5 Business Entity Concept- The business and the businessman are two different and distinct entities. I. e. that the firm and the partners, the company and the shareholders, the owners and the organization have their own distinct identities. All accounting is done from the perspective of the business. The accountant regards owners, creditors, suppliers, customers as parties transacting with the business. All transactions are viewed from the point of view of the business.
Money Measurement Concept- Only those facts that can be expressed in monetary terms are to be recorded. Thus important elements of a business enterprise like morale of workers, honesty of management etc. though important, can’t be recorded. The use of a monetary yardstick serves as a common denominator to express other elements of business such as land, equipment, goodwill etc. Going Concern Concept- This assumes that the business entity will remain in existence in perpetuity. Cost Concept- Assets acquired by a business are recorded at their actual cost.
This concept in tandem with the going concern concept does not consider the existing market price of the assets because such assets would never be sold and hence should be valued at cost. The depreciation is also therefore charged on the original cost. The principle of Conservatism- This principle modifies the cost concept to the extent that it asks accountants to “anticipate no profit but expect all kinds of losses”. Thus inventory and stocks are valued at cost price or market price, whichever is less. Accrual Concept- Incomes are what the business earns and expenses are what the business incurs.
As a rule any transaction which leads to the increase in the owner’s equity is an income and anything that reduces the owner’s equity is an expense. The Dual Entity Concept- It is the fundamental concept in accounting. The whole accounting mechanism depends on the function of this concept. According to this concept, each transaction has two aspects. The Basic Accounting Equation – Assets = Liabilities + Capital. To understand and verify this equation one first needs to be sure as regards the terms used. Assets are defined as anything owned or receivable by the business.
They are the resources owned by the business. E. g. Land, building, machine, cash, debtors etc. Liabilities – Anything owed or payable by the business, liabilities are the claims of various parties against the assets of the firm. Capital – Amount required to start or expand business given by the owners and could be in any form. I. e. the owner may give capital in cash or in the form of any other asset. The basic accounting equation states that the total assets of any enterprise would always be equal to the sum total of its liabilities and capital.
One could understand this equation intuitively as assets of the business would necessarily have to be financed and this could be funded by either the owners or outsiders and generally such funding is a combination of the two. A more comprehensive understanding of the basic equation would involve taking up a few business transactions and analyzing their effect on the basic equation. Mr. A started business with cash Rs. 100,000 and land Rs. 60,000. 1,00,000 + 60,000 = 0 + 1,60,000 Cash Land Liability Capital Purchases of merchandise Rs. 60,000. 0,000 + 60,000 + 60,000 = 0 + 1,60,000 Cash Stocks Land Liability Capital We see the effect of the two business transaction on the basic equation. In the first instance two assets namely cash and land come into existence and against these two on the right hand side we have the owner’s equity. In the second instance we notice that cash reduces but also gives rise to another asset that is the merchandise purchased. We’ll further see how other transactions get incorporated in this equation. Purchased on credit a machine from Mr.
Z Rs. 40,000 40,000 + 40,000 + 60,000 + 60,000 = 40,000 + 1,60,000 Cash Machine Stock Land Mr. Z Capital The purchase of machine should have resulted in reduction of cash but since it was on credit the cash didn’t reduce, instead this purchase of machine resulted in the increase of a liability on the right hand side. Took a loan from bank Rs. 60,000. 1,00,000 + 40,000 + 60,000 + 60,000 = 40,000 + 60,000 + 1,60,000 Cash Machine Stock Land Mr.
Z Bank Loan Capital From the four events that have occurred so far, we observe that anything that increases the left hand side also results in an increase on the right hand side and this shall happen in every possible event. Thus we can safely state that the sum total of assets will always be equal to the total of liability and capital. As has been stated earlier, the enterprise and the owner are separate entities and capital has been given by the owner to the enterprise which implies that capital is nothing but a loan of the owner to the enterprise therefore, repayable and hence a liability.
We therefore restate the equation as: Assets = Liability + Liability Outsiders Owner’s / Insider’s Thus the total assets of any business will always be equal to the sum total of the outsider’s funds and the owner’s equity. The total assets will always be equal to the total liabilities. Assets = Liabilities If what is stated is true and it is true as has been proved, why does one conduct business? Businesses are run to earn profits. So where does profit appear in the basic equation? To answer this we take another event involving profit.
Sold half the merchandise for Rs. 50,000. 1,50,000 + 40,000 + 60,000 + 30,000 = 40,000 + 60,000 + 1,60,000 + 20,000 Cash Machine Land Stock Mr. Z Bank Capital Profit Loan The sale of the merchandise results in a profit of Rs. 20,000 and since this profit is not withdrawn by the owner it has been reinvested for expansion purposes and has resulted in the increase of his equity.
Profits are earned by the business so that it can be used to compensate the owner for taking the risk of investing in the business. Such profits when not withdrawn are ploughed back for expansion purposes and are kept back in the form of reserves, surplus and funds. Thus all profits, reserves and surpluses are payable by the business, payable to the owners but payable nevertheless. The Double Entry System: Every event has two effects on the basic equation. They are equal, opposite and simultaneous.
The left hand side effect is conventionally called debit and the right hand side effect is called credit. Debit v/s Credit – Pacioli considered as a father of modern accounting developed the modern accounting model and stated that “debits are always equal to credits and assets are always equal to liabilities and owner’s equity”. The left hand side effect is the asset effect and the right hand side effect is the liability effect. Since the left hand side is debit and the right hand side is credit it follows : Debit all assets Credit all liabilities.
Since debit and credit are opposite of each other the basic equation can now be restated as – Assets = Liabilities + Capital Debit Credit Debit Credit Debit Credit + – – + – + From this it is clear that owner’s equity is increased by credits and reduces when it is debited. Since incomes increase the owner’s equity and expenses reduce the owner’s equity we can further add a rule: Debit expenses and losses
Credit incomes and gains Before we go any further let us try using the two rules formulated above to record certain events in the books of the business. 1. Mr. A started business with cash Rs. 100,000 and land Rs. 60,000. This would be recorded as Cash a/c ….. dr 100,000 Land a/c ….. dr 60,000 Capital a/c 1,60,000 Being business commenced. Since cash is an asset it has been debited as is land and since capital is a liability it has been credited. 2. Purchases of merchandise Rs. 0,000. Purchases a/c …. dr 60,000 Cash a/c 60,000 Being merchandise purchased for cash. Purchases being an expense has been debited and as cash reduces it has been Credited. 3. Purchased on credit a machine from Mr. Z Rs. 40,000 Machine a/c ……dr 40,000 Z’s a/c 40,000 Being machine purchased on credit. Since machine is an asset it has been debited and since Mr. Z is providing the credit he is a liability and hence credited. 4.
Took a loan from bank Rs. 60,000 Cash a/c ……….. dr 60,000 Bank loan a/c 60,000 Being loan taken. Cash being an asset is debited and bank loan being a liability is credited. 5. Paid rent Rs. 5,000 and salaries Rs. 7,000 Rent a/c……….. dr 5,000 Salaries a/c ……. dr 7,000 Cash a/c 12,000 Being expenses paid. Rent and salaries being expenses are debited and since cash reduces it has been credited. 6 Sold half the merchandise for Rs. 50,000. Cash a/c …….. dr 50,000
Sales a/c 50,000 Being sales on cash. Cash increases and so it has been debited and sales being an income has been c credited. The above method of recording transaction is called Journalizing. The journal is an accounting record which lists chronologically the transactions of the business and their impact on various accounts in terms of debits and credit Posting to the ledger | Debit Cash A/c Credit | |Particulars |Amt. |Particulars |Amt. | To Capital A/c |1,00,000 |By Purchases A/c |60,000 | |To Bank Loan A/c | |By Salaries A/c | | |To Sales A/c |60,000 |By Rent A/c | | | | | |7,000 | | |50,000 | | | | | |By Balance c/d |5,000 | | | | | | | | | | | | | | | | | | | |1,38,000 | | |2,10,000 | |2,10,000 |
A ledger represents a group of accounts. Transactions entered in the journal are transferred to the ledger. Let us post the above transactions into the ledger. | Debit Land A/c Credit | |Particulars |Amt. |Particulars |Amt. | |To Capital A/c |60,000 | | | | | | | | | | | | | | | |By Balance c/d | | | | | |60,000 | |60,000 | |60,000 | Debit Capital A/c Credit |Particulars | Amt. |Particulars |Amt. | | | |By Cash A/c |1,00,000 | | | |By Land A/c |60,000 | |To Balance c/d | | | | | |1,60,000 | | | | |1,60,000 | |1,60,000 | Debit Purchases A/c Credit |Particulars |Amt. |Particulars |Amt. |To Cash A/c |60,000 | | | | | | | | | | |By Balance c/d | | | | | |60,000 | | |60,000 | |60,000 | Debit Machinery A/c Credit |Particulars | Amt. |Particulars |Amt. | |To Z’s A/c |40,000 | | | | | |By Balance c/d | | | | | |40,000 | | |40,000 | |40,000 | |Debit Mr. Z’s A/c Credit | |Particulars |Amt. |Particulars |Amt. | | |By Machine A/c |40,000 | | | | | | | | | | | |To Balance c/d | | | | | |40,000 | | | | |40,000 | |40,000 | Debit Salaries A/c Credit |Particulars |Amt. |Particulars |Amt. | |To Cash A/c |7,000 | | | | | | | | | | |By Balance c/d | | | | | |7,000 | | |7,000 | |7,000 | Debit Rent A/c Credit |Particulars |Amt. |Particulars |Amt. |To Cash A/c | | | | | |5,000 | | | | | | | | | | | | | | | | | | | | |By Balance c/d | | | | | |5,000 | | |5,000 | |5,000 | Debit Bank Loan A/c Credit |Particulars |Amt. |Particulars |Amt. | | | |By Cash A/c |60,000 | | | | | | | | | | | |To Balance c/d | | | | | |60,000 | | | | |60,000 | |60,000 | Debit Sales A/c Credit |Particulars |Amt. |Particulars |Amt. | | |By Cash A/c |50,000 | | | | | | | | | | | | | | | | |To Balance c/d | | | | | |50,000 | | | | |50,000 | |50,000 | A few points that could be observed while posting the events to the ledger: • The debit effect in one account is reflected as a credit effect in the other. • The name of the account never appears in the same account. The reason for it being that it would not explain the source.
Thus, in Cash A/c the word Cash does not appear and instead we have various reasons for increase in cash on the debit i. e. Capital A/c, Bank Loan A/c and Sales A/c and the decrease in cash appears on the credit of Cash A/c due to Purchases, Salaries, Rent. • The total of the two sides are always the same and this is achieved by recording the difference as balance. • At the end of the accounting period each account is closed and this is done by taking the total of the side which is more. The difference in the amount of the two sides is shown as “balance” on the side which shows lesser balance. • The balance as discussed above is called the closing balance and is carried forward to the next accounting period on the other side. The closing balance written on the credit side is called the “debit balance” because it appears on the credit, only because the debit total is more. Similarly, the closing balance written on the debit side is called the “credit balance” . Thus Cash A/c shows a debit balance of Rs. 1,38,000 (By Balance c/d) and the Capital A/c shows a credit balance of Rs. 1,60,000 (To Balance c/d). • All further analysis shall be on the basis of these balances. The total of the accounts have relevance only to the extent that they help us to arrive at balances otherwise they have no accounting significance. When accounts are closed some accounts show debit balances others show credit.
As a rule: All expenses and assets will show debit balances. All incomes and liabilities will show credit balances. A summary of such balances is called the trial balance. Preparation of the trial balance Once accounts are closed some accounts show debit balance whereas others show credit. The trial balance is a summary of all such balances and serves two objectives: A) Provides a check on the equality of debits and credits. B) Arranges data in a convenient form for preparing financial statements. Trial Balance at the end of the accounting period….. | Particulars |Debit |Credit | | |Amt. |Amt. | | | | |Cash A/c |1,38,000 | | |Land A/c |60,000 | | |Capital A/c | |1,60,000 | |Purchases A/c |60,000 | | |Machinery A/c |40,000 | | |Mr. Z’s A/c | |40,000 | |Salaries A/c |7,000 | | |Rent A/c |5,000 | | |Bank Loan A/c | |60,000 | |Sales A/c | |50,000 | | Total |3,10,000 |3,10,000 | • Merchandise costing Rs. 30, 000 remains unsold. Passing of adjustment entries
The trial balance is prepared at the end of the accounting period. Certain events relating to the period cannot be posted to the accounts and are therefore not reflected in the trial balance. In our case only half the merchandise has been sold. The other half though purchased has not been used nor sold and therefore exists as inventory at the end of the accounting period. This has to be adjusted. Besides closing inventory adjustments generally relate to the following: • Accrued expenses and incomes. • Income received in advance and expenses paid in advance. • Provision for bad debts. • Provision for depreciation. • Provision for tax. • Provision for dividend. • Appropriating profits to reserves.
The trial balance tallies i. e. the total debits in the trial balance is equal to the sum total of its credits. This implies that up to this stage double entry is complete. If trial balance is to be further posted then the debits would go to the debit and the credits would go to the credit and that too only once. The opposite effect is reflected in the ledger. Anything not appearing in the trial balance is an adjustment and implies that it has not been recorded in the ledger and therefore the double entry is not complete. Thus adjustments has two effects: one debit and the other credit. Preparation of Financial Statements. All financial statements consists of two parts: The Revenue Statement / Trading and Profit and Loss a/c • The Balance Sheet Before we start preparing financial statements we should be very clear about what you mean by expense and what exactly are incomes. Expenses are what we incur. It is the cost of using a benefit. It is what we use and consume and not what we pay for. Similarly, incomes are what we earn, it is the fruit of our labor, it is what we have worked for that constitutes income and not what we receive. Capital Expenditure v/s Revenue Expense: • Capital expenditures are incurred once in a while and give benefit for long term. Such expenditures are non recurring in nature and they are so because the effect of such expenditure lasts for a long time.
They result in assets and include purchase of land, machinery, vehicles, furniture, the payment of preliminary expenses, underwriting commission, discount on issue of shares and debentures etc. • Revenue expenses on the other hand are incurred every now and then and give benefit for a short term. The benefits arising out of such expenses are short lived and therefore they have to be incurred on a recurring basis. These include purchase of merchandise, stationery, fuel, postage stamps, depreciation, discount, commission on sales, advertisement etc. Thus the purchase of a motor car is capital expenditure and the cost of fuel is a revenue expense.
Discount per se is revenue in nature but discount on issue of shares happens once in a while and therefore it is amortized over the years and the amount incurred is shown as an asset. • Deferred Revenue Expense: This is a revenue expense having characteristic of capital expenditure. It is by nature and classification a revenue expense but could give benefit for a long term. E. g. Advertisement to launch a product. Preparation of Financial Statements After the trial balance has been prepared and the adjustment entries have been passed to prepare a final analysis of all the account heads we undertake the exercise of finalizing the accounts. The financial statements are prepared to provide information to the owners, creditors, financial institutions and employees regarding the health of the business.
It comprises of two parts viz. a) The Revenue A/c or the Statement of Profit and Loss. b) The Balance Sheet or the Statement of Sources and Application of Funds. The Trading and Profit and Loss A/c or the Revenue Statement takes into account all revenue expenses and incomes during the accounting period under consideration on an accrual basis. The Balance Sheet is not an account but a statement showing the financial position of a business on a particular date. It is the financial snapshot of the business. It records all capital expenditures and assets as also all the liabilities. Let us prepare the financial statements based on the Trial Balance prepared earlier.
Debit Trading Account for the year ended…… Credit |Particulars |Amt. |Particulars |Amt. | |To Purchases A/c |60,000 |By Sales A/c |50,000 | | | | | | | | | | | | | | | | |To Gross Profit c/d | |By Closing Stock | | | |20,000 | |30,000 | | |80,000 | |80,000 |
Debit Profit and Loss A/c for the year ended…. Credit |Particulars |Amt. |Particulars |Amt. | |To Salaries A/c |7,000 |By Gross Profit b/d | | |To Rent A/c |5,000 | |20,000 | | | | | | |To Net Profit c/d |8,000 | | | | |20,000 | |20,000 | Balance Sheet as on the year ended ……. |Liabilities | Amt. | Assets | Amt. |Capital |1,60,000 |Land A/c | 60,000 | |Profit Balance b/d | |Machinery A/c | | |Bank Loan A/c | |Inventory |40,000 | |Z’s A/c |8,000 |Cash A/c | | | | | |30,000 | | |60,000 | |1,38,000 | | |40,000 | | | | |2,68,000 | |2,68,000 | • The Balance Sheet is prepared for the business and not for the owner (business entity concept) • The figures in the Balance Sheet are expressed in monetary terms (Money Measurement Principle). • Fixed Assets are stated at cost (Cost Concept). • Current Assets i. e. Inventory, is stated at cost or market price whichever is lower (Principle of Conservatism). • Assets are equal to liabilities ( Dual Aspect Concept). Trial Balance account heads appear either in Trading A/c, Profit and Loss A/c or Balance Sheet but only once (no double effect as the effect exists in the account). • The adjustment of unsold merchandise appears on the credit side of Trading A/c and Asset side (Debit effect) of Balance Sheet. This is because unsold merchandise does not appear in Trial Balance and is therefore adjusted and so has two effects. The same information as represented above in T-Shaped Format also known as Horizontal Format. The same information could be presented in a Vertical Format. Before we proceed to the Vertical Format let us analyze the information as represented in the Horizontal Format.
The Gross Profit in the Trading A/c has been arrived at by taking the total of Sales and Closing Inventory and deducting the total of the debit. The Gross Profit can be computed as follows : (Sales + Closing Stock) – (Opening Stock + Purchases + Productive Expenses ) = Gross Profit Cost Of Goods Sold may be defined as – Sales – Gross Profit OR can be expressed through the following formula Cost Of Goods Sold = Opening Stock + Purchases + Productive Expenses -Closing Stock. Let us now present the information in the Horizontal Format. Statement of Profit Or Loss for the accounting period ended …… | Particulars |Amt. |Sales |50,000 | |(Less) Cost Of Goods Sold |30,000 | |Gross Profit |20,000 | |(Less) Operating Expenses: | | |Salaries 7,000 | | |Rent 5,000 |12,000 | |Operating Profit | 8,000 | | Particulars | Amt. | |Sources: | | |Capital |1,60,000 | |Operating Profit |8,000 | |Bank Loan |60,000 | |Mr Z’s A/c |40,000 | |Total 2,68,000 | |Applications: | | |Land |60,000 | |Machine |40,000 | |Inventory |30,000 | |Cash |1,38,000 | |Total |2,68,000 | Statement of Sources and Application Of Funds The above illustration consists of only six transactions and of a simple organization with a sole owner. The business could be organized as a partnership firm with multiple owners or as a corporate entity with thousands of shareholders. The corporate Balance Sheet classifies the various Assets and Liabilities and can be represented as follows Balance Sheet of a Corporate Entity as on the year ended ……. | Liabilities |Amt. | Assets |Amt. |Share Capital | |Fixed Assets | | | | | | | |Reserves and Surplus | |Investments | | | | | | | |Secured Loans | |Current Assets | | | | | | | |Unsecured Loans | |Loans and Advances | | | | | | | |Current Liabilities | |Miscellaneous Expenditure and | | | | |Fictitious Assets | | |Provisions | | | | |Total | |Total | | Note: Contingent Liability.