FINANCIAL ACCOUNTING
(LECTURE # 04)
Learning Objective •
The objective of this lecture is to develop an understanding in the students about the basic concepts like: o The separate business entity, o Single and double entry book-keeping, o Debit and Credit o The dual aspect of a transaction, o Accounting equation
Separate Entity Concept • • •
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In accounting, ‘The Business’ is treated independently from the persons who own it. This means, although anything owned by the business belongs to the owners of the business and anything owed by the business is payable by the owners but for accounting purposes, we assume that the business is independent of its owners. This means, if the business purchases a machine or piece of equipment, business will own and obtain benefit from that equipment. Likewise, if the business borrows money from ‘someone’ it will have to repay the money. This ‘someone’ includes even the owner of the business. This treatment of the business independently from its owners is called the ‘Separate Entity Concept’. We will discuss this concept again in detail when we study the different types of business entities.
Single Entry Book-Keeping • • •
•
In single entry book keeping system, as is clear from the name, only one aspect of the transaction is recorded. This actually is not a system but is a procedure by which small business concerns, like retailers and small shopkeepers, keep record of their sale / income. In this system, there are usually two to three registers “Khata”. In one register cash received from customers is recorded, whereas the other one is a person-wise record of goods sold on credit “Udhar Khata”. There may or may not be a register of suppliers to whom money is payable. That means, only one aspect of transaction i.e. either cash receipt or the fact that money is receivable from someone is recorded.
FINANCIAL ACCOUNTING
(LECTURE # 04)
Double Entry Book-Keeping • • • • •
The concept of double entry is based on the fact that every transaction has two aspects i.e. receiving a benefit and giving a benefit. The accounting system that records both the aspects of transaction in books of accounts is called double entry system. The account that receives the benefit is debited and the account that provides the benefit is credited. ‘Debit’ and ‘Credit’ are denoted by ‘Dr’ and ‘Cr’ respectively. The ultimate result of the system is that for every Debit (Dr) there is an equal Credit (Cr).
Single & Double Entry Book-Keeping Distinguished • •
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•
The double entry system is a more sophisticated, comprehensive and reliable form of single entry book keeping system. Single entry system records only one aspect of the transaction such as: o Cash received from sale is recorded in cash register only, o Goods sold on credit are recorded in the individual’s account only, o When cash is received from the customer, to whom something was sold on credit, the receipt may just be recorded in the account of individual only. Double entry system records both the aspects of the transaction; o When good are sold on cash the two aspects of the transaction are – the seller has sold goods and received cash against them. The goods sold are benefit transferred to the purchaser (Credit) whereas the cash against the goods is benefit received (Debit). o When the goods are sold on credit the benefit given is the same i.e. goods sold but the benefit received is not cash but a right to receive cash from the customer. Therefore, in this case Debit is given to customer’s account instead of cash. o When cash is received from the customer the right to receive cash ceases. So, the benefit received is cash and benefit transferred is the right to receive cash. Here cash will be Debited and customer will be Credited. Adopting the double entry accounting system can, therefore, have following benefits: o Every transaction has equal Debit and Credit; hence the total of all Debit accounts will be equal to the total of all Credit accounts at any given time. This serves as a quick test of mathematical accuracy of book keeping. o Since all aspects of transactions are recorded, therefore, the books are more informative. In the example discussed, the trader, if he keeps double entry books, will know the exact figure of total sale, cash in hand and receivable from customers from their respective accounts at any desired time.
FINANCIAL ACCOUNTING
(LECTURE # 04)
Debit and Credit • • •
We have used two terms in our above discussion Debit and Credit. What do these terms mean? Debit and Credit are two Latin words and as such it is difficult to say what do these mean. But we can develop an understanding as to what does these terms stand for.
DEBIT • It signifies the receiving of benefit. In simple words it is the left hand side. CREDIT • It signifies the providing of a benefit. In simple words it is the right hand side. Debit and Credit will be explained in details and with examples in our future discussions.
Dual Aspect of Transactions • • • •
• •
We have just said that for every debit there is an equal credit. This is also called the dual aspect of the transaction i.e. every transaction has two aspects, debit and credit and they are always equal. This means that every transaction should have two-sided effect. For example Mr. A starts his business and he initially invests Rupees 100,000/- in cash for his business. Out of this cash following items are purchased in cash; o A building for Rupees 50,000/-; o Furniture for Rupees 10,000/-; and o A vehicle for Rupees 15,000/This means that he has spent a total of Rupees 75,000/- and is left with Rupees 25,000 cash. We will apply the Dual Aspect Concept on these events from the viewpoint of business. When Mr. A invested Rupees 100,000/-, the cash account benefited from him. The event will be recorded in the books of business as, DEBIT Cash Rs. 100,000 CREDIT Mr. A Rs. 100,000 Analyse the transaction. The account that received the benefit, in this case is the cash account, and the account that provided the benefit is that of Mr. A.
FINANCIAL ACCOUNTING
(LECTURE # 04)
•
Building purchased – The building account benefited from cash account
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DEBIT Building Rs. 50,000 CREDIT Cash Rs. 50,000 Furniture purchased – The furniture account benefited from cash account
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DEBIT Furniture Rs. 10,000 CREDIT Cash Rs. 10,000 Vehicle purchased – The vehicle account benefited from cash account DEBIT CREDIT
Vehicle Cash
Rs. 15,000 Rs. 15,000
Basic Principle of Double Entry • •
We can devise the basic principle of double entry book-keeping from our discussion to this point. “Every Debit has a Credit” which means that “All Debits are always equal to All Credits”.
Assets • •
Assets are the properties and possessions of the business. Properties and possessions can be of two types, one that have physical existence (called tangible) and the other that have no physical existence (called intangible). o Tangible Assets – Furniture, Vehicle etc. o Intangible Assets – Right to receive money etc.
FINANCIAL ACCOUNTING
(LECTURE # 04)
Accounting Equation •
From the example that we just discussed, if the debits and credits are added up, the situation will be as follows: DEBITS Cash Rs. 100,000/Building Rs. 50,000/Furniture Rs. 10,000/Vehicle Rs. 15,000/CREDITS Mr. A Rs. 100,000/Cash Rs. 75,000/• The total Equation becomes: DEBITS = CREDITS Cash + Building + Furniture + Vehicle = Cash + Mr. A • Cash on Left Hand Side is Rupees 100,000/- and on Right Hand Side it is Rs. 75,000/-. If it is gathered on the Left Hand Side it will give a positive figure of Rupees 25,000/- (which you will notice is our balance of cash in hand). Now the equation becomes: DEBITS Cash + Building 25,000+ 50,000 • • •
•
=
+ Furniture+ Vehicle = + 10,000 + 15,000 =
CREDITS Mr. A 100,000
Keeping the entity concept in mind we can see that the business owns the building, furniture, vehicle and cash and will obtain benefit from these things in future. Any thing that provides benefit to the business in future is called ‘Asset’. Similarly the business had obtained the money from Mr. A and this money will have to be returned in form of either cash or benefits. Any thing for which the business has to repay in any form is called ‘Liability’. So cash, building, furniture and vehicle are the assets of the business and the amount received from Mr. A for which the business will have to provide a return or benefit is the liability of the business. Therefore, our equation becomes: Assets = Liabilities The liabilities of the business can be classified into two major classes i.e. the amounts payable to ‘outsiders’ and those payable to the ‘owners’. The liability of the business towards its owners is called ‘Capital’. Therefore, our accounting equation finally becomes: Assets = Capital + Liabilities