Chapter 1

Introduction to Accounting
Types of Financial Statements

Users of Financial Statements

Foundations of Accounting

The concept of accounting has been in vogue for many centuries. It was more than
3000 years ago that scribes in Babylonia and Egypt received what in effect was formal
accounting training in schools. Accounting profession declined in the middle ages but
was revived in Italy during the crusades. Full blown double entry bookkeeping
appears in Genoese records of 1340. For centuries, accounting was primarily
associated mainly with government activities. However, the industrial revolution
brought additional accounting needs. Large scale enterprises required huge capital to
finance them and large number of people to direct their operations. This led to
investor-manager combination. The investor who finances the project like to know
how the firm is protecting and utilizing the resources entrusted to it. This led to the
growth of accounting as a profession.
The importance of accounting further grew with managers realizing the importance of
accounting information in improving the effectiveness of decision making process.
Thus accounting took a new shape of management accounting.
Today, most organizations have the accounting group as the largest staff unit. The
accounting group essentially consists of two types of people: (1) Book keepers and
other clerical employees who maintain the detailed operating records and (2)
Professional accountants who decide how items should be reported, prepare the
reports, interpret them, analyze, design and operate the systems through which
information flows and ensure that the information is accurate.
Although accounting is a staff function performed by accounting professionals within
an organization, the ultimate responsibility for the generation of accounting
information - financial or managerial - rests with management. Management’s
responsibility for accounting is the reason that one of the top officers of many
businesses is the controller. The controller’s responsibility is to satisfy the needs of
other managers related to management accounting information and comply with the
requirements of financial reporting. For proper flow of such information, the
controller’s office employs accounting professionals in both management and
financial accounting. These accountants design, install and operate the information
systems required to generate financial and managerial reports.
Bookkeeping: It is an art of recording or noting the facts of financial transactions in
simple and easy to understand way. This forms the basis to measure the operating
performance of the business and to analyze the financial position of the business.
“Accounting is the process of identifying, measuring and communicating economic
information so that they can make informed judgments and decisions”. Accounting as
a function is related to all the functions in an organization like planning,
implementation, marketing, control, etc. This wide range of involvement of
accounting as a function increases the scope of accounting as a profession.
Accounting professionals are responsible for preparing and finalizing the financial
statements.

TYPES OF FINANCIAL STATEMENTS

Typically, major financial statements, which result from accounting, are:
Profit and Loss statement
Balance sheet
A profit and loss statement depicts how much profits or losses an organization has
made in a time period. A balance sheet is a statement of what an organization owes
and what it owns at any given point of time. The above statements are used by many
groups of people with different purposes.
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 Introduction to Accounting

USERS OF FINANCIAL STATEMENTS

Management
Managers are responsible for the financial performance of an organization. They must
periodically compile and interpret financial statements to measure the financial
performance. The managers are also interested in various cost and control information
pertaining to different departments or functions to understand how far the organization has
been successful in achieving its financial goals and to take corrective measures.
Shareholders, Security Analysts and Investors
Shareholders and investors are the owners of a firm. They need to have information to
know how the firm is performing. Analysts who advise the potential investors are
largely interested in assessing the profitability, examining the financial strength and
estimating value of firms.
Lenders
Financial statements are normally used by lenders to judge the profitability and
liquidity of a business and to assess the security of the fund they are going to lend.
The lenders and creditors are primarily interested in ensuring the safety of their loans.
Banks use financial statements of a firm to assess its working capital needs. The focus
of all the above groups is to evaluate the risk in investing in a firm.
Suppliers
Suppliers of raw materials to a company are usually interested in the short-term
liquidity of the company. Information in financial statements helps them analyze the
liquidity position of a firm.
Customers
The quality of goods and services of the firm, legal obligations associated with
guarantees, warranties and after-sales-service contracts tend to establish long-term
relationships between a business and its customers. The financial statements may be
used by the customers to draw inferences about the long-term viability of the firm.
Employees
Employees have a vested interest in the continued and profitable operations of the
organization in which they are working. Financial statements can be used as important
sources for obtaining information regarding the current and future profitability and
solvency.
Government and Regulatory Authorities
Income tax authorities are interested in assessing the taxable profits generated by a
frim. Similarly, regulatory authorities may use financial statements to check whether
organizations have followed the rules and procedure set by them.
Others
Diverse persons such as academicians, researchers and analysts may approach
business firms for financial information. To draw conclusions, they study the financial
statements in depth.
End-users of financial statements need not be from finance background. They might
not be in a position to understand the complex technicalities of financial statements.
People who do not have detailed understanding of financial accounting process and
the related legal provisions are sure to fail to make any sense out of the information
presented in annual reports. Therefore, annual reports provide summarized
information from balance sheets and profit and loss accounts in non-technical
language. Experts, however, feel that in this process of summarization, the meaning
content of financial information may be diluted or lost. Because of lack of well laid

3
Foundations of Accounting

out procedures, rules and regulations for financial reporting, experts felt that the
accompanying graphs, pie charts, etc. tend to overplay the accomplishment of a
company and downplay the information which shows its poor performance. This has
paved way for Financial Accounting Standard Board (FASB) in USA (Similar to
Accounting Standard Board of the Institute of Chartered Accountants of India) to
issue a series of guidelines on financial reporting concepts and practices.
According to FASB, there are two main objectives of financial reporting:
1. Information about enterprise earnings and its components measured by accrual
accounting provides a better indication of enterprise performance than
information about current cash receipts and payments.
2. Financial reporting should also provide information about an enterprise’s
economic resources, obligations and owner’s equity, liquidity or solvency and
management explanations and interpretations of information provided.
FASB has issued several guidelines for improving the information provided in
financial statements. Each new disclosure provides some additional useful information
to readers of financial statements. But again financial statements, footnotes,
supplementary statements, etc. complicate the entire reporting process. Many users of
financial statements argue that more summarized presentation may result in effective
communication of financial information. Summary reporting is something less than
the full text of current annual reports to shareholders but something more than the
brief presentation of financial highlights and summary indicators that generally appear
in the annual reports. However, one should clearly understand that summary report
would not eliminate the statements to be included in the filing of annual report. The
summary report would just serve as primary information for the people who are not
experts in reading financial statements.

4
 Introduction to Accounting

Case 1
Wonder World Super Market
(Importance of Accounting)
Ramesh Miglani, an engineer from USA, returned to his motherland on August 1,
1997. He thought of starting his own business instead of working for a company. The
idea of starting a supermarket flashed in his mind. He, being from a well to do family,
thought of a big supermarket and named it as WONDER WORLD SUPER MARKET.
He listed down the basic requirements to start his business. On his father’s advice, he
took a loan of Rs. 30 lakhs from State Bank of India. His father also supported him by
giving Rs.10 lakhs.
Ramesh first purchased 500 square yards of land on the road side and constructed a
big showroom. To give an attractive look, he opted for marble flooring in the
showroom. Arrangements for window displays were made and glass almirahs were
constructed to arrange goods attractively. He appointed 10 workers to help customers
locate the position of goods. He established two separate counters, one for cash and
other for supply baskets & trolleys to carry goods.
Apart from all these arrangements, he placed pretty indoor plants at the each corner of
the showroom. The entire showroom was air-conditioned. By December 25, 1997, his
attractive and well-equipped supermarket was ready. He planned to inaugurate it on
January 1, 1998.
As his planning was perfect, he had nothing to do the rest of five days. So he thought
of verifying the bills he had and calculating the total amount he had spent by then.
He was yet to confirm whether he had spent Rs.40 lakhs on showroom and the
workers were efficient enough in making purchases. Such thought provoking
questions made him busy for two days. The next day he found out that he had bills of
Rs.29.6 lakhs, while there was no account for the balance amount. His bank A/C
showed a balance of Rs.2.6 lakhs only. He was unsure whether there was any misuse
of money. He tried hard to find out if there were loopholes in the system so that
pilferage was done. He felt that he was in a miserable situation. He sat as if the whole
burden of world sat on his shoulders.
He pondered over this problem and decided to write all the bills in a book but it
resulted in a big list. Though his attempt was correct, he was unaware of ABCs of the
system of recording the items in the books of account.
Ramesh approached one of his friends, Ms. Nalinakshi Ayyangar, a science graduate,
who was also in business. He discussed his problems with her. He said that out of the
bills worth Rs.30 lakhs, part of the bills were made for credit purchases. Wages were
paid to the workers appointed for the maintenance of the supermarket and to the
workers who made furniture. He raised doubts on whether the treatment to bill on
purchasing goods for cash was the same as the goods purchased on credit. He raised a
series of such doubts. Nalinakshi told him that she was also not good at accounting and
hence she was taking her uncle’s advice, who was a chartered accountant. Her uncle gave
her a bird’s eye view on the concept of accounting. Accounting is the art of recording
the business transactions in a chronological order so as to make the reader
understand the transaction and find out net result of business. She also appointed an
accountant to record all transactions from time to time.
To clarify his doubts, she told him that expenditure was divided into capital
expenditure and revenue expenditure. Wages paid to workers who made furniture are
treated as capital expenditure because the payment is made only once at the time of
acquisition of fixed asset, viz. furniture. While wages paid to workers appointed for

5
Foundations of Accounting

the maintenance of showroom is revenue expenditure because such expenditure is

incurred at regular interval.
Further, she told him that it would be very difficult to remember all expenses made
and incomes received without a proper record. As they are large in numbers, they
should be written in a set of books regularly. Only relevant information should be
recorded. Irrelevant information like personal expenditure except those withdrawn
from the business should not be written. She said that all transactions of similar nature
if recorded in a single book would help us in developing an effective control system
and timely availability of information. Some accounts such as purchase or sales
should be summarized at regular interval to find out the profit or loss and the financial
position of the business at any point of time.
Nalinakshi explained him that it is always beneficial to have permanent record of all
business transactions. It helps not only as a historical record but also detects errors and
minimize frauds. She commented that had he recorded all his bills in books as and
when the money was spent, he would have been in a position to tell the actual amount
spent in developing the supermarket and could have found the areas where the money
has not been accounted for.
Receiving Nalinakshi’s advice, Ramesh requested her to help in recording the
transactions in the books of account. She smiled and explained that it would be
impossible for her to record transactions as it would take lot of time. She advised him
to appoint an accountant to solve his problem of recording the transactions in the
books of account and to make employees accountable for the amount spent by them.

6
Chapter 2

Accounting Concepts
Business Entity Concept
Going Concern Concept
Cost Concept
Money Measurement Concept
Duality or Accounting Equivalence Concept
Accounting Period Concept
Matching Concept
Conservatism Concept
Materiality Concept
Realization Concept
Foundations of Accounting

This Chapter focuses on various accounting concepts, which should be understood

before learning the accounting mechanism.
BUSINESS ENTITY CONCEPT
The legal entity of a corporate business is distinct from the entity of its owners and
managers and people understand it well. Less understood, however, is that the
accounting entity of a business is distinct from its owners. For example, for many
purposes, legal entity of a sole proprietary business may not be very distinct from the
entity of the proprietor himself. However, the business entity concept requires that this
should not come in the way of treating the business as a distinct accounting entity for
the purposes of treating transactions relating to the operations of the business. It is in
accordance with this concept that when an owner brings capital into the business, the
business in turn is deemed to owe the capital to the owner. Again, coming to the
business between the sole proprietary concern and its sole proprietor, usually the
proprietor may not pay himself a salary, even when he works for his business.
However, in accordance with the business as a separate entity, his position as an
owner must not come in the way of his charging a salary to the business for the
services rendered by him. This is because (as far as the business is concerned) the
service rendered cannot be regarded cost free. The reward of ownership is to be
manifested only in the form of profit, which must be arrived at after charging ‘all
costs’.
GOING CONCERN CONCEPT
A business entity is assumed to carry on its operations forever. Even if all the
members of the management die, the concern will continue to exist. Going concern
concept implies that the resources of the concern should be used for the purposes for
which they are meant to be used. This concept implies that the land, buildings,
machinery, etc., which are required for carrying out the production and selling of
certain products, would continue to be with the concern for a long time.
COST CONCEPT
Cost concept implies that in accounting, all transactions are generally recorded at cost,
and not at market value. For example, if a piece of land is acquired for Rs.2 lakh, it
would continue to be shown in the balance sheet at Rs.2 lakh, even when the market
value of the land rises to say Rs.5 lakhs. The cost concept is closely related to going
concern concept. If the land is acquired for the operations of the business and would
continue to be used for its operations and would not be sold shortly, then it is largely
immaterial what the land’s market value is, since it is not going to be sold anyway.
Thus, it is consistent with going concern concept to keep recording the land at cost i.e.
Rs.2 lakhs on an ongoing basis.
MONEY MEASUREMENT CONCEPT
All transactions are recorded through a common denominator, namely the monetary
unit. Thus, if a certain event, which cannot be measured in monetary terms, no matter
how significant it is for the health of or even existence of the business, cannot be
recorded in accounts. For example, the purchase of an inconsequential asset such as
tables and chairs, which is easily measured in rupee terms, is accounted for in the
business. However, the retirement or death of the Chairman of a company has far
reaching consequences for the health of the business. It is not accounted for, since no
monetary measurement of the event is feasible.
DUALITY OR DOUBLE ENTRY CONCEPT
This concept states that for every transaction, there will be two aspects. For example,
when capital is introduced into the business, there is a cash inflow and capital forms a
liability and the cash inflow is an asset. Similarly, when an equipment is purchased for

8
 Accounting Concepts

cash, the new asset comes in (use of fund), and the cash will decrease (source of
fund). Or when the equipment is purchased for credit, the new asset comes in (use of
fund) and a liability will occur (source of fund). So for every transaction, there are two
aspects. In effect, all the transactions affect the basic equation given as under:
Owners’ equity + Outside liability = Assets.
ACCOUNTING PERIOD CONCEPT
To be able to prepare the income statement for a business, the period for which it is to
be prepared must first be specified. An accounting period may be a calendar year or a
financial year. In some businesses, such as trading, the operating period may be
relatively small, say a month or even less, while in other cases, it may stretch well
beyond a year. Under the Companies Act, a company is normally not permitted to
have the accounting period extending beyond fifteen months.
MATCHING CONCEPT
In order to determine the profits or losses accrued in an accounting period, the
expenses must relate to the goods or services sold during the period. The expenses
incurred in the production of goods and services should be matched with the revenues
realized from the sale of the goods and services.
CONSERVATISM CONCEPT
The idea behind this concept is that recognition of revenue requires better evidence
than recognition of expenses. This concept emphasizes that revenues are recognized
only when they are reasonably certain and expenses are to be recognized as soon as
possible. For example, a sales manager might have finalized a deal with his client for
a sale of 100 units of a product. But, unless these items are produced and delivered to
the client, there is no reasonable certainty about receiving the payment for these 100
units. It is only thereafter that he can record the sales amount on those 100 units as
due from the client. But on the other hand, if we come to know that a customer has
lost all his assets and is likely to default payment, then we should immediately either
make provision for such loss or write them off.
CONSISTENCY CONCEPT
The consistency concept requires that once an entity has decided on one method, it
will treat all subsequent events of the same character in the same fashion unless it has
a sound reason to change the method of treatment of that event. For example, if a
concern is charging depreciation by one method it is expected to follow the same
method in the subsequent years also.
MATERIALITY CONCEPT
All financial transactions need to be recorded in the books of accounts. However,
there may be transactions which may be insignificant and are not shown separately.
They are usually clubbed with others. There is no agreement as to the exact line
separating material events from immaterial events. The decision depends on judgment
and common sense.
REALIZATION CONCEPT
According to this concept, revenues are recognized only when the goods and services
have been delivered and there is certainty that the revenue will be realized. If from the
past experience, it is realized that revenue is realized for the 95% of the sales, a
provision of 5% can be created for doubtful accounts. For example, orders may be
obtained at time 1, which may be accepted at time 2, the work towards the production
of the order may commence at time 3, the production process is completed at time 4,
the goods are dispatched at time 5, and the cash is received at time 6 and so on. At

9
Foundations of Accounting

which time, can one say that the revenue is realized, or a sale is made? Normally,
revenue is said to be realized when efforts rendered are rewarded either in cash (or
kind) or in the form of a promise of reward sometime in future. Now in the above
context, a reward or a promise of reward sometime in future may be normally
forthcoming only after the goods are dispatched. Thus, revenue is normally
recognized only when goods or services are transferred and a reward or a promise of
reward is forthcoming. If there is no transfer of goods or services, normally no reward
may be expected either now or in future and hence no revenue will be realized.
Similarly, if there is no reward or a promise of reward in return for the goods or
services rendered, then such rendering of goods or services would merely be an act of
philanthropy or squandering and cannot be construed as a “Sale”. Thus, normally,
revenue is recognized at the time of transfer of goods or services irrespective of
whether the payment is made immediately or in future. However, there are exceptions
to the above rule of revenue recognition.

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 Accounting Concepts

Case 2
Manthani & Co
(Accounting Concepts)
Mr. Madhav Rao had a heavy breath, “Have I committed any mistake?” the question
lingered in his mind. He looked at the following statement once again:
Accounts Main Book
18.12.96 Land 2,25,000 10.9.96 sales 10,000
18.12.96 Misc.exp 15,000
13.6.97 Machinery 1,00,000
13.6.97 Misc. exp 6,060
13.6.97 Wages 1,400
1.12.96 Car 2,12,000
1.12.96 Car expenditure (of which 22,000
40% personal use)
25.9.97 Purchases 31,250

Mr. Madhava Rao, a chartered Accountant from Manthani, started a manufacturing

unit of abrasives. He tried his level best to set up the business but neglected in
completing the accounts. As a strategic person and the CEO of his unit, he thought
that it was not worth spending his time in maintaining the books of account. Secondly,
he being a chartered accountant knew in and out of accounting and felt that he did not
need an experienced and qualified accountant. Looking at the new unit established, it
was also clear to him that the unit could not afford the wage bill of an experienced
accountant. Therefore, he decided to appoint an inexperienced or a fresher to carry out
accounting responsibilities. He also thought that it would be enough if the employee
was a good number cruncher.
He announced it in a local newspaper through a classified ad for a walk-in-interview
for the post of accountant. He decided to give a monthly salary of Rs.2000 per month
keeping in mind that his unit was in semi urban area. Seven candidates appeared for
the interview. Finally, he shortlisted one candidate, Ms. Rose Mary, who was a
graduate with 45% marks and a Math student in her XII standard. She had worked for
a very small period of 3 months in a local company filling a temporary vacancy in
accounts department. She was an ever smiling girl, unmarried and willing to learn.
Though not a very good number cruncher, she was reasonably good at it.
Mr. Madhava Rao gave her the following transactions as her first assignment of
recording the first transactions in the books of account on October 1, 1997:
1. Dt.18.12.1996, purchased land for Rs.1, 00,000 and registration charges were
Rs.15, 000. (current market price is Rs.2,25,000).
2. Dt.13 06 1997, purchased machinery for Rs. 1, 24,740. Installation charges were
Rs.7460, which included wages Rs.1400. Realizable value today is Rs.1, 00,000.
3. Dt. 1.12.1996, purchased car for Rs.2, 12,000.
4. Dt. 25.9.1997, raw material purchased for Rs.31,250 from Selva Raj & Co on
credit.
5. The car was also used for personal works for seven months. Out of the total
expenses of Rs.22, 000, 40% was for his personal use.

11
Foundations of Accounting

6. His wife Neeru, a Law graduate, helped him in managing the affairs of his office
from February 1997 onwards. A similar services would have cost him an amount
of Rs.5,000 p.m. on a retainership basis. Mr. Madhava rao would like to record
the same in books of accounts.
7. A sale order of Rs.10,000 received on 10.9.1997 completed manufacture on
28.9.1997 and supplied on credit on 29.9.1997.
Ms. Rose Mary accepted the job and made her efforts in recording the transactions.
She found that there were no books of account. Therefore, she started recording the
transactions on her scribbling pad and placed in front of Mr. Madhav.
Madhav: Ms. Mary, are you aware that the books of account are to be maintained in
systematic books and not in scribbling pads?
Mary: Yes sir, I know. We need a cash book, sales and purchase registers, journal and
ledgers. I have made my efforts only to show that I know accounting and secondly I
found no pre set of books of accounts in our organization. I thought that I would
inform you about.
Madhav: Good! Do you know the place of these transactions?
Mary: Yes sir. All cash transactions in cash book, credit purchases in purchase
register, credit sale in sales register and all others in journals. Ledgers are meant for
keeping accounts as a secondary data.
Madhav: Good! You have recorded the cost of land as Rs.2, 25,000 and the cost of
machinery at Rs.1, 00,000. Land registration charges, wages for installation and other
installation expenses are shown separately. Can you explain the logic?
Mary: Yes sir. Land and machinery are recorded at the current market price to give a
true and fair view of books of account. Other incidental expenses are properly
accounted for determining the net effect on the profit or loss of our firm.
Madhav: No Mary. You have ignored the basic accounting concepts. We have a
concept known as COST CONCEPT. According to this concept, assets are recorded at
the price paid to acquire them rather than the current market price. This cost forms
the basis for all subsequent accounting for the assets. Market values keep changing
and accountants cannot keep track of them. The depreciation is charged on these
assets based on the cost price itself. This point is substantiated by the GOING
CONCERN CONCEPT also. For example, if the machinery fails to work from
tomorrow onwards, its value becomes almost negligible. But, we don’t envisage that
situation, because the concept of going concern is followed. Now, can you explain
why you have not recorded the transactions of personal use of car and retainer
services provided by Neeru?
Mary: Yes sir. Your car expenses and services of your wife are not recorded because
this is your own firm.
Madhav: You are once again wrong, Mary. Personal expenses of the proprietor and
services provided by retainers should be recorded under the BUSINESS ENTITY
CONCEPT. According to the concept, the business unit is regarded as separate and
distinct from the persons who supply the capital to it. All the transactions of a
business are recorded in the books treating business as an entity. If the distinction is
not made, the affairs of the business will be mixed up with private transactions of the
proprietor and the true position of the business will not be ascertained.
For recording the transactions like services rendered by Neeru, the services should be
quantified in monetary terms as per MONEY MEASUREMENT CONCEPT. All
transactions that can be measured in terms of money should be recorded in monetary
terms. Only those transactions which cannot be measured in monetary terms will not
be recorded in books of account. For example, sales policy, working conditions of the
workmen, etc. cannot be expressed in monetary terms and hence will not be recorded.

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 Accounting Concepts

Mary: Thank you very much sir for your kind explanation. I have something more to
clarify. In my previous employment, I observed that the company had considered
some debts as doubtful and written them off without completing the recourse against
them. Is the accounting policy correct? I also observed that they had changed the
depreciation policy from written down value method to straight line method for
showing profits of the loss making company. Does accounting allow such
manipulation?
Madhav: Very good question, Mary. Normally writing off of debts is a management
decision. However, there is a concept known as CONSERVATISM. This concept or
convention is meant for playing safe. This principle preaches that all possible losses
should be provided as early as possible but profits should be realized only when you
are sure of it or as late as possible. For example, the provision of possible bad debts
can be made in anticipation of bad debts. Similarly, stocks should be valued at market
price or cost price whichever is lower. The only danger in this concept is that if this
principle is used without any reservation, it may result in secret reserves.
Normally, changing the depreciation policy is not permitted in accounting. But, if the
management desires to change the policy to give a true and fair picture of their
financial position, such changes can be implemented but a footnote should be given to
make analysts understand the effect. This is based on the CONVENTION OF
CONSISTENCY and CONVENTION OF DISCLOSURE.
Mary: Sir, another question. In my previous employment, I observed that they were
making their final accounts after a lapse of 18 months as against my usual observation
of 12 months every where. Is this permitted in accounting?
Madhav: Nice. There is no hard and fast rule that the accounts should be made only after
12 months. ACCOUNTING PERIOD CONCEPT tells us that accounting results should
be published periodically. Normally, it is 12 months period. But if the firm desires to find
the same in different intervals, say 9 months or 15 months, the accounting does not object
it. The accounting period cannot be more than 15 months in India.
However, there should be a proper understanding regarding two more concepts here.
One is MATCHING CONCEPT. As per this concept, irrespective of your accounting
period, the profits or losses can be determined only after matching the expenses to the
services provided or sales made by the company during that period. The other concept
is ACCRUAL CONCEPT. As per this concept, the expenditure income whether paid
or not and income earned whether received or not, should be recorded.
I hope you understand this.
Mary: Sir, I have a small doubt. Can you clarify me the two way effect of the
transactions?
Madhav: You are very inquisitive. Each transaction has a dual effect, i.e. there is a
give and take for each transaction. For example, when a car is purchased for
Rs.212000, there are two things that are actually happening – one is that the car is the
asset which is owned by Madhav now, but then he is also parting with the cash to that
extent. This concept is termed as DUAL ASPECT CONCEPT.
There is an equation in accounting called ACCOUNTING EQUATION, i.e.
OWNER’S EQUITY + LIABILITIES = ASSETS
Mary: Yes sir. Thank you very much.
Madhav felt relieved. He was not wrong in recruiting Mary.

13
Chapter 3

Journal
Double Entry System of Financial Accounting

Rules of Debit and Credit

 Journal

DOUBLE ENTRY SYSTEM OF FINANCIAL ACCOUNTING

Earlier, organizations used to maintain accounts in the single entry system which
recognized only cash transactions. But now, accounts are invariably maintained in the
double entry system. Accounts are maintained on accrual basis under this system. A
cost incurred (i.e. accrued) is duly accounted for irrespective of whether it is paid or
not during the period. In addition, all transactions are supposed to have dual aspects –
a debit aspect and a credit aspect. Since the system records both the debit and the
credit aspects of a transaction, it is known as double entry system. Legally, a sole
proprietary business, a partnership firm or a business organized by a Hindu Undivided
Family (HUF) is free to choose the method and system of accounting. For income tax
purposes, persons carrying on business should get their accounts audited by an
accountant if the total sales, turnover, or gross receipts exceed Rs.40 lakhs in a year. A
person carrying on profession is also required to get his accounts audited if his gross
receipts exceed Rs.10 lakhs during a year. However, in the case of companies
registered under the Companies Act 1956, (as private limited companies or as public
limited companies) the provisions of the Companies Act stipulate that accounting
records should be maintained, audited and presented to shareholders every year. Such
audited accounts should also be filed with the Registrar of Companies. The format of
the financial statements is specified in schedule VI of the Companies Act.
Nature of Accounts and Rules of Debit and Credit:
Accounts are broadly classified into two heads:
I. Personal Accounts. These are the accounts of individuals, body of persons and
representative personnel accounts with whom a trader deals. Examples would be:
Mohan, Ashok, Rama Bros, Delhi Cloth Mills, Chelmsford club, Bank of Baroda,
capital, drawings, etc.
II. Impersonal accounts. These are those accounts which do not affect particular
person, but affect business in general, such as machinery, furniture, cash, rent,
salaries, etc.
Impersonal accounts are further subdivided into two classes:
a. Real Accounts: These are the accounts of property or possessions i.e. accounts
relating to tangible things such as cash, stock-in-hand, plant and machinery,
investments, buildings, etc.
b. Nominal Accounts: These are the accounts relating to gains, incomes, expenses or
losses, e.g. discount, commission, exchange, rent, salary, conveyance,
entertainment, advertisement, stationery consumed, brokerage, etc.
RULES OF DEBIT AND CREDIT
Personal Accounts Debit the receiver
Credit the giver
Real Accounts Debit what comes in
Debit what goes out
Nominal Accounts Debit all expenses and losses
Credit all incomes and gains
A transaction has two aspects and may affect any of the above mentioned two
accounts. For example, when cash is received from Mr. Gopal, it affects Gopal, which
is a personal account, and Cash which is a real account.
Journal: This is the basic book of original entry. All transactions are recorded in
chronological order as and when they take place. The recording of transactions in the
journal is called Journalizing. A journal provides a chronological record of all the

15
Foundations of Accounting

transactions with details of the accounts debited and credited and the amount of each
transaction. A separate entry has to be recorded for each transaction and it has to be
analyzed to determine which account is to be debited and which account is to be
credited. The format of journal is as follows:
Date Particulars LF Debit (Rs.) Credit(Rs.)

1. In the date column, the date of the transaction is entered.

2. The account to be debited is written first in the particulars’ column with the
amount to be debited in the amount (Debit) column. The account to be credited is
written second in the particulars column with the amount to be credited in the
amount (Credit) column.
3. After each entry, a brief explanation of each transaction called ‘Narration’ is
given in the particulars’ column.
In the LF (ledger folio) column, the page number of the ledger where the transaction
is posted is given.
Illustration No.1
During January 1998, Shripat transacted the following business:
Date Particulars Amount (Rs.)
1 Commenced business with cash 50000
3 Purchased goods on credit from Gopal 30000
4 Purchased goods for cash 5000
5 Paid Shyam in advance for goods ordered 3000
6 Received cash from Mohan as advance for goods 5000
ordered by him
7 Purchased furniture for office use in cash 3000
8 Paid wages 400
8 Received commission (in cash) 300
9 Goods returned to Gopal 500
10 Goods sold to karim 15000
12 Paid for postage and telegrams 300
13 Goods returned by Karim 500
19 Sold goods for cash 1000
21 Drew Cash for personal use 1500
23 Bought goods for cash 2000
31 Paid rent 250

Solution:
Journal entries in the books of Shripat for the month of January, 1998
Date Particulars LF Amount Amount
1 Cash a/c Dr 50000
To Capital a/c 50000
(being the cash brought into business as
capital)

16
 Journal

Date Particulars LF Amount Amount

(Logic: Cash is a real account. Debit what
comes in. Proprietor’s Capital is a personal
account. Credit the giver)
3 Purchases a/c Dr 30000
To Gopal’s a/c 30000
(being the goods purchased on credit from
Gopal)
(logic: Goods is a real account. Debit what
comes in. Gopal is a personal account. Credit
the giver)
4 Purchases a/c Dr 5000
To Cash a/c 5000
(being goods purchased for cash)
(Logic: Goods is a real account. Debit what
comes in. Cash is a real account. Credit what
goes out.)
5 Shyam’s A/c Dr 3000
To Cash a/c 3000
(being the amount paid to Shyam)
(Logic: Shyam is a personal account. Debit
the receiver. Cash is a real account. Credit
what goes out)
6 Cash a/c Dr 5000
To Mohan’s a/c 5000
(being the cash received from Mohan)
(Logic: Cash is a real account. Debit what
comes in. Mohan is a personal account. Credit
the giver.)
7 Furniture a/c Dr 3000
To Cash a/c 3000
(being furniture purchased for cash)
(Logic: Furniture is a real account. Debit what
comes in. Cash is a real account. Credit what
goes out.)
8 Wages a/c Dr 400
To Cash a/c 400
(being wages paid)
(Logic: Wages is a nominal account. Debit all
expenses. Cash is a real account. Credit what
goes out.)
8 Cash a/c Dr 300
To Commission a/c 300
(being commission received)

17
Foundations of Accounting

Date Particulars LF Amount Amount

(Logic: Cash is a real account. Debit what
comes in. Commission is a nominal account.
Credit all incomes.)
9 Gopal a/c Dr 500
To Purchase Returns a/c 500
(being goods returnes to Gopal)
(Logic: Gopal is a personal account. Debit the
receiver. Goods is a real account. Credit what
goes out)
10 Karim a/c Dr 15000
To Sales a/c 15000
(being goods sold to Karim)
(Logic: Karim is a personal account. Debit the
receiver. Goods is a real account. Credit what
goes out)
12 Postage and telegrams a/c Dr 300
To Cash a/c 300
(being Postage and telegrams paid)
(Logic: Postage and telegrams is a nominal
account. Debit all expenses. Cash is a real
account. Credit what goes out.)
13 Sales Returns a/c Dr 500
To Karim’s a/c 500
(being goods returned by Karim)
(Logic: Goods is a real account. Debit what
comes in. Karim is a personal account. Credit
the giver.)
19 Cash a/c Dr 1000
To Sales a/c 1000
(being goods sold for cash)
(Logic: Cash is real account. Debit what
comes in. Goods is a real account. Credit what
goes out)
21 Shripat’s Drawing a/c Dr 1500
To Cash a/c 1500
(being the cash drawn for personal use)
(Logic: Personal drawing is a personal
account. Debit the receiver. Cash is a real
account. Credit what goes out.
23 Purchase a/c Dr 2000
To Cash a/c 2000
(being goods purchased for cash)
(Logic: Goods is a real account. Debit what
comes in. Cash is a real account, credit what
goes out.)

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 Journal

Date Particulars LF Amount Amount

31 Rent a/c Dr 250
To Cash a/c 250
(being rent paid)
(Logic: Rent is a nominal account. Debit all
expense. Cash is a real account. Credit what
goes out.)

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Foundations of Accounting

Problems
1. Enter the following transactions in the general Journal of Narasimha for the
month of January 1998.
Jan. 1 Narasimha commenced his business with a capital of Rs.10,000/-
Jan 5 Credit sales to Hari Rs.3,200
Jan 5 Bought goods from Kamal (Credit) Rs.1,920
Jan 6 Bought goods from Jaimal on credit Rs.2,300
Jan 8 Bought office furniture for cash from Modern Furniture Rs.3,050
Jan12 Paid cartage to Golden Company Rs. 70
Jan 15 Paid carriage out to Hamid Rs. 20
Jan17 Paid trade expenses Rs. 10
Jan 18 Paid advertisement expenses to Anil Agencies Rs.200
Jan 19 Received interest from Anil Rs. 50
Jan 20 Deposited cash into bank Rs.1,000
Jan 22 Paid Rent Rs. 150
Jan 27 Paid insurance premium Rs. 30
Jan 29 Paid salary to Narendra a clerk

2. Give journal entries for the following transactions and specify the nature of
account (whether personal, real or nominal), the rule applicable, and the point of
view of business.
1 Amar started business by investing cash Rs.50,000. He bought goods worth
Rs.4,000 and furniture worth Rs.500.
2 Purchased building for Rs.10,000
3 Purchased goods for cash Rs.3,000
4 Purchased goods on credit Rs.2,500
5 Paid cartage Rs.20
6 Sold goods for cash Rs.2,550
7 Sold goods for cash to Avtar Rs.240
8 Sold goods to Mahendra on credit Rs.4,650
9 Paid freight Rs.120
10 Deposited cash into bank Rs.8,000
11 Paid salary Rs.460
12 Withdrew from the bank Rs.200 for office use.
13 Withdrew from the bank Rs.300 for private use.
14 Charged interest on capital Rs.1,250.

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 Journal

3. Enter the following transactions in the Journal of Kashinath for the month of
March 1998:
March 1 Kashinath commenced business with a Capital of Rs. 30,000
2 Bought Machinery Rs.5,000
3 Bought goods for cash from Madan Lal Rs.2,500
4 Sold goods for cash to Giri Rs.4,000
5 Purchased goods from Jaisimha Rs.3,000
6 Cash Sale Rs.5,000
10 Received interest from Mukund Rs.2,000
11 Deposited Cash into Bank Rs.2,000
14 Paid cash to Jaisimha Rs.2,900 in full settlement of his account
16 Sold goods to Venkat Rs.4,000
18 Venkat settled his account by cheque for Rs.3,890
29 Paid rent by cheque Rs.500

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Foundations of Accounting

Case 3
Shiva Chocolate Agencies (A)
(Journalizing Transactions)
Shiva is a self employed person and belongs to Nalgonda. He is an M.A. (Eco) from a
local college. To start his own unit, he has obtained an agency from Nutrine. The
normal lot which he has to purchase and distribute requires the working capital of
Rs.1,25,000. The space for business is his own house and he has fixed a notional rent
of Rs.200 pm. He has employed only one employee for marketing the toffee in the
town and offered him a salary of Rs.800 pm. In-house responsibilities, like writing
letters, maintaining books, activities related to bank and general PR job, etc. are
handled by Shiva.
Shiva is unaware of maintenance of books of account. He has requested his friend’s
son, Mr. Aditya, who is in the final year of his commerce graduation to give him the
guidance for maintaining the books of account.
As Aditya has briefed that the simple transactions are to be recorded, he has
developed the format in a register and wrote some examples for future reference.
Date Particulars LF Debit Credit
1.11.97 Cash A/c Dr 1,50,000
To Shiva’s Capital A/c 1,50,000
(being capital introduced into business)
2.1.97 Purchases A/c Dr 1,25,000
To Cash 1,25,000
(being cash purchases made)
3.1.97 Mr.Ramlal Dr 35,000
To Sales 35,000
(being goods sold to Ramlal)
4.1.97 Postages A/c Dr 20
To Cash A/c 20
(being postage expenses met through cash)
25.1.97 Furniture A/c Dr 1600
To Cash 1600
(being furniture purchased by paying cash)
30.1.97 Cash A/c Dr 20,000
To Ramlal 20,000
(being cash received from Ramlal)

Aditya also explained to Shiva that in accounting convention, each and every
transaction has two aspects. One is termed as the debit and the other is termed as
credit. There are three golden rules based on which the accounting system runs.
Rule No. 1 : Debit What comes in
Credit What goes out

22
 Journal

Rule No. 2 : Debit All expenses and losses

Credit All incomes and gains
Rule No. 3 : Debit The receiver
Credit The giver
The process of recording the transactions in a book called `Journal’ is called the
journalizing of transactions.
Shiva has understood the way in which the entries are made and has sought certain
clarifications. Aditya advised that he would be in a position to help him once a record
of this nature is made readily available to him. A month has passed. Shiva found that
the following transactions took place.
Date Particulars of the transactions Amount
October Rs.
1997
1 Brought in capital 125000
2 Deposited in Bank 50,000
5 Purchased goods from Nutrine (40% Down payment through a 1,00,000
bank cheque)
7 Sold goods to Ramlal on credit 12,000
8 Returned goods to Nutrine due to low quality 5,000
9 Ramlal returned goods 2,000
10 Purchased Furniture by paying cash 15,000
11 Withdrawn cash from Bank for official use 500
12 Sold goods to Manish & co for cash 22,000
15 Purchased machinery for packing payment made in cash 12,750
18 Issued cheque for Nutrine 30,000
19 Paid in cash for the stationery purchases 5,412
20 Received from Ramlal 10,000
24 Deposited in Bank 30,000
27 Typewriter was purchased on credit from Neeraj 2000
28 Shiva withdrew cash for personal use from Bank 2,700
30 Paid salary 800
Shiva has recorded all the transactions based on the explanation given by Aditya and
based on the above three golden rules.
Journal Entries in The Books of Shiva
Date Particulars LF Debit Credit
1-10-97 Cash a/c Dr 125000
To Capital a/c 125000
(being cash brought into business as capital)
2-10-97 Bank a/c Dr 50000
To Cash a/c 50000
(being cash deposited in bank)

23
Foundations of Accounting

Date Particulars LF Debit Credit

5-10-97 Purchases a/c Dr 100000
To Nutrine a/c 60000
To Bank a/c 40000
(being goods purchased from Nutrine with
40% down payment through a cheque)
7-10-97 Ramlal’s a/c Dr 12000
To sales a/c 12000
(being goods sold on credit to Ramlal)
8-10-97 Nutrine a/c Dr 5000
To purchase returns a/c 5000
(being goods returned to Nutrine)
9-10-97 Sales Returns a/c Dr 2000
To Ramlal a/c 2000
(being goods returned by Ramlal)
10-10-97 Furniture a/c Dr 15000
To cash a/c 15000
(being furniture purchased by remitting cash)
11-10-97 Cash a/c Dr 500
To Bank a/c 500
(being cash withdrawn from bank for official
use)
12-10-97 Cash a/c Dr 22000
To Sales a/c 22000
(being sales made in cash)
15-10-97 Machinery a/c Dr 12750
To Cash a/c 12750
(being machinery purchased and payment
made by cheque)
18-10-97 Nutrine a/c Dr 30000
To Bank a/c 30000
(being payment made to Nutrine by cheque)
19-10-97 Stationery a/c Dr 5412
To Cash a/c 5412
(being stationery purchased in cash)
20-10-97 Cash a/c Dr 10000
To Ramlal a/c 10000
(being cash received from Ramlal)

24
 Journal

Date Particulars LF Debit Credit

24-10-97 Bank a/c Dr 30000
To Cash a/c 30000
(being cash deposited in bank)
27-10-97 Typewriter a/c Dr 2000
To Neeraj a/c 2000
(being typewriter purchased on credit )
28-10-97 Drawings a/c Dr 2700
To Bank a/c 2700
(being cash withdrawn for personal use)
30-10-97 Salary a/c Dr 800
To Cash a/c 800
(being salary paid)

25