Introduction
During the accounting period the accountant records
transactions as and when they occur. At the end of each accounting period the
accountant summaries the information recorded and prepares the trial balance
to ensure that the double entry system has been maintained. This is often
followed by certain adjusting entries which are to be made to account the
changes that have taken place since the transactions were recorded. When the
recording aspect has been made as complete and up-to-date as possible the accountant
prepares financial statements reflecting the financial position and the results
of business operations. Thus the accounting process consists of three major
parts:
·
The recording of business transactions during
that period;
·
The summarising of information at the end of the
period and
·
The reporting and interpreting of the summary
information.
The success of the accounting process can be judged from the
responsiveness of financial reports to the needs of the users of accounting
information. This lesson takes the readers into the accounting process.
The Account
The transactions that take place in a business enterprise
during a specific period may effect increases and decreases in assets,
liabilities, capital, revenue and expense items. To make up to-date information
available when needed and to be able to prepare timely periodic financial
statements, it is necessary to maintain a separate record for each item. For
e.g. It is necessary to have a separate record devoted exclusively to record
increases and decreases in cash, another one to record increases and decreases
in supplies, a third one on machinery, etc. The type of record that is
traditionally used for this purpose is called an account. Thus an account is a
statement wherein information relating to an item or a group of similar items
are accumulated. The simplest form of an account has three parts:
i. A title which gives the name of the item recorded in the
account
ii. A space for recording increases in the amount of the
item, and
iii. A space for recording decreases in the amount of the
item.
Rule:
Left side - (debit side)
Right side - (credit side)
Debit And Credit
The left-hand side of any account is called the debit side
and the right-hand side is called the credit side. Amounts entered on the left
hand side of an account, regardless of the tile of the account are called
debits and the amounts entered on the right hand side of an account are called
credits. To debit (dr) an account means to make an entry on the left-hand side
of an account and to credit (cr) an account means to make an entry on the
right-hand side. The words debit and credit have no other meaning in
accounting, though in common parlance; debit has a negative connotation, while
credit has a positive connotation.
Double entry system of recording business transactions is
universally followed. In this system for each transaction the debit amount must
equal the credit amount. If not, the recording of transactions is incorrect.
The equality of debits and credits is maintained in accounting simply by
specifying that the left side of asset accounts is to be used for recording
increases and the right side to be used for recording decreases; the right side
of a liability and capital accounts is to be used to record increases and the
left side to be used for recording decreases. The account balances when they
are totalled, will then conform to the two equations:
1. Assets = liabilities + owners’ equity
2. Debits = credits
|
Debit
Signifies |
Credit
Signifies |
|
1. Increase in asset accounts 2. Decrease in liability
accounts 3. Decrease in owners’ equity
accounts |
1. Decrease in asset accounts 2. increase in liability
accounts 3.increase in owners’ equity
accounts |
From the rule that credit signifies increase in owners’
equity and debit signifies decrease in it, the rules of revenue accounts and
expense accounts can be derived. While explaining the dual aspect of the
concept in the preceding lesson, we have seen that revenues increase the
owners’ equity as they belong to the owners. Since owners’ equity accounts
increase on the credit side, revenue must be credits. So, if the revenue
accounts are to be increased they must be credited and if they are to be
decreased they must be debited. Similarly we have seen that expenses decrease
the owners’ equity. As owners’ equity account decreases on the debit side
expenses must be debits. Hence to increase the expense accounts, they must be
debited and to decrease it, they must be credited. From the above we can arrive
at the rules for revenues and expenses as follows:
|
Debit Signifies |
Credit Signifies |
|
Increase in expenses Decrease in revenues |
Increase in revenues Decrease in expenses |
The Ledger
A ledger is a set of accounts. It contains all the accounts
of a specific business enterprise. It may be kept in any of the following two
forms:
(i) bound ledger and
(ii) loose leaf ledger
A bound ledger is kept in the form of book which contains
all the accounts. These days it is common to keep the ledger in the form of
loose-leaf cards. This helps in posting transactions particularly when
mechanised system of accounting is used.
Journal
When a business transaction takes place, the first record of
it is done in a book called journal. The journal records all the transactions
of a business in the order in which they occur. The journal may therefore be
defined as a chronological record of accounting transactions. It shows names of
accounts that are to be debited or credited, the amounts of the debits and
credits and any other additional but useful information about the transaction.
A journal does not replace but precedes the ledger. A proforma of a journal is
given in illustration 1.
Illustration 1:
|
Date |
Particulars |
L.F. |
Debit |
Credit |
|
2005 August 3 |
Cash a/c dr. To sales a/c |
3 9 |
30,000 |
30,000 |
In illustration 1 the debit entry is listed first and the debit amount appears in the left-hand amount column; the account to be credited appears below the debit entry and the credit amount appears in the right hand amount column. The data in the journal entry are transferred to the appropriate accounts in the ledger by a process known as posting. Any entry in any account can be made only on the basis of a journal entry. The column l.f. which stands for ledger folio gives the page number of accounts in the ledger wherein posting for the journal entry has been made. After all the journal entries are posted in the respective ledger accounts, each ledger account is balanced by subtracting the smaller total from the bigger total. The resultant figure may be either debit or credit balance and vice-versa.
Thus the transactions are recorded first of all in the
journal and then they are posted to the ledger. Hence the journal is called the
book of original or prime entry and the ledger is the book of second entry. While
the journal records transactions in a chronological order, the ledger records
transactions in an analytical order.
The Trial Balance
The trial balance is simply a list of the account names and
their balance as of a given moment of time with debit balances in one column
and credit balances in another column. It is prepared to ensure that the
mechanics of the recording and posting of the transaction have been carried out
accurately. If the recording and posting have been accurate then the debit
total and credit total in the trial balance must tally thereby evidencing that
an equality of debits and credits has been maintained. In this connection it is
but proper to caution that mere agreement of the debt and credit total in the
trial balance is not conclusive proof of correct recording and posting. There
are many errors which may not affect the agreement of trial balance like total
omission of a transaction, posting the right amount on the right side but of a
wrong account etc.
Illustration 2:
January 1 - started business
with rs.3,000
January 2 - bought goods worth
rs.2,000
January 9 - received order for
half of the goods from ‘g’
January 12 - delivered the
goods, g invoiced rs.1,300
January 15 - received order for
remaining half of the total goods purchased
January 21 - delivered goods and
received cash rs.1,200
January 30 - g makes payment
January 31 - paid salaries
rs.210
- received interest rs.50
Let us now analyse the transactions one by one.
January 1 – Started Business With Rs.3,000:
The two accounts involved are cash and owners’ equity. Cash,
an asset increases and hence it has to be debited. Owners’ equity, a liability
also increases and hence it has to be credited.
January 2 – Bought Goods Worth Rs.2,000:
The two accounts affected by this transaction are cash and
goods (purchases). Cash balance decreases and hence it is credited and goods on
hand, an asset, increases and hence it is to be debited.
January 9 – Received Order For Half of The Goods From ‘G’:
No entry is required as realisation of revenue will take
place only when goods are delivered (realisation concept).
January 12 – Delivered The Goods, `G’ Invoiced Rs.1,300:
This transaction affects two accounts – goods (sales) a/c
and receivables a/c. Since it is a credit transaction, receivables increase (asset)
and hence it is to be debited. Sales decreases goods on hand and hence goods
(sales) a/c is to be credited. Since the term ‘goods’ is used to mean purchase
of goods and sale of goods, to avoid confusion, purchase of goods is simply
shown as purchases a/c and sale of goods as sales a/c.
January 15 – Received Order For Remaining Half of Goods:
No entry.
January 21 – Delivered Goods And Received Cash Rs.1,200:
This transaction affects cash a/c. Since cash is realised,
the cash balance will increase and hence cash account is to be debited. Since
the stock of goods becomes nil due to sale, sales a/c is to be credited (as
asset in the form of goods on hand has reduced due to sales).
January 30 - `G’ Makes Payment:
Both the accounts affected by this transaction are asset
accounts – cash and receivables. Cash balance increases and hence it is to be
debited. Receivables balance decreases and hence it is to be credited.
January 31 – Paid Salaries Rs.210:
Because of payment of salaries cash balance decreases and
hence cash account is to be credited. Salary is an expense and since expense
has the effect of reducing owners’ equity and as owners’ equity account
decreases on the debit side, expenses account is to be debited.
January 31 – Received Interest Rs.50:
The receipt of interest increases cash balance and hence
cash a/c is to be debited. Interest being revenue which has the effect of
increasing the owners’ equity, it has to be credited as owners’ equity account
increases on the credit side.
When journal entries for the above transactions are passed, they would be as follows:
|
Date |
Particulars |
L.F. |
Debit |
Credit |
|||
|
Jan. 1 |
Cash A/C Dr. To Capital A/C (Being Business Started) |
3,000 |
3,000 |
||||
|
Jan. 2 |
Purchases A/C Dr. To Cash (Being Goods Purchased) |
2,000 |
2,000 |
||||
|
Jan. 12 |
Receivables A/C Dr. To Sales A/C (Being Goods Sold On Credit) |
1,300 |
1,300 |
||||
|
Jan. 21 |
Cash A/C Dr. To Sales A/C (Being Goods Sold For Cash) |
1,200 |
1,200 |
||||
|
Jan. 30 |
Cash A/C Dr. To Receivables A/C (Being Cash Received For Sale Of Goods) |
1,300 |
1,300 |
||||
|
Jan. 31 |
Salaries A/C Dr. To Cash A/C (Being Salaries Paid) |
210 |
210 |
||||
|
Jan. 31 |
Cash A/C Dr. To Interest A/C (Being Interest Received) |
50 |
50 |
||||
Cash Account
|
Debit |
Rs. |
Credit |
Rs. |
|
To Capital A/C |
3,000 |
By PurchasesA/C |
2,000 |
|
To Sales A/C |
1,200 |
By Salaries A/C |
210 |
|
To Receivables A/C To Interest A/C |
1,300 50 |
By Balance C/D |
3,340 |
|
5,550 |
5,550 |
||
Capital Account
|
Rs. |
Credit |
Rs. |
|||
|
To Balance C/D |
3,000 |
By Cash A/C |
3,000 |
||
|
3,000 |
|
3,000 |
|
||
|
Debit |
Rs. |
Credit |
Rs. |
|
|
|
To Cash A/C |
2,000 |
By Balance C/D |
2,000 |
|
|
|
2,000 |
|
2,000 |
|||
|
Debit |
Rs. |
Credit |
Rs. |
|
|
|
To Balance C/D |
1,300 |
By Cash A/C |
1,300 |
|
|
|
1,300 |
|
1,300 |
|||
|
Debit |
Rs. |
Credit |
Rs. |
||
|
To Balance C/D |
2,500 |
By Receivables A/C By Cash A/C |
1,300 1,200 |
||
|
2,500 |
|
2,500 |
|
||
|
Debit |
Rs. |
Credit |
Rs. |
|
|
|
To Cash A/C |
210 |
By Balance C/D |
210 |
|
|
|
210 |
|
210 |
|||
|
Debit |
Rs. |
Credit |
Rs. |
||
|
To Balance C/D |
50 |
By Cash A/C |
50 |
||
|
50 |
|
50 |
|
||
Trial Balance
|
Debit |
Rs. |
Credit |
Rs. |
|
Cash Purchases Salaries |
3,340 2,000 210 |
Capital Sales Interest |
3,000 2,500 50 |
|
5,550 |
5,550 |
||
CLOSING ENTRIES
The principle of framing a closing entry is very simple. If
an account is having a debit balance, then it is credited and the profit and
loss account is debited. Similarly if a particular account is having a credit
balance, it is closed by debiting it and crediting the profit and loss account.
In our example sales account and interest account are revenues, and purchases
account and salaries account are expenses. Purchases account is an expense
because the entire goods have been sold out in the accounting period itself and
hence they become cost of goods sold out. This aspect would become more clear
when the reader proceeds to the lessons on profit and loss account. The closing
entries would appear as follows:
Journal
|
Particulars |
L.F. |
Debit |
Credit |
|
1 |
Profit And Loss a/c Dr. To Salaries A/C To Salaries A/C |
2,210 |
210 2,000 |
|
2 |
Sales A/C Dr. To Profit And Loss A/C |
2,500 |
2,500 |
|
3 |
Interest A/C Dr. To Profit And Loss A/C |
50 |
50 |
Now profit and loss a/c, retained earnings a/c and balance sheet can be prepared which would appear as follows:
Profit And Loss Account
|
Debit |
Rs. |
Credit |
Rs. |
|
Purchases A/C Salaries A/C Retained Earnings A/C |
2,000 210 340 |
Sales Interest |
2,500 50 |
|
2,550 |
5,550 |
||
|
Debit |
Rs. |
Credit |
Rs. |
|
Balance |
340 |
Profit And Loss A/C |
340 |
|
340 |
340 |
||
|
Liabilities |
Rs. |
Assets |
Rs. |
|
Capital Retained Earnings |
3,000 340 |
Cash |
3,340 |
|
3,340 |
3,340 |
||
Adjustment Entries
Because of the adopting of accrual accounting, after the
preparation of trial balance, adjustments relating to the accounting period
have to be made in order to make the financial statements complete. These
adjustments are needed for transactions which have not been recorded but which
affect the financial position and operating results of the business. They may
be divided into four kinds: two in relation to revenues and the other two in
relation to expenses. The two in relation to revenues are:
(i) Unrecorded Revenues:
Income earned for the period but not received in cash. For
e.g. Interest for the last quarter of the accounting period is yet to be
received though fallen due. The adjustment entry to be passed is:
Accrued interest a/c (Dr)
Interest a/c (Cr)
(ii) Revenues Received In Advance:
i.e. Income relating to the next period received in the
current accounting period: e.g. Rent received in advance. The adjustment entry
is:
Rent a/c (dr)
Rent received in advance a/c (cr)
The two relating to expenses are:
(i) Unrecorded Expenses:
i.e. Expenses were incurred during the period but no record
of them as yet has been made: e.g. Rs.500 wages earned by an employee during
the period remaining to be paid. The adjustment entry would be:
Wages a/c (Dr)
Accrued wages a/c (Cr)
(ii) Prepaid Expenses:
i.e., expenses relating to the subsequent period paid in
advance in the current accounting period. An example which is frequently cited
for this is insurance paid in advance. The adjustment entry would be:
Prepaid insurance a/c (Dr)
Insurance a/c (Cr)
In the above four cases unrecorded revenues and prepaid
expenses are assets and hence debited (as debit may signify increase in assets)
and revenues received in advance and unrecorded expenses are liabilities and
hence credited (as credit may signify increase in liabilities).
Besides the above mentioned four adjustments, some more are
to be done before preparing the financial statements. They are:
1. Inventory at the end
2. Provision of depreciation
3. Provision for bad debts
4. Provision for discount on receivables and payables
5. Interest on capital and drawings
Preparation Of Financial Statements
Now everything is set ready for the preparation of financial
statements for the accounting period and as of the last day of the accounting
period. Generally agreed accounting principles (gaap) require that three such
reports be prepared:
(i) a balance sheet
(ii) a profit and loss account (or) income statement
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