29 May 2016

Basis of accounting with example

There are two basis of accounting, "Cash Basis" and "Mercantile Basis" (also called "Accrual Basis").

 

  • Cash Basis: 

Cash basis of accounting is an old concept. Although many small business are still using this system, for it's less complexity. Cash basis is faster and easier than accrual basis. In this system a revenue is being recorded after securing the cash or cash equivalent. Similarly, an expense is being recorded only after the payment is made. There for occurrence of any income or expenses are not recordable happenings, the only happening matters, is the flow of money.

  • Mercantile / Accrual Basis :

Mercantile Basis is more scientific system than cash basis. It need more technical skill to follow but it also gives more transparency over the actual financial position of business. A business having good number of day to day transaction, should follow mercantile basis instead of cash basis of accounting. In mercantile basis all revenues are recorded as soon the revenue generates. Similarly all expenses are recorded once they are charged. Farther entries are also required on payments or receipts. All private or public limited companies are liable to maintain their books in mercantile basis of accounting as it is a legal formality, applicable for all companies. Non-companies, though is is not necessary, are also recommended to follow this system for it's greater transparency.

 

Examples:

Scenario-1 : In a particular business, a monthly salary expenses of Rs. 1,50,000/- is needed to run the entire work flow. It gives salary to the employees on 3rd day of every month by cash.The organization follows the cash basis of accounting.

 

Scenario-2 : As the business grows, the number of employees, total salary and all day to day transactions are also increased parallely. There for the management decides to run the business on mercantile basis. They also decides to give salary by cheque of ICICI Bank. Total salary increased to Rs. 5,00,000.

 

Interpretation:

 

In the 1st scenario, only one entry should be passed on 3rd day of each month. Now assume the salary for the month of April, 2012 is to be recorded, which gets due on 30th April, 2012, but paid on 3rd May, 2012. Here, the entry should be recorded on  as follow:

Date

Particulars

Dr. Amount (Rs.)

Cr. Amount (Rs.)

3rd May, 2012

Salary A/C ..... Dr.

  To Cash A/C

1,50,000

-

-

1,50,000

In the 2nd scenario, two entries are required, one on on the last day of the month, to process the salary and another one on 3rd day of the next month, for the actual payment. Now assume the salary for the month of April, 2013 is to be recorded, which gets due on 30th April, 2013, but paid on 3rd May, 2013. Here, the entries should be recorded as follow:

Date

Particulars

Dr. Amount (Rs.)

Cr. Amount (Rs.)

30th April, 2013

Salary A/C .................. Dr.

     To Salary payable A/C        

5,00,000

-

-

5,00,000

3rd May, 2013

Salary payable A/C ..... Dr.

     To ICICI Bank A/C

5,00,000

-

-

5,00,000

Here, the "Salary payable A/C" is credited on 30th April, 2013 and the same also debited on 3rd May, 2013. Hence, on 3rd May, the net effects are same for both cash and mercantile basis but on 30th April to 2nd May, only in mercantile basis the due amount of salary can be reflected in the books of account, where cash basis failed to give the correct picture.

 

27 May 2016

Accounting Concepts

Accounting concepts are some basic assumption that you need to keep in mind for maintaining books of account. Accounting concepts tells the particular way of your performance for accounting purpose. These are the main foundation of accounting. In this post I am going to discuss about some essential fundamental accounting concepts that provides the accounting base.

  • Entity concept: According to the entity concept, business is the artificially created entity, which is completely separate from its founder/owner. Therefore it is strongly recommended that the name of the correct entity should be mentioned in the header part of all books of account. For example - If Mr. X purchase a land for his business X Ltd., then the asset will be treated as an "Investment" in the books of Mr. X, while the same will be treated as capital to the business, X. Ltd. Hence, the financial position of a business is not equal to the financial position of it's owner, they both have their own legal identities. 
  • Money measurement concept: Money measurement concept is the most basic concept of
    accounting. In this concept no event can be recorded without monetary value in accounting. Money is the measurement unit for all accounting transaction. Money measurement concept draw a boundary over accounting data.
  • Going concern concept: This concept suggest that a business
    should be established with the aim of carrying it's presence year after year. Even the death of any partner is not enough to collapse the business. Once the business is formed, the presence of any member is fully immaterial, it remains continuous in future. Going concern concept is also known as "Continuity concept".
  • Periodicity concept: As per the periodicity or accounting period concept all books of account should be closes within a predefined time interval like a year, quarter or month.
    In general case, the closure date of all books of account is 31st March of each year and should be reopened from 1st April of the next year. For example, if the book beginning date is 1st April, 2012, then closure date for the same is, 31st March, 2013, such a period of 12 months is called financial year. Periodicity concept provide a time limit for finalization of accounts.
  • Dual aspect concept: Dual aspect concept is the very fundamental concept of accounting.
    This concept is the base of the double entry system. All accounting transaction should have two equal and opposite effect into the financial position of a business, which can be denoted by "Debit side effect" and "Credit side affect". Dual aspect concept suggest to record both aspect of a transaction instead of a single side entry. This concept works, based on the basic accounting equation, i.e: Asset = Capital + Liability or Capital = Asset - Liability. 
  • Matching concept: 
    In matching concept all expenses of an accounting period, whether paid or payable, are reported in the income statement, along with the revenue of the same accounting period.
    Matching concept can be followed only in accrual basis of account. Unlike cash basis, the flow of cash is immaterial to record as expenses.
  • Conservatism concept: 
    According to this concept all losses and liabilities, even if the occurrence is uncertain, should be accounted as soon they are noticeable, but incomes and assets should be considered only after it's actual realization. The risk of unexpected short of liquidity is minimum in this concept of accounting.
  • Accrual concept: As per the accrual concept, the books of accounts should be maintained in mercantile system.
    In this system any income on expense can be simply recorded once it occurs, realization of cash flow is not required to record a transaction. This concept provides the "Accrual basis" of accounts. Following accrual basis is a legal requirement to maintaining accounting books of a company.
  • Realization concept: This concept is the opposite of accrual concept.
    Realization concept provides the "Cash basis" of accounts, which suggest to record a transaction only after realization of a inflow or outflow of cash, occurrence of income or expense is not enough to record a transaction.
  • Consistency concept:
    This concept advice to follow consistently all the already implied accounting methods or principles, instead of changing them frequently. This concept provides uniformity in the accounting system of an organization year after year.

24 May 2016

Golden rules with examples

'Golden rule' identifies that, when a class of account get debited and credited. Debit (Dr.) and Credit (Cr.) are treated as the notation in accounting, which indicates the direction of money flow. These two are the main base of accounting. There are two rules of debit and credit, based on two different approach, say 'Traditional' and 'Modern' approach.

Golden rules based on 'Traditional Approach': 

As per the traditional approach of accounting, accounts are broadly classified into a Personal and three impersonal accounts, these are Real, Nominal and Valuation account. Rules are made for these four classes as follow:
  • Personal Account: "Debit the receiver" and "Credit the giver"
  • Real Account: "Debit what comes in" and "Credit what goes out"
  • Nominal Account: "Debit all expenses & losses" and "Credit all incomes and gains" 
  • Valuation Account: "Debit when decrease" and "Credit when increase"  
Examples:
 1. A car purchased from Mr. Y.
 2. Cash paid to Mr. Y.
 3. Rent paid by cheque.
 4. Provision made for bad debt.
 5. Goods sold to Mr. X.
Sl/No.
Account name
Account type
Action
Reason
1
Car
Real
Dr.
Comes in
Mr. Y
Personal
Cr.
Giver
2
Cash
Real
Cr.
Goes out
Mr. Y
Personal
Dr.
Receiver
3
Rent
Nominal
Dr.
Expense
Bank
Personal*
Cr.
Giver
4
Provision for bad debt
Valuation
Cr.
Increase
Profit & loss
Nominal
Dr.
Expense
5
Sales
Nominal
Cr.
Income
Mr. X
Personal
Dr.
Receiver

*Bank is not a real account. It is a personal account according to traditional approach and an asset account according to modern approach. Don’t be confuse in this.
 

Golden rules based on 'Modern Approach': 

As per the modern approach of accounting, accounts are classified into five classes, these are Capital, Asset, Liability, Expense and Income. Rules are made for these five classes as follow:

Class of account
If increase
If decrease
Capital
Cr.
Dr.
Asset
Dr.
Cr.
Liability
Cr.
Dr.
Expense
Dr.
Cr.
Income
Cr.
Dr.

Examples:
 1. Land & building invested as capital.
 2. Salary paid to Employees.
 3. Rent received by cheque.
 4. Furniture purchased from ABC ltd.
 5. Cheque paid to ABC ltd.
Sl/No.
Account name
Account type
Action
Reason
1
Land & building
Asset
Dr.
Increase
Capital
Capital
Cr.
Increase
2
Salary
Expense
Dr.
Increase
Cash
Asset
Cr.
Decrease
3
Rent
Income
Cr.
Increase
Bank
Asset
Dr.
Increase
4
Furniture
Asset
Dr.
Increase
ABC. Ltd
Liability
Cr.
Increase
5
Bank
Asset
Cr.
Decrease
ABC. Ltd
Liability
Dr.
Decrease