Basic Accounting Concepts

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BASIC ACCOUNTING CONCEPTSThe Entity Concept: In accounting, the entity of business is considered separate from the existence of its owners. Accounts are kept for the entity as distinct from owners. When the owners invest money in the business or earn profits, their capital accounts are credited and when they draw money or goods from the business, their capital accounts are debited. This concept applies to corporate bodies (entity is separate from the shareholders who own it) and non-corporate bodies (proprietors and partnerships). The Money Measurement Concept: Money being a common unit of measurement for goods and services, all transactions in account books are recorded in terms of money.

The Going Concern Concept: The going concern concept is the backbone of accounting and is based on the following assumptions: i) Business has an indefinite life. ii) Assets are depreciated on the basis of their expected life without caring for their current values. The Cost Concept: According to this concept, all transactions and events are recorded in the books of account at the actual price involved, i.e., cost. All assets are carried in the books of account from year to year at their acquisition cost (historical cost) irrespective of any change in their market value. Acquisition cost is considered highly objective, reliable, definite and free from bias. However, there are problems:

The Cost Concept: i) When due to price rise, the prices of all commodities go up substantially, the financial position of a firm depicted on cost concept basis does not reflect true picture. ii) Some assets reflect their immediate realisable value; e.g. marketable securities, Sundry Debtors. iii) Inventories are valued on cost or market price whichever is Lower. Dual Aspect Concept: Every transaction entered into by a firm has two aspects, debit and credit. The total assets of a business are, therefore, always equal to its total liabilities. Or Assets = Liabilities + Capital

Materiality: It states that the cost of data collection in terms of time, efforts, and expense should not exceed the benefits to be derived from such an effort. The convention emphasises that accounting should be concerned with significant and material events for recording purposes. Consistency: According to this convention, an enterprise should be consistent in the accounting policies from one accounting period to another period. This, however, does not prevent adoption of changes in accounting policies and practices if these are warranted by changed conditions. Reasons for such changes and the implications of changed policies need to be disclosed in the annual report.

Conservatism: This concept states that anticipate no profit and provide for all possible losses, i.e., all likely losses should be recognized even if they have not yet occurred and profits should be recognized only when they have been earned. In other words, the profits should never be overstated, though they may be understated. For example, costing of inventory, investments etc.

Accounting Equation The accounting equation is a statement of equality between debit and credit. It signifies that the assets of a business always equal the total liabilities and capital (owners equity). Assets = Liabilities + Capital 1.If a proprietor starts business with say, Rs. 30,000, the firm will have so much money but the firm will also owe that amount to the proprietor, so that Cash = Capital Rs. 30,000 = Rs. 30,000

2.The proprietor purchases furniture for Rs. 3,000 Cash + Furniture = Capital Rs. 27,000 + 3,000 = Rs. 30,000

3.Goods purchased on credit for Rs. 7,000

Cash + Furniture + Stock = Creditors + Capital Rs. 27,000 + 3,000 + 7,000 = Rs. 7,000 + 30,000 4.Goods sold for cash for Rs. 6,000 Cash + Furniture + Stock = Creditors + Capital Rs. 33,000 + 3,000 + 1,000 = Rs. 7,000 + 30,000 5.Creditors paid Rs. 3,000 Cash + Furniture + Stock = Creditors + Capital Rs. 30,000 + 3,000 + 1,000 = Rs. 4,000 + 30,000 6.Assume rent paid Rs. 2,000. Rent being an expense reduces Cash & Capital Cash + Furniture + Stock = Creditors + Capital Rs. 28,000 + 3,000 + 1,000 = Rs. 4,000 + 28,000

7.Furniture depreciated by Rs. 5,00 Cash + Furniture + Stock = Creditors + Capital Rs. 28,000 + 2,500 + 1,000 = Rs. 4,000 + 27,500 8.Salary Rs. 2,000 remains outstanding Cash + Furniture + Stock = Creditors + O/S Liability + Capital Rs. 28,000 + 2,500 + 1,000 = Rs. 4,000 + 2,000 + 25,500 9.Goods costing Rs. 1,000 are sold for Rs. 1,500 Profit increases the Capital, Loss reduces it Cash + Furniture = Creditors + O/S Liability + Capital Rs. 29,500 + 2,500 = Rs. 4,000 + 2,000 + 26,000 10.Cash Withdrawn for personal use: Rs. 5,000 Cash + Furniture = Creditors + O/S Liability + Capital Rs. 24,500 + 2,500 = Rs. 4,000 + 2,000 + 21,000 Thus after every transactions assets are equal to Liability and Capital.

Accounting Process Origination of the Transaction Recording of the Transaction in the Journal Posting to the Ledger Preparation of Trial Balance Preparation of Financial Statements

Accounting Data Base System Each transaction is first recorded in a book of original entry (also known as book of prime entry) and later it is posted to the general ledger. These books constitute the accounting data-base. 1. Journal 2. Cash Book 3. Special Form Journals (a) Sales Day Book (b) Purchase Day Book 4. General Ledger

JournalThe journal is the book of prime or original entry in which all transactions are first recorded in a chronological order as and when they take place. It is also called subsidiary book of account. From Journal, transactions are transferred (posted) to Ledger. The Journal is defined as a book that records all transactions. However, in view of recording of transactions in special books like cash book, Sales day book and purchases day book, the majority of transactions are taken care of. Thus journal records only residual transactions of a nonrepetitive nature such as credit purchase of machinery. Since it is not a cash transaction, nor is it a revenue purchase, it is recorded in journal proper. It also serves some important purposes: i) It provides a connecting link between two accounting periods (opening and closing entries). ii) It rectifies errors in books of accounts. iii) It records adjustment entries, at the end of each year.

Cash BookSince most of the transactions are in the form of cash receipts and cash payments, a cash book is maintained to record such receipts and payments. On the debit (left) side of the cash book, we record all receipts and on the credit (right) side all payments. Cash book is both a journal and a ledger. It is a journal since all transactions are recorded chronologically, and a ledger since it also serves the purpose of a T account by providing cash balance. Special Form Journals Since purchases and sales constitute a large number of repetitive transactions, we keep special journals to record these transactions. For sales transactions, there is sales day book or sales journal and for purchase transactions, there is purchase day book or purchase journal. These books record credit sales and credit purchases only (as cash sales and cash purchases are recorded in the cash book). And these are recorded by single entries that are totalled & posted to a Control account in the Ledger.

Thus the total of the sales day book is credited to sales account and debited to accounts receivable. A separate A/cs Rec. Ledger is kept for separate accounts of individual customers. Similarly, all credit purchases are posted in the purchase day book, and the creditors ledger contains the same information supplier-wise. The total of purchase day book is debited to purchase a/c and credited to A/cs Payable. Control Account: shows in a summary form the debits and credits that are shown in detail in subsidiary ledgers. Thus Sales A/c, Purchase A/c, A/cs Rec. and A/cs payable constitute the control accounts as their details can be seen in sales day book, debtors ledger, purchase day book and creditors ledger.

General Ledger: The next stage in the accounting process after recording the transactions in any one of the above books, is posting of the transactions to the debit and credit sides of the respective accounts in the ledger. General Ledger contains T accounts of: 1.Owners equity 2. Assets like buildings, furniture, stationery, plant and machinery, sundry Drs., prepaid expenses, inventory etc. 3. Liabilities like Long-term Loans, Short-term Loans, bank overdraft, Crs., outstanding expenses, bills payable etc. 4. Revenue items like sales, interest earned, discount and commissions recd. 5. Expense like depn., salaries, wages, insurance, rent, income tax etc.

Each folio in the Ledger is serially numbered and is devoted to one specific account only. Whenever a number of accounts of similar nature are required, a special ledger is opened. For example, a Sundry Drs. Ledger may be maintained which will contain the individual A/cs of all credit customers. Then only total Drs. a/c will appear in the General Ledger representing all credit customers. A creditors ledger can also be maintained likewise.

SummaryJournal Proper : Misc. & residual transactions and opening & closing entries Cash Book : Cash transactions including those involving Bank A/c. Purchase Day Book : Credit-purchases of revenue nature Sales Day Book General Ledger : Credit Sales Transactions : Owners equity, Assets & Liability A/c, Rev.& Expense A/cs Creditors Ledger : A/cs of individual creditors Debtors Ledger: : Individual A/cs of customers to whom credit had been granted

Rules of Debit and Credit Business transactions are classified into three categories: i) Transactions relating to persons ii) Transactions relating to properties and assets iii) Transactions relating to incomes and expenses. On this basis, it becomes nec