Basic Accounting


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Learn basics of Accounting
Target Audience: MBA Students

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  • Trial balances can be in their more traditional format of debits in one column and credits in another column or in an alternative format of all balances listed in one column with credits shown as negative/bracketed numbers.
    Preparing a trial balance will not easily discover any accounting errors that do not affect debits and credits differentially. For example, debiting the wrong account but using the correct amount will not cause the trial balance to be out of balance.
  • Basic Accounting

    1. 1. Mechanics of Accounting
    2. 2. Types of Accounts • There are four types of accounts: – Assets: things the business owns. – Liabilities: debts the business owes. – Income: the revenue generated from the sale of goods or services. – Expenses: the costs incurred in producing the goods and services. • The main difference between these categories is that business profit is calculated as profit = income − expenses while the capital of the business (the owner’s investment) is calculated as capital = assets − liabilities
    3. 3. • Revenue expense are costs in the for day to day running of the business for example servicing a machine, spare parts etc. Revenue expenditure is normally charged against profit in the Income statement in the year it is expensed. EXPENDITURE Outlay as is necessary for the MAINTENANCE of earning capacity including the upkeep of the fixed assets in a fully efficient state. Revenue Expenditures
    4. 4. • Capital expenditure is an item that will help generate profits over the longer term (12 months or more) like a purchase of a machine or equipment etc. The item is depreciated over the item’s useful life and each depreciable amount is charged to the Income statement in the year the item has helped generate profit. CAPITAL EXPENDITURE Outlay resulting in the increase or acquisition of an asset or INCREASE in the earning capacity of a business Capital Expenditures
    5. 5. A capital expenditure is an amount spent to acquire or improve a long-term asset such as equipment or buildings. Usually the cost is recorded in an account classified as Property, Plant and Equipment. The cost (except for the cost of land) will then be charged to depreciation expense over the useful life of the asset. A revenue expenditure is an amount that is expensed immediately—thereby being matched with revenues of the current accounting period. Routine repairs are revenue expenditures because they are charged directly to an account such as Repairs and Maintenance Expense. Even significant repairs that do not extend the life of the asset or do not improve the asset (the repairs merely return the asset back to its previous condition) are revenue expenditures. Capital v/s Revenue Expenditures
    6. 6. Capital v/s Revenue Expenditures 1. Accounting fraud occur because management choose to classify the revenue expenditure as capital expenditure. The revenue expenditure should be taken up into the Income Statement but instead it is deferred into the Balance Sheet. In the process, lesser expenses are being charge into the Income Statement, hence profit is overstated to impress the investors or outsiders 2. Strong GAAP and Accounting standards have classified what should be assets, what should be deferred in the balance sheet so that there should be a clearer demarcation between Capital and Revenue expenditure 3. That certain expenses are recognized as being of a capital nature, although no tangible property may have been acquired as a result. Examples are research and development expenditure, pre-incorporation and preliminary expenses, interest on borrowings for building, legal expenses to acquire property, additional renovations to properties and others 4. The classification of what is capital expenditure of a company might not applies to another company that is not in the same industry. Say in a property based company, most land & buildings are revenue expenditure as they are purchased with the intent for re-sale. 5. The purpose of expenditure if it is to Maintain the business it is revenue and if it is to Improve the business it is capital.
    7. 7. • Revenue expenditure is all the sunk cost incurred in the course of the day to day running of the organization. • Capital expenditure ,can be said as the transaction cost incurred in course of installing fixed assets in the organization Capital v/s Revenue Expenditures
    8. 8. Types of Accounts Accounts Personal (persons – customers, creditors) Impersonal Nominal (relating to expenses, losses, incomes) Real (relating to assets)
    9. 9. Personal Accounts  It deals with the accounts relating to persons and takes the following forms: – Natural person, Artificial Person or legal body – Representative Personal Account: Outstanding liabilities for Rent, Salary, etc. or prepaid expenses for Insurance Premium, Rent, etc. – The proprietor being an individual his capital A/c and his Drawing A/c are also known as Personal Accounts
    10. 10. Real Accounts  It deals with the accounts relating to the properties and assets which are possessed by the business concern. – Example: Cash Account, Machinery Account, Building Account, Purchase Account, Sales Account, etc
    11. 11. Nominal Accounts  It relates to the items which exist in name only. Expenses, Incomes, etc. are there in business activities – Example: Rent Account, Salary Account, Dividend Account, etc
    12. 12. Classify ………P , R / N A. Rent a/c B. Buildings a/c C. Machinery a/c D. Furniture a/c E. Mohan a/c F. Salaries a/c G. Interest a/c H. Sham a/c I. Ali a/c J. Capital a/c K. Bank loan a/c L. Cash a/c
    13. 13. Classify ………P , R / N A. Rent a/c……………..n B. Buildings a/c ……………..r C. Machinery a/c ……………..r D. Furniture a/c ……………..r E. Mohan ……………..p F. Salaries a/c ……………..n G. Interest a/c ……………..n H. Sham ……………..p I. Alii ……………..p J. Capital a/c ……………..p K. Bank loan a/c ……………..p L. Cash a/c ……………..r
    14. 14. Asset • It results in acquiring some property or benefit of a lasting nature or something that can be converted into cash or any benefit can be derived out of it later on as well – Fixed asset – Current asset / floating asset – Liquid asset – Intangible assets – Fictitious assets – useless trademarks, preliminary expenses
    15. 15. Classify ……….which assets A. Leasehold premises B. Accounting machines C. Goodwill D. Stock of raw materials E. Motor vehicles F. Cash in hand G. Govt. securities H. Copyright of book I. Amounts due from customers J. Lose tools K. Cost of floating a company
    16. 16. Classify ……….which assets A. Leasehold premises Fixed B. Accounting machines Fixed C. Goodwill Intangible D. Stock of raw materials Current E. Motor vehicles Fixed F. Cash in hand Liquid G. Govt. securities Liquid H. Copyright of book Intangible I. Amounts due from customers Current J. Lose tools Fixed K. Cost of floating a company Fictitious
    17. 17. Forms of Transactions • Transactions may take place in one of two forms: – Cash: If the business sells goods/services for cash, the double entry is an increase in income and an increase in the bank account (an asset). If the business buys goods/services for cash, either an asset or an expense will increase (depending on what is bought) and the bank account will decrease – Credit: If the business sells goods/services on credit, the double entry is an increase in debts owed to the business (called debtors, an asset) and an increase in income. If the business buys goods/services on credit, either an asset or an expense will increase (depending on what is bought) and the debts owed by the business will increase (called creditors, a liability)
    18. 18. Forms of Transactions When goods are bought, they become an asset called inventory (or stock). When the same goods are sold, there are two transactions: 1. The sale, either by cash or credit; and 2. The transfer of the cost of those goods, now sold, from inventory to an expense, called cost of sales.
    19. 19. ** HOW TO RECORD A TRANSACTION • To record transactions, we need to decide: – what type of account is affected (asset, liability, income or expense) or P, R, N ; and – whether the transaction increases or decreases that account.
    20. 20. Table 1: Business Transactions and the Double Entry
    22. 22. Types of Accounts Accounts Personal (persons – customers, creditors) Impersonal Nominal (relating to expenses, losses, incomes) Real (relating to assets) Dr – Receiver Cr – Giver Dr – expenses/loss Cr – incomes/gains Dr – Comes In Cr – Goes out
    23. 23. Transaction recording ….. Sl. No. Transaction Total assets Owing to outsiders Capital /Owner’s Equity 1 Commenced business with Rs. 100,000 100,000 100,000 2 Borrowed Rs. 50,000 50,000 50,000 150,000 50,000 100,000 3 Paid Expenses Rs. 10,000 -10,000 -10,000 140,000 50,000 90,000 4 Returned Rs 20,000 to the lender -20,000 -20,000 120,000 30,000 90,000 5 Made a profit of Rs 25,000 25,000 25,000 145,000 30,000 115,000
    24. 24. Journal Entries …….. • Chronological order of entries • Account to be debited to be written first • A full explanation of the entry is given – why this entry is made is given just below called as narration – a journal entry without narration is not meaningful.
    25. 25. Journal Entry Date Particulars L.F Debit Credit Rs. P. Rs. P. 2010 July 1 Cash A/c Dr To Loans Payable (Received proceeds from Bank ABC Loan) 5 61 250,000 00 250,000 00
    26. 26. Journal Entries …….. 1. I start business with Rs 150,000 as my capital 2. Out of Rs 150,000 I deposit Rs 100,000 with the bank account 3. Goods are purchased on credit basis from M/s Ram Lal for Rs 60,000 4. A computer is purchased for cash for Rs 54,500 5. Goods are sold on credit to M/s Ali Brothers for RS 10,000 6. Goods are purchased for cash Rs5000 7. Cash is received for sale of goods to M/s Rao Brothers Rs 7000 8. Rent is paid to the landlord Rs 2000 9. A machinery is received & payment is made by cheque Rs 240,000 10. Borrowed Rs 50,0000 from a friend Mr K.Lal 11. Interest paid to Mr K.Lal Rs 600 12. Interest of Rs 600, is due to Mr K.Lal but not yet paid 13. There is fire & certain goods are destroyed; the value is Rs 10,000 14. Paid insurance premium Rs 4500 by cheque
    27. 27. Ans ……(narration + amount has to be there ………) 1. Cash a/c Dr To Capital A/c (…….. Narration …..) 2. Bank a/c Dr To Cash A/c 3. Goods A/c Dr To M/s Ram Lal 4. Computer A/c Dr To Cash a/c 5. Ali Brothers a/c Dr To Goods A/c 6. Goods A/c Dr To Cash A/c 7. Cash A/c Dr To Goods A/c 8. Rent a/c Dr To Cash A/c 9. Machinery a/c Dr To Bank A/c 10. Cash A/c Dr To Loan from K.Lal a/c 11. Interest A/c Dr To Cash a/c 12. Interst a/c Dr To K.Lal A/c 13. Loss by fire A/c Dr To Goods A/c 14. Insurance Premium A/c Dr To Bank A/c
    28. 28. Make the entries for the CASE given Mr. Raj starts his business with Rs 200,000. He opens a bank account & deposits Rs 180,000. He purchases furniture for Rs 8000 & makes payment by cheque. He purchased goods from M/s Jyothi on credit Rs 56000. He also purchased goods worth Rs 11000 from M/s Khan & made cash payment. He sold goods on credit to M/s Mohanlal worth 15,000. Paid for office stationary Rs 2500. Paid rent of Rs 2000 to Mr Satish by cash. Received cash from M/s Mohanlal Rs14,700 & allowed them a discount of Rs 300.
    29. 29. Ledger • The accounts are all contained within a ledger, which is simply a collection of all the different accounts for the business. • The ledger would summarize the transactions for each account, as shown in Table 2
    30. 30. Table 2: Summarizing Business Transactions in a Ledger
    31. 31. Ledger • The ledger is the source of the financial reports that present the performance of the business. • The ledger would also contain the balance of each account brought forward from the previous period. In our simple example, assume that the business commenced with £50,000 in the bank account that had been contributed by the owner (the owner’s capital). Table 3 shows the effect of the opening balances.
    32. 32. Table 3: Summarizing Business Transactions with Opening Balances in a Ledger
    33. 33. Ledgers • While journals are chronologically listings of accounting transactions (debits/credits), those transactions’ effects will not be reflected in the financial statements until they are posted to the general ledger. • The general ledger contains all the accounts and their balances, regardless of which financial statement the accounts affect. – Posting is the process of transferring the debits and credits from the journals to the ledgers. • So an entry that increases cash (via a debit) has not actually increased the cash general ledger account until the journal entry has been posted to the general ledger.
    34. 34. Trial Balances • Trial balances are listings of all the general ledger accounts and their respective balances. • The purposes of the trial balance are to: 1. prove that debits equal credits and 2. review the accounts and their balances to see if any obvious errors exist. • Besides checking for balance between debits and credits, the trial balance can be used to prepare adjusting entries or even to prepare financial statements once the balances are properly adjusted. • A trial balance can be prepared at any point in the accounting cycle or fiscal year. • It is an internal tool and is not a financial statement. • The accounts are grouped by financial statement, with balance sheet accounts listed first, and then in the order they would appear on the respective financial statement.
    35. 35. Closing Entries • While all general ledger accounts have running balances (net of all debits and credits), some accounts should be set back to zero at the start of each major accounting period (usually annually). • This is called closing the accounts and is accomplished by closing entries. • Accounts that should be closed are called “temporary” or “nominal” accounts and include the accounts that report results of operation. This would be all accounts reflected on the income statement, as well as the dividends account. • Balance sheet accounts are never closed. • After closing entries, the balance in the retained earnings account will reflect all past periods’ impacts (revenues, expenses, and dividends).
    36. 36. Basics of Financial Accounting Format of Trading Account Dr. Trading Account for the year ending…. Cr. Particulars Amt. Particulars Amt. To Opening Stock xxx By Sales xxx To Purchases xxx By Closing Stock xxx To Direct expenses xxx By Profit & Loss Account xxx To Profit & Loss Account xxx (Balancing figure being (Balancing figure being Gross Loss) Gross Profit) xxx xxx
    37. 37. Basics of Financial Accounting Format of Profit & Loss Account Dr. P/L a/c for the year ending…. Cr. Particulars Amt. Particulars Amt. To Gross Loss b/d xxx By Gross Profit b/d xxx To Admn. Expenses xxx By Discount received xxx To Depreciation xxx By Net Loss transferred to xxx To Interest xxx Capital A/c To Bad debts xxx To Discount To Provision for Tax xxx To Net Profit transferred to Capital A/c xxx
    38. 38. Basics of Financial Accounting Format of Balance Sheet (Horizontal) Balance Sheet as on…. LIABILITIES Amt. ASSETS Amt. Share Capital xxx Fixed Assets xxx Reserves & Surpluses xxx Investments xxx Secured Loans xxx Current Assets, Loans & xxx Advances Unsecured Loans xxx Miscellaneous Expenditure xxx & Losses Current Liabilities & Provisions xxx xxx xxx
    39. 39. Basics of Financial Accounting Format of Balance Sheet (Vertical) Balance Sheet as on…….. I. Sources of funds 1. Shareholders funds Share capital Reserves & Surplus 2. Loan Fund Secured loans Unsecured loans II. Application of funds 1. Fixed Assets 2. Investments 3. Current assets , loans and advances LESS: Current liabilities and provisions 4. Miscellaneous expenditure
    40. 40. Financial Reports • To produce financial reports we need to separate the accounts for income and expenses from those for assets and liabilities. • In this example, we would produce a Profit and Loss account based on the income and expenses:
    41. 41. Balance Sheet • The Balance Sheet lists the assets and liabilities of the business, as shown in Table 4 • The Balance Sheet must balance, i.e. assets are equal to liabilities. • Although shown separately, capital is a type of liability as it is owed by the business to its owners
    42. 42. Table 4: Balance Sheet
    43. 43. Vertical Format of Presenting A Balance Sheet