buyers, Suppliers, Bank, and Lenders. Personal Account may be further classified as: 1. Natural Persons Ex: Ramkumar, Serena 2. Artificial Person Ex: Companies & Organizations like RK films, SRF limited, Ramanujam & Co. 3. Representative Person Ex: Outstanding salaries (representing employees), Prepaid Rent (representing house owners), Sales Tax, Excise Duty (representing Government) etc. These accounts appear in Balance Sheet |
Real Accounts | Accounts where properties & possessions are recorded, like Fixed and Current assets. Ex: Cash, Building, Plant & Machinery, Vehicles These accounts appear in Balance Sheet |
Nominal Accounts | Accounts relating to Expenses & income, Losses & gains. Ex: Sales, Purchase, Discount Allowed, Discount Received, Repairs, Salaries, Interest Paid, Depreciation etc. These accounts appear in Profit & Loss Account |
GENERAL RULES OF DEBIT & 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 be stated as under:
Personal Accounts | Debit: The Receiver Credit: The Giver |
Real Accounts | Debit: What Comes in Credit: What Goes out |
Nominal Accounts | Debit: All Expenses and Losses Credit: All Incomes and Gains |
Debit is expressed with a sign Dr and Credit is shown as Cr.
EFFECTS OF DEBIT & CREDIT
CLASSIFICATION | DEBIT | CREDIT | NORMAL BALANCE |
Assets | Increase | Decrease | Debit |
Liabilities | Decrease | Increase | Credit |
Capital | Decrease | Increase | Credit |
Expenses | Increase | Decrease | Debit |
Income | Decrease | Increase | Credit |
FINANCIAL STATEMENTS
TRIAL BALANCE
As explained, all monetary events are classified into various Account Heads that are periodically summarized. This periodical summary is known as Trial Balance. In Double Entry System, for every transaction, Debit aspect always equal to Credit aspect, so in Trial Balance also, Debit and Credit totals are balanced. Trial Balance checks the accuracy of the books of accounts. In other words, Trial Balance is the closing balance of all Accounts for a specific date.
FINAL ACCOUNTS STATEMENTS
From trial balance, the following financial statements are made for interpreting Financial Transactions.
Profit & Loss (or Income and Expenditure Statement) for a specific period consisting of Nominal Accounts to reflect the Profit or Loss for the period. Trading Organizations normally split it into two components, namely Trading Account, Profit & Loss Account.
LIABILITIES | ASSETS | ||
Particulars | Amount | Particulars | Amount |
Capital | Fixed Assets | ||
Loans Taken | Current Assets | ||
Current Liabilities | |||
Total | Total | ||
Trading Account shows Gross Profit (or Gross Loss) earned by trading activities (for computation of Gross Profit, Sales and Closing Stock is considered as Income, Opening Stock, Purchases and Direct Expenses are treated as Expenses. Excess income over expenditure is the Gross Profit). Profit & Loss Account reveals Net Profit Income; Net Profit is computed by deducting all Indirect Expenses there from).
Balance Sheet (or Statement of Affairs) as on the last date of the period consisting of Real and Personal Accounts revealing what the organizations owns and what it owes on the specific date.
At the ends of financial period, Journal entry is passed to transfer closing balance of all nominal accounts to Profit & Loss Account and closing balance of all nominal accounts becomes zero.
Dr. | Income Accounts (equal to the credit balance |
Cr. | Profit & Loss Accounts |
Dr. | Profit & Loss Account |
Cr. | Expenses Account (equal to the debit balance) |
MANUAL vs. COMPUTERIZED ACCOUNTING
MANUAL ACCOUNTING
In manual system, you first create ledgers; carry forward previous year’s closing balance as Opening Balance for the current year. Record cash transaction in Cash Book and non-cash transactions in Journal (or subsidiary books as explained earlier), then amounts from Cash Book and Journal are posted into respective ledgers.
Whenever you need to know balance of any ledger, you are required to total amounts in both Debit and Credit columns of the ledger and compute the difference to derive the closing balance for the Ledger as on that date. To prepare Final Accounts (Profit & Loss Account, Balance Sheet) for any period, you have to compute closing balance of ledgers for the period and then prepare a Trail Balance. You pass Journal entries to transfer balances of Nominal account to Profit & Loss Account, carry over Real & Personal ledger balances to Balance Sheet.
Next year, when you create New Year books, again you create all the ledgers afresh and enter opening balance (a sheer repetition and monotonous job).
COMPUTERIZED ACCOUNTING
When you opt for Computerized Accounting first time, you have to create all the Ledgers and enter opening balance (in subsequent years you need not to create the Ledgers and enter opening balances, it would be done on it’s own by the computer carrying over balances of Real and Personal accounts) and place them under proper Group at this stage. Thereafter, you enter all transactions in Vouchers (different types of Vouchers to record diverse nature of transactions). That’s all you have to do and everything else (like posting to Ledger, preparation of Trial Balance, Final Accounts etc.) is done by the computer.
Practical experience shows that it is almost impossible to find software that can meet all the requirements, yet is simple to use. The software should make a balance to address most of the common requirements, to be useful for practical purpose.
In light these characteristics and requirements of a good Integrated Accounting System, we now discuss TALLY, a versatile Integrated Accounting System.
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