The Basis of Accounting Explained

THE SYSTEM OF ACCOUNTING
Volume III
THE BASIS OF ACCOUNTING
WRITTEN BY:
SYED AQEEL RAZA
MASTER OF COMMERCE & POLITICS

ACCOUNTING FOR BASES
All accounting system is based on payment and receipt by cash and bank which depends
on cash and accrual base accounting and sometime requires cash and accrual base mix
accounting to remove draw backs of cash accounting.
CASH BASE ACCOUNTING
In general, any item which a bank accepts at the face valve of deposit or
which may be transferred to another party at face value may be considered
cash.
In cash base accounting system, transactions are recognized on receipt and
payment of cash or a company records cash receipts in the period that they
are received and expenses in the period in which they are paid. Revenues
and expenses are reported in income statement when the cash is received
and expenses occurred.
It is usually applied or followed by individual or small and non-
manufacturing businesses. If a business expands, it may move to accrual
method of accounting.
Cash accounting is the opposite of accrual accounting wherein revenue and
expenses are recorded when they are incurred but controlled under cash
accounting because the revenue and expense which were recorded in their
respective accounts as they incurred and the effect in their accounts
receivable or payable is paid by cash or bank.
<THE SYSTEM OF ACCOUNTING < VOLIUM 1< SYED AQEEL RAZA<aqeelraza@live.com>

Cash accounting has some draw backs;
- Daley in recognition of income
If a cheque from customer and a cheque to supplier is received and given
on the 30th
of the month but could not cashed or deposited at the bank, it
will be recognized in next month.
- Delay in recognition of taxable income
A business receives a cheque from a customer near the end of it fiscal year,
but does not cash it until the next year will make cause of recognition of
taxable income in the current year.
- Delay of expenses in recognition of taxable income.
A business pays its suppliers early in order to recognize more expenses in
the current fiscal year which will reduce its taxable income in the current
year.
- Unable to present profitability
The delay in recording revenue and expenses will make the cause of
presenting accurate profitability which will also affect on company’s
budget.

How to remove draw-backs?
- As soon as the cheque from customer and the cheque to supplier is
received or given must be accounted for either cashed or not in their
accounts. The Invoices of sale and purchase must be accrued as and
when they incurred. As far as the expenses are concerned, they may be
taken or accrued at the end of the year enable account to show clear
picture somehow.
Hence, we can say that the draw backs of cash accounting can be removed
by mix accounting system “cash and accrual accounting.”
Advantage of cash accounting;
- Cash accounting can also be cost-effective in case of sole proprietorship
or partnership and for companies that conduct mostly cash transactions.
- Cash accounting requires less staff, financial resources and easy to
understand.
- Cash accounting clearly represents cash flows and outflows in business
than the accrual method of accounting.
- Cash accounting provides tax benefits of payments received in 2015 for
the work of previous year would be counted as income for 2015 tax year
and reduced net income for the year 2015 tax year.

Many devices for cash and receipt has been described such as cash book,
petty cash book, General Journal and special journals; cash receipt journal,
cash payment journal, purchase journal, sales journal, purchase return and
allowances journal, sales return and allowances journal etc. on which we
have discussed on our previous version.
All payments and receipt are done by cash with the company and the cash
with bank. The cash in the company is applied in small cash payments and
small receipts in cash is also used in it but the payment to suppliers from
whom we purchase goods is paid by bank issuing cheque in the name of
supplier which goes in clearing and after processing the amount is
transferred to supplier account and so on the cheque we deposit of the
customer which we receive against sale or services rendered comes to our
account.
Therefore, cash and bank are two name of one thing “cash” must be
compared with company cash book and bank book and it is also necessary
to have a complete knowledge regarding the bank procedures and
documents used for banking.
There are many kinds of bank accounts used for keeping cash and operating
for personal and business but profit and loss sharing account (PLS) and
Current Account (CD) are mostly used in business which are described
below to have complete knowledge of them;

PROFIT AND LOSS SHARING ACCOUNT (PLS A/C)
This kind of account can be operated by any person, firm or organization by
depositing minimum balance Rs.100/=or above which allows profit variable
on the amount deposited over a specified period and keeps in share the
loss as the case may be to the account holder. The account holder can
withdraw or deposit the amount up to the limit prescribed.
This account is operated under interest free system but the interest is
under question.
CURRENT ACCOUNT (CD A/C)
This accountis usually operated by the business man and can be opened by
Rs.1000/= as an initial deposit at the time of opening the account. The bank
issues cheque book 25, 50, 100 leafs as per requirement.
There is no interest on this account.
Besides, profit and loss sharing account and current account, bank
introduces many other accounts like;
- Home safe accounts
- Student saving account
- Saving account
- Islami Banking account
- Fixed Deposit Account
- Credit card
- Debit card
- Visa card

Banks also issues certificates having interest on completion of specified
period.
Bank uses many forms or documents to make transaction from him but the
following forms are used mainly to operate any account or doing
transaction:
- Cheque book
- Pay-in-slip/deposit slip book
- Pay order/demand draft making form
- On line transfer form
BANK’S INTEREST AND CHARGES
The bankers enjoys higher rate of interest or profit and allows small rate of
interest or profit to the account holder by whose money he enjoys big
income. The bank deposit or transfer the amount of interest in the account
and informs the account holder by credit memo.
The bank also deducts charges of different nature from his account holders
in making transaction through bank from which some are mentioned here;
Cheque book charges
Minimum balance charges
Commission
Excise duty
Withholding tax – filler
Withholding tax- non-filler
Pay order making charges
Demand draft making charges
On line transfer charges
Postage charges

BANK STATEMENT
A copy of the account for a period, monthly, half yearly or annually is sent
by the bank to the account holder for checking of withdrawals, deposits
and balance which is reconciled by company’s cash book.
BANK RECONCILIATION
The bank reconciliation is the matching statement of two balances at the
end of the month or year such as cash book balance and bank statement
balance. It is made to search the causes of disagreement in balances and to
test the accuracy of the transactions posted in cash book. In case of any
unknown discrepancy or difference, the bank is informed within a
reasonable time.
The balance in cash book and in bank statement may differ;
- Cheques issued but not presented to the bank for payment on the end
date of the bank statement.
- Cheques deposited into the bank but not collected the amount till the
end of the date of bank statement.
- Interest of the bank not recorded into cash book.
- Bank charges, mark-up on over draft are not recorded in the cash book.
- Cheques issued but not recorded in the cash book.
- Wrong posting of amount by the bank in the account.
- Wrong positing of amount in the cash book.
- Unknown collection or credit shown in bank statement.
- Unknown payment or debit shown in bank statement.
- Bank commission, excise duty, cheque book charges, pay order charges,
demand draft charges, any instrument making charges, and tax on cash
withdrawn are ascertained on seeing the bank statement.
- Many other causes of disagreement with cash and bank.
- <THE SYSTEM OF ACCOUNTING < VOLIUM 1< SYED AQEEL RAZA<aqeelraza@live.com>

METHOD OF BANK RECONCILIATION STATEMENT
There are two method are applied for bank reconciliation wherein;
o Correct method
o Adjusted method
In corrected method, the items which are shown in bank statement but not
in cash book will be recorded in cash book before making bank
reconciliation or on the way of finding out difference at once and in
adjusting method after making bank reconciliation statement but the main
object is to determine the correct balance of both cash book and the bank
statement.
PROCEDUTURE OF BANK RECONCILIATION
Keep two books before you and examine each other by ticking the amount,
cheque number, bank deposit slip number and any other reference match
with cash book and bank statement. The ticked items are agreed but un-
ticked items are under question and need clarification.
Following are the steps and points for making bank reconciliation
statement;
- At first, both the balances are written like balance as per cash book
(business record) and balance as per bank statement (Bank record) for
example;
Bank statement Cash book
Balances 24,750 18,000

1- Out-standing cheques, unpaid cheques, un-presented cheques
Out-standing cheques or unpaid cheques are the cheques which are issued
for payment but not presented or collected by the party to whom the
cheque is issued remained unpaid by the bank before the end of the month
or end date of bank statement June 30, 2015.
The out-standing cheques or unpaid cheques are reduced by the bank as
and when they are presented by the party. The Cash book had already been
reduced by the cheques as and when they were issued and the bank book
would be reduced as and when they were presented in bank.
Cheques issued for payment, but not presented for payment before June
30, 2015 as detailed below;
Cheque No. 500500 Rs. 1, 000
Cheque No. 500510 Rs.2, 000
Cheque No. 500515 Rs.3, 000
Cheque No. 500518 Rs. 5,000
Balances 24,750 18,000
Less: un-presented cheques
Cheque No. 500500 Rs. 1, 000
Cheque No. 500510 Rs.2, 000
Cheque No. 500515 Rs.3, 000
Cheque No. 500518 Rs. 5,000 (-) 11, 000

2- Deposit in transit, uncollected cheques
The deposit in-transit or uncollected cheques are the cheques which will be
added in bank book but added in cash book and as and when the amount
will be transferred from the bank of other branch or bank. Hence, the
cheques which are in transit or uncollected are added in the column of
bank statement. The reason of not showing in bank statement is deposit to
near date of end date of statement or some reasons having objections
wherein insufficient balance, wrong date, amount difference in figures and
words and many other reasons.
Cheque deposited into bank but not shown in bank statement or bank
collection;
No.130025 dt: 28/6 Rs.3000/=
No.313454 dt: 29/6 Rs.2000/=
No. 505352 dt: 30/6 Rs. 1500/=
Balances 24,750 18,000
Cheque No. 500500 Rs. 1, 000
Cheque No. 500510 Rs.2, 000
Cheque No. 500515 Rs.3, 000
Cheque No. 500518 Rs. 5,000 (-) 11, 000
Add: deposit-in-transit
No.130025 DT: 28/6 Rs.3000/=
No.313454 DT: 29/6 Rs.2000/=
No. 505352 DT: 30/6 Rs. 1500/= (+) 6,500

3- Bank deductions such as collection charges, commission, excise duty,
withholding tax, postage, cheque book charges, etc.
On viewing bank statement, we ascertained that bank has deducted many
charges in shape of collection charges, commission, excise duty,
withholding tax, postage, cheque book charges, pay order making charges,
demand draft making charges, on line transfer charges, etc. etc. if these
charges are not recorded in cash book, we record them and they will
reduce the balance of cash book.
Bank deducted following charges during the month of June 2015 which are
not shown in cash book;
10/6 Cheque Book charges 150/=
15/6 Bank commission Rs.100/=
16/6 Tax on Cash withdrawn Rs.50/=
25/6 on line transfer charges Rs.100/= (-) 400
Balances 24,750 18,000
Cheque No. 500500 Rs. 1, 000
Cheque No. 500510 Rs.2, 000
Cheque No. 500515 Rs.3, 000
Cheque No. 500518 Rs. 5,000 (-) 11, 000

No.130025 dt: 28/6 Rs.3000/=
No.313454 dt: 29/6 Rs.2000/=
No. 505352 dt. 30/6 Rs. 1500/= (+) 6,500
10/6 Cheque Bookcharges150/=
Less:Bank chargesand Tax
15/6 Bank commissionRs.100/=
16/6 Tax on Cash withdrawnRs.50/=
25/6 on line transferchargesRs.100/= (-) 400
4- Bank collection not recorded in cash book.
The bank collections such as bank interest on deposit, notes receivable,
interest on notes receivable and bank interest on notes if shown in bank
statement but not shown in cash book shall increase the balance of cash
book.
Bank collected following but not recorded in cash book.
20/6 Bank interest on deposit 100/=
25/6 notes receivable 1000/=
25/6 interest on notes receivable 50/=

Balances 24,750 18,000
Cheque No. 500500 Rs. 1, 000
Cheque No. 500510 Rs.2, 000
Cheque No. 500515 Rs.3, 000
Cheque No. 500518 Rs. 5,000 (-) 11, 000
No.130025 dt: 28/6 Rs.3000/=
No.313454 dt: 29/6 Rs.2000/=
No. 505352 dt: 30/6 Rs. 1500/= (+) 6,500
Less:Bank chargesand Tax (C. Book)
Add: Bank collection not record in C. Book
25/6 interest on notes receivable 50/= (+) 1,150

5- Bank debit and credit not known
Because of having on line most of the transactions, the amount could not
be identified by some reasons and needs to be settled later but made the
cause of increase and decrease in balance of bank book not in cash book.
The difference of two balances may keep on temporary in bank
reconciliation shortly and later on in suspense account as “unknown
parties” and find out the difference of the matter. As soon they are
identified must be moved to their right place.
Bank can also debit the amount of any cheque of the other party wrongly in
bank statement must be notified to bank for correction immediately.
Less: unknown debit (Cash Book)
Unknown debit shown in bank book)
# 430449 18/6 Rs. 2000/=
Add: unknown credit (in cash book)
Unknown credit shown in bank book
# 535383 28/6 Rs.1000/=
# 494693 30/6 Rs.1500/=
Balances 24,750 18,000
Cheque No. 500500 Rs. 1, 000
Cheque No. 500510 Rs.2, 000
Cheque No. 500515 Rs.3, 000
Cheque No. 500518 Rs. 5,000 (-) 11, 000
No.130025 dt: 28/6 Rs.3000/=
No.313454 dt: 29/6 Rs.2000/=
No. 505352 dt: 30/6 Rs. 1500/= (+) 6,500

Less:Bank chargesand Tax (C .Book)
Add: Bank collection not record in C. Book
25/6 interest on notes receivable 50/= 1,150
Less: unknown debit (Cash Book)
Unknown debit shown in bank book)
# 430449 18/6 Rs.2000/= (-) 2,000
Add: unknown credit (in cash book)
Unknown credit shown in bank book
# 535383 28/6 Rs.1000/=
# 494693 30/6 Rs.1500/= 3,500
Corrected balance 20,250 20,250
BANK RECONCILIATION STATEMENT
Balance as per cash Bank Statement 24,750.-
Less: Un-present/out-standing cheques 11,000.-
Add: Deposit-in-transit 6,500.-
----------
Balance as per Bank statement 20,250.-
======

Balance as per Cash book 18,000.-
Less: Bank charges 350 + 50 Tax - 400.-
Add: Bank interest on deposit 100-
Notes receivable 1,000.-
Interest on notes receivable 50
Less: Unknown debit -2000
Add: Unknown credit 3500
--------
Balance as per Cash book 20,250
======
The journal entries of the amount that could not be shown in ledger
account must be recorded in order to match balances with cash book and
bank book and provide balance for issuing cheques.
Adjusting Entries;
Bank charges 350
Tax on cash withdrawn 50
Bank 400
Bank 1,150
Bank profit 100
Notes receivable 1000
Interest on notes receivable 50
Unknown parties 2000
Bank 2000
Bank 3500
Unknown parties 3500

ACCRUAL BASE ACCOUNTING
In accrual base accounting, transactions are recorded in ledger under
journalizing and as when they transact and reported in income statement
when they earned or occurred of the period that closes accounting. Now,
the cash received or paid will have no concern with revenues and expenses
but receivable and payable which is the result of accrual base accounting.
As far as usually expenses are concerned, the accrual of them daily is not in
practice. Now, this question can be arisen that will the profit cover the
transaction of the date? The answer will be no, then the accrual base
accounting need to accrue all transactions on accrual basis if we require
profit and loss and balance sheet on daily basis.
CASH AND ACCRUAL BASE MIX ACCOUNTING
In cash base accounting cash is received or paid against transactions as and
when they occurred and in accrual base accounting, the journal entry of the
transactions is recorded as and when it occurred before cash receipt and
payment.
In cash and accrual mix base accounting, usually cash is received or paid
against transactions but the transactions relate to receivable or payable are
journalized and remaining transactions of the date of accounting period are
recorded at the time of closing accounts.
It is up to entity’s requirement that it adopts the system among cash,
accrual and mix accounting system.

CASH FLOW STATEMENT
Generally, the income statement and balance sheet are
prepared under accrual basis of accounting but the cash
flow statement is one of the main financial statements
among balance sheet, income statement and statement of
stock holders’ equity which reports the cash generated or
actual cash-like assets from operating, investing and
financial activities used during the time interval.
The cash flow statement includes only inflows and
outflows of cash and excludes transactions that do not
directly affect cash receipts and payments.
The cash flow statement is the reconciliation of opening
balance of cash and closing balance of cash and cash
equivalent at the beginning of the period and ending of
the period.
The cash flow statement bases on cash report on three
types of financial activities: operating activities, investing
activities and financing activities.

1- OPERATING EXPENSES
Operativeactivities include production, sales and delivery of the company’s
product as well as collecting payment from its customers.
These activities usually deal with current assets and current liabilities and
include;
Cash receipts from customers
Cash paid to suppliers for goods and services
Cash paid to employees/Accrued wages
Interest paid (can be reported under financial activities in IAS 7)
Income tax paid
The receipts are reduced from payments.
2- INVESTING ACTIVITIES
The investing activities deal with sales and purchase of fixed assets and long term
investment as well as any return of investment like dividend and interest receipt and
may include;
Purchase of fixed assets (actual cash paid)
Sale of fixed assets (accrual cash received)
Interest received on investments (actual cash received)
Dividend received (actual cash received)
Dividend paid (actual cash paid)

3- FINANCIAL ACTIVITIES
The financial activities involve in shareholder’s equity and long term
liabilities as well as dividend received and interest paid over it and may
have;
Issue of share capital (actual cash received)
Issue of debenture (actual cash received)
Cash received from long term loans (actual cash received)
Payment of dividends (actual cash paid)
Payment of long term loans (actual cash paid
The balance sheet and income statement are the sourceof making cash
flow statement and enterprises can reportcash flows fromoperating
activities using direct method or indirect method.
1- DIRECT METHOD
Direct method reports major classes of gross cash receipts and gross
cash payments as actual.
DIRECT METHOD
Cash flowfrom operations xxxxx
Cash flow from investing (xxxx)
Cash flow from financing (xxxx)
--------
Net Cash flow xxxx
=====

EXAMPLE:
The cash flow statement under direct method is prepared as given balance
sheet and income statement.
BALNACE SHEET
ASSETS 2013 2014 LIABILITIES 2013 2014
Cash & equivalents 4000 5000 Accounts payable 13000 15000
Accounts Receivable 7000 10000 Accrued Wages 2000 3000
Inventory 12000 15000 Accrued taxes 3000 2000
------------------ ------------------
Total Current Assets 23000 30000 Total Current Liabilities 18000 20000
Net fixed assets 40000 40000 Long term debts 20000 20000
Common Stock 10000 10000
Retained earnings 15000 20000
------------------ ------------------
63000 70000 63000 70000
============ ============

INCOME STATEMENT 2014
Sales 85000
Cost of goods sold 50000
Operating Expenses 15000
Depreciation 3000
Interest 2000 70000
------- --------
Net income before taxes 15000
Income tax -10000
---------
Net income 5000
=====
- Cash flow statement direct method
- Find out net profit from balance sheet
- Cash flow statement indirect method
- Statement of changes in working capital
- Funds Flow Statement

CASH FLOW STATEMENT - DIRECT METHOD
Cash flows from operating activities
----------------------------------------------------
Cash received from customers (C-1) + 82000
Less: Cash paid to creditors (C-2) - 51000
Less: Cash paid for expenses (C-3) - 14000
-------
Cash generated from operation 17000
Less: Income tax paid (C-4) - (11000)
-------
Net cash generated from operating activities 6000
Cash flows from investing activities
Purchase of fixed assets (C-5) - 3000
Net cash used by investing activities (3000)
Cash flows from financing activities
Interest paid -2000
Net cash used by financing activities (2000)
--------
Increase in net cash during the period 1000
Add: Cash and cash equivalent at beginning of period 4000
-------
Cash and cash equivalent at ending of period 5000
====
DIRECT METHOD
Cash flowfrom operations 6000
Cash flow from investing (3000)
Cash flow from financing (2000)
--------
Net Cash flow 1000
=====

Calculation 1 – Cash received from customer
Opening balance of a/c receivable 2013 7000
Add: Sales 2014 85000
---------
Total Credit sale 92000
Less: closingbalance of a/c receivable 2014 10000
---------
Cash (balancing) 82000
======
Calculation 2 – Cash paid to creditors
Inventory account
Opening balanceof Inventory 2013 12000
Less: Inventory 2014 15000
-------
Increase in inventory 3000
Add: Cost of goods sold 2014 50000
-------
Purchases (balancing) 53000
=====
Account payable account
Opening of account payable 2013 13000
Add: Purchases 53000
-------
66000
Less: closing of account payable 2014 15000
-------
=====

Calculation 3 - Cash paid for expenses
Opening of accrued expenses 2013 2000
Add: Operating Expenses 15000
-------
Total expenses 17000
Less closing of accrued expenses 2014 3000
-------
======
Calculation 4 – actual tax paid
Opening of accrued expenses 2013 3000
Add: tax paid for the year 2014 10000
-------
Total taxes 13000
Less: closing of accrued taxes 2000
-------
Cash (Balancing) 11000
=====
Calculation 5 – Fixed assets purchased or sold
Opening of fixed assets 2013 40000
Add: depreciation 3000
Less: Closing of fixed assets 2014 (-) 40000
-------
Cash (Balancing) 3000
=====
- Calculation 6- Net profit before
Retained earnings (closing) 20000
Less: Retained earnings (opening) (15000)
---------
5000
Add:
Interest expense for the period 2000
Income tax for the current period 10000
-------
Income before tax and interest 17000

INDIRECTMETHOD
Indirectmethod converts actual bases net income or loss into cash flow
by using a series of additions and deductions changing in operating
activities reporting increaseand decrease in assets and liabilities.
Operating Activities
o Net profitbefore interest and tax
o Adjustment(non cash item)
Add in net profit
 Depreciation
 Bad debt expenses
 Amortization of goodwill, patent or intangible assets
 Amortization of discounton debenture or share
 Loss on sale of fixed assets
Less in net profit
 Gain on sale of fixed assets
 Dividend and interest received on investment
The result of addition and deletion in net profit (Assets & Liabilities
o Increase in current Assets (except cash/bank)
o Decrease in current assets (except cash/bank)
o Increase in current liabilities (except tax, interest & dividend p/a)
o Decrease in current liabilities (except tax, interest & dividend p/a)

Cash flows from operating activities
Net profit before interest & tax (C-1) 17000
Adjustment for: (non-cash items)
Add:
Depreciation 3000
-------
Operating profit 20000
Increase in Accounts receivable (3000)
Increase in inventory (3000)
Increase in accounts payable 2000
Increase in accrued wages 1000
-3000
-------- ------
Net cash generated from operating activities 17000
Less: Income Tax paid (C-2) -11000
---------
Net cash generated from operative activities 6000
Cash flows from Investing Activities
Purchase of fixedassets (3000)
Net cash used by investing activities (3000)
Cash flows from financing activities
Interest paid (2000)
Net cash used by financing activities (2000)
-------
Increase in net cash during the period 1000
Add:
Cash and cash equivalent at beginning of period 4000
Cash and cash equivalent at ending of period 5000
=====

FUNDS FLOW STATEMENT:
The prior use of fund flow statement has been converted into cash flow statement
under IAS 7 (Revised 1992) International standard of presenting financial statement.
The fund flow statement is based on accrual base accounting which represents the
cash and cash equivalent in funds flow analysis.
Fund = working capital = current assets - current liabilities
SOURCES OF FUNDS
Net profit before interest & tax (C-6) 17000
Adjustment of (non-cash items) Add:
- Depreciation + 3000
Income from business operation 20000
APPLICATION OF FUNDS
Tax paid -11000
Purchase of fixed assets (C-5) -3000
Interest paid -2000
Net increase in working capital -16000
Net increase in working capital 4000
=====

All accounting functions are based on payments and receipts and it is up to
the requirement of an entity to adopt cash base accounting systemwherein
cash payments and receipt are made at same time and in accrual base
accounting system requires accruing all payments and receipts before
payment and receipt or payment receipt may differ in time but in cash base
accounting may require accruals at the time of finalization of accounts.
The cash flow and fund flow statements are made under comparison of
balance sheet and income statement and they were prepared under
accrual base accounting based on paid and received cash.
The cash base accounting can be better for small businesses but in the
business like share business, partnership business etc. wherein the capital
of public is involved accrual base accounting may be adopted for actual
position of funds to be paid or to be received.
WRITER’S VIEW
WRITTEN BY:
SYED AQEEL RAZA
MASTER OF COMMERCE & POLITICS

The Basis of Accounting Explained

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