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Overview of Accounting
Introducing Financial Accounting
The prime motive for doing a business is to earn profit. To know the profit earned or
loss incurred in a particular period, it is necessary to record the financial transactions
for the same period. Financial accounting is an effective tool to record, classify, and
summarize financial transactions.

Accounting is the art of recording, classifying and summarizing financial transactions

and analysing & interpreting the results thereof.

To maintain uniformity in accounting, certain accounting principles are followed. The

accounting principles consist of accounting concepts and accounting conventions.
These are explained here.

Defining Accounting Concepts

Accounting is a business language used to communicate the financial information of
the business to the people concerned. This makes it important for accounting to be
based on certain concepts. These concepts imply the necessary assumptions or
conditions upon which accounting is based.

These can be listed as:

 Business Entity Concept
 Dual Aspect Concept
 Accounting Period Concept

Business Entity Concept

This concept holds prime importance in Financial Accounting. According to this

concept, a business is a separate entity from its owner. Business transactions are
recorded from the point of view of the business entity and not the owner. The
business entity can be a company, firm or proprietorship.

Let us understand with the help of an example. Mr. Sharma is a garment

manufacturer and has a factory outlet at Faridabad called ABC & Co. He invests
money amounting to Rs. 10,000 in the business in the form of capital. In this
scenario, the capital increases the cash balance in the company. Cash account is the
receiver of the money while Capital account of Mr. Sharma is the giver of the money.
Thus, the business owes the money to Mr. Sharma. In other words, the owners are
considered separate from the business. When they introduce or withdraw capital
from the business their Capital account is credited or debited accordingly.
Given here is a diagrammatic representation to explain the case.

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Invests Rs. 10,000 in the

Capital
company as capital
account of
(Capital account of Mr. Sharma is
Mr. Sharma,
the giver)
the
proprietor
ABC & Co.

The capital increases the cash

balance by Rs. 10,000 in the Cash Account
company
(Cash account is the Receiver)

Thus, in this case the two accounts affected are Capital account of Mr. Sharma, the
proprietor and the Cash account.

Let us take another example to explain this concept. ABC & Co. purchases furniture
worth Rs. 6,000 and makes the payment in cash. The furniture is bought in
exchange for cash. The transaction is for the company but the company remains
unaffected by the whole transaction. This is because the two account heads to be
affected in the transaction are Furniture and Cash account.

Given here is a diagrammatic representation to explain this case.

Furniture is purchased
(Furniture account is the
Furniture
receiver)
Account
ABC & Co.

Cash
Cash balance decreases by Rs. Account
6,000 due to the payment for
purchase of furniture
(Cash Account is the giver)

In such a case the company remains neutral and is not affected since the transaction
is between two entities Furniture and Cash that are separate from the company.

Dual Aspect Concept

This concept indicates that each transaction has two aspects and is recorded in two
different accounts. For example, if a business house purchases machine on cash
basis, the Machine account and the Cash account will be affected.

The double-entry system of accounting is based on this concept. The basic

presumption of this system is that every business transaction has two aspects. Under
this system, both the aspects of a transaction are recognized and recorded.

For example, ABC & Co. buys raw material worth Rs. 4,000 on cash basis. One
aspect to be recorded is the increase in the raw material while the other aspect is the
decrease in cash balance by Rs. 4,000. The important point to keep in mind is that
the amount of both the aspects that are recorded should always be equal.

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Accounting Period Concept

The time period during which the transactions of a business are recorded is called
the accounting period. It states that the indefinitely long period of the business life
should be divided into shorter periods for summarizing accounting information.
Accounts for a business are prepared for a specific period, generally a 12-month
period. In India, the accounting period is generally, taken from April 1 to March 31.

Defining Accounting Conventions

Conventions are the customs and traditions that act as a guide to the preparation of
the final accounts. Following these conventions results in the presentation of clear
and meaningful final accounts.

The conventions followed to prepare accounting statements are:

 Convention of Consistency
 Convention of Conservatism

Convention of Consistency

According to the convention of consistency the accounting practices and methods

should not be changed from one accounting period to another. For example, there
are 2 methods to charge depreciation, Written Down value method and Straight Line
method. The method once chosen should be used consistently year after year.
Consistency in accounting practices and methods makes the records of the company
for different years comparable.

Convention of Conservatism

According to this convention the accounting records should present a realistic picture
of the state of affairs of the business. All the prospective losses should be accounted
for and all prospective gains should be ignored. For example, to present a realistic
picture the closing stock is valued at market or cost price whichever is less. If the
market price is Rs. 15 and the cost price is Rs. 10, then the closing stock will be
valued at Rs. 10. On the other hand if the market price is Rs. 12 and cost price is Rs.
14, then the closing stock is valued at Rs. 12.

Now that we have discussed the accounting principles, let us move onto the
accounting terms that are used frequently.

Defining Accounting Terms

Accounting terms are classified under the following categories:
 Assets
 Capital
 Liabilities
 Revenue
 Income
 Expenses
 Sales

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 Purchase
 Debtors
 Creditors
 Stock

Assets

Assets are resources owned by a business. It can be anything that enables a

business to get benefit. For example, land, building, stock of goods, and cash. Assets
can be classified as:
• Fixed assets: Assets purchased for the purpose of operating the business and
not for resale. For example, land, building, machinery, furniture, and car.
• Current assets: Assets kept for a short term for converting into cash or for
resale. For example, unsold goods, cash at bank, and cash in hand.

Liabilities

A liability can be defined as something that a business owes to a third party in the
form of an obligation to pay. For example, when a loan is taken from a bank or a
financial institution it raises a liability for the business. Similarly, all the creditors are
a liability for the business. Liabilities can be classified as:
• Long term Liabilities/Fixed liabilities: Liabilities payable after a long term
(more than one year). For example, long-term loans are a fixed liability.
• Short term Liabilities/Current liabilities: Liabilities payable in a short term
(within one year). For example, creditors, bank overdrafts, bills payable, and
short-term loans.

Capital

Capital is the money that the owner invests to start the business and can claim from
the business. Thus, for the business it is a liability towards the owner since the
owner is a separate entity from the business. It can also be defined as the positive
difference of assets over liabilities. This can be depicted as:
Capital = Assets - Liabilities = Net assets
Thus, the net assets of the business are equal to the amount of capital contributed
by the owner of the business. When the owner invests money in a business the
transaction gives rise to two effects. Firstly, the assets of the business in the form of
cash increase and secondly, the claim of the owner in the form of capital on the
assets of the business is recognized. Capital is also known as equity or owner’s
equity. The owner can be a proprietor, a partner, or a shareholder in a company.

Revenue

Any account head or transaction that affects the profit earned or loss incurred by the
business comes under the Revenue head. Revenue is the net amount that is added
to the capital as a result of operations. It is the net inflow of assets or decrease in
liabilities from selling goods and providing services to customers. Revenue can be
depicted as:
Revenue= (Income – Expenses) + (Sales – Purchases)

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Income

Income is money received by a person or organization because of effort or work

done by the person. In other words, it is return on work done or return on
investments. For example, rent received, interest on fixed deposits, income from
investments, and so on. For professionals such as a doctor the fees that he receives
from his patients will be his income. Thus, the fees or commission earned from
providing services is included in Income.

Expense

Expense is the amount spent in order to produce and sell the goods and services,
which produce the revenue. Expenses can be classified as:
• Direct Expenses: Direct expenses refer to those expenses that are incurred on
the goods purchased till they are brought to the place of business for sale.
Some examples of direct expenses are carriage or freight inwards,
manufacturing wages, power and fuel, factory lighting, and factory rent and
rates and so on. These are also known as Manufacturing expenses.
• Indirect Expenses: Indirect expenses are those expenses that are incurred for
carrying on the day-to-day business. Some examples are office rent, salaries,
and so on. These can be further classified as:
o Selling and Distribution expenses: These expenses are incurred for selling
the goods to the consumer. For example, salesmen salaries, commission
of agents, advertising, freight and carriage on sales, export duties and so
on.
o Administrative and Office Management Expenses: These expenses are
incurred for maintaining the office. These signify the daily costs incurred in
running and maintaining a business For example, office salaries, office rent
and rates, telephone, lighting, printing and stationary and so on.
o Financial Expenses: These expenses are incurred in arranging finance for
the business. For example, interest on loan, interest on capital and so on.

Sales

The term ‘Sales’ refers to the proceeds from the sale of goods only. When goods are
sold for cash, it is called cash sales and when goods are sold on credit, it is called
credit sales. The term ‘Sales’ includes both cash and credit sales.

Purchases

The term ‘Purchases’ refers to inventory purchased by the business concern.

Inventory refers to the goods purchased for resale or for producing the finished
products for sale. When goods are purchased for cash, it is called cash purchase and
when goods are purchased on credit, it is called credit purchase. The term
‘Purchases’ includes both cash and credit purchases.

Debtor

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A debtor is a person or business concern that owes money to another business

concern. Let us understand with the help of an example. ABC & Co. sells garments
worth Rs. 5,000 to a customer on credit i.e. payment for the sale will be received on
a future date. Thus the customer becomes a debtor for ABC. & Co.

Creditor

A creditor is a person or business concern to which a business concern owes money.

Let us understand with the help of an example. ABC & Co. buys raw material worth
Rs. 10,000 from its supplier on credit i.e. payment for the purchase will be made on
a future date. Thus the supplier becomes a creditor for ABC. & Co.

Stock

Stock refers to the goods lying unsold on a particular date. The stock can be either
be opening stock or closing stock. Opening stock is the stock lying unsold at the
beginning of the accounting period while closing stock refers to the stock lying unsold
at the end of the accounting period.

Understanding the Accounting Equation

Following the Double Entry Accounting System, the debit and the credit in accounting
records should always be equal. In other words, the total assets (debit balance
accounts) of a business should be equal to the total liabilities (credit balance
accounts). This relation between assets and liabilities can be expressed as:
Assets = Liabilities + Capital
This equation is known as the Accounting Equation.
According to the accounting equation, an increase or decrease in the assets of a
business is always equal to an increase or decrease in the liabilities of the business.
It may be observed that any increase in assets would either result in a similar
increase in liabilities or a reduction in any other assets in case liabilities do not
increase.

Let us understand with the help of an example. ABC & Co. has cash amounting to Rs.
50,000 Mr. Sharma, the proprietor, provided this cash in the form of capital. Now
since ABC & Co. and Mr. Sharma are separate entities, ABC & Co. has a liability of
Rs. 50,000 towards Mr. Sharma. In this case, the accounting equation becomes:

Assets Liabilities + Capital

Cash = Rs. 50,000 Capital = Rs. 50,000
Total = Rs. 50,000 Total = Rs. 50,000

Now, suppose the company purchases a van for Rs. 2,000 so the asset side of the
accounting equation increases by Rs. 2,000. The payment has been made in cash,
thus, cash balance decreases by Rs. 2,000 Therefore, the net effect on total assets
remains nil and the equation becomes:

Assets Liabilities + Capital

Cash = Rs. 48,000 Capital = Rs. 50,000

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Van = Rs. 2,000

Total = Rs. 50,000 Total = Rs. 50,000

Next, ABC & Co. purchases Furniture worth Rs. 24,000 from Furniture World Inc. on
credit. Thus, the assets side of the accounting equation increases by Rs. 24,000 in
the form of Furniture. On the other hand, since the purchase is on credit, creditors
amounting to Rs. 24,000 appear on the liabilities side of the accounting equation. In
this case, the accounting equation becomes:

Assets Liabilities + Capital

Cash = Rs. 48,000 Capital = Rs. 50,000
Van = Rs. 2,000 Creditors = Rs. 24,000
Furniture = Rs. 24,000
Total = Rs. 74,000 Total = Rs. 74,000

We have discussed the accounting equation with the help of examples. Now let us
discuss the accounting cycle that defines the flow of information in the accounting
books.

Understanding the Accounting Cycle

The accounting cycle defines the sequence of the stages to be followed in financial
accounting. It starts from identifying the financial transactions and ends with the
preparation of financial statements. Thereafter, the statements are analyzed and
interpreted by different users to meet their requirements.

Given here is a diagrammatic representation of the Accounting Cycle.

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Identifying Financial Transactions

The transactions can be for sales, purchase, sale
return, purchase return, payment, receipt and so
on.

Recording Transactions in Accounting Books

The accounting books can be Cash Book, Purchase
Book, Sales Book, Purchase Return Book, Sales
Return Book, Journal Proper and so on.

Classifying transactions under Ledger Accounts

The transactions are posted to various Ledger
Accounts such as Purchase Account, Sales Account,
Capital Account, Cash Account and so on.

Summarizing and presenting Financial

Statements
The information is summarized under Trial Balance and
the Financial Statements. The Financial Statements
comprise of Trading Account, Profit and Loss Account,
and the Balance Sheet.

The stages of the accounting cycle are:

1. Identifying financial transactions: The actual business transactions take place
and the supporting source documents are created at this stage. Supporting
documents primarily include vouchers. Vouchers provide information about
the accounts affected by the transaction, the amount of transaction in money
terms, the date of transaction, and voucher number.
2. Recording transactions in Accounting Books: This stage pertains to the
recording of transactions. Transactions are recorded in the book of accounts.
In other words, the information on the vouchers is recorded in the accounting
books by passing journal entries in the appropriate accounting books.
3. Classifying transactions under various Ledger Accounts : At this stage, the
journal entries are transferred/posted to different accounts. The process of
transferring the journal entries to different accounts is known as Posting. In
simple terms, every transaction will affect at least two accounts and
therefore, two accounts are created. The financial record in the form of
journal entry is transferred to the appropriate accounts.
4. Summarizing and presenting Financial Statements: Many transactions take
place in a business. Therefore, various accounts are created. The accounts do
not give information in a summarized manner. Hence, there is a need for
summarizing information. In financial accounting, initially the accounting
information is summarized in the form of a Trial Balance. The Trial Balance is

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used to prepare and present the Trading account, Profit & Loss account, and
the Balance sheet. With this the accounting cycle comes to an end.

Once the financial statements are ready, they are analysed using different analytical
tools. The tools are the ratios and the fund flow and cash flow statement. Ratios are
used to analyse financial statements while the fund and cash flow statements
analyse the fund flow and cash flow position of the business.

Before we start with the implementation of the accounting cycle, let us first
understand few terms that are important for accounting such as Account, Debit and
Credit.

Account

An Account is a summarized record of various transactions pertaining to a particular

account head. It is commonly referred to as a Ledger Account. Let us understand
with the help of an example. ABC & Co. has a closing cash balance of Rs. 5,000 for
month ending April 2005. During the month of May, furniture worth Rs. 4,000 is
purchased while goods worth Rs. 6,000 are sold. Now to know the closing balance at
the end of the month, the accountant can deduct the outflow and add the inflow of
cash. This process can be cumbersome in case there are numerous transactions for a
single month.

To solve the problem we create an account for cash in which all the transactions
leading to an increase in cash are recorded in one column and the transactions
leading to a decrease in cash are recorded in another column. These two columns
are put in the form of an account. Given here is a simple presentation of an account.

Increases Amount Decreases Amount

(Rs.) (Rs.)

Opening Balance 5,000 Furniture 4,000

Sale of goods 6,000 Closing Balance 7,000
(Balancing figure)
Total 11,000 Total 11,000

Given here is a commonly used layout for an account.

Dat Typ Voucher/Bill Account Debit Credit Balance

e e Number

Under the Type column, the type of transaction is entered such as sales or payment.
The voucher or bill number is entered under the Voucher/Bill Number column. The
name of the Ledger Account that is affected by the transaction is entered under the
Account column. If the Ledger Account being created is debited then the amount is
written under the Debit column. On the other hand if the Ledger Account being
created is credited then the amount is written in the Credit column. The Balance
column displays the balance in the account after a transaction is recorded.

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Given here is another commonly used layout for an account.

Dr. Cr.
Dat Particular Foli Amount Dat Particulars Foli Amount
e s o e o

Total Total

The left hand side of the account is called the debit side while the right hand side is
called the credit side. The folio column records the page or reference number of the
accounting book where the entry was first recorded.
We will use the former account layout for Ledger Accounts.

Debit and Credit

The terms debit and credit refer to the additions to or subtractions from an account.
Debit is an accounting term that means ‘to owe’. It is used to describe a payment,
debt, or an entry in recording a transaction, the effect of which is to decrease a
liability, income, or capital account or increase an asset or expense account. Another
significance of the term ‘debit’ is that all the asset accounts have a debit balance.
Credit is the opposite of debit. It is an accounting term used to describe an entry
that increases an income, liability or capital account, and decreases an expense or
asset account. Another significance of the term ‘credit’ is that all the liability
accounts have a credit balance.

These terms find place in the accounting equation. The assets side of the accounting
equation will have those accounts that have a debit balance and the liabilities side
will have those accounts that have a credit balance.

The transactions that are recorded in the accounting books affect minimum two
accounts. One account will be debited while the other will be credited. Such debiting
and crediting is based on the classification of accounts and golden rules of
accounting.

Applying the Golden Rules of Accounting

The first stage of the accounting cycle i.e. identifying the transactions of financial
nature is a simple task. The problem usually comes at the second stage of the
accounting cycle, when these transactions have to be recorded. For this purpose the
account are classified under three types of accounts.

Classifying the Accounts

The accounts can be classified as:
 Personal accounts
 Real accounts
 Nominal accounts

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Personal Account
Personal Accounts are the account of persons or firms that the business deals with.
They are primarily of three types:
• Natural person’s accounts: represents the accounts of real persons the
business deal with. The proprietor's account, the accounts of suppliers and
customers are some examples of natural person’s accounts.
• Artificial person’s accounts: represents the accounts of firms the business
deals with. The accounts of a limited companies or banks that are not real
persons are the examples of artificial person’s accounts.
• Representative personal account: If a business has not paid the rent of a
number of shops for the past two months then all the landlords are creditors
of the business and the amount due to them is recorded under a common
head called Rent Outstanding Account. This is a representative personal
account. Other examples of representative personal accounts are interest
outstanding and interest paid in advance accounts.

Real Account

Real accounts are the accounts of the properties, assets, and possessions of a
business. They can be of two types:
• Tangible Real accounts: are accounts of things that can be touched,
measured, sold or purchased. Examples of tangible real accounts are furniture
account, plant account, and cash account.
• Intangible Real accounts: are accounts of things that cannot be touched in the
physical sense but can be measured in terms of money value. Goodwill,
trademark, and patent rights are examples of intangible real accounts.

Nominal Accounts

Nominal accounts are the accounts of income, expenses, gains, and losses of a
business. Without nominal accounts, it is difficult for the management to find out
where the money was spent. The net result of all the nominal accounts helps the
management to find out the profit earned or loss incurred by the business. Some
examples of nominal accounts are sales account, purchase account, salaries account,
and electricity account.

Understanding the Golden Rules of Accounting

Certain rules have to be followed to decide which account is to be debited and which
is to be credited. The rules are given here:
Rule 1: Rule for Personal accounts: Debit the receiver and credit the giver.
Rule 2: Rule for Real accounts: Debit what comes in and credit what goes out.
Rule 3: Rule for Nominal accounts: Debit all expenses and losses and credit all
income and gains.

Rule for Personal Accounts

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In a Personal account, the rule to be followed is, “Debit the receiver and Credit the
giver”.

The debit balance in a personal account shows that the business has to receive
money or equivalent and a credit balance shows that the business owes something.
For example, a sale of three pieces of garments (code-001) of Rs. 500 each is made
to Ashok Singh, a customer of ABC & Co. who does not make the payment at the
time of the sale. In such a case Ashok Singh is liable to pay Rs. 1500 to ABC & Co.
Hence, in the books of accounts of ABC & Co., Ashok Singh's account is debited since
he has received goods.
Ashok Singh is
Ashok Singh has receiver of
received goods. goods and is
Ashok
Singh debited.

ABC & Co. Goods have

gone out of the
Sales business, thus
Goods sold to Ashok
Sales a/c is
Singh.
credited
Given here is a tabular representation of the accounts and the effect on the
accounts.

Ledger Nature Of Golden Rule Debited/Credite Amount

Account Accounts Applied d (Rs.)
Ashok Singh Personal Rule 1 Debited: Received 1,500
goods
Sales Nominal Rule 3 Credited: Goods 1,500
gone out of the
business

From the above information, a voucher is made. A voucher is a source or supporting

document. It is the first record prepared for a business transaction and serves as the
basis for recording transactions in the accounting books. Depending on the type of
transaction, different vouchers are created.

In this case, an Invoice or a Bill will be created since a credit sale has been made.
Given here is the format of an Invoice/Bill.

Invoice
ABC & Co.
Voucher No: Date:
(Party Name and Address) Ashok Singh

Quantity Particulars Rate Amount

(Rs.) Rs. P.
3 pieces Garment code- 500 1,500 00
001
Total
1,500 00

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Rupees fifteen hundred only

E. & O. E. Sales Manager

From the above voucher a journal entry can be made. A journal entry is a simple
extraction of data from the source documents. This journal entry is recorded in the
appropriate accounting books in a particular format.
Given here is the journal entry made from the information given in the above
voucher.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.) (Rs.)
D Ashok Singh 1,500
C Sales 1,500
Narration (Being goods sold on credit to Ashok Singh)

In the Debit/Credit Column, specify whether the account is to be debited or credited.

In the Ledger Account column, specify the Ledger Account to be debited or credited.
In the last two columns, mention the debit amount in the debit column and the credit
amount in the credit column.

Note: In the transaction discussed here, Sales account is affected since the goods
are sold for trading purpose. In other words, if selling goods is a regular business
activity, then Sales Account will be affected in a sales transaction.

Rule for Real Accounts

In a Real account, the rule to be followed is, “debit what comes in and credit what
goes out.”

Debiting a real account implies increase in the value of goods, stocks, and any other
property in a business. Crediting a real account denotes decrease in the value of the
goods, stocks, and properties in a business. The debit balance in a real account
means that the firm owns and has assets, such as goods, stocks, and properties.
Credit balance shows that the business has negative balance for these assets. In
practice, there cannot be a credit balance in a real account except when the property
has been sold at a profit.

For example, if ABC & Co. bought Machine (code-001) for Rs. 25,000 then value of
Machine in the business increases. Hence, Machine account is debited. Since
payment is made in cash the balance of cash decreases and Cash account is
credited.

Machine purchased Machine

ABC & Co.

Cash goes out of the Cash

business in exchange
for machine
Given here is a tabular representation of the accounts and the effect on the
accounts.

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Ledger Nature Of Golden Rule Debited/Credite Amount

Account Accounts Applied d (Rs.)
Machine Real Rule 2 Debited: Machine 25,000
has come in the
business
Cash Real Rule 2 Credited: Cash 25,000
gone out of the
business

From the above information, a voucher is made. In this case, a debit voucher is
created. A debit voucher is prepared when payment is made against expenses,
purchase of goods, payment to creditors, deposits in bank and drawings and so on.

Debit Voucher
(Party Name and Address) ABC & Co.
Rs…………..
Received
Receipt

Voucher No: Date:

Debit: Machine a/c 25,000
(Being machine bought on cash basis)

25,000

Authorized Signatory Accountant

From the above voucher a journal entry can be made. Given here is a journal entry.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.) (Rs.)
D Machine 25,000
C Cash 25,000
Narration (Being machine bought for cash)

Note: In this case, the Machine account is affected by the transaction since the
machine is purchased for operating the business. In case the machine was
purchased for trading purpose i.e. purchase and sale of machine was a regular
business activity, then the Sales account will be affected.

Rule for Nominal Accounts

In a Nominal account, the rule to be followed is, “Debit all expenses and losses and
Credit all incomes and gains.”

All debits in a nominal account imply that there has been an expense or the business
has made a loss in a transaction. A credit in a nominal account denotes that the
business has earned money, income or profit. A debit balance in nominal account
indicates a loss or an expense. A credit balance indicates a gain or an income.

For example, ABC & Co. pays Rs. 6,000 salaries in cash. Since payment of salaries is
an expense for the company, Salaries account is debited. Moreover, payment of
salaries is made in cash, thus the balance of cash decreases and Cash account is
credited.

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Expenses incurred for

the business Salaries

ABC & Co.

Cash goes out of the Cash

business

Given here is a tabular representation of the accounts and the effect on the
accounts.

Ledger Nature Of Golden Rule Debited/Credite Amount

Account Accounts Applied d (Rs.)
Salaries Nominal Rule 3 Debited: Expense 6,000
for the business
Cash Real Rule 2 Credited: Cash 6,000
gone out of the
business

From the above information, a voucher is made. In this case, a debit voucher is
prepared for payment against expenses.

Debit Voucher
(Party Name and Address) ABC & Co.
Rs…………..
Received
Receipt

Voucher No: Date:

Debit: Salaries A/C 6,000
(Being salaries paid in cash) 6,000

Authorized Signatory Accountant

From the above voucher a journal entry can be made. Given here is the journal
entry.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.) (Rs.)
D Salaries 6,000
C Cash 6,000
Narration (Being salaries paid in cash)

We have discussed the application of the golden rules for the three types of
accounts. Now let us go through the golden rules summarised here in the form of a
table.

Rules of Debit and Credit

Type of Account Debit Effect Credit Effect
Personal account The receiver The giver

Real account What comes in What goes out

Nominal account All losses and expenses All incomes/gains

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We have discussed the three types of accounts with the help of some transactions.
There are many other transactions that are commonly carried out in a business
scenario. Let us discuss some of these transactions.

Common Transactions for a Business

Besides the credit sale and payment transactions, there are many other transactions
that are carried out in a business scenario. These are discussed here.

Transaction for Cash Sale

ABC & Co. sold 10 pieces of garments (Code-005) worth Rs. 1,000 each on cash
basis.
Given here is a tabular representation of the accounts and the effect on the
accounts.

Ledger Nature Of Golden Rule Debited/Credite Amount

Account Accounts Applied d (Rs.)
Cash Real Rule 2 Debited: Received 10,000
cash
Sales Nominal Rule 3 Credited: Goods 10,000
gone out of the
business

From the above information, a voucher is made. In case of a cash sale, a Cash Memo
is made. Given here is the format of a cash memo.

Cash Memo
ABC & Co.
No. Date:
Quantity Description Rate Amount
(Rs.) Rs. P.
10 Garments (Code-005) 1,000 10,000 00
10,000 00

Goods once sold will not be taken back. For ABC & Co.

From the above voucher a journal entry can be made. Given here is the journal
entry.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.) (Rs.)
D Cash 10,000
C Sales 10,000
Narration (Being goods sold on cash basis)

Transaction for Receipt of Cash

Investments worth Rs. 15,000 are sold on cash basis.

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Given here is a tabular representation of the accounts and the effect on the
accounts.

Ledger Nature Of Golden Rule Debited/Credite Amount

Account Accounts Applied d (Rs.)
Cash Real Rule 2 Debited: Received 15,000
cash
Investment Real Rule 2 Credited: 15,000
Investments sold

From the above information, a voucher is made. In this case, a Credit Voucher is
made. A Credit Voucher is prepared when cash is received against sale of
investments, receipt from debtors and so on.

Given here is the format of a Credit Voucher.

Credit Voucher
ABC & Co.
Voucher No: Date:
Amount
Rs.
Credit: Investment a/c 15,000
(Being goods sold for cash)
Total 15,000
Sd/- Sd/-
Manager Accountant

From the above voucher a journal entry can be made. Given here is the journal
entry.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.) (Rs.)
D Cash 15,000
C Investments 15,000
Narration (Being investments sold on cash basis)

Transaction with Banks

Rs. 12,000 due to XYZ & Co., the creditor, paid by cheque. In such a case, ABC &
Co. issues a cheque for XYZ & Co. and creates a debit voucher for recording the
transaction.

Given here is a tabular representation of the accounts and the effect on the
accounts.

Ledger Nature Of Golden Rule Debited/Credite Amount

Account Accounts Applied d (Rs.)
XYZ & Co. Personal Rule 1 Debited: Received 12,000
cash
PNB Bank Personal Rule 1 Credited: Money 12,000
gone out of PNB
Bank by cheque

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From the above information, a cheque and a debit voucher is made. Given here is
the format of the debit voucher.

Debit Voucher
(Party Name and Address) ABC & Co.
Rs…………..
Received
Receipt
Voucher No: Date:
Debit: XYZ & Co. a/c 12,000
(Being amount due to creditor paid by cheque)
12,000

Authorized Signatory Accountant

From the above voucher a journal entry can be made. Given here is the journal
entry.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.)
(Rs.)
D XYZ & Co. 12,000
C PNB Bank 12,000
Narration (Being amount due to creditor paid by cheque)

Transaction of Non Cash nature

Furniture worth Rs. 24,000 bought on credit from XYZ & Co. In such a case, ABC &
Co. creates a non-cash voucher, also known as transfer voucher. Non-cash vouchers
are prepared for transactions that do not involve cash.

Given here is a tabular representation of the accounts and the effect on the
accounts.

Ledger Nature Of Golden Rule Debited/Credite Amount

Account Accounts Applied d (Rs.)
Furniture Real Rule 2 Debited: Furniture 24,000
has come into the
business
XYZ & Co. Personal Rule 1 Credited: XYZ & 24,000
Co. has given/sold
the furniture to
ABC & Co.

From the above information, a non-cash/transfer voucher is made. Given here is the
format of the non-cash/transfer voucher.

Transfer Voucher

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ABC & Co.

Voucher No: Date:
Amount
Debit: Furniture a/c Rs.
24,000
24,000

Credit: XYZ & Co. a/c 24,000

(Being furniture purchased on credit) 24,000

Sd/- Sd/-
Manager Accountant

From the above voucher a journal entry can be made. Given here is the journal
entry.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.) (Rs.)
D Furniture 24,000
C XYZ & Co. 24,000
Narration (Being furniture purchased on credit)

Classifying and Summarizing Records

The classifying stage of the accounting cycle involves preparing the Ledger Accounts.
Journal entries do not give a clear idea about the effect of transactions on the
business. The common practice is to prepare Ledger Accounts from journal entries.

Classifying transactions under various Account Heads

A Ledger is a book of account in which data from transactions recorded in accounting
books are posted and thereby classified.

In other words, a ledger is a register that contains a record of all the transactions
carried out by a business in a classified form. Transactions are posted to the
appropriate accounts and these accounts are put together in a register that is known
as a Ledger. For example, all the transactions for sales are recorded in the Sales
account while the transactions for cash are recorded in the Cash account. When
these two accounts are put together then we get a Ledger. An account is also known
as Account Ledger or Ledger Account.

Given here is the format of a Ledger Account.

Ledger Account
Dat Typ Voucher/Bill Account Debit Credit Balance
e e Number
(Rs.) (Rs.) (Rs.)

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In the Ledger Account, there are seven columns for date, type, voucher/bill number,
account, debit, credit, and balance. Under the Type column, the type of transaction
is entered such as sales or payment. The voucher or bill number is entered under the
Voucher/Bill Number column. The name of the other Ledger Account that is affected
by the transaction is entered under the Account column. If the Ledger Account being
created is debited then the amount is written under the Debit column. On the other
hand if the Ledger Account being created is credited then the amount is written in
the Credit column. The Balance column displays the balance in the account after a
transaction is recorded.

Let us understand how the journal entries are posted to a Ledger Account. We will
continue with the case scenario of ABC & Co.

Debit/Credit Ledger Account Debit Amount Credit Amount

(Rs.) (Rs.)
D Ashok Singh 1,500
C Sales 1,500
Narration (Being goods sold on credit to Ashok Singh)

Let us first create a Ledger Account for Ashok Singh.

Under the Type column, we will write Sale since the transaction is a sales
transaction. Further under the Account column we will write the name of the other
account that is affected by the transaction. In this case the other account is Sales.
Next we will write the amount under Debit or Credit column depending upon whether
Ashok Singh’s account is debited or credited. In this case, Ashok Singh’s account is
debited thus we will write the amount under Debit Column. Finally under the Balance
column we will write the balance left in the account after the transactions. For the
journal entry of credit sale, the posting in Ashok Singh’s account will be as given
here.

Ashok Singh Account

Date Typ Voucher/Bill Account Debit Credit Balance
e Number
(Rs.) (Rs.) (Rs.)
26/06/05 Sales 001 Sales 500 500

Note: The amount is written under the Debit or Credit column depending on whether
the account being created is debited or credited. It has no relation with the other
accounts that are affected by the transaction. For example, in the case scenario
discussed here, in Ashok Singh’s account, the other account is Sales and the amount
is written under Debit column since Ashok Singh’s account is debited in the journal
entry.

Similarly for Sales account, we will write Ashok Singh account under the Account
column and the amount under the Credit column since Sales account is credited.

Sales Account

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Date Typ Voucher/Bill Account Debit Credit Balance

e Number
(Rs.) (Rs.) (Rs.)
26/06/05 Sales 001 Ashok Singh 500 500

Summarizing records under a Trial Balance

The Ledger Accounts provide necessary information regarding various accounts. The
debit or credit balances of the Ledger Accounts are listed in the Debit and Credit
columns of the Trial Balance.

Trial Balance is a statement prepared to show the debit and credit balances of the
accounts in two different columns. Matching of the Debit and Credit balances in Trial
Balance columns indicate arithmetic accuracy of the accounting records. It also
summarizes the account information in a tabular format.

To prepare the Trial Balance, the debit and the credit balances are written in two
separate columns, which are placed right next to each other, while the account name
is written in the name of account column.

Given here is the format of a Trial Balance. We will continue with the case scenario of
ABC & Co.
Trial Balance of ABC & Co. as on March 31, 2005

Name of Account Dr. Amount Cr. Amount

(Rs.) (Rs.)
Capital (Mr. Sharma’s a/c) 27,000
Cash in hand 12,000
Cash at bank (PNB Bank) 24,050
Opening Stock 4,000
Machinery 10,000
Furniture 4,700
Debtors 950
Loan from Bank 9,000
Creditors 2,000
Loan from a non-financial 20,000
institution
Purchases 4,000
Sales 3,000
Repairs on machinery 100
Taxes 100
Advertisement 500
Rent 100
Salaries 500
Total 61,000 61,000

Presenting Financial Statements

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The objective of preparing financial statements is to present financial information in

a format that will help the business to arrive at balanced business decisions.

We have already prepared the Trial Balance in the previous topic. Now we will
prepare the Financial Statements.

Creating the Income Statement

Primarily, financial statement consists of an Income statement and a Balance sheet

of the business. The Income statement calculates the profit earned or loss incurred
by a business. The Income statement is a summary of various income and expense
items that affect the profit or loss of the business. It is prepared from the Nominal
Accounts that appear in the Trial Balance.

The Income statement is divided into two parts.

 Trading Account
 Profit & Loss Account

Trading Account

The Trading account is created to calculate the gross profit earned or gross loss
incurred by the business. The closing balances of all direct expenses and direct
income included in the Trial Balance are transferred to the Trading account. We can
calculate the gross profit or loss by listing the items of expense on the debit side and
the items of income on the credit side and balance the account.

If the income side is more than the expense side, there is a gross profit. However, if
the expense side is more than the income side, there is a gross loss.
Gross profit or gross loss is defined as the difference between the ‘net sales’ and
‘cost of goods sold’.

Gross profit/gross loss = Net Sales – Cost of goods sold

This equation is known as the gross profit equation.

Net Sales is the difference between ‘total sales’ and ‘sales return’.
Cost of goods sold is the difference between the sum of ‘opening stock, net
purchases, direct expenses’ and the Closing stock.
Cost of Goods Sold = Opening Stock + Net Purchase + Direct Expenses – Closing
Stock

Note: Cost of Goods Sold is an important term in accounting. It is commonly referred

to as COGS.

Direct expenses refer to those expenses that are incurred on the goods purchased till
they are brought to the place of business for sale. Some examples of direct expenses
are carriage inward, manufacturing wages, factory lighting, and power and fuel.

Direct income refers to the income that arises from the sale of trading goods.

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Given here is the format of a Trading Account. We will continue with the case
scenario of ABC & Co. In addition to the Trial Balance, additional information is
given. There is closing stock worth Rs. 12,000 at the end of the year.
Trading Account of ABC & Co.
Dr. for the year ending March 31, 2005 Cr.

Particulars Amount Particulars Amount

(Rs.) (Rs.)
To Opening 4,000 By Sales a/c 3,000
Stock a/c By Closing a/c 12,000
To Purchases 4,000
a/c
To Gross 7,000
Profit
(balancing
figure)
Total 15,000 Total 15,000

Profit & Loss Account

In the Profit & Loss Account only the indirect income and indirect expenses are
considered. There are many indirect expenses, such as rent and indirect incomes
such as interest received on loan extended to a third party that are taken into
account for calculating profit or loss. For this purpose, the Profit & Loss account is
created that helps us to calculate net profit or loss.

The closing balances of all indirect expenses and indirect incomes included in the
Trial Balance are transferred to the Profit & Loss account. We can calculate the net
profit or loss by listing the items of expense on the debit side and the items of
income on the credit side and balance the account.
If the income side is more than the expense side, there is a net profit. However, if
the expense side is more than the income side, there is a net loss.

Net Profit/Net Loss = Gross Profit/Gross Loss – Indirect expenses + Non-sales

income

This equation is known as the net profit equation.

Indirect expenses are those expenses that are incurred for carrying on the day-to-
day business such as rent, salaries, and so on.
Indirect income refers to the income that does not arise from the sale of trading
goods such as interest received on loan given to a third party.

Given here is the format of a Profit & Loss Account. We will continue with the case
scenario of ABC & Co. In the example, the gross profit earned is Rs. 7,000.
Profit & Loss Account of ABC & Co.
Dr. for the year ending March 31, 2005 Cr.

Particulars Amount Particulars Amount

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(Rs.) (Rs.)

To Repairs on 100 By Gross Profit 7,000

machinery a/c
To Tax a/c
100
To
500
Advertisement
a/c
To Rent a/c 100
To Salaries 500
a/c
5,700
To Net Profit
(balancing
figure)

Total 7,000 Total 7,000

Creating the Balance Sheet

The Balance Sheet is a Financial Statement prepared after the Income Statement. It
depicts the financial position of the business by listing the assets and liabilities as on
a certain date. It depicts what the business owes and what it owns on a certain date.

The Balance Sheet is prepared from the Real and Personal Accounts listed in the Trial
Balance. The balances of Real and Personal accounts are grouped as assets and
liabilities and are arranged in a proper way in the Balance sheet. Further, the net
profit or net loss calculated in the Income Statement is added to or subtracted from
the Capital appearing in the Balance Sheet.

Given here is the format of a Balance Sheet.

Balance Sheet of …
as on …
Liabilities Amount Assets Amount

Capital XXX Fixed Assets XXXX

(Add) Net Profit (from Investments XXXX
Income Statement)
XXXX Current Assets XXXX
XXX
XXXX
(Less) Net Loss (from
Income Statement) XXXX
XXX
XXXX
Reserves and Surplus
Long-term Liabilities
Current Liabilities

Total XXXXX Total XXXXX

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Let us understand with the help of an example. We will continue with the case
scenario of ABC & Co. In the example, the net profit earned is Rs. 5,700.

Balance Sheet of ABC & Co.

as on March 31, 2005
Liabilities Amount Assets Amount

Capital Machinery 10,000

27,000
32,700 Furniture 4,700
+ Net Profit
Closing Stock 12,000
5,700
Debtors 950
Loans
Cash at bank (PNB 24,050
Loan from Bank
Bank)
9,000 29,000 12,000
Cash in hand
Loan from Non- 2,000
Financial Institution
20,000
Creditor

Total 63,700 Total 63,700

Note: In the example given here, the closing stock is included both in the Trading
Account and the Balance Sheet. The reason behind this is that the closing stock
information was not given in the Trial Balance; rather it was given as additional
information.

In Financial Accounting if an item is given in the Trial Balance then it will be

transferred to either the Income Statement or the Balance Sheet. On the other hand,
if the item is not given in the Trial Balance and is given as additional information,
then it will have two effects. It will appear both in the Income Statement and the
Balance Sheet.

After the Balance Sheet is created, the accounting cycle comes to an end. Next, the
Financial Statements are analysed and interpreted to find out the strengths and
weaknesses of the business.

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