Basics of Accounting

Nature of Course: Foundation Course

Course Structure

Unit 1: Introduction to Accounting

i. Meaning and Purpose of Accounting

ii. Users of Accounting Information
iii. Types of Business Organizations
iv. Introduction to Financial Statements
v. Elements of Income Statement
vi. Elements of Balance Sheet
vii. Accounting Equation
viii. Overview of Accounting Concepts

Unit 2: Accounting Process

i. Recording of Transactions: Journal
ii. Preparation of Accounts: Ledger
iii. Trial Balance

Unit 3: Final Accounts

i. Trading and Profit & Loss Account
ii. Balance Sheet
Unit 1: Introduction to Accounting

Learning Outcomes:

After completing this unit, you will be able to understand:

1. Meaning and importance of accounting

2. Types of Business Organizations
3. Elements of Income Statement
4. Elements of Balance Sheet
5. Implications of important accounting concepts

1.1 Meaning and Purpose of Accounting

Every organization, be it a small business or large enterprise, enters into numerous transactions in a
given year. Here transaction implies exchange of goods and services. If a transaction involves
exchange in kind then it is called barter transaction, while in cash transactions, goods and services
are exchanged for cash or cash equivalents.

If an entity continues to transact without any record keeping then it will be very difficult to trace
whether the firm has made profit or loss, how much cash it has used for what purpose etc. In order
to assess its performance and to do proper planning for business, it is essential that all the
transactions are systematically recorded and managed further to find out financial performance of
business.

Accounting is the process of systematically recording the transactions and processing the same
through classification and summarization to produce the set of financial statements. These financial
statements provide the information about the profitability and financial position of business entity.
There are many stakeholders in a business which includes owners, lenders, employees, government,
Society etc. which requires the financial information for the specific purposes.

As per American Institute of Certified Public Accountants (AICPA), “Accounting is the art of
recording, classifying and summarizing, in a significant manner and in terms of money, transactions
and events which are, in part at least, of financial character, and interpreting the results thereof”.

1.2 Users of Accounting Information

i. Owners: Business Owners need to know about the profitability of their venture. They need
to plan for future investments and usage of business profits. Financial statements serve as
the primary sources of information for performance analysis and assessment of financial
position.
ii. Management: To plan for future expansion and increasing the efficiency & profitability of
firm management uses the financial records of firm as a basis for forecasting.
 iii. Lenders: Lenders are interested in the long-term profitability and sustainability of firm.
Income Statement enables them to estimate about the future performance based on
current performance. Balance sheet helps them to understand the financial soundness of
firm.
iv. Employees: Employees have their vested interest in the firm as it is the source of their
regular income and employee benefits in the form of gratuity, provident fund etc. They want
to know how the organization is performing.
v. Government: Government needs to know about the organization whether the business is
complying with all the legal, regulatory and accounting related requirements. Government
also collects the taxes from the businesses. The accounting data is required for several
purposes by government authorities like tax assessment, expenses on CSR (corporate social
responsibilities) activities, environmental compliances etc.
vi. Society: Society at large looks forward to business organizations for employment generation,
to act as a disciplined corporate citizen, to provide quality products and services etc. Annual
report of the organization provides the important information about the firm’s business
plans and financial performance.

1.3 Types of Business Organizations:

The business can be operated in different forms. The important legal structures in which a business
can be established include the following:

i. Sole Proprietorship

This is the simplest form of business which can be started by an individual without much
regulatory formalities. The business and owner are considered to be same entity in the eyes of
law. Therefore, income of business is treated as personal income of owner for taxation purpose.
If the business has taken a loan or has a liability and unable to repay it then the lender can
recover the liability from the owner as the owner and business are not different entities i.e.
liability of owners is unlimited in a sole proprietorship business.

ii. Partnership

In a partnership firm the business can be started by two or more persons. Partnerships are
registered under Indian Partnership Act 1932. The rights and obligations of partners are
governed by Partnership Deed and profits are shared in the ratio of capital contributed by them.
Legally business and partners are considered as same entity. Therefore, liability of partners is
unlimited. As the business and partners are same entity, therefore, income of business is treated
as personal income of partners and taxed only once, in the hands of partners.

iii. Limited Liability Partnership

Limited Liability Partnership Act was passed in India in the year 2008. In Limited Liability
Partnership firms, the liability of partners is limited. The firms registered under this act are
considered as separate entity i.e. in the eyes of law the partners are different, and business is
 different. Therefore, the business is responsible to repay its liability and liability of partners is
limited to the capital contributed by them.

iv. Companies

A company is a registered legal entity under Companies Act 2013 or Companies Act 1956,
defines as:

‘‘A registered association which is an artificial legal person, having an independent legal, entity
with perpetual succession, a common seal for its signatures, a common capital comprised of
transferable shares and carrying limited liability.’’

The companies can be registered as any of the following type under this act:

a) One Person Company

Section 2(62) of Companies Act defines a one-person company as a company that has only one
person as to its member. Furthermore, members of a company are nothing but subscribers to
its memorandum of association, or its shareholders. So, an OPC is effectively a company that
has only one shareholder as its member.

Since an OPC is a separate legal entity distinguished from its promoter, it has its own assets and
liabilities. The promoter is not personally liable to repay the debts of the company.

b) Private Limited Company

A Private Ltd Company is registered as a separate legal entity under Companies Act. There are
minimum 2 members and maximum 200 members and business are privately held by these
members/shareholders i.e. they can raise the capital only from these many members. These
shares can be transferred privately among maximum permissible number of shareholders. The
liability of Shareholders is limited to the capital contributed. The company enjoys the perpetual
succession. It can buy and sell the property in its name. It has a common seal and act through
Board of Directors.

c) Public Limited Company

A Public Ltd. Company has minimum 7 members and there is no limit to maximum number of
shareholders. The public limited company enjoys all the benefits available to a Private Ltd.
Company, in addition, they can raise the funds from unlimited members in the form of capital.
Therefore, a Public Ltd. firm can also raise the funds from the general public in the form of
share capital. Once a company raises the capital from general public, the shares are required to
be listed on a stock exchange and to be made available for trading. The Public Ltd. Company is
accountable to its investors and therefore, it has to keep informed its investors about its
financials. It is required to publish its audited results annually and unaudited results on
quarterly basis.
1.4 Financial Statements

Complete set of Financial Statement include the following:

i. Balance Sheet

A balance sheet is a statement of the financial position of a business that lists the assets, liabilities,
and owner's equity at a particular point in time. In other words, the balance sheet illustrates your
business's net worth.

ii. Income Statement

Also known as the profit and loss statement or the statement of revenue and expense, the income
statement primarily focuses on the company's revenues and expenses during a particular period.

iii. Statement of Shareholder’s Equity

Statement of Changes in Equity is the reconciliation between the opening balance and closing
balance of shareholder's equity. It is a financial statement which summarises the transactions
related to the shareholder's equity over an accounting period

iv. Notes to Accounts

Notes to accounts of financial statements consist of details related to the information mentioned in
the main body of financial statements.

v. Cash Flow Statement

A cash flow statement provides information about the changes in cash and cash equivalents of a
business by classifying cash flows into operating, investing and financing activities.

1.5 Elements of Income Statement

Income Statement is also known as Statement of Profit and Loss. It provides the information about
the profit or loss of a business entity over a financial year. If the income during the year is more than
expenses, then it results into profits and vice-versa. The components of Income and Expenses are as
follows:
Fig. 1.1 Elements of Income Statement

Statement of
Profit & Loss

Income Expenses

Manufacturing,
Operating & Non Administrative,
Income from Cash & Non-Cash
Other Income Operating Selling &
Operations Expenses
Expenses Distribution
Expenses

i. Income

Income is the money received by sale of goods & services and investments made. The income results
into increase in equity. Income is classified as follows:

a. Revenue
b. Other Income

Revenue:

Revenue is the income earned by the business through sale of goods and services i.e. through its
ordinary business activities. For example, a firm involved in the business of clothes will get the
revenue from sale of cloth, a real estate developer will earn the revenue by sale of property and a
bank will earn the revenue in the form of interest.

Other Income:

Other income is the income earned by an entity from the sources other than its ordinary business
activities. For example, income received in the form of interest received, rent received, dividend
received, capital gain on the sale of investments etc.

ii. Expenses

Expense is the cost incurred by the business to generate the revenue and to run the business. The
expenses can be classified in the following manner:

a. Manufacturing, Administrative, Selling & Distribution Expenses

b. Operating and Non-Operating Expenses
c. Cash and Non-Cash Expenses
 Manufacturing, Administrative, Selling & Distribution Expenses

Based on the function, expenses can be classified as Manufacturing, Administrative, Selling &
Distribution Expenses. Manufacturing expenses include material expense, wages, carriage inward,
power and fuel etc. Administrative expenses include office rent, electricity, salary, stationary, repair
& maintenance etc. Selling & Distribution expenses include advertising expense, transportation
expense, salesmen travelling expense etc.

Operating and Non-Operating Expenses

Expenses are also categorised as operating and non-operating expense. Operating expense include
every expense which is related to operations of the firm right from purchase to raw material to the
sales of finished goods to customers. It implies that all the manufacturing, admin, selling and
distribution expenses and tax are operating expenses. On the other hand, the finance cost is the
example of non-operating expense because it is related to financing activity and not the operations.
Similarly, loss on sale of old assets is an example of non-operating loss because it is related to
investments and not the operations.

Cash and Non-Cash Expenses

Expenses which results in the cash outlay for example rent expense, salary, purchase are the cash
expenses. The non-cash expense does not result into cash outflow. Depreciation is the primary
example of non-cash expense. Depreciation is the decline in the value of an asset. Depreciation is
caused by the time, usage, wear and tear etc. For example, if you purchase a machinery for rupees
10,00,000 then after one year its value is expected to go down. Though this decline will not result
into any cash outlay but the decline in value of machinery should be recorded as expense in the form
of depreciation

iii. Net Profit

When a company’s income is more than expenses then it earns profit and vice versa. This profit can
be either distributed among the shareholders or it can be retained in the business for future
expansion. The distributed portion of profits among shareholders is called dividend. The portion of
profits which is retained in the business is called retained earnings and it is used for the future
growth of the firm.

Concept of Capital and Revenue Expenditure

You should also have the clarity about capital and revenue expenditure. The benefit of revenue
expenditure exhausts within the accounting year in which they are incurred. They are hey recurring
in nature and involve relatively smaller amount of money. They are treated as expense in the profit
and loss statement of the year. The example of revenue expenditure is purchase of raw material,
payment of salaries, rent etc. On the other hand, capital expenditures involve large sums of money,
they are non-recurring in nature and their benefit will continue beyond the financial year in which
they are incurred and therefore they are treated as assets in the balance sheet. The example of
capital expenditure includes purchase of machinery land building etc.
 1.6 Elements of Balance Sheet

Balance Sheet is a financial statement that summarizes a company’s assets, liabilities and
shareholders’ equity at a specific point in time. These three balance sheet segments give investors
an idea as to what the company owns and owes, as well as the amount invested by the
shareholders.

The components of Balance Sheet are shown with the help of following diagram:

Fig. 1.2 Elements of Balance Sheet

Balance
Sheet

Assets Liabilities Equity

Non-Current Non-
Tangible and Current Share Reserves &
and Current Current
Intangible Assets Liabilities Capital Surplus
Assets Liabilities

Non-
Current Tangible Intangible
Current
Assets Assets Assets
Assets

i. Assets

Assets are the resources that a company owns that have economic value. This typically means they
can either be sold or used by the company to make products or provide services that can be sold.
Assets include physical property, such as plants, trucks, equipment and inventory etc. It also includes
resources that can’t be touched but nevertheless exist and have value, such as trademarks and
patents. Cash itself is an asset, so are investments which a company makes.

Assets can be classified as:

a. Non-Current and Current Assets

b. Tangible and Intangible Assets
Non-Current Assets:

Assets which provide the benefit to the firm for a longer period normally more than a year are
treated as Non-Current Assets. There are different types of Non-Current Assets which includes Plant
& Machinery, Building, Furniture etc.

Current Assets:

Current Assets are the economic resources owned and controlled by an entity and which exhaust
either for a period of less than 12 months or length of operating cycle whichever is longer. The
Operating cycle is the period of conversion of Raw material into finished goods, sale of these goods
and collection of cash from the customers. The components of current assets include Inventory,
Debtors and Bills Receivables, Loans and Advances, Deferred or Prepaid Expenses, Cash and Cash
Equivalent etc.

Tangible Assets:

Tangible assets are the economic resources which are owned and controlled by the business, which
we can touch, feel or see. the examples of tangible assets are building, machinery, furniture etc.

Intangible Assets:

intangible assets are the economic resources which are owned and controlled by the firm which
provide the benefits to the firm, but they cannot be touched or seen. The examples of intangible
assets are patents, copyrights, goodwill, trademarks, software etc. As per accounting rules except
the software, self-generated intangible assets cannot be recorded in the books of account. If the
organization has acquired these assets by paying the consideration, then only they can be recorded
in the books of account.

ii. Liabilities

Liabilities are amounts of money that a company owes to others. This can include all kinds of
obligations, like money borrowed from a bank to launch a new product, money owed to suppliers
for materials, payroll a company owes to its employees, taxes owed to the government. Liabilities
also include obligations to provide goods or services to customers in the future.

a. Non-Current and Current Liabilities

Non-Current Liability:

Non-Current liabilities are the financial obligations which the firm has to repay over a longer period
of normally more than one year. The components of noncurrent liabilities include long term
borrowings, Other Liabilities

Current Liabilities:

Current liabilities are the financial obligations which the firm has to repay normally within a period
of 12 months. The components of current liabilities include Creditors and Bills Payable, Short Term
Borrowings, Other Current Liabilities
iii. Shareholder’s Equity

Shareholders’ equity is sometimes called capital or net worth. It’s the money that would be left if a
company sold all its assets and paid off all its liabilities. This leftover money belongs to the
shareholders, or the owners, of the company.

The components of shareholder’s equity are as follows:

a. Share Capital

Share Capital is the money contributed by the shareholders (owners) of the firm. In a company, the
capital of firm can be contributed by numerous shareholders which include promoter and others. In
a public Ltd company, the shares can be floated among the general public through a public issue for
raising the funds.

The price at which shares are issued to shareholders is called `issue price the issue price has 2
components face value and premium face value is the nominal value of shares which is used for
accounting purpose normally the shares have the face value of rupees 10 , rupees 5 and rupees 2
hey in the books account the share capital is recorded at face value and calculated as number of
shares multiplied by face value the premium is the price charged over and above the face value from
the shareholders

b. Reserves and Surplus

Reserves and Surplus include the claims of shareholder other than capital contributed by them in the
business. As discussed earlier, retained earnings is the portion of profits which is retained in the
business for future growth. These retained earnings are transferred to specific reserves to meet
specific future payments. If a firm create the reserves for general purpose, to meet any future
expenses, this is known as general reserve. if the firm creates reserve for repayment of debentures
in future at the time of maturity, then the reserve is called debenture redemption reserves. Reserves
and surplus represent the accumulated profits over several years on which the shareholders have
the claim. Therefore, these reserves and surplus is shown as the part of shareholders fund.

Reserves can be categorised as revenue reserve capital reserve. if a reserve is created from revenue
profits that is from yearly profits then it is called revenue reserve. Examples of revenue reserves
include general reserve, debenture redemption reserve etc. On the other hand, if the reserve is
created from a capital transaction then it is called capital reserve. An example of capital reserve is
share premium reserve which is created from the premium received on the shares issued by the
form to the shareholders over A share is said to be issued at premium, if the issue price is over and
above the face value of share.

1.7 Accounting Equation

The balance sheet shows:

Assets = Liabilities + Shareholders’ Equity

This equation shows that the sources to finance the assets of business are either in the form of
owned funds (shareholders’ equity) or borrowings (liabilities).
 This is known as accounting equation and this shows the dual aspect of recording of transactions.
This equation remains balanced after every transaction. It can be understood with the example of
following four transactions:

Example: Transaction 1: Capital Introduced in the business Rs 100000

Transaction 2: machinery purchased worth rupees 50,000

transaction 3: building purchase worth rupees 5 lacs through a loan

Transaction 4: sales rupees 40,000

the impact of these transactions can be shown on accounting equation as follows:

Transaction Assets = Shareholder’s equity + Liabilities

1 Cash 100000 = Capital 100000 + 0

2 Cash 50000 = Capital 100000 + 0

Machinery 50000
3 Cash 50000 = Capital 100000 + Loan 500000
Machinery 50000
Building 500000
4 Cash 90000 = Capital 140000 + Loan 500000
Machinery 50000 (Capital rises by income
Building 500000 through sales)

1.8 Overview of Important Accounting Concepts and their Implications

In order to maintain uniformity and consistency in preparing and maintaining books of accounts,
certain rules or principles are followed. These rules/principles are known as accounting concepts and
conventions. These are foundations of preparing and maintaining accounting records. The important
accounting principles are described as follows:

Separate Entity

The business is considered as separate legal entity from its owners. Based on this concept, the
capital contributed by the shareholders is considered as liability on the business because
shareholders are separate entity and business is a separate artificial legal entity

Money Measurement

As per money measurement concept the transactions are to be recorded in terms of money. Only
the transactions which can be measured in monetary terms should be recorded. Any transaction or
event, however, important it could be but if it can't be measured in monetary terms it cannot be
recorded in accounts. For example, if a key executive exits from a company then it may have a huge
impact on the firm because of loss of leadership but this loss can’t be recorded in accounts.
Dual Aspect

As per dual aspect concept, every transaction has two sides that it affects, and both the aspect of
each transaction should be recorded. for example, if Rs 5000 rent is paid then we should record that
rupees 5000 cash is paid on account of rent expense, so the entry will be recorded in cash account as
well as rent account

Realization

Realization concept says that generally the income should be realised in books of account when the
organization has delivered the goods and therefore has earned the income and payment is
reasonably certain

Accrual

Is most important concept in accounting and is the backbone of our accounting system. As per
accrual concept the incomes and expenses are recorded as and when they are accrued irrespective
of payment or receipt of cash. It is only based on this concept that credit sales made in the year is
recorded as income of the year, though the collection from customers may be received in next
financial year. Another example of application of accrual can be that the rent express of the year has
to be recorded in full, though, some rent might be outstanding at the end of the year. I would like to
reinforce the concept that we record incomes and expenses on accrual basis and not on cash basis.

Matching

As per matching concept there should be cause and effect relationship between the expenses and
income. It implies, that against the income those expenses should be matched which are giving rise
to income to calculate the profits. However, in modern accounting system we divert from this
concept in some cases. if an expense has been incurred in the year then it is matched against the
income of this year though the exact cause and effect relationship might not exist. The example of
such exceptions are research and development expense, repair and maintenance expense etc.

Prudence

As per this concept we should anticipate for any losses, but the income should not be anticipated. It
implies that all the estimated losses should be provided for accounting purpose and profit should be
reduced by that amount. In other words, we can say that bad news should travel fast while the good
news should not flow, it should be restricted till it happens.

if an organization anticipates that it will not be able to collect some credit sales from its customer
then based on past experience it should create a provision for doubtful debts as a percentage of the
total amount of debtors. However, a sales order received by organization cannot be shown as
income.

Substance over Form

While recording the transactions, the substance should precede over form of the transaction It
means transactions should be recorded from their actual impact and not the form which appears.
For example, a transaction might appear to be a sale, but it might be a borrowing arrangement. If
the sale is followed by future purchase of similar goods and at pre-specified price, then the
transaction should be recorded as liability and not as sales

Materiality

As per materiality concept only the details which are material and relevant should be incorporated in
accounts while irrelevant details can be avoided, while recording the transactions.

Reliability or Verifiability

Reliability concept implies that the transaction recorded in accounts should be verifiable by
objective evidence.

Consistency

Consistency principle says that there should be consistency in accounting policies for recording the
transactions otherwise financial statements can be misleading for the user. For example,
depreciation can be recorded by two methods. If a firm is using one method of depreciation, then it
should consistently use this method and if there is a need to change the method then reason should
be notified and new method should be followed consistently in future else it will lead to the
confusion for user of financial statement.

Let Us Sum Up:

Accounting is the language of business to communicate with outside world. All the stakeholders of a
business look at financial statements to get the information about the company. There are many
users of accounting information, which include owners, lenders, creditors, government, employees,
customers and society. The business can be of different types which include sole proprietor,
partnerships, limited liability partnership, private limited companies and public limited companies.
these businesses differ in terms of liability of owners whether it is limited or unlimited and w.r.to
their capacity to raise funds. A business prepares the financial statements at the end of accounting
period which include balance sheet, income statement, statement of shareholders equity, cash flow
statement and notes to account. Income statement provides the details of income and expenses of
the business for a year, the profit made, or losses incurred by the business. Balance sheet provide
the financial position of the business at the end of accounting year it gives the details of assets and
liabilities of the business. Balance sheet equation depicts that assets are equal to capital plus
liabilities. this implies that assets are funded by either the funds provided by owners or through
borrowings by the firm. it also indicates that there are two claimants for the assets of business
namely, equity providers and debt providers. In preparation of financial statements certain
commonly accepted principals and concepts are followed which brings uniformity to the statements
and provides a foundation to prepare accounting records. the important principles include accrual,
cost, dual aspect, realization and matching concept.
Key Terms

Transaction: Exchange of goods and services

Asset: the economic resources owned and controlled by the business

Liabilities: obligations of business

Equity: the owners claim in the business

Capital: money contributed by the owners in the business

Retained earnings: the profits retained by the business

Dividend: the proportion of profits distributed by the firm to the owners/shareholders

Revenue: the income generated from the sale of good and services by the business

Expenses: the cost incurred by the business to generate revenue

Shareholders: providers of ownership capital in the business

Lenders: providers of debt capital in the business

Sole proprietorship: the business owned and controlled by a single person

Partnership: the business run by two or more partners and registered under partnership act as
partnership firm

Company: A business established under Companies Act 2013 or 1956. A company is a separate legal
entity and the liability of shareholders is limited to the amount of capital contributed.

Accrual: the process of recording the incomes and expenses as they arise irrespective of receipt and
payment of cash

Additional Learning Resources:

https://www.icai.org/post.html?post_id=15583

http://ncert.nic.in/textbook/textbook.htm?keac1=1-8

https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=23

http://ugcmoocs.inflibnet.ac.in/ugcmoocs/view_module_ug.php/226

https://nptel.ac.in/courses/110/101/110101131/
Unit 2: Accounting Process

After completing this unit, you will be able to understand:

1. the method of recording the transactions in Journal
2. the mechanism of posting the transactions recorded in Journal to relevant account
created in Ledger
3. preparation of trial balance with the help of account balance at the end of accounting
period

2.1 Introduction to Accounting Process:

Accounting Process begins with the systematic recording of all the monetary transactions of a
business entity and further processing of same to arrive at the final accounts of the firm.

Fig 2.1: Accounting Process

• Recording of Transactions in Journal by applying rules of Debit & Credit

Journal

• Posting of transactions recorded in journal to relevant account created

Ledger in ledger

• Preparation of trail balance with the help of account balances calculated

Trial at the end of accounting period
Balance

• Preparation of trading and P&L account and Balance Sheet with the help
Financial of Trial Balance and adjustments, if any
Statements

Various steps of accounting process are explained in the following sections:

2.2 Recording of Transactions: Journal

All the transactions of a business are recorded in the books of original entry, known as journal. The
transactions are recorded in a systematic manner and in line with the accounting concepts and
principles. In order to understand the recording of transactions, we should understand the language
of accounting in the form of Debit (Dr) and Credit (Cr), classification of accounts and rules of
recording for different types of accounts.

For the purpose of recording, all the transactions/items of a business can be classified in any one of
the following five types of accounts:

a. Asset
b. Liability
c. Equity
d. Income
e. Expense

The rules for recording these accounts are as follows:

i. Every increase in asset is recorded as debit (Dr)

ii. As the liability has opposite nature to assets, the rule is opposite i.e. every increase in
liability is recorded as credit (Cr)
iii. Liability and Equity both are sources of funds for business hence they are recorded in
similar manner i.e. increase in equity is recorded as credit (Cr)
iv. Every income gives rise to equity. It implies income and equity moves in same direction.
Following this rule for equity and income is same and income is recorded as credit (Cr)
v. As the expense has opposite nature to income, the rule is opposite i.e. expense is
recorded as debit (Dr)

The rules for decrease in these accounts are opposite. We can summarize the rules for recording
these accounts as follows:

Account Increase is recorded as Decrease is recorded as

Asset Dr Cr
Liability Cr Dr
Equity Cr Dr
Income Cr Dr
Expense Dr Cr

In order to record the transactions in journal, following steps are required:

i. Identify the two-account involved in the transaction

ii. Identify the nature of both accounts whether they are assets, liabilities, equity, income
or expense
iii. identify which account is increasing or decreasing
iv. apply the rule of recording on both the account as described above

Example 2.1:
Let us record the transactions of Wealth Ltd. for the month of Jan’2020 in the journal of the
company, following these rules of recording:

Jan 1 Opening Balance:

Building 500000, Machinery 300000, Stock 50000, Alpha Ltd (Dr) 165000, Cash 200000, Bank
200000, Loan 400000, Money Ltd. (Cr)200000, Gama Ltd. (Cr) 100000

Jan 2 Goods purchased worth Rs 50000

Jan 5 Goods purchased worth Rs 100000 from Money Ltd.

Jan 7 Sold goods worth Rs 200000

Jan 8 Sold goods worth Rs 150000 to Beta Ltd

Jan 9 Paid Rs 200000 to Money Ltd towards the settlement of liability at the beginning of month

Jan 10 Paid Insurance Premium Rs 50000 by cheque

Jan 11 Paid Rent Rs 180000 by cheque

Jan 13 Received Rs 165000 from Alpha Ltd, due on them on Jan 1

Jan 14 Paid Rs 98000 to Money Ltd. by cheque in full settlement of dues to them

Jan 15 Deposited Rs 50000 in bank

Jan 16 Received Rs 147500 from beta Ltd by cheque in full settlement of their dues. Cheque
deposited in bank.

Jan 18 Paid for stationary Rs 10000

Jan 20 Cheque received from Beta Ltd was dishonoured

Jan 22 Sold old Machinery worth Rs 10000 for Rs 12000 in cash

Jan 25 Purchased furniture worth Rs 100000 from B Ltd

Jan 28 Depreciation on Building Rs 10000

Jan 30 Paid Salary Rs 100000

Jan 31 Paid Rent Rs 50000

Solution:

The transactions are recorded in the Journal of Wealth Ltd. for the month of Jan’2020 in the
following manner:

Date Transaction Debit (Rs) Credit (Rs)

Jan.

1. Building A/c 500000

Machinery A/c 300000
Stock A/c 50000
Alpha Ltd (Dr) A/c 165000
Cash A/c 200000
Bank A/c 200000
To Loan A/c 400000
To Money Ltd. (Cr) 200000
To Gama Ltd. (Cr) 100000
To Capital A/c 715000
2. Purchase A/c Dr 50000
To Cash 50000
5. Purchase A/c Dr 100000
To Money Ltd. 100000
7. Cash A/c Dr 200000
To Sales 200000
8. Beta Ltd. A/c Dr 150000
To Sales 150000
9. Money Ltd. A/c Dr 200000
To cash 200000
10. Insurance Premium A/c Dr 50000
To Bank 50000
11. Rent A/c Dr 180000
To Bank 180000
13. Cash A/c Dr 165000
To Alpha Ltd. 165000
14. Money Ltd. A/c Dr 100000
To Discount Received A/c 2000
To cash 98000
15. Bank A/c Dr 50000
To Cash 50000
16. Bank A/c Dr 147500
Discount Allowed A/c Dr 2500
To Beta Ltd. 150000
18. Stationary A/c Dr 10000
To Cash A/c 10000

20. Beta Ltd. A/c Dr 150000

To Discount Allowed A/c 2500
To Bank A/c 147500
22. Cash A/c Dr 12000
To Profit on Sale of Machinery A/c 2000
To Machinery A/c 10000
25. Furniture A/c Dr 100000
To B Ltd. 100000
28. Depreciation A/c Dr 10000
To Building A/c 10000
30. Salary A/c Dr 100000
To Cash A/c 100000
31. Rent A/c Dr 50000
To Cash A/c 50000
Total 3242000 3242000

2.3 Preparation of Accounts: Ledger

Once the transactions are recorded in journal then it has to be posted in the ledger. In ledger there
is separate account for each item. An account is prepared in T-shape with debit entries on left hand
side and credit entries on right hand side. The opening balances of assets, and expenses will be
posted to debit side of account and for liabilities, equity and income accounts, opening balances will
be posted to credit side of account. Based on journal entries, posting will be done on debit/credit
side of different accounts. All the transactions pertaining to an account are posted to its ledger
account. Closing balance of each account is calculated at the end of period by taking the difference
of both the sides of account. Closing balance of account will be written on the side where the total is
less than the other side. Let us create the ledger accounts for the transactions recorded in example
2.1

Ledger Posting of Journalized Transactions of Example 2.1:

Dr Cash A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 To Balance b/d 200000 2 By Purchase 50000
7 To Sales 200000 9 By Money Ltd. 200000
13 To Alpha Ltd. 165000 14 By Money Ltd. 98000
22 To Machinery 10000 15 By Bank 50000
To Profit on Sale of
22 2000 18 By Stationary A/c 10000
Machinery
30 By Salary 100000
31 By Rent 50000
31 By Bal c/d 19000
577000 577000

Dr Bank A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
By Insurance
1 To Balance b/d 200000 10 50000
Premium
15 To Cash 50000 11 By Rent 180000
16 To beta Ltd. 147500 20 By Beta Ltd. 147500
31 By Bal c/d 20000
397500 397500

Building A/c
Dr Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 To Balance b/d 500000 28 By Depreciation 10000
31 By Bal c/d 490000
500000 500000

Furniture A/c
Dr Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
25 To B Ltd. 100000
31 By Bal c/d 100000
100000 100000

Dr Machinery A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 To Balance b/d 300000 22 By Cash 10000
31 By Bal c/d 290000
300000 300000

Dr Profit on Sale of Machinery A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
22 By Cash 2000
31 To Balance c/d 2000
2000 2000

Dr Purchase A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 To Opening Stock 50000
2 To Cash 50000
5 To Money Ltd. 100000 31 By Bal c/d 200000
200000 200000

Dr Rent A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
11 To Bank 180000
31 To Cash 50000
31 By Bal c/d 230000
230000 230000

Dr Salary A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
30 To Cash 100000
31 By Bal c/d 100000
100000 100000

Dr Insurance Premium A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 To Bank 50000
31 By Bal c/d 50000
50000 50000

Dr Stationary A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
18 To Cash 10000
31 By Bal c/d 10000
10000 10000

Dr Depreciation A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
28 To Building 10000
 31 By Bal c/d 10000
10000 10000

Dr Discount Allowed A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
16 To Beta Ltd. 2500 20 By Beta Ltd. 2500
2500 2500

Dr Sales A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
7 By Cash 200000
31 To Balance c/d 350000 8 By Beta Ltd. 150000
350000 350000

Dr Discount Received A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
14 By Money Ltd. 2000
31 To Balance c/d 2000
2000 2000

Dr Alpha Ltd. A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 To Bal b/d 165000 13 By Cash 165000
31 By Bal c/d 0
165000 165000

Dr Beta Ltd. A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
8 To Sales 150000 16 By Bank 147500
 By Discount
20 To Discount Allowed 2500 16 2500
Allowed
20 To Bank 147500 31 By Bal c/d 150000
300000 300000

Dr Money Ltd. A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
9 To Cash 200000 1 By Bal b/d 200000
31 To Balance c/d 0
200000 200000

Dr Gama Ltd. A/c Cr

Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 By Bal b/d 100000
31 To Balance c/d 100000
100000 100000

Dr B Ltd. A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
25 By Furniture 100000
31 To Balance c/d 100000
100000 100000

Dr Loan A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 By Bal b/d 400000
31 To Balance c/d 400000
400000 400000

Dr Capital A/c Cr
Date Amount Date Amount
Particulars Particulars
Jan. (Rs) Jan. (Rs)
1 By Bal b/d 715000
31 To Balance c/d 715000
 715000 715000

2.4 Trial Balance

AT the end of accounting period all ledger accounts are closed, and account balances are calculated.
Trial Balance is a list of all the accounts in which account balances at the end of period are
mentioned in the debit and credit columns. The assets and expenses have the debit balance.
Liabilities, Equity and Incomes have the credit balances. Let us create the trial balance with the help
of ledger account balances calculated for example 2.1:

Trial Balance of Wealth Ltd. As on 31st Jan'2020

Account Debit (Rs) Credit (Rs)
Cash 19000
Bank 20000
Building 490000
Machinery 290000
Furniture 100000
Purchase 200000
Sale 350000
Rent 230000
Stationary 10000
Insurance Premium 50000
Salary 100000
Discount Received 2000
Depreciation 10000
Profit on Sale of Machine 2000
Beta Ltd. 150000
Gama Ltd. 100000
B Ltd. 100000
Loan 400000
Capital 715000
Total 1669000 1669000

The trial balance enlists all the account balances at the end of accounting period. Because each
transaction has two aspects and both the aspects are recorded, therefore for every debit entry there
is a corresponding credit entry. This leads to total of debit column being equal to total of credit
column
With the help of trial balance, financial statements of the entity are prepared. we'll cover the
preparation of trading account, profit & loss account and balance sheet in next unit.

Let Us Sum Up:

The process of accounting begins with the recording of transactions in the books of original entry
known as ‘Journal’. The transactions are recorded by following the rules of debit and credit. Every
transaction has two aspects i.e. it involves two or more accounts and both the aspects are recorded.
All the transactions results into any of the five type of accounts namely, assets, liabilities, equity,
income and expenses. in order to record a transaction, the first step is to identify which accounts are
involved in the transaction and then they are recorded by applying the rules of debit (Dr) and credit
(Cr). If there is an increase in the asset it is debited, liabilities and equity are credited for every
increase. Because every income gives rise to equity therefore rules are similar, and it is credited. The
expenses have opposite nature to income, and they are debited. For decrease side in all the
accounts the rules are just opposite.

once the transactions are recorded in the Journal then they are posted to different accounts in the
book of principal entry known as Ledger. In the Ledger separate account is open for each item for
example Ledger will have cash account, bank account, sales account, purchase account, rent
account, capital account etc. The account is created in T form in which left hand side is debit side
and right had side is credit side. The entries from journal are posted to these accounts based on
same rules. Increase in assets and expenses are recorded on debit side of account and vice-versa.
Increase in Liabilities, Equity and Income is recorded on credit side of account and vice-versa. At the
end of accounting period all the accounts are balanced, and their closing balances are calculated by
taking the difference of smaller side from the total of larger side. These account balances are used to
prepare list of all the accounts with their closing balances, this list is known as trial balance. Trial
balance is the beginning point for the preparation of final accounts of the business which include
income statement and balance sheet.

Key Terms:

Transaction: The exchange of goods and services

Journal: the book of original entry

Ledger: the book of principal entry

Trial balance: a list of all the account balance at the end of accounting period

Debit: in recording the transactions, debit implies increase, for assets and expenses and decrease
for capital, liability & income

Credit: in recording the transactions credit implies increase for equity, liability & income and
decrease for assets and expenses

Additional Learning Resources:

For more details on accounting process, you can refer the following link

https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=23

This link will take you to UGC e-PG Pathshala page for management programme. Select the
Accounting & financial Analysis paper from the drop-down list of papers. Select the relevant module
from the list of modules and watch the self-learn and refer the other study resources.

https://www.icai.org/post.html?post_id=15583
Unit 3: Final Accounts
Learning Outcomes

After completing this unit, you will be able to

1. Understand the meaning and importance of financial statements

2. Prepare the Trading and Profit & Loss Account of a business
3. Prepare the Balance Sheet

3.1 Introduction to Financial Statements

It is important for a business to know how much profit it has made in past year or how much losses it
has incurred. For Example, If the business is not doing well, then the corrective course of action is
required to be taken. The knowledge of past profitability is important for this. It is also equally
important to know how much balances of assets and liabilities it has at the end of year, with which
business will commence for next accounting period. If the expansion is being planned, then it is
important to know the position of assets. The mix of equity and debt used in the business will have a
bearing on future sources of fund. If a business has low debt, then it has low financial risk, therefore,
it will be able to raise funds at low cost in future. If a business has enough cash on its balance sheet,
then it provides it flexibility in operations. All such information is available in financial statements
and required for future planning and management of firm.

Preparation of final accounts begin with the help of trial balance. Trial Balance give the balances of
all the accounts which can be recognized as Assets, Liabilities, Equity, Income and Expenses. The
Assets and Liabilities are used to prepare the balance sheet of business. Income and expenses are
transferred to Income Statement to calculate profit/loss. The Income statement can be divided into
trading and Profit and Loss Account.

Trading Account

Trading Account is prepared to assess the gross profit made by the business in an accounting period.
Gross profit is calculated as the difference between sales and cost of goods sold (CoGS):

Gross Profit = Sales – CoGS

Where, CoGS is the manufacturing cost of goods sold by the firm. CoGS includes material cost and all
manufacturing expenses.

Cost of Goods Sold (CoGS) = Material Cost + Manufacturing Expenses

CoGS= (opening stock + purchases -closing stock) + Wages + Power & Fuel + Carriage Inward + any
other manufacturing expense

Profit and Loss Account

Profit & Loss Account is prepared to calculate the Net Profit of business by deducting all expenses
other than manufacturing expenses from gross profit. These expenses include administrative
expenses, selling & distribution (S&D) expenses, finance cost etc. Finally, if there is any income from
sources other than Sales then it is added to arrive at net profit. The example of other income
includes interest received, dividend received, any capital gains, rent received etc.

Net Profit = Gross Profit +Net Other Income – Expenses Other than Manufacturing Expenses

or

Net Profit = Gross Profit + Net Other Income – Admin Expenses – S&D Expenses -Finance Cost – Tax

Balance Sheet:

Balance sheet is prepared to assess the financial position of business at the end of accounting
period. All the assets, liabilities and equity values given in trial balance are posted to balance sheet.
The net profit calculated in P&L account is added to equity in balance sheet.

Adjustments:

The accrual system of accounting requires adjustments for accrued income and outstanding
expenses (accruals). Moreover, preparation of a profit and loss account requires matching of income
and expenses. These require adjustments for income received in advance and prepaid expenses.
Some more adjustments are required to present a true and fair view of the operating result for the
reporting period and the financial position at the end of the reporting period. Adjustment entries are
passed through the journal proper. The Trial Balance is prepared before these adjustment entries;
therefore, these adjustments are not reflected in trial balance. The accounts balance of income and
expenses, which appear in trial balance are transferred to Income Statement and balance of assets
and liabilities appearing in trail balance are transferred to balance sheet. The passing of adjustment
entries will give rise to dual effect of these adjustments in final accounts i.e. in both the accounts
impacted. Therefore, these adjustments, normally impact income statement as well as balance
sheet. The treatment of important adjustments is provided below:

Adjustment Income Statement Balance Sheet

Accrued expense Added to respective expense Shown as liability

Accrued Income Added to respective income Shown as asset

Deferred expense Deducted from respective expense Shown as asset
Deferred Income Deducted from respective income Shown as liability
Closing Stock Added to Income side in Trading Shown as asset
Account
Depreciation Shown on expense side of P&L Account Shown as deduction from Asset
Provision for Shown on expense side of P&L Account Added to accumulated
depreciation depreciation and shown as
deduction from Asset
Provision for bad debts Shown on expense side of P&L Account Shown as deduction from
(as a claim on profits) Debtors
Provision for Discount Discount is given to only sound debtors. Shown as deduction from
on debtors Therefore, first provision for bad debts Debtors
is deducted from debtors and then
discount rate is applied to calculate the
discount, to be shown as expense
Note: (i) The terms, accrued/due/outstanding /unpaid have similar implications
(ii) The terms, deferred/unexpired/prepaid/advance implies similar meaning

3.2 Trading and Profit and Loss Account

Let us prepare the Trading Account and Profit & Loss Account of a business in T account form with
the help of trial balance given in example 3.1

Example 3.1: Trial Balance of Moon & Co is provided below for the accounting year ending on 31st
March’2020

Account Debit (Rs) Credit (Rs)

Building 700000
Machinery 500000
Opening Stock 10000
Debtors 115000
Bills Receivables 5000
Cash 16000
Bank 30000
Purchase 200000
Purchase Return 5000
Sales 457000
Sales Return 7000
Rent 50000
Salaries 40000
Insurance Premium 20000
Repair & Maintenance 10000
Wages 23000
Power & Fuel 20000
Interest Received 14000
Commission Received 12000
Carriage Inward 5000
Travelling Expenses 9000
Freight Outward 2000
Profit on the sale of Machinery 4000

Capital 600000
Drawings 10000
4% Loan from SBI 500000
Creditors 130000
Bills Payable 50000

Total 1772000 1772000

Adjustments

At the end of year there was Closing Stock worth Rs 5000

The insurance Premium of Rs 4000 was unexpired at the end of year

The Salaries of Rs 20000 was unpaid

The rent includes the advance of Rs 16000 paid for the month of April & May’2020

Depreciation of 5% is to be charged on fixed assets

Interest on loan is due

Create a provision for doubtful debts at the rate of 2% on debtors

Solution:

To prepare the financial statements from the given trial balance, we should mark each account
balance as asset, liability, income, expense and equity.

The account balances marked as income and expenses will be taken to income statement. The
expenses will be recorded on debit side of account while incomes will be recorded on credit side.
The sales and manufacturing expenses will be taken to trading account to calculate gross profit. The
closing balance given in adjustments is taken to income (credit) side of trading account to account
for it as a reduction of purchase account because it has remained unused and will be taken forward
to next year.

The gross profit is transferred to income(credit) side of Profit & Loss account. All the other incomes
from trial balance are also taken to credit side of P&L account while all other expenses are taken to
debit side of P&L account. If the Income is more than expenses, then it results into net profit and
vice-versa.

All the assets, liabilities and equity are transferred to balance sheet. Net profit is added to equity and
net loss will be deducted from equity.

The adjustments are recorded as explained in previous section.

 Trading Account of Moon & Co. for the year ended 31st March'2020
Dr Cr
Amount Amount Amount Amount
Expenses (Rs) (Rs) Income (Rs) (Rs)
To Opening Stock 10000 By Sales 457000
Less: Sales
To Purchases 200000 Return 7000 450000
Less: Purchase By Closing
Return 5000 195000 Stock 5000
To Wages 23000
To Power & Fuel 20000
To Carriage Inward 5000
To Gross Profit 202000
455000 455000

Profit & Loss Account of Moon & Co. for the year ended 31st March'2020
Dr Cr
Amount Amount Amount Amount
Expenses (Rs) (Rs) Income (Rs) (Rs)
To Rent 50000 By Gross Profit 202000
Less: Deferred Rent 16000 34000 By Interest Received 14000
To Salaries 40000 By Commission Received 12000
By Profit on Sale of
Add: Accrued Salaries 20000 60000 Machinery 4000
To Insurance
Premium 20000
Less: Unexpired
Insurance 4000 16000
To Repair &
Maintenance 10000
To Travelling
Expenses 9000
To Freight Outward 2000
To Depreciation 60000
To Interest 20000
To Provision for
doubtful debts 2300
To Net Profit 18700
232000 232000
Balance Sheet of Moon & Co. as on 31st March'2020

Amount Amount Amount Amount

Liabilities (Rs) (Rs) Assets (Rs) (Rs)
Capital 600000 Building 700000
Add: Net Profit 18700 Less: Depreciation 35000 665000
Less: Drawings 10000 608700 Machinery 500000
Less: Depreciation 25000 475000
Closing Stock 5000
Debtors 115000
Less: Provision for
Loan 500000 Doubtful Debts 2300 112700
Creditors 130000 Bills Receivables 5000
Bills Payable 50000 Cash 16000
Accrued
Salaries 20000 Bank 30000
Accrued
Interest 20000 Unexpired Insurance 4000
Deferred Rent 16000

Total
Liabilities 1328700 Total Assets 1328700

Let Us Sum Up:

The preparation of financial statements is the final step of accounting process. Trial Balance serves
as the base document for the preparation of final accounts. From the trial balance, income and
expenses are transferred to income statement in order to arrive at profit/loss for the accounting
period. Assets, Liabilities and Equity are transferred from trial balance to the balance sheet.

There may be adjustments which implies the transactions/events which took place after the
preparation of trial balance and therefore their impact is not reflected in trial balance. These
adjustments normally include closing stock, accrued income & expenses, deferred income &
expenses, depreciation, provision for bad debts etc. These adjustments are adjusted with the
account pertaining to it and their impact is reflected normally in income statement as well as
balance sheet. The guiding principal for this is, if any income and expense appear in the adjustment
and it belongs to this year then, it should be added to respective account. If it doesn’t belong to the
concerned accounting period, then it should be deducted from the respective account. These
adjustments will also result into a liability/asset and will be shown at the relevant side of balance
sheet. The profit/Loss calculated in income statement is adjusted to equity in balance sheet.

Key Terms:

Trial Balance: a list of closing balances of all the accounts

Adjustments: transactions and events which takes place after the preparation of trial balance and
their effect is not their in trial balance

Accrued Expenses: Expenses which are incurred but payment is due and unpaid at the end of year
Deferred or Unexpired Expense: Payment is made for these expenses, but they will accrue in next
accounting period

Accrued Income: Income which has been earned but not received

Unearned or Deferred Income: Income, which is not earned, but payment has been received in
advance

Depreciation: Decline in the value of an asset in an accounting period

Provision: provisions are an amount set aside from profits to cover a probable future expense, or
reduction in the value of an asset

Additional Learning Resources:

For more details on financial statements you can refer the following link:

https://nptel.ac.in/courses/110/101/110101131/

This link will take you to video lectures of financial accounting course at NPTEL. Select the relevant
modules and watch the lecture and refer the other study resources.

To prepare the final accounts you can refer the relevant modules from video lectures of ICAI for
Principles and Practice of Accounting course with the help of following link:

https://cloudcampus.icai.org/page.html?page_id=931