1.

2 FINANCIAL ACCOUNTING & ANALYSIS

Unit I:

Introduction to Financial Accounting: Accounting as an Information System, Importance and Scope,

Limitations; Users of accounting information, Concepts, Principles and Conventions – Generally
Accepted Accounting Principles; The Accounting Equation; Nature of Accounts, Types of books
(Primary and Secondary) and Rules of Debit and Credit; Recording Transactions in Journal; Preparation
of Ledger Accounts; Opening and Closing Entries; Preparation of Trial Balance.

Unit II:

Preparation of Financial Statements: Trading Account, Profit & Loss Account and Balance Sheet,
Adjustment Entries, Understanding contents of financial statements of a joint stock company as per
the Companies Act 2013; Understanding the contents of annual report of a company, Preparation of
cash flow statement as per AS-3 (revised).

Unit III:

Indian Accounting Standards (Ind-AS): Concept, benefits, procedure for issuing Ind-AS in India, salient
features of Ind-AS issued by ICAI; International Financial Reporting Standards(IFRS): Main features,
uses and objectives of IFRS, IFRS issued by IASB and concept of harmonization and convergence,
obstacle in harmonization and convergence, suggestions for increased convergence and
harmonization.

Unit - IV

The Concept of Depreciation, Causes, Factors affecting Depreciation ,Depreciation methods,

Accounting for Depreciation.

Unit V:

Financial Statement Analysis: Objective of financial statement analysis, sources of information;

Techniques of financial statement analysis: Horizontal analysis, Vertical analysis and Ratio Analysis;
Financial Ratios: Meaning and Usefulness of Financial Ratios. Analysis of ratios from the perspective of
Stakeholders like Investors, Lenders, and Short- term Creditors.Liquidity Ratios, Solvency Ratios,
Profitability Ratios, and Turnover Ratios; Limitation of ratio analysis
Unit I
ORIGIN AND GROWTH OF ACCOUNTING
Accounting is as old as money itself. However, the act of accounting was not as developed as it
is today because in the early stages of civilization, the number of transactions to be recorded
were so small. In India, accounting was practiced in twenty three centuries ago as it is cleared
from the book named "Arthashastra" written by Kautilya, King Chandragupta's minister. This
book not only relates to politics and economics, but also explains the art of proper keeping of
accounts.

However, the modern system of accounting based on the principles of double entry system owes
it origin to Luco Pacioli who first published the principles of Double Entry System in 1494 at
Venice in Italy.

MEANING OF ACCOUNTING
The main purpose of accounting is to ascertain profit or loss during a specified period, to show
financial condition of the business on a particular date and to have control over the firm's
property. Such accounting records are required to be maintained to measure the income of the
business and communicate the information so that it may be used by managers, owners and other
interested parties. Accounting is a discipline which records, classifies, summarizes and interprets
financial information about the activities of a concern so that intelligent decisions can be made
about the concern.
The American Institute of Certified Public Accountants has defined the Financial Accounting as
"the art of recording, classifying and summarizing in as significant manner and in terms of
money transactions and events which in part, at least of a financial character, and interpreting the
results thereof".
American Accounting Association defines accounting as "the process of identifying, measuring,
and communicating economic information to permit informed judgments and decisions by users
of the information.

From the above the following attributes of accounting emerge :

(i) Recording : It is concerned with the recording of financial transactions in an orderly
manner, soon after their occurrence In the proper books of accounts.
(ii) Classifying : It Is concerned with the systematic analysis of the recorded data so as to
accumulate the transactions of similar type at one place. This function is performed by
maintaining the ledger in which different accounts are opened to which related transactions are
posted.
(iii) Summarizing : It is concerned with the preparation and presentation of the classified
data in a manner useful to the users. This function involves the preparation of financial
statements such as Income Statement, Balance Sheet, Statement of Changes in Financial
Position, Statement of Cash Flow, Statement of Value Added.
(iv) Interpreting : Nowadays, the aforesaid three functions are performed by electronic
data processing devices and the accountant has to concentrate mainly on the interpretation
aspects of accounting. The accountants should interpret the statements in a manner useful to
 action. The accountant should explain not only what has happened but also (a) why it happened,
and (b) what is likely to happen under specified conditions.

INTRODUCTION TO FINANCIAL ACCOUNTING

Financial accounting is the field of accounting concerned with the summary, analysis and
reporting of financial transactions related to a business. This involves the preparation of financial
statements available for public use.

Accounting as an Information system

An accounting as an information system (AIS) is a system of collecting, storing and processing

financial and accounting data that are used by decision makers. An accounting information
system is generally a computer-based method for tracking accounting activity in conjunction
with information technology resources. Accounting provides all of the organization's information
by preparing financial statements for the users concerned according to their needs. That is why
accounting is called the information system.

OBJECTIVES OF ACCOUNTING

The following are the main objectives of accounting:

 To keep systematic records : Accounting is done to keep a systematic record of financial

transactions. In the absence of accounting there would have been terrific burden on human
memory which in most cases would have been impossible to bear.
 To protect business properties : Accounting provides protection to business properties from
unjustified and unwarranted use. This is possible on account of accounting supplying the
following information to the manager or the proprietor:
(i) The amount of the proprietor's funds invested in the business.
 (ii) How much the business have to pay to others?
(iii) How much the business has to recover from others?
(iv) How much the business has in the form of (a) fixed assets, (b) cash in hand, (c) cash at bank,
(v) Stock of raw materials, work-in-progress and finished goods?

 To ascertain the operational profit or loss : Accounting helps in ascertaining the net profit
earned or loss suffered on account of carrying the business.
 To ascertain the financial position of the business : The Profit and Loss Account gives the
amount of profit or loss made by the business during a particular period. The businessman must
know about his financial position i.e. where he stands ?, what he owes and what he owns? This
objective is served by the Balance Sheet or Position Statement. The Balance Sheet is a statement
of assets and liabilities of the business on a particular date. It serves as barometer for ascertaining
the financial health of the business.

 To facilitate rational decision making : Accounting these days has taken upon itself the task of
collection, analysis and reporting of information at the required points of time to the required
levels of authority in order to facilitate rational decision-making.
 Information System : Accounting functions as an information system for collecting and
communicating economic information about the business enterprise. This information helps the
management in taking appropriate decisions. This function, as stated, is gaining tremendous
importance these days.

Importance of Accounting

Accounting plays a vital role in running a business because it helps you track income and
expenditures, ensure statutory compliance, and provide investors, management, and government
with quantitative financial information which can be used in making business decisions.

There are three key financial statements generated by your records.

 The income statement provides you with information about the profit and loss
 The balance sheet gives you a clear picture on the financial position of your business on a
particular date.
 The cash flow statement is a bridge between the income statement and balance sheet and
reports the cash generated and spent during a specific period of time.

It is critical you keep your financial records clean and up to date if you want to keep your
business afloat. Here are just a few of the reasons why it is important for your business, big or
small!

It Helps in Evaluating the Performance of Business

Your financial records reflect the results of operations as well as the financial position of your
small business or corporation. In other words, they help you understand what’s going on with
your business financially. Not only will clean and up to date records help you keep track of
expenses, gross margin, and possible debt, but it will help you compare your current data with
the previous accounting records and allocate your budget appropriately.

It Ensures Statutory Compliance

Laws and regulations vary from state to state, but proper accounting systems and processes will
help you ensure statutory compliance when it comes to your business.

The accounting function will ensure that liabilities such as sales tax, VAT, income tax, and
pension funds, to name a few, are appropriately addressed.

It Helps to Create Budget and Future Projections

Budgeting and future projections can make or break a business, and your financial records will
play a crucial role when it comes to it.

Business trends and projections are based on historical financial data to keep your operations
profitable. This financial data is most appropriate when provided by well-structured accounting
processes.

It Helps in Filing Financial Statements

Businesses are required to file their financial statements with the Registrar of Companies. Listed
entities are required to file them with stock exchanges, as well as for direct and indirect tax filing
purposes. Needless to say, accounting plays a critical role in all these scenarios.

Scope of Accounting

Financial accounting:
Financial accounting is a particular part of bookkeeping, including a course of recording,
summing up, and revealing the horde of exchanges coming about because of business activities
throughout some undefined time frame. Work openings for a financial bookkeeper can be found
in both private sectors and in public sectors.
Management accounting:
Management accounting is the method involved with planning reports about business activities
that assist supervisors with settling on the present moment and long-haul choices and decisions.
It helps a business seek after its objectives by recognising, estimating, examining, deciphering,
and imparting data to directors.
Cost accounting:
Cost accounting is the analysing and reporting of an organisation’s expense or cost structure.
Cost bookkeeping is a course of doling out expenses to cost protests that ordinarily incorporate
an organisation’s items, administrations, and whatever other exercises that include the
organisation.

Limitations of Accounting
Besides studying accounting, it is also important to understand the limitations of
accounting. These limitations have been discussed below:
 Historical Costs - To measure the values, accounting considers historical costs.
However, this process does not allow considering important areas of accounting
like inflation, price changes and similar things as such. Further, this reduces the
importance of accounting information and records. Hence, historical costs are
considered to be one of the important limitations of accounting.
 Estimates - Another important limitation of accounting is estimation. The reason
behind is that not all accounting can be done to establish the exact amount and
hence it is essential to estimate. But the drawback in such a scenario is that the
accountant makes the estimation based on his or her judgment. This estimation is
extremely subjective as they are based on the assumption of future events. Such
estimation results in doubtful debts and often at times leads to depreciation.
 Verifiability - The correctness of the financial statement or for that matter an
audit, cannot be guaranteed. The verification of the statements depends only on the
judgment and ability of the auditor and hence creates plenty of limitations in
accounting.
 Measurability - Events or things that do not have monetary value cannot be
measured in accounting. Such events or things include management, reputation,
loyalty, and dedication which cannot be expressed in money and therefore has no
place in accounting. These important qualities are responsible for the growth of the
organization but they cannot be measured and put in financial statements. Thus it
becomes one of the important limitations of financial accounting.
 No Future Assessments - The financial statements prepared are based on the date
or the period of preparation. But when it reaches the authorities of the company to
assess the future position of the firm it does not have any clarification as it does
not provide the record of the present. All businesses are dynamic and change is
inevitable. To understand more about this limitation, the student can refer to the
limitations of accounting Class 11.
 Errors and Frauds - These two limitations are the most common ones in
accounting. Error is ought to happen as the financial statements are prepared by
humans and not machines and fraudulency occurs whenever there is the
involvement of manipulation or similar other external or internal factors. These
factors are very hard to recognize and rectify at the same time. Thus, this
limitation is highly dangerous for any business or firm.
  Users of Accounting

Internal Users(Primary Users) External Users(Secondary Users)

Internal Management Investors

Proprietor/ Partners Lenders

Employees Legal Bodies

Customers

Suppliers

General Public

Government

Researchers

Followings are internal users of accounting information:

• Management – Organization’s internal management includes all junior and senior business
managers.
• Owners/Partners – Owners are the legal stakeholders of the business and the ultimate signing
authority.
• Employees – Full-time & part-time workers. They are essentially on the company’s payroll.
Following are the secondary users of accounting information:

• Investors – They may be current investors, minority stakeholder, potential future investors, etc
• Lenders – Banks and Non-banking financial companies which provide loans in the form of cash
or credit are termed as lenders.
• Regulatory and Tax Authorities – Regulatory bodies such as the stock exchange & authorities
include the govt. along with various statutory and tax departments
• Customers – Are buyers of goods or services and may exist at any stage of a business cycle.
They may be producers, manufacturers, retailers, etc.
• Suppliers – Are the sellers of goods and services.
• The general public is also among users of accounting information. They are keen to know the
financial health of a business to get a fair idea of the firm’s niche market, business environment,
and economic atmosphere of the country.

GAAP (generally accepted accounting principles) is a collection of commonly followed

accounting rules and standards for financial reporting. The acronym is pronounced gap.
GAAP emerged in the 1970s and involved the following four major rules and standards:

 Accrual accounting methods. GAAP uses accrual accounting, which records revenue
when a service or good is sold but not when payment is received; direct expenses for
goods sold are recorded when a sale is transacted, and indirect expenses are recorded
when expenses are paid.
 Depreciation and capital expenditures. Costs of major asset acquisitions are accounted
for over the entire life of the asset. For example, an item with a 10-year life is accounted
for at 10% for 10 years.
 Reporting of historical costs. Some assets -- such as property, equipment and facilities
-- are accounted for using original purchase costs rather than current market values.
 Reporting of bad debts. Companies with significant money owed by customers, or
accounts receivable, must report the possibility that some or all of that money may not be
received and becomes lost revenue.

10 principles of GAAP

1. Regularity. The business and accounting staff apply GAAP rules as standard practice.
2. Consistency. Accounting staff apply the same standards through each step of the
reporting process and from one reporting cycle to the next, paying careful attention to
disclose any differences.
3. Sincerity. Accounting staff provide objective and accurate information about business
finances.
4. Permanence. Accounting staff use consistent procedures in financial reporting, enabling
business finances to be compared from report to report.
5. Noncompensation. Accountants provide complete transparency of positive and negative
factors without any compensation. In other words, they do not get paid based on how
good or bad the reporting turns out.
6. Prudence. Financial data is based on documented facts and is not influenced by
guesswork.
7. Continuity. Financial data collection and asset valuations should not disrupt normal
business operations.
8. Periodicity. Financial data should be organized and reported according to relevant
accounting periods. For example, revenue or expenses should be reported within the
corresponding quarter or other reporting period.
9. Materiality. Accountants must rely on material facts and disclose all material financial
and accounting facts in financial reports.
10. Good Faith. There is an expectation of honesty and completeness in financial data
collection and reporting.
MEANING AND FEATURES OF ACCOUNTING PRINCIPLES

For searching the goals of the accounting profession and for expanding knowledge in this field, a
logical and useful set of principles and procedures are to be developed. We know that while
driving our vehicles, follow a standard traffic rules. Without adhering traffic rules, there would
be much chaos on the road. Similarly, some principles apply to accounting.

Thus, the accounting profession cannot reach its goals in the absence of a set rules to guide the
efforts of accountants and auditors. The rules and principles of accounting are commonly
referred to as the conceptual framework of accounting.

The American Institute of Certified Public Accountants (AICPA) has advocated the use of the
word” Principle” in the sense in which it means “rule of action”. It discuses the generally
accepted accounting principles as follows :

Financial statements are the product of a process in which a large volume of data about aspects
of the economic activities of an enterprise are accumulated, analysed and reported. This process
should be carried out in conformity with generally accepted accounting principles. These
principles represent the most current consensus about how accounting information should be
recorded, what information should be disclosed, how it should be disclosed, and which financial
statement should be prepared. Thus, generally accepted principles and standards provide a
common financial language to enable informed users to read and interpret financial statements.

Generally Accepted Accounting Principles encompass the conventions, rules and procedures
necessary to define accepted accounting practice at a particular time.

ACCOUNTING CONCEPTS AND CONVENTIONS

 Business Entity Concept. In accounting we make a distinction between business and the owner.
All the books of accounts records day to day financial transactions from the view point of the
business rather than from that of the owner. The proprietor is considered as a creditor to the
extent of the capital brought in business by him. For instance, when a person invests Rs. 10
lakh into a business, it will be treated that the business has borrowed that much money from the
owner and it will be shown as a ‘liability’ in the books of accounts of business. A business and
its owner should be treated separately as far as their financial transactions are concerned.
 Money Measurement Concept. In accounting, only those business transactions are recorded
which can be expressed in terms of money. In other words, a fact or transaction or happening
which cannot be expressed in terms of money is not recorded in the accounting books. As money
is accepted not only as a medium of exchange but also as a store of value, it has a very important
advantage since a number of assets and equities, which are otherwise different, can be measured
and expressed in terms of a common denominator.

 Dual Aspect Concept. Financial accounting records all the transactions and events involving
financial element. Each of such transactions requires two aspects to be recorded. The recognition
of these two aspects of every transaction is known as a dual aspect analysis. The term ‘double
entry’ book keeping has come into vogue because for every transaction two entries are made.
According to this system the total amount debited always equals the total amount credited. It
follows from ‘dual aspect concept’ that at any point in time owners’ equity and liabilities for any
accounting entity will be equal to assets owned by that entity. This idea is fundamental to
accounting and could be expressed as the following equalities:

Assets = Liabilities + Owners Equity.......................(1)

Owners Equity = Assets - Liabilities.......................(2)

The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’
denotes the resources supplied by the owners of the entity while the term ‘liabilities’ denotes the
claim of outside parties such as creditors, debenture-holders, bank against the assets of the
business. Assets are the resources owned by a business. The total of assets will be equal to total
of liabilities plus owners capital because all assets of the business are claimed by either owners
or outsiders.
 Going Concern Concept. Accounting assumes that the business entity will continue to operate
for a long time in the future unless there is good evidence to the contrary. The enterprise is
viewed as a going concern, that is, as continuing in operations, at least in the foreseeable future.
In other words, there is neither the intention nor the necessity to liquidate the particular business
venture in the predictable future. In accounting, a business is expected to continue for a fairly
long time and carry out its commitments and obligations. This assumes that the business will not
be forced to stop functioning and liquidate its assets at “fire-sale” prices.
 Cost Concept. The term ‘assets’ denotes the resources land building, machinery etc. owned by a
business. The money values that are assigned to assets are derived from the cost concept.
According to this concept an asset is ordinarily entered on the accounting records at the price
paid to acquire it. For example, if a business buys a plant for Rs. 5 lakh the asset would be
 recorded in the books at Rs. 5 lakh, even if its market value at that time happens to be Rs. 6 lakh.
Thus, assets are recorded at their original purchase price and this cost is the basis for all
subsequent accounting for the business. The assets shown in the financial statements do not
necessarily indicate their present market values. The term ‘book value’ is used for amount shown
in the accounting records.

 Accounting Period Concept. Each business chooses a specific time period to complete a cycle
of the accounting process—for example, monthly, quarterly, or annually—as per a fiscal or a
calendar year.

 The Matching Concept. This concept is based on the accounting period concept. In reality we
match revenues and expenses during the accounting periods. Matching is the entire process of
periodic earnings measurement, often described as a process of matching expenses with
revenues. In other words, income made by the enterprise during a period can be measured only
when the revenue earned during a period is compared with the expenditure incurred for earning
that revenue. Broadly speaking revenue is the total amount realised from the sale of goods or
provision of services together with earnings from interest, dividend, and other items of income.
 Accrual Concept. It is generally accepted in accounting that the basis of reporting income is
accrual. Accrual concept makes a distinction between the receipt of cash and the right to receive
it, and the payment of cash and the legal obligation to pay it. This concept provides a guideline to
the accountant as to how he should treat the cash receipts and the right related thereto. Accrual
principle tries to evaluate every transaction in terms
of its impact on the owner’s equity. The essence of the accrual concept is that net income arises
from events that change the owner’s equity in a specified period and that these are not
necessarily the same as change in the cash position of the business. Thus it helps in proper
measurement of income.
 Realizations Concept. Realization is technically understood as the process of converting non-
cash resources and rights into money. As accounting principle, it is used to identify precisely the
amount of revenue to be recognised and the amount of expense to be matched to such revenue
for the purpose of income measurement. According to realisation concept revenue is recognised
when sale is made. Sale is considered to be made at the point when the property in goods passes
to the buyer and he becomes legally liable to pay. This implies that revenue is generally realised
when goods are delivered or services are rendered. The rationale is that delivery validates a claim
against the customer. However, in case of long run construction contracts revenue is often
recognised on the basis of a proportionate or partial completion method. Similarly, in case of
long run installment sales contracts, revenue is regarded as realized only in proportion to the
actual cash collection. In fact, both these cases are the exceptions to the notion that an exchange
is needed to justify the realisation of revenue.
 Accounting Conventions

 Convention of Conservatism . This convention requires that the accountants must follow the
policy of ‘’playing safe” while recording business transactions and events. That is why, the
accountant follow the rule anticipate no profit but provide for all possible losses, while recording
the business events. This rule means that an accountant should record lowest possible value for
assets and revenues, and the highest possible value for liabilities and expenses. According to this
convention, revenues or gains should be recognised only when they are realised in the form of
cash or assets (i.e. debts) the ultimate cash realisation of which can be assessed with reasonable
certainty. Further, provision must be made for all known liabilities, expenses and losses,
Probable losses regarding all contingencies should also be provided for. ‘Valuing the stock in
trade at market price or cost price which ever is less’, ‘making the provision for doubtful debts
on debtors in anticipation of actual bad debts’, ‘adopting written down value method of
depreciation as against straight line method’, not providing for discount on creditors but
providing for discount on debtors’, are some of the examples of the application of the convention
of conservatism.

 Consistency Convention. The convention of consistency requires that once a firm decided on
certain accounting policies and methods and has used these for some time, it should continue to
follow the same methods or procedures for all subsequent similar events and transactions.

 Materiality Convention. Materiality convention states that items of small significance need not
be given strict theoretically correct treatment. There are many events in business which are
insignificant in nature. The cost of recording and showing in financial statement such events may
not be well justified by the utility derived from that information. For example, an ordinary
calculator costing Rs. 100 may last for ten years.

 Convention of Full disclosure entails the disclosure of all information, both favourable and
unfavorable to a business enterprise, and which are of material value to creditors and debtors.

ACCOUNTING EQUATION

Dual concept states that 'for every debit, there is a credit'. Every transaction should have two-
sided effect to the extent of same amount. This concept has resulted in accounting equation
which states that at any point of time assets of any entity must be equal (in monetary terms) to
the total of owner's equity and outsider's liabilities. In other words, accounting equation is a
statement of equality between the assets and the sources which finance the assets and is
expressed as :

Assets = Sources of Finance

Assets may be tangible e.g. land, building, plant, machinery, equipment, furniture, investments,
cash, bank, stock, debtors etc. or intangible e.g. patent rights, trade marks, goodwill etc.,
 Sources include internal i.e. capital provided by the owner and external i.e. liabilities. Liabilities
are the obligations of the business to others/outsiders. The above equation gets expanded.

Assets = Liabilities + Capital

All transactions of a business can be referred to this equation : Assets = Liabilities + Owner's

equity

A = L + OE

To further explain the transaction of revenues, expenses, losses and gains, the equation can be
expanded thus :

Assets + Expenses = Liabilities + Revenue + Owner's equity or

Assets = Liabilities + (Revenue – Expenses) + Owner's equity Or
Assets = Liabilities + Owner's equity + Owner's equity (income) which ultimately becomes
Assets = Liabilities + Owner's equity
Example
 Commenced business with cash Rs. 50,000
 Purchased goods for cash Rs. 20,000 and on credit Rs. 30,000
 Sold goods for cash Rs. 40,000 costing Rs. 30,000
 Rent paid Rs. 500
 Bought furniture Rs. 5,000 on credit
 Bought refrigerator for personal use Rs. 5,000

 Business receives cash Rs. 50,000 (asset) and it owes Rs. 50,000 to the proprietor as his capital
i.e. equity
Assets (=) Liabilities (+) Owner's equity Cash Rs. 50,000 = Nil +Capital Rs. 50,000

 Purchased goods for cash Rs. 20,000 and on credit Rs. 30,000. Business
has acquired asset namely – goods worth Rs. 50,000 and another asset namely = cash has
decreased by Rs. 20,000 while liability– creditors have been created of Rs. 30,000.
Assets (=) Liabilities (+) Owner's equity Cash 30,000 + Goods 50,000
= Creditors 30,000 +Capital 50,000

 Sold goods for cash Rs. 40,000 costing Rs. 30,000

This transaction has resulted in decrease of goods by Rs. 30,000 and increase in cash by Rs.
40,000 thus Increasing equity by Rs. 10,000 Assets (=) Liabilities (+) Owner's equity
Cash 70,000 + Goods 20,000 = Creditors 30,000 + Capital 60,000
 Classification of Accounts

Accounts are classified using two approaches:

 Traditional approach (also known as the British approach)

 Modern approach (also known as the American approach)

Classification of Accounts Under the Traditional Approach

According to the traditional approach, accounts are classified into three types: real accounts,
nominal accounts, and personal accounts. Given that it is an old system for classifying accounts,
it is used rarely in practice.

Personal Accounts

Personal accounts are the accounts that are used to record transactions relating to individual
persons, firms, companies, or other organizations. Ex: an individual’s accounts (e.g., Mr. X’s
account), the accounts held by modern enterprises, and city bank accounts.

Impersonal Accounts

Impersonal accounts are those that do not relate to persons. There are two types:

1. Real accounts
2. Nominal accounts

Real Accounts

Real accounts exist even after the end of accounting period. For the next accounting period, these
accounts start with a non-zero balance, which is carried forward from the previous accounting
 period. Ex: machinery accounts, land accounts, furniture accounts, cash accounts, and accounts
payable accounts.

Usually, real accounts are listed in the balance sheet of the business. For this reason, they are
sometimes referred to as balance sheet accounts.

Nominal Accounts

Nominal accounts are closed at the end of the accounting period. For the next account period,
these accounts start with a zero balance. Nominal accounts typically cover issues such as income,
gains, expenses, and losses.

Normally, nominal accounts are used to accumulate income and expense data. In turn, these data
can be used to prepare income statements or trading and profit and loss accounts. For this reason,
nominal accounts are sometimes referred to as income statement accounts.

Examples of nominal accounts include sales, purchases, gains on asset sales, wages paid, and
rent paid.

Classification of Accounts Under the Modern Approach

The modern approach has become a standard for classifying accounts in many developed
countries.

Specifically, under the modern approach, accounts are classified into the following five groups:

1. Asset accounts: Ex: land accounts, machinery accounts, accounts receivable accounts, prepaid
rent accounts, and cash accounts.
2. Liability accounts: Ex: loan accounts, accounts payable accounts, wages payable accounts,
salaries payable accounts, and rent payable accounts.
3. Revenue accounts: Ex: sales accounts, service revenue accounts, rent revenue accounts, and
interest revenue accounts.
4. Expense accounts: Ex:- wage expense accounts, commission expense accounts, salary expense
accounts, and rent expense accounts.
5. Capital/owner’s equity accounts: An example is an individual owner’s account (e.g., Mr. X’s
account).

Classify these accounts using both the traditional and modern approaches.

1. Plant and machinery

2. Purchases
3. Sales
4. Rent
5. Land and building
6. Cash
7. Sam’s capital
8. Loan from city bank

Traditional classification:

1. Plant and machinery > Real account

2. Purchases > Nominal account
3. Sales > Nominal account
4. Rent expense > Nominal account
5. Land and building > Real account
6. Cash > Real account
7. Sam’s capital > Personal account
8. Loan from city bank > Personal account

Modern classification:

1. Plant and machinery > Asset account

2. Purchases > Expense account
3. Sales > Revenue account
4. Rent expense > Expense account
5. Land and building > Asset account
6. Cash > Asset account
7. Sam’s capital > Capital/owner’s equity account
8. Loan from city bank > Liability account

Double Entry System

Double-entry bookkeeping is a method of recording transactions where for every business
transaction, an entry is recorded in at least two accounts as a debit or credit. In a double-entry
system, the amounts recorded as debits must be equal to the amounts recorded as credits.

Double entry system of accounting is based on the dual aspect concept. It includes two aspects,
they are Debit aspects and Credit aspects.

Debit Aspects- This includes either Receiving aspects, incoming aspects or Expenditure aspects,
these are known as Debit aspects.

Credit Aspects- The another aspects may be Giving aspects, outgoing aspects or income aspects.
These are known as Credit aspects.
 Stages of Double Entry System

There are three distinct stages are includes a complete system of double entry.

i) Recording of transactions in the journal.

ii) Posting of journal entry in to the respective ledger accounts and then preparing a trial
balance.
iii) Closing of books of accounts and preparing final accounts.
Rules for Double Entry System
An account is statement and it is a record of transactions relating to a person, or a firm, or a
property, or a liability, or an income or expenditure. There are three kinds of rules for double
entry system. They are as follows:-

 Personal Accounts
Under this statement, a separate account will be prepared for each person. It includes Natural
person’s account, Artificial person’s account and representative personal accounts. Some of the
examples of personal account are Ramu’s account, Bank account, Any firms account, any
companies account, prepaid expense account, outstanding wages account etc.

Rule for personal Account:-

“Debit the receiver

Credit the giver”

 Real Accounts
Under the real account, a separate account will create for each class of property or asset. There
will have an account relating to a property, an asset or a possession of property. Some of the
examples for real account are Cash account, Furniture account, Goodwill account etc.

Rule for Real Account:-

“Debit what comes in

Credit what goes out”

 Nominal Account
These includes the expenses and losses or incomes and gains of business. Some of the examples
of Nominal account are wages account, discount received account, interest account etc.
Rule for Nominal Account:-

“Debit all expenses and losses

Credit all incomes and gains”

Double-entry System

Assets: Debit increase in asset to asset account

Credit decrease in asset to asset account
Liabilities& Equity: Credit increase in liability or equity to liability or equity account
Debit decrease in liability or equity to liability or equity account

Income & Expenditure: Debit all expenses

Credit all income
Therefore,

Assets = Liabilities + Capital + Revenues - Expenses – Drawings (or Dividends)

Assets Liabilities

Debit Credit Debit Credit

Increase Decrease Decrease Increase
(+) (-) (-) (+)

Income &
Equity
Expenditure
Debit Credit Debit Credit
Decrease Increase
Expenses Income
(-) (+)
 Preparing Journal
Journal is called a subsidiary book. Journal is known as the books of original Entry or Books of
prime entry. The transactions are recorded in the journal in chronological order. With the help of
a journal, ledger accounts are prepared. The journal entries are usually recorded using the double
entry method of bookkeeping. Each transaction is recorded in two columns, debit and credit.

Specimen of Journal Entry

Date Particulars LF Debit ( ) Credit ( )

Ledger Folio: This column is meant to record the reference of the main book, i.e., ledger and is
not filled in when the transactions are recorded in the journal. The page number of the ledger in
which the accounts are appearing is indicated in this column, while the debits and credits are
posted on the ledger accounts.

Ledger

A ledger contains summarized information from the journals and is recorded as debits and
credits. The ledger is used to prepare financial statements and contains a list of all the accounts.
A ledger is a book or collection of accounts in which account transactions are recorded. Each
account has an opening or carry-forward balance and would record transactions as either a debit
or credit in separate columns and the ending or closing balance.

Specimen of Ledger Entry

Date Particulars JF Date Particulars JF
To name of the account By name of the
to be credited account to be debited
Dr Cr

Subsidiary Books
Subsidiary Books are books of Original Entry. They are also known as Day Book or special
journals. We record transactions of similar nature are in Subsidiary Books.
Different Types of Subsidiary Books
• We can divide the subsidiary books into the following types:
• Cash book
• Purchases book
• Sales book
• Purchases return or return outwards book
• Sales return or return inwards book
• Bills receivable book
• Bills payable book
• Journal proper
Cash Book
• It records all the cash and bank receipts and payments. It is a book of original entry as we record
transactions in it for the first time from the source documents such as vouchers, invoices, etc.
• A cash book has a debit and a credit side both. Thus, it is similar to a ledger account. Hence, it
acts as a subsidiary book as well as a ledger account.
• An organization can maintain a single column, double column or triple column cash book as per
its requirements. A single column cash book consists of only cash column.
• A double column cash book consists of cash and bank column. While the triple column cash
book consists of cash, bank, and discount column. Usually, the firms use triple column cash
book.
• Some organizations also maintain a petty cash book which records the petty or small cash
expenses of the firm.
Types of Cash Book
• Simple Cash Books:-This is also known as a Single Column Cash Book. This cash book will
only record cash transactions. The cash coming in (receipts) will be on the left and the cash
payments will be on the right. And since we will record all cash transactions here there is no
need for a cash ledger account. Since there is only one column we do not record bank
transactions in this cash book. Cash book can never have a credit balance. Cash books only show
a debit balance.
• Two Column Cash Books:-Here instead of one column, we have an additional column for
discounts. So along with the cash transactions, we will also record the discounts in the same cash
book. So both discounts received and the discount that is given is recorded here. Discount is a
nominal account – so the discount is given (loss) is on the debit side and discount received
(profit) is on the credit side.
• Three Column Cash Books:-This cash book has the cash, the discount and additionally the bank
columns in it. Since the development of banking most firms, these days prefer to deal in cheques
or other such bills of exchange. And so having a bank column in your cash book makes things
concise and simpler to understand.
• So when you receive a cheque and you deposit it in the bank the same day you make the entry in
the bank column (the debit side in this case). But say you send the cheque later (not the same
day) then this will be a contra entry. A contra entry is transactions that happen between a cash
account and a bank account.
• Petty Cash Book
• In a firm, there are usually cash transactions happening in all the departments. These we will
record in one of the above formats of cash books. But there are many cash transactions
happening for very small amounts. Sometimes there are dozens of such transactions that occur in
just one day. These are known as petty transactions. Examples are expenses for postage,
stationery, traveling, food bills, etc.
• So since the number of such transactions tends to be very high we maintain a separate cash book
for them – the petty cash book. Such a cash book is maintained by the petty cashier
 Format of Cash Book

• Purchases book:-A firm records all its credit purchases of goods in Purchase Book or Purchase
Day Book. While it records all the cash purchases of goods in the Cash Book. We do not record
Purchases of assets in Purchase Book. Thus, they are recorded in the Journal Proper.
• Sales Book
A firm records all credit sales of goods in the Sales Book or Sales Day Book. It records cash
sales of goods in the Cash Book. We do not record the sale of assets in the Sales Book. Thus, we
shall record them in the Journal Proper.
• Purchase Return or Return Outward Book
We record the return of goods purchased in the Purchase Return Book. A Debit Note is prepared
for every return of goods in duplicate. It contains the name of the supplier, details of goods
returned and reason thereof. It needs to be dated and serially numbered.
• Sales Return or Return Inwards Book
We record the return of goods sold in the Sales Return Book. A Credit Note is prepared for every
return of goods in duplicate. The Credit Note contains the name of the customer, details of goods
returned and reason thereof. It also needs to be dated and serially numbered.
• Bills Receivable Book:-We record all the acceptance of the bills in our favor in the Bills
receivable book. We need to post the total of bills receivable book to the Bills receivable A/c.
Also, we need to post the individual accounts of the customers.
• Bills Payable Book
We record all the acceptance of the bills that we issue in favor of others in the Bills payable
book. We need to post the total of bills payable book to the Bills payable A/c. Also, we need to
post the individual accounts of the suppliers.

• Journal Proper
It includes transactions relating to credit purchase and sale of assets, depreciation, outstanding
and pre-paid expenses, accrued and unearned income, opening and closing entries, adjustment
entries and rectification entries.

Preparation of Trial Balance

 A trial balance is a bookkeeping worksheet in which the balance of all ledgers are compiled into debit
and credit account column totals that are equal. The general purpose of producing a trial balance is to
ensure the entries in a company's bookkeeping system are mathematically correct. The trial balance is
prepared after posting all financial transactions to the journals and summarizing them on the
ledger statements. The trial balance is made to ensure that the debits equal the credits in the
chart of accounts. Ideally, the totals should be the same in an error-free trial balance.

Format of a Trial balance

Trial Balance of ………………… as on

Basic Terminologies of Accounting

• Accounts receivable (AR) The amount of money owed by customers or clients to a business
after goods or services have been delivered and/or used.
• Accounting : A systematic way of recording and reporting financial transactions for a business
or organization.
• Accounts payable (AP): The amount of money a company owes creditors (suppliers, etc.) in
return for goods and/or services they have delivered.
• Assets (fixed and current) (FA, CA) Current assets (CA) are those that will be converted to
cash within one year. Typically, this could be cash, inventory or accounts receivable. Fixed
assets (FA) are long-term and will likely provide benefits to a company for more than one year,
such as a real estate, land or major machinery.
• Balance sheet (BS): A financial report that summarizes a company's assets (what it owns),
liabilities (what it owes) and owner or shareholder equity, at a given time.
• Capital (CAP) : A financial asset or the value of a financial asset, such as cash or goods.
Working capital is calculated by taking your current assets subtracted from current liabilities—
basically the money or assets an organization can put to work.

• Credit (CR) : An accounting entry that may either decrease assets or increase liabilities and
 equity on the company's balance sheet, depending on the transaction. When using the double-
entry accounting method there will be two recorded entries for every transaction: A credit and a
debit.
• Creditor:-The person to whom amount is owed by the enterprise on account of goods purchased
or services availed. The creditors are collectively called “Sundry Creditors” or “ Total Creditors”
or “ Trade Creditors”.
• Debit (DR) : An accounting entry where there is either an increase in assets or a decrease in
liabilities on a company's balance sheet.
• Debtor:- The person from whom amounts are due for goods sold or services rendered. The
debtors are collectively called “Sundry Debtors” or “Total Debtors”. The total amount due from
sundry debtors is called “ book debts”.
• Equity and owner's equity (OE) : In the most general sense, equity is assets minus liabilities.
An owner’s equity is typically explained in terms of the percentage of stock a person has
ownership interest in the company. The owners of the stock are known as shareholders
• Generally accepted accounting principles (GAAP) : A set of rules and guidelines developed
by the accounting industry for companies to follow when reporting financial data. Following
these rules is especially critical for all publicly traded companies.
• Trial balance : A business document in which all ledgers are compiled into debit and credit
columns in order to ensure a company’s bookkeeping system is mathematically correct.
• Liabilities (current and long-term) definition: A company's debts or financial obligations
incurred during business operations. Current liabilities (CL) are those debts that are payable
within a year, such as a debt to suppliers. Long-term liabilities (LTL) are typically payable over a
period of time greater than one year. An example of a long-term liability would be a multi-year
mortgage for office space.
• Profit and loss statement (P&L) definition: A financial statement that is used to summarize a
company’s performance and financial position by reviewing revenues, costs and expenses during
a specific period of time, such as quarterly or annually.