Wednesday, April 13, 2011

Purpose Of Keeping Accounts

Generally people have a short memory, and businessmen are no exceptions. They have to do many transactions daily. A businessman gives cash to and receives cash from a number of suppliers and customers. He purchases and sells goods and other articles for cash and on credit. He incurs a number of expenses daily and earns income from different sources. At times he sells business properties, which are no longer required, and at other times makes additions to properties already existing. He cannot remember for long all the varied transactions taking place daily in his business. He must, therefore, make a written record of his varying transactions, so that in times of need he may refresh or supplement his memory by referring to his written records. In other words, he should keep accounts.

Book Keeping is the art of recording daily business transactions regularly in a set of books, following a definite system.

- Only the transactions of a financial nature are recorded.
- The recording of transactions is made in a definite set of books specially designed for the purpose.
- Records are maintained date-wise.

Accounting: Accounting is preparation of statements or accounts in a summarized and classified manner to find out the profit or loss, and to ascertain the financial position of the business. Accounts are maintained in a "T" form.

Meaning of DEBIT and CREDIT: The left hand side of each account (utilized for recording transactions in respect of which that account has received benefit) is called the "debit" side, and the recording of transactions on the debit side of any account is technically known as "debiting an account". Thus, to debit an account means to enter the transaction on the debit (left) side of that account.

Similarly, the right hand side of each account (utilized for recording transactions in respect of which that account has given benefit) is called the "credit" side, and the recording of transactions on the credit side of any account is technically known as "crediting an account". Thus, to credit an account means to enter the transaction on the credit (right) side of that account.

Double Entry System of Book Keeping: Every business transaction has a two-fold effect. It affects two different accounts in opposite directions. A complete record of any transaction would, therefore, require the entry to be made in both the accounts, debiting the one and crediting the other. This recording of the two-fold effect of every transaction is known as Double Entry. According to William Pickles, the two-fold effect of every transaction is recorded under double entry system - one effect being the receiving of some benefit, and the other being the giving of some benefit. In other words, every transaction involves two accounts, a receiving account and a giving account. The receiving account is debited and the giving account is credited.

Trial Balance: At the end of  the financial period, which is normally a year, (may be less) if the debit and credit sides of every ledger account is totalled and all accounts' individual balancing figures, either debit balance (debit side heavier) or credit balance (credit side heavier) are taken into consideration and columned up into two debit and credit columns, their totals should tally, since every debit has a corresponding credit under double entry system of book keeping.. This statement is called trial balance. A trial balance should always tally (total of debit balances = total of credit balances) irrespective of when it is prepared.

Manufacturing account and trading account: A manufacturing concern needs to prepare a manufacturing account as well as a trading account. A trading account is required to be prepared by all.

In the manufacturing account (in the same "T" form) all manufacturing expenses' balance from the trial balance are written. This total gives the total manufacturing cost.
All expenses always have a debit balance. So these manufacturing expense accounts in the ledger are closed
by transferring them to the manufacturing account thus:

Respective Expense account
 - credit side: By manufacturing account      say 20,000
Manufacturing account 
- debit side: To respective expense account           same 20,000  (double entry completed, and the respective expense account gets closed, with no balance)
Total of all manufacturing expense balances thus get transferred to the manufacturing account. Now the manufacturing account has all debits which gives a total, say 5,00,000. Then the manufacturing account is closed by transferring this debit balance total of 5,00,000 to the trading account in the folowing manner.

Manufacturing account
 - credit side: By Trading account   5.00,000

In the trading account the manufacturing cost (as ascertained from the manufacturing account) is tranferred by completing the double entry thus:
In trading account 
- debit side: To manufacturing account   5,00,000. Just balances get rolled over from one account to the other.
If it is not a manufacturing concern, then there will be no Manufacturing Account, but only Trading Account.
In trading account 
- debit side: To Purchases account   5,00,000.  (from trial balance, Purchases account debit balance)
Now other "direct" trading expenses (wages, carriage inward etc), again from the trial balance, are posted in the Trading accont thus. (the same way as all the manufacturing expenses are posted in the manufacturing account above.)

In trading account 
- debit side: To respective expense account balance from trial balance  say, 10,000 (there may be multiple trading expenses. Same treatment for each.)

Trading account Total now comes to say 5,00,000 + 10,000 + 5,000 + 25,000 = 5,40,000

In the credit side of the trading account we write: By sales account  say 7,50,000 (this 7,50,000 sales account credit balance figure again comes from the trial balance)

The balancing figure 7,50,000 - 5,40,000 = 2,10,000 is the gross profit earned. Had sales been less than 5,40,000 (say 5,00,000) it would have resulted in a gross loss to that extent (40,000).

Again rolling this gross profit or gross loss to the next account, namely Profit and Loss Account, takes place thus:

In Trading Account 
Credit side
- By Profit and Loss account  2,10,000 (gross profit transferred to P/L account)
Debit side
To Profit and Loss account  40,000 (gross loss transferred to P/L account)

Profit and Loss Account: Remaining indirect expenses' and indirect incomes' account balances, again from the trial balance, are transferred in the same way in the Profit and Loss account.

Profit and Loss Account
To Trading account  (gross loss)     40,000    OR  By Trading account (gross profit) 2,10,000 
To other respective indirect expense    2,000               By other respective indirect income 500
---- more -----                                                   --- more ----

Balancing figure gives net profit or net loss which is either debited (if loss) or credited (if profit) to the Capital Account.
                                 Balance Sheet
Liabilities                            |                     Assets

Now in the trial balance, the balances that remain unused are all either assets or liabilities. Those are put here. Total assets (machinery, furniture, cash/bank, money receivable etc) must always be equal to total liabilities (internal:  liability of the business towards the owner, that is the capital contributed by them(shares etc), AND external: towards outsiders, like money payable)

Total assets must always be equal to total liabilities.

This finishes the Final Accounts part, where somewhere or other every ledger account balance, either debit or credit, as shown in the trial balance, must necessarily have been used.

The owner now know the profit or loss, as shown in the Profit and loss Account, and the financial position of the company, as shown by the Balance Sheet.

Hierarchy of preparation: Trial balance, Manufacturing account, Trading Account, Profit and Loss Account and Balance Sheet.
Golden rule of accountancy

There are basically three types of accounts
1. Personal account:
                      Debit    : the receiver of benefit
                      Credit   : the giver of benefit

2. Nominal  account: ( All expenses and incomes)
                      Debit : All expenses and losses
                     Credit : All incomes and gains

3. Real Account: All assets and liabilities
                      Debit: what comes in
                      Credit: What goes out.
Trial Balance is prepared on a particular date.

Manufacturing, Trading and Profit and Loss Accounts are prepared for a particular period.
                    say, for the year ended March 31, 2014

Again, Balance Sheet, showing the financial position of the company, is always "as on a particular date."

Up to maintenance of ledger accounts, that is journal entry, double entry ledger posting, it is book keeping.
Preparation of Trial Balance, Manufacturing, Trading, Profit and Loss account and balance sheet is accounting. Accounting starts where book keeping ends.

Simply, every account is like a tank. One side dumping/recording the "in(s)" and the other dumping/recording the "out(s)", and then finding the balancing figures and working with those balancing figures, starting from preparation of Trial Balance.

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