3. Decrease in owners’ equity accounts 3.increase in owners’ equity
accounts
From the rule that credit signifies increase in owners’ equity and
debit signifies decrease in it, the rules of revenue accounts and expense
accounts can be derived. While explaining the dual aspect of the concept
in the preceding lesson, we have seen that revenues increase the owners’
equity as they belong to the owners. Since owners’ equity accounts increase
29
on the credit side, revenue must be credits. So, if the revenue accounts are
to be increased they must be credited and if they are to be decreased they
must be debited. Similarly we have seen that expenses decrease the owners’
equity. As owners’ equity account decreases on the debit side expenses
must be debits. Hence to increase the expense accounts, they must be
debited and to decrease it, they must be credited. From the above we can
arrive at the rules for revenues and expenses as follows:
Debit Signifies
Credit Signifies
Increase in expenses
Increase in revenues
Decrease in revenues
Decrease in expenses
1.2.3.3 The Ledger
A ledger is a set of accounts. It contains all the accounts of a specific
business enterprise. It may be kept in any of the following two forms:
(i) bound ledger and
(ii) loose leaf ledger
A bound ledger is kept in the form of book which contains all the
accounts. These days it is common to keep the ledger in the form of loose-
leaf cards. This helps in posting transactions particularly when mechanized
system of accounting is used.
1.2.3.4 Journal
When a business transaction takes place, the first record of it is
done in a book called journal. The journal records all the transactions of
a business in the order in which they occur. The journal may therefore
be defined as a chronological record of accounting transactions. It shows
names of accounts that are to be debited or credited, the amounts of the
debits and credits and any other additional but useful information about
the transaction. A journal does not replace but precedes the ledger. A
proforma of a journal is given in illustration 1.
30
Illustration 1:
Journal
Date
Particulars
L.F.
Debit
Credit
2005
Cash a/c dr.
3
30,000
30,000
August 3
To sales a/c
9
In illustration 1 the debit entry is listed first and the debit amount
appears in the left-hand amount column; the account to be credited
appears below the debit entry and the credit amount appears in the right
hand amount column. The data in the journal entry are transferred to the
appropriate accounts in the ledger by a process known as posting. Any
entry in any account can be made only on the basis of a journal entry. The
column l.f. which stands for ledger folio gives the page number of accounts
in the ledger wherein posting for the journal entry has been made. After
all the journal entries are posted in the respective ledger accounts, each
ledger account is balanced by subtracting the smaller total from the bigger
total. The resultant figure may be either debit or credit balance and vice-
versa.
Thus the transactions are recorded first of all in the journal and
then they are posted to the ledger. Hence the journal is called the book
of original or prime entry and the ledger is the book of second entry.
While the journal records transactions in a chronological order, the ledger
records transactions in an analytical order.
1.2.3.5 The Trial Balance
The trial balance is simply a list of the account names and their
balance as of a given moment of time with debit balances in one column
and credit balances in another column. It is prepared to ensure that the
mechanics of the recording and posting of the transaction have been
carried out accurately. If the recording and posting have been accurate
then the debit total and credit total in the trial balance must tally thereby
evidencing that an equality of debits and credits has been maintained.
In this connection it is but proper to caution that mere agreement of the
debt and credit total in the trial balance is not conclusive proof of correct
recording and posting. There are many errors which may not affect the
agreement of trial balance like total omission of a transaction, posting the
31
right amount on the right side but of a wrong account etc.
The points which we have discussed so far can very well be explained
with the help of the following simple illustration.
Illustration 2:
January 1 - started business with rs.3,000
January 2 - bought goods worth rs.2,000
January 9 - received order for half of the goods from ‘g’
January 12 - delivered the goods, g invoiced rs.1,300
January 15 - received order for remaining half of the total goods purchased
January 21 - delivered goods and received cash rs.1,200
January 30 - g makes payment
January 31 - paid salaries rs.210
- received interest rs.50
Let us now analyze the transactions one by one.
January 1 – Started Business With Rs.3,000:
The two accounts involved are cash and owners’ equity. Cash, an asset
increases and hence it has to be debited. Owners’ equity, a liability also
increases and hence it has to be credited.
January 2 – Bought Goods Worth Rs.2,000:
The two accounts affected by this transaction are cash and goods
(purchases). Cash balance decreases and hence it is credited and goods on
hand, an asset, increases and hence it is to be debited.
January 9 – Received Order For Half Of The Goods From ‘G’:
No entry is required as realization of revenue will take place only
when goods are delivered (realization concept).
January 12 – Delivered The Goods, `G’ Invoiced Rs.1,300:
This transaction affects two accounts – goods (sales) a/c and
receivables a/c. Since it is a credit transaction, receivables increase
32
(asset) and hence it is to be debited. Sales decreases goods on hand and
hence goods (sales) a/c is to be credited. Since the term ‘goods’ is used to
mean purchase of goods and sale of goods, to avoid confusion, purchase of
goods is simply shown as purchases a/c and sale of goods as sales a/c.
January 15 – Received Order For Remaining Half Of Goods:
No entry.
January 21 – Delivered Goods And Received Cash Rs.1,200:
This transaction affects cash a/c. Since cash is realized, the cash
balance will increase and hence cash account is to be debited. Since the
stock of goods becomes nil due to sale, sales a/c is to be credited (as asset
in the form of goods on hand has reduced due to sales).
January 30 - `G’ Makes Payment:
Both the accounts affected by this transaction are asset accounts –
cash and receivables. Cash balance increases and hence it is to be debited.
Receivables balance decreases and hence it is to be credited.
January 31 – Paid Salaries Rs.210:
Because of payment of salaries cash balance decreases and hence
cash account is to be credited. Salary is an expense and since expense
has the effect of reducing owners’ equity and as owners’ equity account
decreases on the debit side, expenses account is to be debited.
January 31 – Received Interest Rs.50:
The receipt of interest increases cash balance and hence cash a/c is
to be debited. Interest being revenue which has the effect of increasing the
owners’ equity, it has to be credited as owners’ equity account increases on
the credit side.
When journal entries for the above transactions are passed, they
would be as follows:
33
Journal
Date
Particulars
L.F.
Debit
Credit
Cash A/C Dr. To
Jan. 1
Capital A/C (Being
3,000
3,000
Business Started)
Purchases A/C Dr.
Jan. 2
To Cash (Being Goods
2,000
2,000
Purchased)
Receivables A/C Dr.
Jan. 12
To Sales A/C (Being
1,300
1,300
Goods Sold On Credit)
Cash A/C Dr.
To
Sales
A/C
Jan. 21
1,200
1,200
(Being Goods Sold For
Cash)
Cash A/C Dr.
To Receivables A/C
Jan. 30
1,300
1,300
(Being Cash Received
For Sale Of Goods)
Salaries A/C Dr.
Jan. 31
To Cash A/C
210
210
(Being Salaries Paid)
Cash A/C Dr.
To Interest A/C
Jan. 31
50
50
(Being Interest
Received)
Now the above journal entries are posted into respective ledger accounts
which in turn are balanced.
Cash Account
Debit
Rs.
Credit
Rs.
To Capital A/C
3,000
By PurchasesA/C
2,000
To Sales A/C
1,200
By Salaries A/C
210
To Receivables
1,300
A/C
By Balance C/D
3,340
To Interest A/C
50
5,550
5,550
34
Capital Account
Debit
Rs.
Credit
Rs.
3,000
3,000
To Balance C/D
By Cash A/C
3,000
3,000
Purchases Account
Debit
Rs.
Credit
Rs.
2,000
2,000
To Cash A/C
By Balance C/D
2,000
2,000
Receivables Account
Debit
Rs.
Credit
Rs.
1,300
1,300
To Balance C/D
By Cash A/C
1,300
1,300
Sales Account
Debit
Rs.
Credit
Rs.
1,300
2,500
By Receivables
To Balance C/D
A/C
1,200
By Cash A/C
2,500
2,500
Salaries Account
Debit
Rs.
Credit
Rs.
210
210
To Cash A/C
By Balance C/D
210
210
Interest Account
Debit
Rs.
Credit
Rs.
To Balance C/D
50
50
By Cash A/C
50
50
Now A Trial Balance Can Be Prepared And When Prepared It Would Appear
As Follows:
Trial Balance
Debit
Rs.
Credit
Rs.
Cash
3,340
Capital
3,000
Purchases
2,000
Sales
2,500
Salaries
210
Interest
50
5,550
5,550
35
1.2.3.6 Closing Entries
Periodically, usually at the end of the accounting period, all revenue
and expense account balances are transferred to an account called income
summary or profit and loss account and are then said to be closed. (a detailed
discussion on profit and loss account can be had in a subsequent lesson). The
balance in the profit and loss account, which is the net income or net loss
for the period, is then transferred to the capital account and thus the profit
and loss account is also closed. In the case of corporation the net income or
net loss is transferred to retained earnings account which is a part of owners’
equity. The entries which are passed for transferring these accounts are called
as closing entries. Because of this periodic closing of revenue and expense
accounts, they are called as temporary or nominal accounts. On the other
hand, the assets, liabilities and owners’ equity accounts, the balances of which
are shown on the balance sheet and are carried forward from year to year are
called as permanent or real accounts.
The principle of framing a closing entry is very simple. If an account
is having a debit balance, then it is credited and the profit and loss account
is debited. Similarly if a particular account is having a credit balance, it is
closed by debiting it and crediting the profit and loss account. In our example
sales account and interest account are revenues, and purchases account and
salaries account are expenses. Purchases account is an expense because the
entire goods have been sold out in the accounting period itself and hence they
become cost of goods sold out. This aspect would become more clear when the
reader proceeds to the lessons on profit and loss account. The closing entries
would appear as follows:
Journal
P articulars
L.F.
Debit
Credit
Profit And Loss a/c
Dr.
210
1
2,210
To Salaries A/C
2,000
To Salaries A/C
Sales A/C Dr.
2
To Profit And Loss
2,500
2,500
A/C
Interest
A/C
Dr.
3
50
50
To Profit And Loss
A/C
Now profit and loss a/c, retained earnings a/c and balance sheet can be
prepared
which would appear as follows:
36
Profit And Loss Account
Debit
Rs.
Credit
Rs.
Purchases A/C
Salaries A/C
2,000
R e t a i n e d
210
Sales
2,500
Earnings A/C
Interest
50
340
2,550
5,550
Retained Earnings Account
Debit
Rs.
Credit
Rs.
Balance
340
Profit And Loss
A/C
340
340
340
Balance Sheet
Liabilities
Rs.
Assets
Rs.
Capital
3,000
Retained Earn-
Cash
3,340
ings
340
3,340
3,340
1.2.3.7 Adjustment Entries
Because of the adopting of accrual accounting, after the preparation
of trial balance, adjustments relating to the accounting period have
to be made in order to make the financial statements complete. These
adjustments are needed for transactions which have not been recorded but
which affect the financial position and operating results of the business.
They may be divided into four kinds: two in relation to revenues and the
other two in relation to expenses. The two in relation to revenues are:
(i) Unrecorded Revenues:
Income earned for the period but not received in cash. For e.g.
Interest for the last quarter of the accounting period is yet to be received
though fallen due. The adjustment entry to be passed is:
37
Accrued
interest
a/c
(Dr)
Interest a/c
(Cr)
(ii) Revenues Received In Advance:
i.e. Income relating to the next period received in the current
accounting period: e.g. Rent received in advance. The adjustment entry is:
Rent
a/c
(dr)
Rent received in advance a/c
(cr)
The two relating to expenses are:
(i) Unrecorded Expenses:
i.e. Expenses were incurred during the period but no record of them
as yet has been made: e.g. Rs.500 wages earned by an employee during the
period remaining to be paid. The adjustment entry would be:
Wages a/c
(Dr)
Accrued
wages
a/c
(Cr)
(ii) Prepaid Expenses:
i.e., expenses relating to the subsequent period paid in advance in
the current accounting period. An example which is frequently cited for
this is insurance paid in advance. The adjustment entry would be:
Prepaid insurance a/c
(Dr)
Insurance a/c
(Cr)
In the above four cases unrecorded revenues and prepaid expenses
are assets and hence debited (as debit may signify increase in assets) and
revenues received in advance and unrecorded expenses are liabilities and
hence credited (as credit may signify increase in liabilities).
Besides the above mentioned four adjustments, some more are to be done
before preparing the financial statements. They are:
38
1. Inventory at the end
2. Provision of depreciation
3. Provision for bad debts
4. Provision for discount on receivables and payables
5. Interest on capital and drawings
1.2.3.8 Preparation Of Financial Statements
Now everything is set ready for the preparation of financial
statements for the accounting period and as of the last day of the accounting
period. Generally agreed accounting principles (gaap) require that three
such reports be prepared:
(i) a balance sheet
(ii) a profit and loss account (or) income statement
(iii) a fund flow statement
A detailed discussion on these three financial statements follows in the
succeeding lessons.
1.2.3.9 Introduction To Tally Package
Today an increasingly large number of companies have adopted
mechanized accounting. The main reasons for this development are that:
(i) the size of firms have become very large resulting in manifold increase
in accounting data to be collected and processed.
(ii) the requirements of modern management which want detailed analysis
in many ways, of the accounting and statistical information for the efficient
discharge of their duties.
(iii) collection of statistics not only for the firm’s own use but also for
submission to various official authorities.
In this context, the use of computers in accounting is worth
mentioning. Late 80’s and early 90’s was an era of financial accounting
software. Many software developers offered separate financial and
39
inventory software to take care of the needs of the concerns but users
wanted a single software that will take care of production and inventory
management i.e. They wanted a single software where, if an invoice is
entered, that will update accounts as well as inventory information. Here
tally comes in handy.
Tally is one of the acclaimed accounting software with large user
base in india and abroad, which is continuously growing. There is good
potential for tally professionals even in small towns. Tally which is a vast
software covers a lot of areas for various types of industries and is loaded
with options. So, every organization needs a hardcore tally professional to
exploit its full c