ACCOUNTING CONCEPTS, PRINCIPLES AND

CONVENTIONS

INTRODUCTION

Let us imagine a situation where you are a proprietor and you take copies of your books of
account to five different accountants. You ask them to prepare the financial statements on the
basis of the above records and to calculate the profits of the business for the year. After few
days, they are ready with the financial statements and all the five accountants have calculated
five different amounts of profits and that too with very wide variations among them. Guess in
such a situation what impact would it leave on you about accounting profession. To avoid this, a
generally accepted set of rules have been developed. This generally accepted set of rules
provides unity of understanding and unity of approach in the practice of accounting and also in
better preparation and presentation of the financial statements.

Accounting is a language of the business. Financial statements prepared by the accountant
communicate financial information to the various stakeholders for decision-making purpose.
Therefore, it is important that financial statements prepared by different organizations should be
prepared on uniform basis. Also there should be consistency over a period of time in the
preparation of these financial statements. If every accountant starts following his own norms and
notions for accounting of different items then there will be an utter confusion.

To avoid confusion and to achieve uniformity, accounting process is applied within the
conceptual framework of Generally Accepted Accounting Principles (GAAPs). The term
GAAPs is used to describe rules developed for the preparation of the financial statements and
are called concepts, conventions, postulates, principles etc. These GAAPs are the backbone of
the accounting information system, without which the whole system cannot even stand erectly.
These principles are the ground rules, which define the parameters and constraints within which
accounting reports are generated. Accounting principles are basic norms and assumptions on
which the whole accounting system has been developed and established. Accountant also
adheres to various accounting standards issued by the regulatory authority for the
standardization of accounting policies to be followed under specific circumstances. These
conceptual frameworks, GAAPs and accounting standards are considered as the theory base of
accounting.

Accounting concepts
Accounting concepts define the assumptions on the basis of which financial statements of a
business entity are prepared. Certain concepts are perceived, assumed and accepted in accounting to
provide a unifying structure and internal logic to accounting process. The word concept means idea
or notion, which has universal application. Financial transactions are interpreted in the light of the
concepts, which govern accounting methods. Concepts are those basic assumptions and
conditions, which form the basis upon which the accountancy has been laid. Unlike physical
science, accounting concepts are only result of broad consensus. These accounting concepts lay
the foundation on the basis of which the accounting principles are formulated.

Accounting principles
Accounting principles are a body of doctrines commonly associated with the theory and
procedures of accounting serving as an explanation of current practices and as a guide for selection of
conventions or procedures where alternatives exits.
Accounting principles must satisfy the following conditions:
1. They should be based on real assumptions;
CAPITAL 7,00,000 MACHINERY 5,00,000
CASH 2,00,000
7,00,000 7,00,000
LIABILITIES AMT ASSETS AMT
2. They must be simple, understandable and explanatory;
3. They must be followed consistently;
4. They should be able to reflect future predictions;
5. They should be informational for the users.
Accounting conventions
Accounting conventions emerge out of accounting practices, commonly known as accounting
principles, adopted by various organizations over a period of time. These conventions are derived by
usage and practice. The accountancy bodies of the world may change any of the convention to
improve the quality of accounting information. Accounting conventions need not have universal
application.
In the study material, the terms accounting concepts, accounting principles and accounting
conventions have been used interchangeably to mean those basic points of agreement on which
financial accounting theory and practice are founded.

CONCEPTS, PRINCIPLES & CONVENTION

Now we shall study in detail the various accounting concepts on which accounting is based. The
following are the widely accepted accounting concepts:
(a) Entity concept : Entity concept states that business enterprise is a separate identity apart from
its owner. Accountants should treat a business as distinct from its owner. Business transactions are
recorded in the business books of accounts and owners transactions in his personal books of
accounts. The practice of distinguishing the affairs of the business from the personal affairs of
the owners originated only in the early days of the double-entry book-keeping. This concept helps
in keeping business affairs free from the influence of the personal affairs of the owner. This basic
concept is applied to all the organizations whether sole proprietorship or partnership or corporate
entities.
Entity concept means that the enterprise is liable to the owner for capital investment made by the
owner. Since the owner invested capital, which is also called risk capital he has claim on the profit
of the enterprise. A portion of profit which is apportioned to the owner and is immediately payable
becomes current liability in the case of corporate entities.


Example: Mr. X started business investing ` 7,00,000 with which he purchased machinery for
` 5,00,000 and maintained the balance in hand. The financial position of the business (which is
shown by Balance Sheet) will be as follows:
Balance Sheet







This means that the enterprise owes to Mr. X ` 7,00,000. Now if Mr. X spends ` 5,000 to meet
his family expenses from the business fund, then it should not be taken as business expenses
and would be charged to his capital account (i.e., his investment would be reduced by `
5,000). Following the entity concept the revised financial position would be


Balance Sheet (Rs in 000)
Liability

Capital
Less : Drawings


700
5

`


695

695
Assets

Machinery
Cash

`
500
195,

695


(b) Money measurement concept : As per this concept, only those transactions, which can
be measured in terms of money are recorded. Since money is the medium of exchange and
the standard of economic value, this concept requires that those transactions alone that are capable
of being measured in terms of money be only to be recorded in the books of accounts.
Transactions, even if, they affect the results of the business materially, are not recorded if they are
not convertible in monetary terms. Transactions and events that cannot be expressed in terms of
money are not recorded in the business books. For example; employees of the organization are,
no doubt, the assets of the organizations but their measurement in monetary terms is not
possible therefore, not included in the books of account of the organization. Measuring unit
for money is taken as the currency of the ruling country i.e., the ruling currency of a country
provides a common
denomination for the value of material objects. The monetary unit though an inelastic yardstick,
remains indispensable tool of accounting.
It may be mentioned that when transactions occur across the boundary of a country, one may
see many currencies. Suppose an Indian businessman sells goods worth ` 50 lakhs at home and he
also sells goods worth of 1 lakh Euro in the United States. What is his total sales? ` 50 lakhs
plus 1 lakh Euro.
These are not amenable to even arithmetic treatment. So transactions are to be recorded at uniform
monetary unit i.e. in one currency. Suppose EURO 1 = ` 55.
Total Sales = ` 50 lakhs plus 55 lakhs = ` 105 lakhs. Money Measurement Concept imparts the
essential flexibility for measurement and interpretation of accounting data.
This concept ignores that money is an inelastic yardstick for measurement as it is based on the
implicit assumption that purchasing power of the money is not of sufficient importance as to
require adjustment. Also, many material transactions and events are not recorded in the books of
accounts just because it cannot be measured in monetary terms. Therefore it is recognized by all
the accountants that this concept has its own limitations and inadequacies. Yet it is used for
accounting purposes because it is not possible to adopt a better measurement scale.
Entity and money measurement are viewed as the basic concepts on which other procedural
concepts hinge.
(c) Periodicity concept : This is also called the concept of definite accounting period. As
per going concern concept an indefinite life of the entity is assumed. For a business entity it
causes inconvenience to measure performance achieved by the entity in the ordinary course of
business.
If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as financial
position only at the end of its life.
So a small but workable fraction of time is chosen out of infinite life cycle of the business entity
for measuring performance and looking at the financial position. Generally one year period is
taken up for performance measurement and appraisal of financial position. However, it may also be
6 months or 9 months or 15 months.
According to this concept accounts should be prepared after every period & not at the end of the
life of the entity. Usually this period is one calendar year. In India we follow from 1st April of a
year to 31
st
March of the immediately following year.

Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an
unduly long time-frame. This concept makes the accounting system workable and the term
accrual meaningful. If one thinks of indefinite time-frame, nothing will accrue. There cannot be
unpaid expenses and non-receipt of revenue. Accrued expenses or accrued revenue is only with
reference to a finite time-frame which is called accounting period.
Thus, the periodicity concept facilitates in :
(i) Comparing of financial statements of different periods
(ii) Uniform and consistent accounting treatment for ascertaining the profit and assets of the
business
(iii) Matching periodic revenues with expenses for getting correct results of the business
operations
(d) Accrual concept : Under accrual concept, the effects of transactions and other events are
recognised on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or
paid) and they are recorded in the accounting records and reported in the financial statements of the
periods to which they relate. Financial statements prepared on the accrual basis inform users not
only of past events involving the payment and receipt of cash but also of obligations to pay cash in
the future and of resources that represent cash to be received in the future.
To understand accrual assumption knowledge of revenues and expenses is required. Revenue is the
gross inflow of cash, receivables and other consideration arising in the course of the ordinary
activities of an enterprise from sale of goods, from rendering services and from the use by others of
enterprises resources yeilding interest, royalties and dividends. For example, (1) Mr. X started a
cloth merchandising. He invested ` 50,000, bought merchandise worth ` 50,000. He sold such
merchandise for ` 60,000. Customers paid him ` 50,000 cash and assure him to pay ` 10,000
shortly. His revenue is ` 60,000. It arose in the ordinary course of cloth business; Mr. X received
` 50,000 in cash and ` 10,000 by way of receivables.
Take another example; (2) an electricity supply undertaking supplies electricity spending
` 16,00,000 for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of
electricity charges. This is also revenue which arose from rendering services.
Lastly, (3) Mr. A invested ` 1,00,000 in a business. He purchased a machine paying
` 1,00,000. He hired it out for ` 20,000 annually to Mr. B. ` 20,000 is the revenue of Mr. A; it
arose from the use by others of the enterprises resources.
Expense is a cost relating to the operations of an accounting period or to the revenue earned
during the period or the benefits of which do not extend beyond that period.
In the first example, Mr. X spent ` 50,000 to buy the merchandise; it is the expense of generating
revenue of ` 60,000. In the second instance ` 16,00,000 are the expenses. Also whenever
any asset is used it has a finite life to generate benefit. Suppose, the machine purchased by
Mr. A in the third example will last for 10 years only. Then ` 10,000 is the expense he met. For
the time being, ignore the idea of accounting period.
Accrual means recognition of revenue and costs as they are earned or incurred and not as money is
received or paid. The accrual concept relates to measurement of income, identifying assets and
liabilities.
Example: Mr. J D buys clothing of ` 50,000 paying cash ` 20,000 and sells at ` 60,000 of
which customers paid only ` 50,000.
His revenue is ` 60,000, not ` 50,000 cash received. Expense (i.e., cost incurred for
the revenue) is ` 50,000, not ` 20,000 cash paid. So the accrual concept based profit is
` 10,000 (Revenue Expenses).
As per Accrual Concept : Revenue Expenses = Profit
Accrual Concept provides the foundation on which the structure of present day accounting has
been developed.

Alternative as per Cash basis
Cash received in ordinary course of business Cash paid in ordinary course of business =
profit.
Revenue may not be realised in cash. Cash may be received simultaneously or
(i) before revenue is created (A. 1)
(ii) after revenue is created (A. 2)
Expenses may not be paid in cash. Cash may be paid simultaneously or (i) before expense is made
(B. 1) (ii) after expense is made (B. 2)
A. 1 creates a liability when cash is received in advance. A. 2 creates an asset called Trade
receivables. B. 1 creates an asset called Trade Advance when cash is paid in advance while B. 2
creates a liability called payables or Trade payables or outstanding liabilities. If the expenses
remain unpaid in respect of goods, it is called Trade payables, if it remains unpaid for other
expenses, it is called Expense payables.
(e) Matching concept : In this concept, all expenses matched with the revenue of that period
should only be taken into consideration. In the financial statements of the organization if any
revenue is recognized then expenses related to earn that revenue should also be recognized.
This concept is based on accrual concept as it considers the occurrence of expenses and income
and do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain
items like prepaid and outstanding expenses, unearned or accrued incomes.
It is not necessary that every expense identify every income. Some expenses are directly related to
the revenue and some are time bound. For example:- selling expenses are directly related to sales
but rent, salaries etc are recorded on accrual basis for a particular accounting period. In other
words periodicity concept has also been followed while applying matching concept.
Mr. P K started cloth business. He purchased 10,000 pcs. garments @ ` 100 per piece and
sold 8,000 pcs. @ ` 150 per piece during the accounting period of 12 months 1st January
to 31st December, 2011. He paid shop rent @ ` 3,000 per month for 11 months and paid
` 8,00,000 to the suppliers of garments and received ` 10,00,000 from the customers.
Let us see how the accrual and periodicity concepts operate.
Periodicity Concept fixes up the time-frame for which the performance is to be measured and
financial position is to be appraised. Here, it is January 2011-December, 2011. So revenues and
expenses are to be measured for the year 2011 and assets and liabilities are to be ascertained as
on 31st December, 2011.
Accrual Concept operates to measure revenue of ` 12,00,000 (arising out of sale of garments 8,000
Pcs ` 150) which accrued during 2011, not the cash received ` 10,00,000 and also the expenses
correctly. Shop rent for 12 months is an expense item amounting to ` 36,000, not ` 33,000 the
cash paid.
Should the accountant treat ` 10,00,000 as expenses for purchase of merchandise ? And should
he treat ` 1,64,000 as profit? (Revenue ` 12,00,000-Merchandise ` 10,00,000. Shop Rent `
36,000). Obviously the answer is No. Matching links revenue with expenses.
Revenue Expenses = Profit
But this unqualified equation may create misconception. It should be defined as :
Periodic Profit = Periodic Revenue Matched Expenses
From the revenue of an accounting period such expenses are deducted which are expended to
generate the revenue to determine profit of that period.
In the given example revenue relates to only sale of 8,000 pcs. of garments. So the cost of 8,000
pcs of garments should be treated as expenses.
Thus, Profit







Assets = Revenue
Less : Expenses:
Merchandise
Shop Rent



8,00,000
`36,000
` 12,00,000



` 8,36,000
` 3,64,000



` 2,00,000



Liabilities
:
Inventory (2,000 pcs 100)
Trade receivables

Cash (Cash Receipts ` 10,00,000 cash payments `
8,33,000)



Trade Payables
Expense Payables
Capital (for Profit)
` 2,00,000


1,67,000
`
5,67,000



`2,00,000 `
3,000
` 3,64,000
` 5,67,000
Thus, accrual, matching and periodicity concepts work together for income measurement and
recognition of assets and liabilities.
(f) Going Concern concept : The financial statements are normally prepared on the assumption
that an enterprise is a going concern and will continue in operation for the foreseeable future.
Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail
materially the scale of its operations; if such an intention or need exists, the financial statements
may have to be prepared on a different basis and, if so, the basis used is disclosed.
The valuation of assets of a business entity is dependent on this assumption. Traditionally,
accountants follow historical cost in majority of the cases.
Suppose Mr. X purchased a machine for his business paying ` 5,00,000 out of ` 7,00,000 invested
by him. He also paid transportation expenses and installation charges amounting to ` 70,000. If
he is still willing to continue the business, his financial position will be as follows:

Balance Sheet (Rs in 000)
Liability
Capital

`
7,00

7,00
Assets
Machinery
Cash

`
5,70
1,30
7,00

Now if he decides to back out and desires to sell the machine, it may fetch more than or less than
` 5,70,000. So his financial position should be different. If going concern concept is taken, increase/
decrease in the value of assets in the short-run is ignored. The concept indicates that assets are
kept for generating benefit in future, not for immediate sale; current change in the asset value is not
realisable and so it should not be counted

(g) Cost concept : By this concept, the value of an asset is to be determined on the basis of historical
cost, in other words, acquisition cost. Although there are various measurement bases, accountants
traditionally prefer this concept in the interests of objectivity. When a machine is acquired by
paying ` 5,00,000, following cost concept the value of the machine is taken as ` 5,00,000. It
is highly objective and free from all bias. Other measurement bases are not so objective.
Current cost of an asset is not easily determinable. If the asset is purchased on 1.1.1995 and such
model is not available in the market, it becomes difficult to determine which model is the
appropriate equivalent to the existing one. Similarly, unless the machine is actually sold, realisable
value will give only a hypothetical figure. Lastly, present value base is highly subjective because
to know the value of the asset one has to chase the uncertain future.
However, the cost concept creates a lot of distortion too as outlined below :
(a) In an inflationary situation when prices of all commodities go up on an average, acquisition
cost loses its relevance. For example, a piece of land purchased on 1.1.1995 for ` 2,000 may
cost ` 1,00,000 as on 1.1.2011. So if the accountant makes valuation of asset at historical cost, the
accounts will not reflect the true position.
(b) Historical cost-based accounts may lose comparability. Mr. X invested ` 1,00,000 in a
machine on 1.1.1995 which produces ` 50,000 cash inflow during the year 2011, while Mr. Y
invested
` 5,00,000 in a machine on 1.1.2005 which produced ` 50,000 cash inflows during the year. Mr.
X earned at the rate 20% while Mr. Y earned at the rate 10%. Who is more-efficient ?
Since the assets are recorded at the historical cost, the results are not comparable. Obviously it is a
corollary to (a).
(c) Many assets do not have acquisition costs. Human assets of an enterprise are an example.
The cost concept fails to recognise such asset although it is a very important asset of any
organization.
Many other controversial issues have arisen in financial accounting that revolves around the
cost concept which will be discussed at the advanced stage. However, later on we shall see that
in many circumstances, the cost convention is not followed. See conservatism concept for an
example, which will be discussed later on in this unit.
(h) Realisation concept : It closely follows the cost concept. Any change in value of an asset is
to be recorded only when the business realises it. When an asset is recorded at its historical cost
of ` 5,00,000 and even if its current cost is ` 15,00,000 such change is not counted unless there
is certainty that such change will materialise.
However, accountants follow a more conservative path. They try to cover all probable losses but
do not count any probable gain. That is to say, if accountants anticipate decrease in value they
count it, but if there is increase in value they ignore it until it is realised. Economists are highly
critical about the realisation concept. According to them, this concept creates value distortion
and makes accounting meaningless.
Example : Mr. X purchased a piece of land on 1.1.1995 paying ` 2,000. Its current market value is
` 1,02,000 on 31.12.2011. Should the accountant show the land at ` 2000 following cost
concept and ignoring ` 1,00,000 value increase since it is not realised? If he does so, the financial
position
would be


Balance Sheet
Liability

`

Asset

`

Capital

2,000
2,000

Land

2,000
2,000

Is it not proper to show it in the following manner?

Balance Sheet
Liabilities

`

Asset

`

Capital
Unrealised Gain

2,000
1,00,000
1,02,000

Land

1,02,000


1,02,000

Now-a-days the revaluation of assets has become a widely accepted practice when the change
in value is of permanent nature. Accountants adjust such value change through creation of
revaluation (capital) reserve.
Thus the going concern, cost concept and realization concept gives the valuation criteria.

(i) Dual aspect concept : This concept is the core of double entry book-keeping. Every
transaction or event has two aspects:
(1) It increases one Asset and decreases other Asset;
(2) It increases an Asset and simultaneously increases Liability;
(3) It decreases one Asset, increases another Asset;
(4) It decreases one Asset, decreases a Liability
Alternatively
(5) It increases one Liability, decreases other Liability;
(6) It increases a Liability, increases an Asset;
(7) It decreases Liability, increases other Liability;
(8) It decreases Liability, decreases an Asset.

So every transaction and event has two aspects.
This gives basic accounting equation :
Equity (E) + Liabilities (L) = Assets
(A) or
Equity (E)= Assets (A) Liabilities(L)
Or, Equity + Long Term Liabilities + Current Liabilities = Fixed Assets + Current Assets
Or, Equity + Long Term Liabilities = Fixed Assets + (Current Assets Current
Liabilities) Or, Equity = Fixed Assets + Working Capital Long Term Liabilities
Whatever is received as funds is either expended (Expenses) Debited to Profit & Loss
Account
Or Lost Losses are transferred to Capital Account
Or saved Shown on the Assets side of the Balance Sheet
Therefore, Capital + Income/Profits + Liabilities = Expenses + Net Loss +
Assets Or, Capital + Income Expenses + Net Profits = Assets Liabilities
Since the net profit / loss is transferred to equity, the net effect is
Equity + Liabilities = Assets


(j) Conservatism: Conservatism states that the accountant should not anticipate income and
should provide for all possible losses. When there are many alternative values of an asset, an
accountant should choose the method which leads to the lesser value. Later on we shall see that
the golden rule of current assets valuation - cost or market price whichever is lower originated
from this concept.
The Realisation Concept also states that no change should be counted unless it has materialised.
The Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain
but it is desirable to guard against all possible losses.
For this concept there should be atleast three qualitative characteristics of financial statements,
namely,
(i) Prudence, i.e., judgement about the possible future losses which are to be guarded, as
well as gains which are uncertain.
(ii) Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as
well as to exclude uncertain gains,
(iii) Faithful representation of alternative values.
Many accounting authors, however, are of the view that conservatism essentially leads to
understatement of income and wealth and it should not be the basis for the preparation of
financial statements.
(k) Consistency : In order to achieve comparability of the financial statements of an enterprise
through time, the accounting policies are followed consistently from one period to another; a
change in an accounting policy is made only in certain exceptional circumstances.
The concept of consistency is applied particularly when alternative methods of accounting are
equally acceptable. For example a company may adopt any of several methods of depreciation
such as written-down-value method, straight-line method, etc. Likewise there are many methods
for valuation of inventories. But following the principle of consistency it is advisable that the
company should follow consistently over years the same method of depreciation or the same
method of valuation of Inventories which is chosen. However in some cases though there is no
inconsistency, they may seem to be inconsistent apparently. In case of valuation of Inventories if
the company applies the principle at cost or market price whichever is lower and if this principle
accordingly results in the valuation of Inventories in one year at cost price and the market price
in the other year, there is no inconsistency here. It is only an application of the principle.
But the concept of consistency does not imply non-flexibility as not to allow the introduction of
improved method of accounting.
An enterprise should change its accounting policy in any of the following circumstances only:
a. To bring the books of accounts in accordance with the issued Accounting Standards.
b. To compliance with the provision of law.

c. When under changed circumstances it is felt that new method will reflect more true and fair
picture in the financial statement.

(l) Materiality: Materiality principle permits other concepts to be ignored, if the effect is not
considered material. This principle is an exception of full disclosure principle. According to
materiality principle, all the items having significant economic effect on the business of the enterprise
should be disclosed in the financial statements and any insignificant item which will only increase the
work of the accountant but will not be relevant to the users need should not be disclosed in the
financial statements

The term materiality is the subjective term. It is on the judgement, common sense and discretion of the
accountant that which item is material and which is not. For example stationary purchased by the
organization though not used fully in the accounting year purchased still shown as an expense of that
year because of the materiality concept. Similarly depreciation on small items like books, calculators
etc. is taken as 100% in the year of purchase though used by the company for more than a year. This is
because the amount of books or calculator is very small to be shown in the balance sheet though it is the
asset of the company

The materiality depends not only upon the amount of the item but also upon the size of the
business, nature and level of information, level of the person making the decision etc. Moreover an item
material to one person may be immaterial to another person. What is important is that omission of any
information should not impair the decision-making of various users
Fundamental Accounting Assumptions
There are three fundamental accounting assumptions :
(i) Going Concern
(ii) Consistency
(iii) Accrual
All the above three fundamental accounting assumptions have already been explained in this unit.
If nothing has been written about the fundamental accounting assumption in the financial
statements then it is assumed that they have already been followed in their preparation of financial
statements. However, if any of the above mentioned fundamental accounting assumption is not followed
then this fact should be specifically disclosed

Financial Statements
The aim of accounting is to keep systematic records to ascertain financial performance and financial
position of an entity and to communicate the relevant financial information to the interested user
groups. The financial statements are basic means through which the management of an entity
makes public communication of the financial information along with selected quantitative details.
They are structured financial representations of the financial position and the performance of an
enterprise. To have a record of all business transactions and also to determine whether all these
transactions resulted in either profit or loss for the period, all the entities will prepare financial
statements viz., balance sheet, profit and loss account, cash flow statement etc. by following
various accounting concepts, principles, and conventions which have been already discussed.



















ACCOUNTING PROCESS

By this time, you must have understood that accounting is the process of identifying,
measuring, recording, classifying, summarising, analysing, interpreting and communicating the
financial transactions and events. Accounting helps in keeping systematic records to ascertain
financial performance and financial position of an entity and to communicate the relevant
financial information to the interested user groups. Transactions and events recorded by
suitable account headings are analysed in term of debit and credit; and thus assets become equal to
equity and liabilities. Accounts are classified as personal, real and nominal types. Transactions and
events are first journalised, then posted to suitable ledgers accounts and all accounts are
balanced at the end of year. Generally balances of the nominal accounts are transferred to profit and
loss account for determination of profit or loss and balance of personal and real accounts are
carried to balance sheet.

The process of accounting, depicting how information flows from the source documents up to
the stage where final accounts are prepared, can be shown as:

Source Documents



Book of Original Entry



Ledger Accounts



Trial Balance


Final Accounts

Represents all documents in business which contains financial
records and act as evidence of the transactions which have taken
place.

These are books which are used in recording the transactions for
the first time. The books are maintained for memorandum purpose
only and will not form part of the double entry system. Examples
include; Purchase day book, Cash book, Sales day book and
purchases return day book

These form part of double entry system and used to record the
transactions for the period. These are accounts where information
relating to a particular asset, liability, capital, income and expenses
are recorded.

Contains the totals from various ledger accounts and act as a
preliminary check on accounts before producing final accounts.


Financial Statements are produced to show the financial
performance and financial position of a business entity.

Double entry system:
Double entry system of book-keeping has emerged in the process of evolution of various
accounting techniques. It is the only scientific system of accounting. According to it, every
transaction has two-fold aspectsdebit and credit and both the aspects are to be recorded in
the books of accounts. For example, if a business acquires something then either it must have
been given by someone or it must have been acquired by giving up something. On purchase of
furniture either the cash balance will be reduced or a liability to the supplier will arise. This
has been made clear already, the Double Entry System is so named since it records both the
aspects. We may define the Double Entry System as the system which recognises and records
both the aspects of transactions. This system has proved to be systematic and has been found of
great use for recording the financial affairs for all institutions requiring use of money.



ACCOUNTS:
We have seen how the accounting equation becomes true in all cases. A person starts his
business with say, Rs. 10,000; capital and cash are both Rs. 10,000. Transactions entered into
by the firm will alter the cash balance in two ways, one will increase the cash balance and
other will reduce it. Payment for goods purchased, for salaries and rent, etc., will reduce it;
sales of goods for cash and collection from customers will increase it.
We can change the cash balance with every transaction but this will be cumbersome. Instead it
would be better if all the transactions that lead to an increase are recorded in one column and those
that reduce the cash balance in another column; then the net result can be ascertained. If we add all
increases to the opening balance of cash and then deduct the total of all decreases we shall know the
closing balance. In this manner, significant information will be available relating to cash
The two columns which we reffered above are put usually in the form of an account, called
the 'T' form. This is illustrated below by taking imaginary figures:



What we have done is to put the increase of cash on the left hand side and the decrease on the
right hand side; the closing balance has been ascertained by deducting the total of payments,
Rs. 2,000 from the total of the left - hand side. Such a treatment of receipts and payment of
cash is very convenient.
The proper form of an account is as follows:
ACCOUNT
Dr. Cr.

Date


Particulars


Ref.


Amount


Date


Particulars


Ref.


Amount


Rs.


Rs.

The columns are self-explanatory except that the column for reference (Ref.) is meant to indicate the
sources where information about the entry is available
DEBIT & CREDIT:

We have seen that by deducting the total of liabilities from the total of assets the amount of
capital is ascertained, as is indicated by the accounting equation.
Assets = Liabilities + Capital or
Assets Liabilities = Capital

We have also seen that if there is any change on one side of the equation, there is bound to be
similar change on the other side of the equation or amongst items covered by it. This is again
illustrated below:



As has been seen previously, what has been given above is suitable only if the number of
transactions is small. But if the number is large, a different procedure of putting increases and
decreases in different columns will be useful and this will also yield significant information.
The transactions given above are being shown below according to this method.
Total Assets

= Liabilities

+ Owner's Capital

Increase
Rs.

Decrease
Rs.

Decrease
Rs.

Increase
Rs.

Decrease
Rs.

Increase
Rs.

(1) 10,000


10,000

(2) 5,000


5,000


(3)

2,000


2,000


(4)

1,000

1,000


Total 15,000

3,000

1,000

5,000

2,000

10,000

Balance 12,000


=

4,000


+ 8,000

It is a tradition that:
(i) increases in assets are recorded on the left-hand side and decreases in them on the right-
hand side; and
(ii) in the case of liabilities and capital, increases are recorded on the right-hand side and
decreases on the left-hand side.
When two sides are put together in T form, the left-hand side is called the 'debit side' and the
right hand side is 'credit side'. When in an account a record is made on the debit or left-hand
side, one says that one has debited that account; similary to record an amount on the right-
hand side is to credit it.
From the above, the following rules can be obtained:
When there is an increase in the amount of an asset, its account is debited; the account will
be credited if there is a reduction in the amount of the asset concerned : Suppose a firm
purchases furniture for Rs. 800, the furniture account will be debited by Rs. 800 since the
asset has increased by this amount. Suppose later the firm sells furniture to the extent of Rs.
300, the reduction will be recorded by crediting the furniture account by Rs. 300.
(ii) If the amount of a liability increases, the increase will be entered on the credit side of the
liability account, i.e. the account will be credited : similarly, a liability account will be debited
if there is a reduction in the amount of the liability. Suppose a firm borrows Rs. 500 from
Mohan; Mohan's account will be credited since Rs. 500 is now owing to him. If, later, the loan
is repaid, Mohan's account will be debited since the liability no longer exists.
(iii) An increase in the owner's capital is recorded by crediting the capital account :
Suppose the proprietor introduces additional capital, the capital account will be credited. If the
owner withdraws some money, i.e., makes a drawing, the capital account will be debited.
(iv) Profit leads to an increase in the capital and a loss to reduction : According to the rule
mentioned in (iii) above, profit may be directly credited to the capital account and losses
may be similarly debited.
However, it is more useful to record all incomes, gains, expenses and losses separately. By
doing so, very useful information will be available regarding the factors which have
contributed to the year's profits and losses. Later the net result of all these is ascertained and
adjusted in the capital account.
(v) Expenses are debited and Incomes are credited : Since incomes and gains increase
capital, the rule is to credit all gains and incomes in the accounts concerned and since
expenses and losses decrease capital, the rule is to debit all expenses and losses. Of course, if
there is a reduction in any income or gain, the account concerned will be debited; similarly, for
any reduction in an expenses or loss the concerned account will be credited.
The rules given above are summarised below:
(i) Increases in assets are debits; decreases are credits;
(ii) Increases in liabilities are credits; decreases are debits;
(iii) Increases in owner's capital are credits; decreases are debits; (iv)
Increases in expenses are debits; decreases are credits; and
(v) Increases in revenue or incomes are credits; decreases are debits.
The terms debit and credit should not be taken to mean, respectively, favourable and
unfavourable things. They merely describe the two sides of accounts.

TRANSACTIONS:
In the system of book-keeping, students can notice that transactions are recorded in the books of
accounts. A transaction is a type of event, which is generally external in nature and can be
determined in terms of money. In an accounting period, every business has huge number of
transactions which are analysed in financial terms and then recorded individually, followed by
classification and summarisation process, to know their impact on the financial statements. A
transaction is a two way process in which value is transferred from one party to another. In it
either a party receives a value in terms of goods etc. and passes the value in terms of money or
vice versa. Therefore, one can easily make out that in a transaction, a party receives as well as
passes the value to other party. For recording transaction it is very important that they are
supported by a substantial document like purchasing invoices, bills, pay-slips, cash-memos,
passbook etc.
Transactions analysed in terms of money and supported by proper documents are recorded in
the books of accounts under double entry system. To analyse the dual aspect of each transaction,
two approaches can be followed:
(1) Accounting Equation Approach.
(2) Traditional Approach.
Accounting Equation Approach.
The relationship of assets with that of liabilities and owners' equity in the equation form is
known as 'Accounting Equation'. Basic accounting equation comes into picture when sum
total of capital and liabilities equalises assets, where assets are what the business owns and
capital and liabilities are what the business owes. Under double entry system, every business
transaction has two-fold effect on the business enterprise where each transaction affects changes
in assets, liabilities or capital in such a way that an accounting equation is completed and
equated. This accounting equation holds good at all points of time and for any number of
transactions and events except when there are errors in accounting process.
Let us suppose that an individual started business by contributing Rs. 5,00,000 and taking
loan of Rs.1,00,000 from a bank to be repayable, after 5 years. He purchased furniture costing
Rs. 1,00,000, and merchandise worth Rs. 5,00,000. For purchasing the merchandise he paid
Rs. 4,00,000 to the suppliers and agreed to pay balance after 3 months. Assume that all these
transactions and events occurred at to, base point of time.
The contribution by the owner is termed as capital; the borrowings are termed as loans or
liabilities. Whenever the loan is repayable in the short-run, say within one year, it is called
short-term loan or liability. On the other hand, if the loan is repayable within 4 or 5 years or
more, it would be termed as long term loan or liability.
Some other short-term liabilities relating to credit purchase of merchandise are popularly called
as trade creditors, and for other purchases and services received on credit as expense creditors.
These short-term liabilities are also termed as current liabilities.
On the other hand, money raised has been invested in two types of assetsfixed assets and
current assets. Furniture is a fixed asset, if it lasts long, say more than one year, and has utility
to the business, while inventory and cash balance will not remain fixed for long as soon as the
business starts to roll-these are current assets.
Often the owner's claim or fund in the business is called equity. Owner's claim implies capital
invested plus any profit earned minus any loss sustained.
Now at to we have an equation:
Equity + Liabilities = Assets
or, Equity + Long-Term Liabilities = Fixed Assets + Current Assets -
Current Liabilities
Check : L.H.S.
Equity

Rs. 5,00,000

Long Term Liabilities

Rs. 1,00,000

Current Liabilities

Rs. 1,00,000

Rs. 7,00,000

R.H.S.


Fixed Assets:


Furniture

Rs. 1,00,000

Current Assets:


Inventory

Rs. 5,00,000

Cash

Rs. 1,00,000

Rs. 7,00,000

Cash = Capital + Loan - Furniture - Payment to Creditors
= Rs. 5,00,000 + Rs. 1,00,000 - Rs. 1,00,000 - Rs. 4,00,000 = Rs. 1,00,000
EQUITY = ASSETS - LIABILITIES

Traditional Approach

Under traditional approach of recording transactions one should first understand the term
debit and credit and their rules. The term debit and credit have already been explained .
Transactions in the journal are recorded on the basis of the rules of debit and credit only. For
the purpose of recording, these transactions are classified in three groups:

(i) Personal transactions.
(ii) Transactions related to assets and properties.
(iii) Transactions related to expenses, losses, income and gains.

CLASSIFICATION OF ACCOUNTS
(i) Personal Accounts: Personal accounts relate to persons, debtors or creditors. Example
would be; the account of Ram & Co., a credit customer or the account of Jhaveri & Co., a
supplier of goods. The capital account is the account of the proprietor and, therefore, it is


Accounts






Personal Accounts



Impersonal Accounts




Real


Nominal


Natural


Artificial
(legal)


Representative




also personal but adjustment on account of profits and losses are made in it. This account is
further classified into three categories:
(a) Natural personal accounts: It relates to transactions of human beings like Ram, Rita, etc.
(b) Artificial (legal) personal account: For business purpose, business entities are treated to
have separate entity. They are recognised as persons in the eye of law for dealing with other
persons. For example: Government, Companies (private or limited), Clubs, Co-operative
societies etc.
(c) Representative personal accounts: These are not in the name of any person or
organisation but are represented as personal accounts. For example: outstanding liability
account or prepaid account, capital account, drawings account.
(ii) Impersonal Accounts: Accounts which are not personal such as machinery account,
cash account, rent account etc. These can be further sub-divided as follows:

(a) Real Accounts: Accounts which relate to assets of the firm but not debt. For example,
accounts regarding land, building, investment, fixed deposits etc., are real accounts. Cash in
hand and Cash at the bank accounts are also real.
(b) Nominal Accounts: Accounts which relate to expenses, losses, gains, revenue, etc. like
salary account, interest paid account, commission received account. The net result of all the
nominal accounts is reflected as profit or loss which is transferred to the capital account.
Nominal accounts are, therefore, temporary.

GOLDEN RULES OF ACCOUNTING
All the above classified accounts have two rules each, one related to Debit and one related to
Credit for recording the transactions which are termed as golden rules of accounting, as
transactions are recorded on the basis of double entry system.
1. Personal account is governed by the following two rules:
Debit the receiver
Credit the giver
2. Real account is governed by the following two
rules: Debit what comes in
Credit what goes out
3. Nominal account is governed by the following two rules:
Debit all expenses and losses
Credit all incomes and gains
JOURNAL:
Transactions are first entered in this book to show which accounts should be debited and
which credited. Journal is also called subsidiary book. Recording of transactions in journal is
termed as journalizing the entries.

JOURNALISING PROCESS
All transactions are first recorded in the journal as and when they occur; the record is
chronological; otherwise it would be difficult to maintain the records in an orderly manner. The
form of the journal is given below :
JOURNAL


Date Particulars

(1) (2)
Dr. Cr.
L.F. Amount Amount
. Rs. Rs.
(3) (4) (5)

The columns have been numbered only to make clear the following but otherwise they are not
numbered. The following points should be noted

(i) In the first column the date of the transaction is entered-the year is written at the top,
then the month and in the narrow part of the column the particular date is entered.
(ii) In the second column, the names of the accounts involved are written; first the account to
be debited, with the word "Dr" written towards the end of the column. In the next line, after
leaving a little space, the name of the account to be credited is written preceded by the word
"To" (the modern practice shows inclination towards omitting "Dr." and "To"). Then in the
next line the explanation for the entry together with necessary details is given-this is called
narration.
(iii) In the third column the number of the page in the ledger on which the account is written up
is entered.
(iv) In the fourth column the amounts to be debited to the various accounts concerned are
entered.
In the fifth column, the amount to be credited to various accounts is
entered
POINTS TO BE TAKEN INTO CARE WHILE RECORDING A TRANSACTION IN
THE JOURNAL
1. Journal entries can be single entry (i.e. one debit and one credit) or compound entry
(i.e. one debit and two or more credits or two or more debits and one credit or two or more
debits and credits). In such cases, it is important to check that the total of both debits and
credits are equal.
2. If journal entries are recorded in several pages then both the amount column of each
page should be totalled and the balance should be written at the end of that page and also that
the same total should be carried forward at the beginning of the next page.
An entry in the journal may appear as follows:
Rs. Rs.
May 5 Cash Account Dr. 450
To Mohan 450
(Being the amount received from
Mohan in payment of the amount
due from him)
We will now consider some individual transactions.
(i) Mohan commences business with Rs. 5,000. This means that the firm has
Rs. 5,000 cash. According to the rules given above, the increase in an asset has to be debited
to it. The firm also now owes Rs. 5,000 to the proprietor, Mohan as capital. The rule given
above also shows that the increase in capital should be credited to it. Therefore, the journal
entry will be:
Cash Account Dr.

Rs. 5,000


To Capital Account


Rs. 5,000

(Being capital introduced by
Shri Mohan)



(ii) Out of the above, Rs. 500 is deposited in the bank. By this transaction the cash balance is
reduced by Rs. 500 and another asset, bank account, comes into existence. Since increase in
assets is debited and decrease is credited, the journal entry will be:

Bank Account Dr.

Rs. 500


To Cash Account


Rs. 500

(Being cash deposited in
Bank)



(iii) Furniture is purchased for cash Rs. 200. Applying the same reasoning as above the entry
will be:
Furniture Account Dr.

Rs. 200


To Cash Account


Rs. 200

(Being Furniture
purchased vide CM
No....)



(iv) Purchased goods for cash Rs. 400. The student can see that the required entry is:
Purchases Account Dr.

Rs. 400


To Cash Account


Rs. 400

(Being goods
purchased vide CM
No....)



(v) Purchased goods for Rs. 1,000 credit from M/s.Ram Narain Bros. Purchase of
merchandise is an expense item so it is to be debited. Rs. 1,000 is now owing to the supplier;
his account should therefore be credited, since the amount of liabilities has increased. The entry
will be:






(vi) Sold goods to M/S Ram & Co. for cash Rs. 600. The amount of cash increases and
therefore, the cash amount should be debited; sale of merchandise is revenue item so it is to be
credited. The entry will be:
Cash Account Dr.

Rs. 600


To Sales Account


Rs. 600

(Being goods sold vide
CM No....)


(vii) Sold goods to Ramesh on credit for Rs. 300. The stock of goods has decreased and
therefore, the goods account has to be credited. Ramesh now owes Rs. 300; that is an asset and
therefore, Ramesh should be debited. The entry is:
Ramesh Dr.

Rs. 300


To Sales Account


Rs. 300

(Being goods sold vide
Bill No....)



(viii)Received cash from Ramesh Rs. 300. The amount of cash increased therefore the cash
account has to be debited. Ramesh no longer owes any amount to the firm, i.e., this particular
form of assets has disappeared; therefore, the account of Ramesh should be credited. The entry is:
Cash Account Dr.

Rs. 300


To Ramesh


Rs. 300

(Being cash received
against Bill No....)



(ix) Paid to M/s Ram Narain Bros. Rs. 1,000. The liability to M/S Ram Narain Bros. has
been discharged; therefore this account should be debited. The cash balance has decreased
and, therefore, the cash account has to be credited. The entry is:
M/S Ram Narain Bros. Dr.

Rs. 1,000


To Cash Account


Rs. 1,000

(Being cash paid
against Bill No....)



(x) Paid rent Rs. 100. The cash balance has decreased and therefore, the cash account
should be credited. No asset has come into existence because of the payment; the payment
is for services enjoyed and is an expense. Expenses are debited. Therefore, the entry should
be:
Rent Account Dr.

Rs. 100


To Cash Account


Rs. 100

(Being rent paid for the
month of .......)


(xi) Paid Rs. 200 to the clerk as salary. Applying the reasons given in (x) above, the required entry
is:
Salary Account Dr.

Rs. 200


To Cash Account


Rs. 200

c as s Acco D .

Rs. 1,000


To M s Ram a a B os.


Rs. 1,000

B oods c as d
v d B o.....



(Being salary paid to
Mr..... for the month of
...........)



(xii) Received Rs. 20 interest. The cash account should be debited since there is an increase in
the cash balance. There is no increase in any liability; since the amount is not returnable to
any one, the amount is an income, incomes are credited. The entry is :
Cash Account Dr.

Rs. 20


To Interest Account


Rs. 20

(Being interest received
from........ for the
period ............)



When transactions of similar nature take place on the same date, they may be combined while
they are journalised. For example, entries (x) and (xi) may be combined as follows:

Rent Account Dr.

Rs. 100


Salary Account Dr.

Rs. 200


To Cash Account
(Being expenses done as
per detail attached)


Rs. 300


When journal entry for two or more transactions are combined, it is called composite journal
entry. Usually, the transactions in a firm are so numerous that to record the transactions for a
month will require many pages in the journal. At the bottom of one page the totals of the two
columns are written together with the words "Carried forward" in the particulars column.
The next page is started with the respective totals in the two columns with the words "Brought
forward" in the particulars column.
Analyse transactions of M/S Sahil & Co. for the month of March, 2014 on the basis of double
entry system by adopting the following approaches:
(A) Accounting Equation Approach.
(B) Traditional Approach.
Transactions for the month of March, 2014 were as follows:
1. Sahil introduced cash Rs. 40,000.
2. Cash deposited in the City Bank Rs. 20,000.
3. Cash loan of Rs. 5,000 taken from Mr. Y.
4. Salaries paid for the month of March, 2006, Rs. 3,000 and Rs. 1,000 is still payable for
the month of March, 2014.
5. Furniture purchased Rs. 5,000.
What conclusions one can draw from the above analysis?
Solution
(A) Analysis of Business Transaction: Accounting Equation Approach




Transaction


Analysis


Account Affected
and Nature of
Account


Rule


Entry

Introduction of
Rs. 40,000 cash
by the Proprietor

Cash received
Investment
by owner

Cash Asset


Capital Capital

Debit increase in
asset

Credit increase
in capital

Debit Cash


Credit Capital

Cash
deposited
in bank
Rs. 20,000

Bank balance
increases


Cash balance
decrease

Bank Asset



Cash Asset

Debit increase in
asset


Credit decrease
in asset

Debit Bank



Credit Cash

Loan from Y
Rs. 5,000

Cash balance
increases
Creates an
obligation to
repay Y

Cash Asset

Y's Loan
Liability

Debit increase
in assets
Credit increase
in liabilities

Debit Cash

Credit Y's Loan

Salaries paid
Rs. 3,000 and
outstanding
Rs. 1,000

Salaries for
services received
Rs. 4,000
paid Rs. 3,000
Obligation to pay
Rs. 1,000

Salary Temporary
capital (Expense)
CashAsset

Salaries
outstanding
Liability

Debit increase in
expenses

Credit decrease
in asset
Credit increase
in liabilities

Debit Salary
(Rs. 4,000)

Credit Cash (Rs.
3,000) Credit
Salaries
outstanding (Rs.
1,000)

Furniture
purchased
Rs. 5,000

Increases furniture
owned Cash
decreases

FurnitureAsset

CashAsset

Debit increase
in asset
Credit decrease
in asset

Debit Furniture

Credit Cash


(B) Analysis of Business Transactions: Traditional Approach
Transaction

Analysis

Account Affected
and Nature of
Account

Rule

Entry

Introduction of
Rs. 40,000 cash
by the proprietor

Cash is received
by business Owner
has given cash

CashReal

CapitalPersonal

Debit what
comes in
Credit the giver

Debit Cash

Credit Capital

Cash deposited
in bank
Rs. 20,000

Bank receives
cash
Cash goes out
of business

BankPersonal

CashReal

Debit the receiver

Credit what
goes out

Debit Bank


Credit Cash

Loan from Y
Rs. 5,000

Business gets cash
Y pays cash

CashReal
Y's LoanPersonal

Debit what
comes in
Credit the giver

Debit Cash

Credit Y's Loan

Salary paid
Rs. 3,000 and
still payable
Rs. 1,000

Cost of services
used Rs. 4,000
Cash goes out
Rs. 3,000
Still payable or
outstanding for
services received
Rs. 1,000

Salary Nominal

CashReal

Salary Outstanding
Personal

Debit all expenses

Credit what
goes out
Credit the giver

Debit Salary
(Rs. 4,000)
Credit Cash
(Rs. 3,000)
Credit Salary
outstanding
(Rs. 1,000)

Furniture
purchased
Rs. 5,000

Furniture is
purchased
Cash is paid

Furniture Real

CashReal

Debit what
comes in
Credit what
goes out

Debit Furniture


Credit Cash

Conclusion:
It is evident from above analysis that procedure for analysis of transactions, classification of
accounts and rules for recording business transactions under accounting equation approach
and traditional approach are different. But the accounts affected and entries in affected accounts
remain same under both approaches. Thus, the recording of transactions in affected accounts
on the basis of double entry system is independent of the method of analysis followed by a
business enterprise. In other words, accounts to be debited and credited to record the dual
aspect remain same under both the approaches.

Ledgers

INTRODUCTION
After recording the transactions in the journal, recorded entries are classified and
grouped into by preparation of accounts and the book, which contains all set of accounts
(viz. personal, real and nominal accounts), is known as Ledger. It is known as principal
books of account in which account-wise balance of each account is determined
ledger account Specimen
A ledger account has two sides-debit (left part of the account) and credit (right part of the
account). Each of the debit and credit side has four columns. (i) Date (ii) Particulars (iii) Journal
folio i.e. page from where the entries are taken for posting and (iv) Amount.
Dr. Account Cr.
Date

Particulars

J.F.

Amount (Rs).

Date

Particulars

J.F.

Amount (Rs.)



POSTING:
The process of transferring the debit and credit items from journal to classified accounts in the
ledger is known as posting.

RULES REGARDING POSTING OF ENTRIES IN THE LEDGER
1. Separate account is opened in ledger book for each account and entries from ledger
posted to respective account accordingly.
2. It is a practice to use words 'To' and 'By' while posting transactions in the ledger. The
word 'To' is used in the particular column with the accounts written on the debit side while 'By'
is used with the accounts written in the particular column of the credit side. These 'To' and
'By' do not have any meanings but are used to represent the account debited and credited.
3. The concerned account debited in the journal should also be debited in the ledger but
reference should be of the respective credit account. For example: Rent paid by cash Rs. 500.
The journal entry for this transaction would be.

BALANCING AN ACCOUNT:
At the end of the each month or year or any particular day it may be necessary to ascertain
the balance in an account. This is not a too difficult thing to do; suppose a person has bought
goods worth Rs. 1,000 and has paid only Rs. 850; he owes Rs. 150 and that is balance in his
account. To ascertain the balance in any account, what is done is to total the sides and ascertain
the difference; the difference is the balance. If the credit side is bigger than the debit side, it is
a credit balance. In the other case it is a debit balance. The credit balance is written on the
debit side as, "To Balance c/d"; c/d means "carried down". By doing this, two sides will be
equal. The totals are written on the two sides opposite one another.
Then the credit balance is written on the credit side as "By balance b/d (i.e., brought down)".
This is the opening balance for the new period. The debit balance similarly is written on the
credit side as "By Balance c/d", the totals then are written on the two sides as shown above as
then the debit balance written on the debit side as, "To Balance b/d", as the opening balance
of the new period.
It should be noted that nominal accounts are not balanced; the balance in the end are transferred to
the profit and loss account. Only personal and real accounts ultimately show balances. In the
illustration given above, one will have noticed that the capital account, the purchases
account, sales account, the discount account, the rent account and the salary account have
not been balanced. The capital account will have to be adjusted for profit or loss and that is
why it has not been balanced yet.
Trial Balance

INTRODUCTION
Preparation of trial balance is the third phase in the accounting process. After posting the
accounts in the ledger, a statement is prepared to show separately the debit and credit balances.
Such a statement is known as the trial balance. It may also be prepared by listing each and
every account and entering in separate columns the totals of the debit and credit sides.
Whichever way it is prepared, the totals of the two columns should agree. An agreement
indicates reasonable accuracy of the accounting work; if the two sides do not agree, then
there is simply an arithmetic error(s).
This follows from the fact that under the Double Entry System, the amount written on the debit sides of
various accounts is always equal to the amounts entered on the credit sides of other accounts and vice versa.
Hence the totals of the debit sides must be equal to the totals of the credit sides. Also total of the debit balances
will be equal to the total of the credit balances. Once this agreement is established, there is reasonable
confidence that the accounting work is free from clerical errors, though is not proof of cent per cent accuracy,
because some errors of principle and compensating errors may still remain. Generally, to check the arithmetic
accuracy of accounts, trial balance is prepared at monthly intervals. But because double entry system is
followed, one can prepare a trial balance any time. Though a trial balance can be prepared any time but it
is preferable to prepare it at the end of the accounting year to ensure the arithmetic accuracy of all the
accounts before the preparation of the financial statements. It may be noted that trial balance is a statement
and not an account.
Objectives of TB
The preparation of trial balance has the following objectives:
(i) Trial balance enables one to establish whether the posting and other accounting processes
have been carried out without committing arithmetical errors. In other words, the trial
balance helps to establish arithmetical accuracy of the books.
(ii) Financial statements are normally prepared on the basic of agreed trial balance; otherwise
the work may be cumbersome. Preparation of financial statements, therefore, is the second
objective.
The trial balance serves as a summary of what is contained in the ledger; the ledger may have
to be seen only when details are required in respect of an account.
The under mentioned points may be noted:
(i) A trial balance is prepared as on a particular date which should be mentioned at the top
(ii) In the second column the name of the account is written.
(iii) In the fourth column the total of the debit side of the account concerned or the debit
balance, if any is entered.
(iv) In the next column, the total of the credit side or the credit balance is written.
(v) The two columns are totalled at the end.
The first and third column needs no explanation.
METHODS OF PREPARING TB
1. TOTAL METHOD
Under this method, every ledger account is totaled and that total amount (both of debit side
and credit side) is transferred to trial balance. In this method, trial balance can be prepared
as soon as ledger account is totaled. Time taken to balance the ledger accounts is saved under
this method as balance can be found out in the trial balance itself. The difference of totals of
each ledger account is the balance of that particular account. This method is not commonly
used as it cannot help in the preparation of the financial statements.
2. BALANCE METHOD
Under this method, every ledger account is balanced and those balances only are carry forward to
the trial balance. This method is used commonly by the accountants and helps in the
preparation of the financial statements. Financial statements are prepared on the basis of the
balances of the ledger accounts.
3.TOTAL AND BALANCE METHOD
Under this method, the above two explained methods are combined. Under this method
statement of trial balance contains seven columns instead of five columns





TRIAL BALANCE
The form of the trial balance is simple as shown below:

T B as at.......................
S. No Ledger Accounts L.F. Dr. Amount
(Total or Balance)
Rs.


Cr. Amount
(Total or Balance)
Rs.

FINAL ACCOUNTS
Trial balance proves the arithmetical accuracy of the business transactions, but it is not the end. The
businessman is interested in knowing whether the business has resulted in profit or loss and what the
financial position of the business is at a given period. In short, he wants to know the profitability and
the financial soundness of the business. The trader can ascertain these by preparing the final accounts. The
final accounts are prepared at the end of the year from the trial balance. Hence the trial balance is
said to be the connecting link between the ledger accounts and the final accounts

Parts of Final Accounts
The final accounts of business concern generally includes two parts. The first part is Trading and
Profit and Loss Account. This is prepared to find out the net result of the business. The second part is
Balance Sheet which is prepared to know the financial position of the business. However
manufacturing concerns, will prepare a Manufacturing Account prior to the preparation of
trading account, to find out cost of production.
Trading Account
Trading means buying and selling. The trading account shows the result of buying and selling of goods
At the end of each year, it is necessary to ascertain the net profit or net loss. For this purpose, it is first
necessary to know the gross profit or gross loss. The trading account is prepared to ascertain this.
The difference between the selling price and the cost price of the goods is the gross earning of the business
concern. Such gross earning is called as gross profit. However, when the selling price is less than the cost
of goods purchased, the result is gross loss.
Items appearing in the debit side
1. Opening stock: Stock on hand at the begining of the year is termed as opening stock. The
closing stock of the previous accounting year is brought forward as opening stock of the current
accounting year. In the case of new business, there will not be any opening stock.
2. Purchases: Purchases made during the year, includes both cash and credit purchases of goods.
Purchase returns must be deducted from the total purchases to get net purchases.
3. Direct Expenses: Expenses which are incurred from the stage of purchase to the stage of
making the goods in saleable condition are termed as direct expenses. Some of the direct expenses are:
i. Wages: It means remuneration paid to workers.

ii. Carriage or carriage inwards: It means the transportation charges paid to bring the goods from the place
of purchase to the place of business.

iii. Octroi Duty: Amount paid to bring the goods within the municipal limits.

iv. Customs duty, dock dues, clearing charges, import duty etc.: These expenses are paid to the
Government on the goods imported.

v. Other expenses : Fuel, power, lighting charges, oil, grease,waste related to production and
packing expenses
Items appearing in the credit side
Sales: This includes both cash and credit sale made during the year. Net sales is derived by deducting
sales return from the total sales.
ii. Closing stock: Closing stock is the value of goods which remain in the hands of the trader at
the end of the year. It does not appear in the trial balance. It appears outside the trial balance. (As it
appears outside the trial balance, first it will be recorded in the credit side of the trading account and then
shown in the assets side of the balance sheet).
Balancing
The difference between the two sides of the Trading Account, indicates either Gross Profit or Gross
Loss. If the credit side total is more, the difference represents Gross Profit. On the other hand, if the
total of the debit side is more, the difference represents Gross Loss. The Gross Profit or Gross Loss
is transferred to Profit & Loss Account.


Profit and Loss Account
After calculating the gross profit or gross loss the next step is to prepare the profit and loss account.
To earn net profit a trader has to incur many expenses apart from those spent for purchases and
manufacturing of goods. If such expenses are less than gross profit, the result will be net profit.
When total of all these expenses are more than gross profit the result will be net loss.
Balancing
The difference between the two sides of profit and loss account indicates either net profit or net
loss.If the total on the credit side is more the difference is called net profit. On the other hand if the
total of debit side is more the difference represents net loss. The net profit or net loss is transferred
to capital account.
Balance Sheet:
This forms the second part of the final accounts. It is a statement showing the financial position of a
business. Balance sheet is prepared by taking up all personal accounts and real accounts (assets and
properties) together with the net result obtained from profit and loss account. On the left hand side
of the statement, the liabilities and capital are shown. On the right hand side, all the assets are
shown. Balance sheet is not an account but it is a statement prepared from the ledger balances. So
we should not prefix the accounts with the words To and By. Balance sheet is defined as a
statement which sets out the assets and liabilities of a business firm and which serves to ascertain
the financial
position of the same on any particular date.
Need:
The need for preparing a Balance sheet is as follows:
i. To know the nature and value of assets of the business
ii. To ascertain the total liabilities of the business.
iii. To know the position of owners equity.
Format
The Balance sheet of a business concern can be presented in the
following two forms
i. Horizontal form or the Account form
ii. Vertical form or Report form

i) Horizontal form of Balance Sheet:
The right hand side of the balance sheet is asset side and the left hand side is liabilities side. All
accounts having debit balance will appear in the asset side and all those having credit balance will
appear in the liability side.
ii) Vertical form of Balance Sheet
In this, Balance Sheet is presented in a statement form.

Classification of Assets and Liabilities
Assets
Assets represents everything which a business owns and has money value. In other words, asset
includes possessions and properties of the business. Asset are classified as follows:
Tangible
Intangible Fictitious
Fixed
Current
a) Tangible Assets:
Assets which have some physical existence are known as tangible assets. They can be seen, touched
and felt, e.g. Plant and Machinery Tangible assets are classified into
i. Fixed assets :
Assets which are permanent in nature having long period of life and cannot be converted into cash
in a short period are termed as fixed assets.
ii. Current assets :
Assets which can be converted into cash in the ordinary course of business and are held for a short
period is known as current assets.
This is also termed as floating assets. For example, cash in hand, cash at bank, sundry debtors etc.
b) Intangible Assets
The assets which have no physical existence and cannot be seen or felt. They help to generate
revenue in future, e.g. goodwill, patents, trademarks etc.
c) Fictitious Assets
These assets are nothing but the unwritten off losses or non-recoupable expenses. They are really
not assets but are worthless items. For example, Preliminary expenses.
Liabilities
The amount which a business owes to others is liabilities. Credit balance of personal and real
accounts together with the capital account are liabilities.
Long Term
Current
Contigent
a) Long Term Liabilities
Liabilities which are repayable after a long period of time are known as Long Term Liabilities. For
example, capital, long term loans etc.
b) Current Liabilities
Current liabilities are those which are repayable within a year. For example, creditors for goods
purchased, short term loans etc.
c) Contingent liabilities
It is an anticipated liability which may or may not arise in future. For example, liability arising for
bills discounted. Contigent liabilities will not appear in the balance sheet. But shown as foot note

Marshalling of Assets and Liabilities
The term Marshalling refers to the order in which the various assets and liabilities are shown in
the balance sheet. The assets and liabilities can be shown either in the order of liquidity or in the
order of permanence.
a) In order of liquidity
Liquidity means convertability into cash. Assets will be said to be liquid if it can be converted into
cash easily, they are placed at the top of the balance sheet. Liabilities are arranged in the order of
their urgency of payment. The most urgent payment to be made is listed at the top of the balance
sheet.
b) In order of permanence
This order is exactly the reverse of the above. Assets and liabilities are recorded in the order of their
life in the business concern.
Balance Sheet Equation
An important thing to note about the Balance Sheet is that, the total value of the assets is always
equal to the total value of the liabilities. This is because the liability to the owner - capital, is always
made up of the difference between assets and liabilities. Thus,
Assets = Liabilities + Capital
or
Capital = Assets - Liabilities
While preparing the trial balance in case it does not tally the difference is transferred to an
imaginary account called as suspense account. In case the suspense account is not closed before the
preparation of the final accounts then it has to be placed in the balance sheet, so that it can be
rectified later. If suspense account has a debit balance it will appear as the last item in the asset
side. In case it
shows a credit balance it will appear as the last item in the liability side.

Adjustments
Some important and common items, which need to be adjusted
at the time of preparing the final accounts are discussed below.
1. Closing stock
2. Outstanding expenses
3. Prepaid Expenses
4. Accrued incomes
5. Incomes received in advance
6. Interest on capital
7. Interest on drawings
8. Interest on loan
9. Interest on investment
10. Depreciation
11. Bad Debts
12. Provision for bad and doubtful debts
13. Provision for discount on debtors
14. Provision for discount on creditors.
Note : All adjustments are given outside the trial balance.

Banking Financial Statement

Meaning of Banking
Banks are vital to business and may be likened to the heart in a human being, circulating
money through the economy.

Banks in India and their activities are regulated by the Banking Regulation Act, 1949.
Banking : Under Section 5(b) of the said Act Banking means,
Accepting deposits of money from public for the purpose of lending

These deposits are repayable on demand and can be withdrawn by cheque, draft or otherwise

Banking Company: Any bank which transacts this business as stated in section 5 (b) of the act in
India is called a banking company. However merely accepting public deposits by a company for
financing its own business shall not make it a bank. It may be mentioned that the Banking
Regulation Act, 1949 is not applicable to a primary agricultural society, a co-operative land
mortgage bank and any other co-operative society.
Accounts

Sections 29 to 34A of the Banking Regulation Act deal with accounts and audit. At the end of each
financial year every banking company incorporated in India in respect of business transacted
by it shall prepare with reference to that year or period, a Balance Sheet (Form A) and Profit and
Loss Account (Form B) as on the last working day of that year or the period in the forms set out in
the Third Schedule of Banking Regulation Act.
Similarly, every banking company incorporated outside India is required to prepare Balance
Sheet and Profit and Loss Account in respect of all business transacted through its branches in
India..

The statement of accounts must be signed by the manager or principal officer and by at least three
directors or all directors if there are not more than three directors in case of a banking company
incorporated in India. In case of a banking company incorporated outside India, the statement of
accounts must be signed by the manager or agent of the principal office of the company in India.
Under Section 30 of the Banking Regulation Act, the Balance Sheet and Profit and Loss
Account prepared in accordance with Section 29 shall be audited by a person duly qualified
under any law for the time being in force to be an auditor of companies. Every banking
company is required to take previous approval of the Reserve Bank of India before appointing, re-
appointing or removing any auditor or auditors. In addition, the Reserve Bank can order special
audit of the banking companies accounts if it thinks fit in the public interest of the banking
company or its depositors.
Main Characteristics of a Banks Book-Keeping System
The book-keeping system of a banking company is substantially different from that of a trading or
manufacturing enterprise. A bank maintains a large number of accounts of various types for its
customers. As a safeguard against any payment being made in the account of a customer in excess
of the amount standing to his credit or a cheque of a customer being dishonoured due to a mistake
in the balance in his account, it is necessary that customers accounts should be kept up-to-date
and checked regularly. In many other mercantile enterprises, books of primary entry (i.e., day
books) are generally kept up-to- date while their ledgers including the general ledger and
subsidiary ledgers for debtors, creditors etc. are written afterwards. However a bank cannot
afford to ignore its ledgers, particularly those concerning the accounts of its customers and has to
enter into the ledgers every transactions as soon as it takes place. In bank accounting, relatively less
emphasis is placed on day books. These are merely treated as a means to an end-the end being to
keep up-to-date detailed ledgers and to balance the trial balance everyday and to keep all control
accounts in agreement with the detailed ledgers.

Presently most if not all of the Banks' accounting is done on Core Banking Solutions (CBS)
wherein all accounts are maintained on huge servers with posting being effected instantly
through vouchers, debit cards, internet banking etc.

The main characteristics of a banks system of book-keeping are as follows:
(a) Voucher posting Vouchers are nothing but loose leaves of journals or cash books on which
transactions are recorded as they occur. Entries in the personal ledger are made directly from
vouchers instead of being posted from the books of prime entry.
(b) Voucher summary sheets - The vouchers entered into different personal ledgers each day are
summarised on summary sheets, totals of which are posted to the control accounts in the general ledger.
(c) Daily trial balance - The general ledger trial balance is extracted and agreed every- day.
(d) Continuous checks - All entries in the detailed personal ledgers and summary sheets are
checked by persons other than those who have made the entries. A considerable force of such
check is employed, with the general result that most clerical mistakes are detected before another
day begins.

(e) Control Accounts - A trial balance of the detailed personal ledgers is prepared
periodically, usually every two weeks, agreed with general ledger control accounts.

(f) Double voucher system - Two vouchers are prepared for every transaction not involving
cash - one debit voucher and another credit voucher.
Forms of Balance Sheet and Profit and Loss Account
The Committee under the Chairmanship of Shri A. Ghosh, Deputy Governor, RBI, after due
deliberation suggested suitable changes/amendments in the forms of balance sheet and profit and
loss account of banks, having regard to :

1. need for better disclosure

2. expansion of banking operations both area-wise and sector-wise over the period

3. need for improving the presentation of accounts etc.

The formats are given below as specified in Banking Regulation Act in Form A of Balance
Sheet, Form B of Profit and Loss Account and eighteen other schedules of which the last two
relates to Notes and Accounting Policies.















Third Schedule (See Section 29) Form A

Schedule As on 31.3__
(current year)
As on 31.3__
(previous year)
Capital & Liabilities
Capital 1
Reserves & Surplus 2
Deposits 3
Borrowings 4
Other liabilities and
provisions
5
Total
Assets
Cash and Balances with
Reserve Bank of India
6
Balances with banks and
money at call and short
notice
7
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11
Total
Contingent Liabilities
Bills for Collection
12




















Form of Profit & Loss Account for the year ended 31st March





I. Income
Interest earned
Other income Total
II. Expenditure Interest
expended Operating expenses
Provisions and contingencies Total
III. Profit/Loss
Net profit/loss () for the year Profit/Loss
() brought forward Total
IV. Appropriations
Transfer to statutory reserves
Transfer to other reserves




Schedule




13
14



15
16

Year ended
As on 31.3....
(Current
year)
(000 omitted)
Year ended
As on 31.3....
(Previous year)

Liabilities Side of Balance Sheet of a Bank

Schedule 1 : Capital of a Bank

We have to show paid up capital of bank. If bank is incorporated outside India, then its start up capital
will be shown under this schedule in balance sheet's liabilities side.

Schedule 2 : Reserves and Surplus

a) Statutory reserve
b) Capital reserve
c) Share premium
d) Revenue and other reserve
e) balance of profit and loss account

Schedule 3 : Deposits

Deposits of customers in bank will be the liability of bank. This liability will be classified in saving
banks deposit, term deposits, demand deposits.

Schedule 4 : Borrowing

Sometime bank takes loan from RBI or other banks. All these borrowings are the liabilities of bank.

Schedule 5 : Other Liabilities and Provisions

In these liabilities, we can include bill payable, outstanding interest and provision for taxes.

Assets Side of Balance Sheet of a Bank

Schedule 6 : Cash and Balance with RBI

RBI has made rule of depositing some money with him. So, cash and balance with RBI will be the
asset of a bank.
Schedule 7 : Balance with Banks and Money at Call and Short Notice

Above schedule 3 is deposit liability. But some of these deposit bank keeps in his pocket in cash form
or money at call or short notice. So, this is the asset of bank.

Schedule 8 : Investment

Bank is not doing social activities. It is doing business. Most of his deposit is invested in good and
profitable schemes. All investment of bank will be the asset of bank. It will be shown under schedule 8.
In investment of bank, we can include investment in govt. securities, investment in shares, bonds,
debentures and investment in subsidiaries.


Schedule 9 : Advances

Bank gives advance to other banks in the form of cash credit, bank overdraft and loan payable on
demand. All these advances are the assets of a bank and will be shown under schedule 9 in the asset
side of balance sheet of a bank.

Schedule 10 : Fixed Assets

Banks all branch offices building and land will be part of its fixed asset, if these are own of bank. Bank
may have other fixed assets like furniture, fixtures, equipment, computers and ATM Machines. All
addition in it will add in the opening balance of fixed asset. All deduction will deduct from the balance
of fixed asset. We deduct depreciation of each fixed asset except land.

Schedule 11 : Other Assets

In other assets, we can show stock of stationery and stamps, tax paid in advance, interest receivables,
and bills for collections.















PROFIT & LOSS ACCOUNT-BANK

Interest earned

13

I. Interest/discount on
advances/bills






II. Income on Investments


III. Interest on balances with Reserve
Bank of India and other
Interbank funds
IV. Others

Includes interest and discount on all types of loans
and advances like cash credit, demand loans,
overdraft, export loans, term loans, domestic
and foreign bills purchased and discounted
(including those rediscounted), overdue, interest and
also interest subsidy, if any, relating to such
advances/bills.
Includes all income derived from the
investment portfolio by way of interest and dividend
Includes interest on balances with Reserve Bank and
other banks, call loans, money market placements,
etc.

Includes any other interest/discount income not
included in above heads.

Other Income

14

I. Commission, exchange and
brokerage








II. Profit on sale of
investments Less Loss on sale of
investments



III. Profit on revaluation of
investments Less: Loss on
revaluation of
investments

Includes all remuneration on services such as
commission on collections,
commission/exchange on remittances and transfers,
commission on letter of credit and guarantees,
commission on Government business
commission on other permitted agency business
including consultancy and other services, broke-rage,
etc. on securities. It does not include foreign exchange
income.
Includes profit/loss on sale of
securities, furniture land and buildings, motor of
vehicle, gold, silver etc.. Only the net position should
be shown. If the net position is a loss, the
amount should be shown as deduction.
The net profit/loss on revaluation of assets may also
be shown under this item.

IV. Profit on sale of land, building
and other assets Less : Loss on sale of
land, buildings and other assets
V. Profit on exchange
transactions Less : Loss on
exchange transactions
VI. Income earned by way of dividends
etc. from subsidiaries,
companies and/or joint ventures
abroad/in India
VII. Miscellaneous income





Includes profit/loss on dealing in
foreign exchange all income earned by way of
foreign exchange commission and charges on
foreign exchange, transactions excluding interest
which will be shown under interest. Only the net
position should be shown. If the net position is a loss,
it is to be shown as a deduction.


Includes recoveries from constituents for the
godown rents, income from banks properties,
security charges, insurance etc. and any other
miscellaneous income. In case any item under this
head exceeds one percentage of the total income,
particulars may be given in the notes.

Interest Expended

15

I. Interest on deposits


II. Interest on Reserve Bank of
India/inter-bank borrowings
III. Others

Includes interest paid on all types of deposits
including deposits from banks and others institutions.
Includes discount/interest on all borrowings and
refinance from Reserve Bank of India and other
banks.
Includes discount / interest on all
borrowings/refinance from financial
institutions. All otherpayments like interest on
participation certificates, penal interest paid, etc.
may also be included here.

Operating expenses

16

I. Payments to and
Provisions for employees



II. Rent, taxes and
lighting

Includes staff salaries / wages, allowances, bonus,
other staff benefits like provident fund, pension,
gratuity liveries to staff, leave fare concessions,
staff welfare, medical allowance to staff etc.
Includes rent paid by the banks on building and other
municipal and other taxes paid (excluding income
tax and interest tax) electricity and other similar
charges and levies. House rent allowance and
other
similar payments to staff should appear




III. Printing and Stationery




IV. Advertisement and publicity

V. Depreciation on Banks property


VI. Directors fees, allowances
and expenses






under the head Payments to and provisions
for employees.
Includes books and forms and stationery used by
the bank and other printing charges which are
not incurred by way of publicity expenditure.
Includes expenditure incurred by the bank for
advertisement and publicity purposes
including printing charges of publicity matter.
Includes depreciation on banks own property: motor
cars and other vehicles, furniture, electric fittings,
vaults, lifts, leasehold properties, non
banking assets, etc.
Includes sitting fees and all other items of
expenditure incurred on behalf of directors. The daily
allowances, hotel charges, conveyance charges, etc.
which though in the nature of reimbursement of
expenses incurred may be included under this head.
Similar expenses of local Committee members may also be
included under this head.
Includes fees paid to the statutory auditors and
branch auditors for professional services
VII. Auditors fees and
expenses (including branch
auditors fees and expenses)









VIII. Law charges


IX. Postage, telegrams,
telephones, etc.
X. Repairs and
maintenance

rendered and all expenses for performing
their duties, even though they may be in
the nature of reimbursement of expenses.
If external auditors have been appointed by
banks themselves for internal inspections and
audits and other services the expenses incurred in
that context including fees may not be included
under this head but shown under other expenditure.
All legal expenses and reimbursement of expenses
incurred in connection with legal services are to be
included here.
Includes all postal charges like stamps, tele-gram,
telephones, teleprinter, etc.
Includes repairs to banks property, their
maintenance charges, etc..
















Provisions and
contingencies



Treatment of
accumulated losses

XI. Insurance





XII. Other expenditure

Includes insurance charges on banks property,
insurance premium paid to Deposit
Insurance & Credit Guarantee Corporation, etc. to
the extent they are not recovered from the
concerned parties.
All expenses other than those not included in any of
the other heads like, licence fees, donations,
subscriptions to papers, periodicals,
entertainment expenses, travel expenses, etc. may be
included under this head. In case any particular item
under this head exceeds one percentage of the total
income particulars may be given in the notes.
Includes all provisions made for bad and doubtful
debts, provisions for taxation, provisions for
diminution in the value of investments, transfers to
contingencies and other similar items.
While preparing the Balance Sheet and Profit and
Loss Account accumulated losses should be
brought forward under Item III or Form B before
appropriation of the balance profit made.