Financial Management & Cost Accounting

Module 2. Accounting procedure

Lesson 5
TYPES OF ACCOUNTS AND RULES FOR DEBIT AND CREDIT

5.1 Accounting Mechanics: The Double Entry System

Today's accounting system is based on the double entry system developed in the 15^th Century by Lucas pocioli, a fransican monk. The double entry system is based on the basic premise that

Total liabilities = Total Assets

Or

(Owner’s capital + outsider's funds) = Total Assets

It states that each and every financial transaction that takes place in a business organization has two aspects (or two effects which are equal and opposite). For example if furniture is purchased by cash, then furniture account increase but at the same time cash decreases by the same amount. “A dual entry system of accounting is defined as the system which recognizes and records both the aspects of transactions."

5.1.1 T-accounts (or Ledgers)

A given financial transaction has two aspects and it is bound to affect two concerned accounts. The entries in the given account are made in a "t" – account. It consists of two sides left side and right side. The left side is called debit side and the right side is called credit side. Making an entry on the left side of t-account is called debiting the account, and in the same way making an entry on the right side of t- account is called crediting the account.

Table 5.1.A typical 'T' account is shown below

Dr.					Cr.
Date	Particulars	J.F.	Amt. (Rs.)		Date	Particulars	J.F.	Amt. (Rs.)

J.F. – refers to the page number of the journal at which the transaction is recorded

(J.F =Journal Folio)

Up to this point, it is understood that in double entry system, a given transaction affects two accounts. Out of the given two accounts one a/c is to be debited and the other a/c is to be credited (by the same amount).In order to decide whether the account is to be debited or credited depends upon which type of account it is.

There are three types of accounts – Personal, Real and Nominal. The rules regarding Dr and Cr these accounts are given below

1. Personal Accounts

The accounts of all those persons organizations / entities from whom the company has either to receive money or has to pay money, are called personal accounts.

2. Real Accounts

The firm also owns property like land, building, plant and machinery, stock, cash etc. The accounts of various assets or property acquired by the firm, are classified as Real account.

3. Nominal Accounts

The accounts of various items which represent either income and gain or expenses and loss of the firm are nominal accounts. For example accounts of rent, wages, salary, telephone bills are classified as nominal accounts. Similarly dividend received a/c. interest earned a/c, commission a/c are also nominal accounts.

Table 5.2 Rules for Debit and Credit

Type of Account	Rules : Debit (Dr)	Rules Credit (Cr.)
1. Personal A/c	The Receiver	The Giver
2. Real Account (For Example–Stock A/c, goods a/c, furniture a/c, machinery a/c, cash a/c, etc.)	Debit what comes in. (For ex. If stock or goods are purchased, then the stock a/c is debited because these “stock comes in”. Debiting stock a/c simply means putting the entry on the left hand side of stock a/c)	Credit what goes out (For ex. If goods or stock a/c is credited, because ‘stock goes out’. Crediting the stock simply means putting the entry on the Right hand side of stock a/c)
3. Nominal Account (ex. commission, wages, rent, light bill etc)	Debit all expenses and losses (For ex. – when rent, wages, etc are paid. They represent expenses are to be debited. i.e. rent and wages a/c shall be debited (debited means entry on left side of account).	Credit all incomes and Gains (For ex. If commission and fees are earned, and then they represent “incomes” for the firm. According to the rule income are to be credited. Therefore commission (when earned) will be credited. (i.e. entry will be made on right side of the account.)

Document used to Record (or capture) the details of a given transaction are:-

1. Payment Voucher.

A payment voucher records all the details of a particular transaction whenever a payment is made by the company. A payment voucher is a standard form and contains all details of the payment being made. For example, when an expense is incrcurred, the supplier sends a bill which is to be paid. The account department prepares a payment voucher for that bill, and then makes a payment.

2. Receipts on Money Receipt.

Whenever the company receives cash/cheque etc from any person / organization, then it gives a receipt to the person / organization. This receipt contains all relevant data of the transaction, such as date, amount, name of person, particulars, etc.

3. Journal Voucher

A journal voucher is used to record all the residual transactions. An internal transaction of the company which does not involve cash receipt or cash payment is to be recorded in a journal voucher.

5.3 The Accounting Procedure

The objective of accounting is to record cash and Credit transaction of the firm and after proper treatment, preparing the final accounts of the firm. The steps which are followed in accounting to accomplish goal are –

1. Recording of all business transaction in a primary book called journal.
2. All the entries of the journal must be then posted to appropriate ledgers. It is called ledger – posting.
3. All the ledgers are then balanced and their balances ascertained.
4. Preparation of final accounts – Trading a/c, P and L a/c and Balance sheet from the trial balance.

5.4 Some Basic Terminology used in Accounting

1. Cash Basis of Accounting

It is one of the two main methods of accounting (Cash basis and Accrual basis). In this method the entire accounting is done by considering cash transactions only – i.e. all the income are recognized as income such as accrued income, income generated but not received etc are ignored. Another example is – sales is recognized not at the point of sale but at the time when cash is received. Similarly all expenses are recognized as an expenses only if actual cash is paid. Therefore accrued expense, prepaid – expense etc do not have any place in cash basis of accounting.

Used by

This system of accounting is generally used by individuals like doctors, lawyers engineers, brokers, small traders etc.

Advantages

It is simple method. It avoids the difficulties of accounting adjustments at the close date (i.e. at end of accounting year)

Disadvantages

These systems can not accurately reveal the profit / loss during a given accounting period.

2. Mercantile Basis of Accounting (Accrual Basis):

This method is commonly used by business concerns. All incomes are recognized as incomes of the particular year in which they were generated (irrespective of the fact whether cash was received or not). Similarly all expenses are charged to the period in which they relate (irrespective of the fact that whether cash has been actually paid or not). for ex. – in accrual basis of accounting – if sales are made at the last day of accounting period, but the cash is not received, (it is expected to be received after 20 days) then, such a transaction, the sale is considered to be of the earlier year (irrespective of the fact whether cash has been received or not).

Similarly, if expenses are incurred this year, but the cash is to be paid in next accounting year, then also, it is to be considered as an expense of this year only (because the particular expense relates to this year only and not to any other year !)

Thus, from the above it can be seen that, the accrual basis of accounting strictly follows the accounting period concept. It has the ability to accurately reveal, the profit / loss incurred during a given accounting period. This is so because it considers each and every income pertaining to the particular accounting year (irrespective of the fact whether cash is received or not).This system of accounting requires the adjustments at the end of accounting period. It produces the final accounting which exhibits a true and fair view of the state of affairs.

3. Transaction

A business transaction means exhange of benefits (or value) between two persons / (entities). It arises out of exchange of goods / services. It has dual aspects – Receiving and giving the benefit.

Cash Transaction

A transaction which involves immediate payment (or Receipt) of cash, is called cash transaction.

Credit Transaction

For example when goods worth Rs. 2000 are sold on credit to Mr. Rajesh, then in such a case, Mr. Rajesh does not immediately pay cash to the firm. Such a transaction (buying or selling) in which the receipt of cash is postponed to a future date is a credit transaction.

A simple accounting entry, involving cash transaction :

Transaction : “Purchased Rs. 500 worth stationery by paying cash”

Rewriting the rules of debit and credit –

- Personal a/c - Debit the Receiver - Credit the giver

- Real a/c - Debit what comes in - Credit what goes out

- Nominal a/c - Debit all expenses and losses - Credit all incomes and gains

In the above transaction, the company receives. Stationery worth Rs. 500 (so stationery increases) but at the same time cash reduces by Rs. 500.

Attempting a very simple accounting entry, by following the rules stated above. We come to know that –

A dual entry system involves two affected accounts, one account is debited and other is credited by the same account. (But for that which account should be debited and which should be credited, we have to look at the above given rules).

Similarly, In an accounting entry, if the transaction was on credit (i.e. it did not involve immediate payment of cash, but cash payment was postponed to a future date).

The transaction becomes:

“Purchased stationery worth Rs. 500, on credit, from “Mahavir Stationery Stores”. one thing is certain from the above, that stationery a/c (stationery comes in), is a real a/c; and it will be debited.

Stationery a/c Real a/c Comes in Stationery a/c Debited

But, now another account, has to be credited by the same amount i.e. Rs.500. (But which account?). In case of a cash transaction, we identified that cash a/c was the relevant account, and as cash decreased by Rs.500, the rule followed was :

Cash account (real account) Goes out cash a/c should be credited.

But in case of a credit transaction; one thing is sure that stationery a/c is to be debited but the other account to be credited is that of the ‘’supplier’’.

Credit Transactions are mainly of two types –

1. Credit Purchase

2. Credit Sales

Credit Purchase

In credit purchases, the company has taken the benefit (goods / services etc) but the company owes money to the concerned supplier. And the accounts persons/entities organizations to which the company owes money are credited. (Moreover these persons are called creditors of the company)

In our case,

CREDIT PURCHASE

Received by company

Stationery Mahavir Stationery Stores

From the above diagram, it is clear that,

Stationery a/c	Real a/c	Come in	Debit
Mahavir Stationery Stores a/c	Personal a/c	Giver	Credit

From the above, it can be concluded that -

1. Mahavir stationery store is the supplier.
2. The company has to pay Rs.500 to Mahavir Stationery Stores a/c (i.e. the company owes Rs.500 to Mahavir Stationery Stores.)

 

Credit Sales

It means the sales of goods has been made to the customer but he will make the payment within the credit period..

CREDIT SALES

Company (Seller) Mr. Joseph (Buyer)

In credit sales (by the company) to a buyer Mr. Joseph, Mr. Joseph owes money to the company. Always, the accounts of persons / entities / organizations, who owe money to the company, i.e. the company has to receive money from them, are debited. They are also called the Debtor of the company

From the above diagram, it is clear that,

Joseph’s a/c	Personal a/c	receiver	Debit
Sales a/c	Real a/c	Goes out	Credit