17 Fundamentals of accounting

P. Santhi

1. INTRODUCTION

The main purpose of accounting is to ascertain profit or loss during a specified period, to show financial position of the business on a particular date and to have control over the firm’s property. Such accounting records are required to be maintained to measure the income of the business and communicate the information so that it may be used by managers, owners and other parties. Let us learn the fundamentals of accounting in detail.

2. LEARNING OBJECTIVES

At the end of this lesson you will be able to

Analyse the various business transactions, rules for recording them and posting in ledger
Ascertain and appreciate the financial result and financial position of a business

3. MEANING OF ACCOUNTING

Before getting into the objectives of accounting, the concept of accounting should be understood. Accounting is a discipline which records, classifies, summarises and interprets financial information about the activities of a concern so that intelligent decisions can be made about the concern. American Accounting Association defines accounting as “the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information.” Book keeping is the science and art, of correctly recording in books of accounts all business transactions that result in transfer of money. Book keeping is more of a routine work which is a part of accounting.

3.1 Objectives of Accounting

The objectives of accounting are

Making decisions concerning the use of limited resources including identification of crucial decision areas and determination of objectives and goals.
Effectively directing and controlling the organization’s human and materials resources.
Maintaining systematic records and reporting on the custodianship of resources, and
Facilitating special functions and control.

3.2 Bases of Accounting

3.2.1 Cash basis of accounting

Under the cash basis of accounting actual receipts and actual payments in cash are recorded.

3.2.2 Accrual Basis of Accounting

The income whether received or not but has been earned or accrued during the period forms part of the total income of that period. Similarly, if the firm has taken benefit of a particular service , but has not paid within that period, the expense will relate to the period in which the service has been utilized and not to be period in which the payment for it is made.

3.2.3 Hybrid or Mixed Basis of Accounting

Under mixed basis of accounting both cash basis and accrual basis are followed.
Income are recorded on cash basis whereas expenses are taken on accrual basis.

3.3. Self check exercises

Which of the following is the objectives of accounting?

Ascertaining financial results of the business
Reporting on effective utilisation of resources
Ensuring arithmetical accuracy of accounts
All of the above

(Ans. d)

4. ACCOUNTING PRINCIPLES

Accounting principles are guidelines to establish standards for sound accounting practices and procedures in reporting the financial status and periodic performance of the business. Accounting principles can be classified into two categories namely, Accounting concepts, and Accounting conventions.

4.1 Accounting Concepts

Accounting Concept defines the assumptions on the basis of which Financial Statements of a business entity are prepared. The following are the widely accepted accounting concepts.

4.1.1 Entity Concept :- Entity Concept says that business enterprises has a separate identity apart from its owner. Therefore, whenever business received cash from the proprietor, cash a/c is debited as business received cash and capital a/c is credited. The concept of separate entity is applicable to all forms of business organization.

4.1.2 Money Measurement Concept :- According to this concept, only those transactions, which can be measured in terms of money are recorded. For example, health condition of the Managing Director of the company, working environmnent of the workers, sale policy etc. do not find place in accounting because it is not measured in terms of money.

4.1.3 Cost Concept :- By this concept, the value of assets is to be determined on the basic of historical cost. Transaction are entered in the books of accounts at the amount actually involved. Many assets de not have acquisition cost. Human assets of an enterprises are an example. The cost concept fails to recognize such assets although it is a very important assets of any organization.

4.1.4 Going Concern Concept :- According to this concept the financial statements are normally prepared on the assumption that an enterprises is a going concern and will continue in operation for the foreseeable future. Transaction are therefore recorded in such a manner that the benefits likely to accrue in future from money spent.

4.1.5 Dual aspect Concept :- This concept is the care of double entry book-keeping. Every transaction or event has two aspects.

4.1.6 Realization Concept: – It closely follows the cost concept any change in value of assets is to be recorded only when the business realize it. i.e. either cash has been received or a legal obligation to pay has been assumed by the customer.

4.1.7 Accrual Concept:- Under accrual concept the effect of transaction and other events are recognized on mercantile basis. When they accrue and not as cash or a cash equivalent is received or paid and they are recorded.

4.1.8 Accounting Period Concept:- This is also called the concept of definite periodicity. As per going concept on indefinite life of the entity, it is reasonable to divide the life of the business into accounting period.

4.1.9 Matching Concept:- According to this concept, all expenses matched with the revenue of that period should only be taken into consideration.

4.1.10 Objective Concept:-evidence. In other words, documents.

As per this concept, all accounting must be based on objective the transactions recorded should be supported by verifiable

4.2 Accounting Conventions

The term “Accounting Conventions” refers to the customs or traditions which are used as a guide in the preparation of accounting reports and statements. The important accounting conventions in use:

4.2.1 Convention of consistency:- According to this convention the accounting practices should remain unchanged from one period to another. An Enterprise should change its accounting policy in any of the following circumstances only.

To bring the books of accounts in accordance with the issued accounting standard.
To compliance with the provision of law.
When under changed circumstances it is felt that new method will reflect more true and fair picture in the financial statement.

4.2.2 Convention of Conservatism:- This is the policy of playing safe game. It takes into consideration all prospective losses but leaves all prospective profits . The financial statements are usually drawn up on a conservative basis. The anticipated profit are ignored but anticipated losses are taken into account while drawing the statements.

4.2.3 Convention of Disclosure:- Apart from statutory requirement, good accounting practice also demands that significant information should be disclosed in financial statements. Such disclosures can also be made through footnotes.

4.2.4 Convention of Materiality:- According to this conventions, the accountant should attach importance to material detail and ignore insignificant details in the financial statement.

5. Classification of Accounts Personal Accounts Real or Property Accounts Nominal or Fictitious Accounts

6. Systems of Accounting

The following are two systems of accounting:

Single Entry System:- Under this system, only personal accounts with or without subsidiary books are maintained.

Double Entry System:- Method of writing every transaction in two accounts is known as Double Entry System of Accounting.

Rules of the Double Entry System

There are separate rules of the double entry system in respect of personal, real and nominal accounts.

Personal Accounts : These accounts record a business’s dealings with persons or firms.
Real Accounts:These are accounts of assets.
Nominal Accounts :These accounts deal with expenses, incomes, profits and losses

7. Accounting Equation

Rules of debit and credit through accounting equation which is given below

Assets = Equities

The properties owned by a business are called assets and the rights to properties are known as liabilities or equities of the business. Equities may be divided in to equities of creditors representing debts of the business known as liabilities and equity of the owners known as capital. Keeping in view the two types of equities the equation given above can be stated as below:

Assets =Liabilities +Capital

The equation given above is the basic accounting equation on which the double entry accounting is built up.

Rules of Accounting Equation

1. Recording Assets

Increase in assets are debits and decrease in assets are credits

2. Recording Liabilities

Increase in Liabilities are credits and decrease Liabilities are debits

3. Recording Capital

Increase in Capital are credits and decrease Capital are debits

4.Recording Expenses

Increase in Expenses are debits and decrease in Expenses are credits

5.Recording Incomes or profits

Increase in Incomes or profits are credits and decrease Incomes or profits are debits

8. Accounting Cycle

It refers to a complete sequence of accounting procedures which are required to be repeated in the same order during such each accounting period. Accounting cycle includes

(a) Recording: All transactions should be recorded in the Journal or Subsidiary books as and when they take place.

(b) Classifying: All entries in the Journal or Subsidiary books should be posted to the appropriate ledger accounts

(c) Summarising: Last stage is to prepare the trial balance and final accounts with a view to ascertain the profit or loss made during a trading period and financial position of the business on a particular date.

The business transactions are recorded either in the journal or subsidiary books

8.1 Journals

Journal is derived from the French word ‘Jour’ which means a day. Journals, therefore, means a daily record of business transactions. Journalizing means recording a transaction in the journal and the form in which it is recorded is known as a Journal entry.

8.2 Subsidiary Books

Subsidiary books comprise of the following:

Purchases book to record credit purchase of goods.
Sales book to record credit sales of goods.
Purchase return book to record returns to suppliers.
Sales returns book to record returns from customers.
Cash book to record all cash receipts and payments.
Bills receivable book to record bills received.
Bills payable book to record bills payable accepted.
General journal or journal proper to record any other transactions which cannot be entered in the above specialized subsidiary books.

8.3 Ledger

A ledger account may be defined as a summary statement of all the transactions relating to a person, asset, expense or income which have taken place during a given period of time and shows their net effect.

Ledger Posting of Journal

Every transaction is first recorded in the journal in the form of a journal entry. The process of transferring the transaction from the journal to the ledger is known as posting. The following example will make clear the process of posting:

2016, 4thApril. Goods sold for cash Rs.2,500.

8.4 Trial Balance

The fundamental principle of Double Entry System of Accounting is that for every debit, there must be a corresponding credit. Therefore,that the sum total of debit amounts should be equal to the credit amounts of the ledger at any date. Thus, at the end of the financial year or at any other time, the balances of all the ledger accounts are extracted and are written up in a statement known as Trial Balance. The agreement of the Trial Balance reveals that both the aspects of each transaction have been recorded and that the books are arithmetically accurate. If the Trial Balance does not agree, it shows that there are some errors which must be detected and rectified if the correct final accounts are to be prepared.

8.5 Final Accounts

Final accounts are prepared to achieve the objectives of accountancy. In order to know the profit or loss earned by a firm, Income Statement or Trading and profit and loss account is prepared. Balance Sheet or Position Statement will portray the financial condition of the firm on a particular date. Final accounts include the preparation of:

I. Trading and Profit and Loss Account or Revenue Account ; and

II.Balancesheet .

8.5.1Trading Account

This account is prepared to know the trading results of the business i.e, how much gross profit the business has earned from buying and selling during a particular period. The difference between the sales and cost of goods sold is gross profit.

A proforma of a trading account is given below:

Trading account for the year ended………

8.5.2 Profit and Loss Account

This account is prepared to calculate the net profit of the business. There are certain items of income and expenses of the business which must be taken in to consideration for calculating net profit of the business. A proforma of Profit and Loss account is given below:

8.5.3 Balancesheet

A Balance sheet is a statement prepared with a view to measures the financial position of a business on a certain fixed date. A properly drawn up balance sheet gives information relating to the nature and value of assets and liabilities, solvency of the firm and whether the firm is overtrading. A proforma of Balancesheet is given below:

8.6. More to ponder

Do you think change in the method of calculating depreciation affect the net profit of the business?
Do you think wages paid for erection of machinery is treated as capital expenditure?

8.7. Limitations of Accounting

Records only monetary transaction
Effect of price level changes not considered
No realistic information
Personal judgment of accountant affects the accounting statements
Permits alternative treatments
No real test of managerial performance
Historical in nature

8.8. Self-check exercises

Gross Profit + Opening stock + Purchases + Direct expenses – Sales = ?
A commission of 10% on net profits after charging such commission will be calculated …………. .
Medicines given to the office staff by a manufacturer of medicine will be debited to ………..
(Ans. 1. Closing stock 2. 10/110 of residual profit 3. Salaries account)

9. SUMMARY

The main objective of the management is to manage the business in a systematic way following a plan, allocating responsibilities to implement the plan and organising methods to execute the plan effectively. To achieve this, accounting can be useful by providing timely accounting information to the management in such a form so that it may be helpful in formulating policies, making decision, planning activities and controlling business operations.

you can view video on Fundamentals of accounting

References

ü Jain,S.P and Narang K.L.(2017). Advanced Accountancy, New Delhi: Kalyani Publishers.