Learning Objectives After studying this unit, you will be able to :
1. 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 aspects–debit 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.
2. ADVANTAGES OF DOUBLE ENTRY SYSTEM
This system affords the under mentioned advantages:
(i) By the use of this system the accuracy of the accounting work can be established, through the device of the trial balance.
(ii) The profit earned or loss suffered during a period can be ascertained together with details.
(iii) The financial position of the firm or the institution concerned can be ascertained at the end of each period, through preparation of the balance sheet.
(iv) The system permits accounts to be kept in as much details as necessary and, therefore affords significant information for the purposes of control etc.
(v) Result of one year may be compared with those of previous years and reasons for the change may be ascertained.
It is because of these advantages that the system has been used extensively in all countries.
We have seen how the accounting equation becomes true in all cases. A person starts his business with say, 10,000; capital and cash are both 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 referred 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, 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:
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.
4. DEBIT AND 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.
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 among 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.
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; similarly to record an amount on the right-hand side is to credit it.
From the above, the following rules can be obtained:
(i) 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 ` 800, the furniture account will be debited by 800 since the asset has increased by this amount. Suppose later the firm sells furniture to the extent of ` 300, the reduction will be recorded by crediting the furniture account by 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 500 from Mohan; Mohan’s account will be credited since 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, favorable and unfavorable things. They merely describe the two sides of accounts.
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.
6. 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 5,00,000 and taking loan of 1,00,000 from a bank to be repayable, after 5 years. He purchased furniture costing 1,00,000, and merchandise worth 5,00,000. For purchasing the merchandise he paid 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 payables, and for other purchases and services received on credit as expense payables. These short-term liabilities are also termed as current liabilities.
On the other hand, money raised has been invested in two types of assets–fixed 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.
Cash = Capital + Loan - Furniture - Payment to Trade payables
= 5,00,000 + 1,00,000 - 1,00,000 - 4,00,000 = 1,00,000
Let us use Eo, Lo and Ao to mean Equity, Liabilities and Assets respectively at t0. Thus the basic accounting equation becomes E0 + L0 = A0
or E0 = A0 - L0 ...(Eq. 1)
Now, let us suppose that at the end of period inventory valuing 2,50,000 is in hand, cash 2,00,000, trade payables,50,000 bank loan 1,00,000 (interest was properly paid), furniture 80,000 (20,000 is taken as loss of value due to use). So at t1 -
Equity = Assets - Liabilities
i.e., E1 = A1 - L1 or E1 + L1 = A1 ...(Eq. 2)
Let us compare E1 with E0. Equity is reduced by 1,20,000 (5,00,000 - 3,80,000). Reduction in equity is termed as loss.
Since the business sustained loss during the period, E2 becomes less than E0.
E1 < E0 implies loss during t01 Similarly, E2 < E1 implies loss during t12 and so on.
On the other hand, E1 > E0 implies profit earned by business during t01, E2 > E1 implies profit earned during t12 and so on.
So if En > En-1, in general terms, equity has increased, while En < En-1 implies that equity has declined. Increase in equity is termed as profit while decrease in equity is termed as loss.
Illustration 2: Develop the accounting equation from following information available at the beginning of accounting period:
At the end of the accounting period the balances appear as follows :
(a) Reset the equation and find out profit.
(b) Prepare Balance Sheet at the end of the accounting period.
Solution (a) Accounting equation is given by Equity + Liabilities = Assets Let us use E0, L0 and A0 to mean equity, liabilities and assets respectively at the beginning of the accounting period.
E0 = 1,00,000
L0 = Loan + Trade payables = 50,000 + 70,000
A0= Fixed Assets + Inventories + Trade receivables + Cash at Bank = 80,000 + 60,000 + 50,000 + 30,000
So, at the beginning of accounting period E0 + L0 = A0
i.e., 1,00,0 00 + 1,20,000 = 2,20,000
Let us use E1, L1, A1 to mean equity, liabilities and assets respectively at the end of the accounting period.
L1 = Loan + Trade payables = 50,000 + 80,000
A1= Fixed Assets + Inventories + Trade receivables + Cash at Bank = 72,000 +90,000 + 50,000 + 60,000
E1 = A1 - L1 = 2,72,000 - 1,30,000 = 1,42,000
Profit = E1 - E0 = 1,42,000 - 1,00,000 = 42,000
(b) Balance Sheet
7. 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 in para 4 of this Unit.
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.
7.1 CLASSIFICATION OF ACCOUNTS
(i) Personal Accounts: Personal accounts relate to persons, trade receivables or trade payables. 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 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.
7.2 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.