Financial
Accounting: Terms & Concepts
By Qaswar Nawaz Warraich
ACCA-Affiliate
03446551266
http://qssacc.blogspot.com
Book-
keeping
Book- keeping is the art of
recording business transactions in a systematic manner.
Accounting
The art of recording, classifying and summarizing
the financial data, in a systematic way.
BRANCHES OF
ACCOUNTING
The changing business scenario
over the centuries gave rise to specialized branches of accounting which could
cater to the changing requirements. The branches of accounting are;
i) Financial accounting;
ii) Cost accounting; and
iii) Management accounting.
Accounting
concepts:
The term ‘concept’ is used to
denote accounting postulates, i.e., basic assumptions or conditions upon the
edifice of which the accounting super-structure is based. The following are the
common accounting concepts adopted by many business concerns.
1. Business Entity Concept 2.
Money Measurement Concept
3. Going Concern Concept 4. Dual
Aspect Concept
5. Periodicity Concept 6.
Historical Cost Concept
7. Matching Concept 8.
Realization Concept
9. Accrual Concept 10. Objective Evidence Concept
BASES OF
ACCOUNTING
There are three bases of
accounting in common usage. Any one of the following bases may be used to
finalize accounts.
1. Cash basis
2. Accrual or Mercantile basis
3. Mixed or Hybrid basis.
Single Entry: It is
incomplete system of recording business transactions. The business organization
maintains only cash book and personal accounts of debtors and creditors. So the
complete recording of transactions cannot be made and trail balance cannot be prepared.
Double Entry: It this system
every business transaction is having a twofold effect of benefits giving and
benefit receiving aspects. The recording is made on the basis of both these
aspects. Double Entry is an accounting system that records the effects of
transactions and other events in at least two accounts with equal debits and credits.
Debit
Entry on the left side of a
double-entry bookkeeping system that represents the addition of an asset or
expense or the reduction to a liability or revenue.
Account
It is a statement of the various
dealings which occur between a customer and the firm.
It can also be expressed as a clear and
concise record of the transaction relating to a person or a firm or a property
(or assets) or a liability or an expense or an income.
Capital
It means the amount (in terms of
money or assets having money value) which the proprietor has invested in the
firm or can claim from the firm. It is also known as owner’s equity or net
worth.
Owner’s equity means owner’s
claim against the assets.
It will always be equal to assets
less liabilities, say:
Capital = Assets - Liabilities.
Liability
A
liability is a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits.
It means the amount which the
firm owes to outsiders that is, excepting the proprietors.
In the words of Finny and Miller,
“Liabilities are debts; they are amounts owed to creditors; thus the claims of
those who are not owners are called liabilities”.
In simple terms, debts repayable to outsiders by the
business are known as liabilities.
Asset An asset is a resource
controlled by the entity as a result of past events and from which economic
benefits are expected to flow to the entity.
Revenue Income from the trading activities of the
business. (normally Sales.)
Goods
It is a general term used for the
articles in which the business deals; that is,
only those articles which are bought for resale for
profit are known as Goods.
Expense
The terms ‘expense’ refers to the
amount incurred in the process of earning
revenue. If the benefit of an
expenditure is limited to one year, it is treated as an
expense (also know is as revenue expenditure) such
as payment of salaries and rent.
Expenditure
Expenditure takes place when an
asset or service is acquired. The purchase of
goods is expenditure, where as
cost of goods sold is an expense. Similarly, if an asset
is acquired during the year, it
is expenditure, if it is consumed during the same year, it
is also an expense of the year.
Purchases
Buying of goods by the trader for
selling them to his customers is known as purchases.
Sales
When the goods purchased are sold out, it is known
as sales.
Stock
The goods purchased are for
selling, if the goods are not sold out fully, a part
of the total goods purchased is
kept with the trader unlit it is sold out, it is called stock.
If there is stock at the end of the accounting
year, it is called the closing stock.
This closing stock at the yearend will be the opening stock for the subsequent year.
Opening stock: The stock at the
beginning of an accounting period is called opening stock.
Purchases: The total value
of goods purchased after deducting purchase returns is debited to trading a/c.
Purchases comprise of cash purchases am credit purchases.
Direct expenses:
Direct
expenses are incurred to make the goods sale able. They include wages, carriage
and freight on purchases, import duty, customs duty, clearing and forwarding
charges etc.
Sales: It includes both
credit and cash sales. Sales returns are reduced from sales and net sales are
shown on the credit side of trading account. The sales and returns are
extracted from the trial balance.
Closing stock: Closing stock is
the value of goods remaining at the end of the accounting period.
Drawings
It is the amount of money or the
value of goods which the proprietor takes for his domestic or personal use. It
is usually subtracted from capital.
Proprietor
The person who makes the
investment and bears all the risks connected with the business is known as
proprietor.
Debtor
A person who owes money to the
firm mostly on account of credit sales of goods is called a debtor.
For example, when goods are sold
to a person on credit that person pays the price in future, he is called a
debtor because he owes the amount to the firm.
Creditor
A person to whom money is owed by
the firm is called creditor. For example, Madan is a creditor of the firm when
goods are purchased on credit from him.
Account
Payable
Amount owed to a creditor for
delivered goods or completed services.
Account
Receivable
Claim against a debtor for an
uncollected amount, generally from a completed transaction of sales or services
rendered.
Discount
When customers are allowed any
type of deduction, in the price of goods by the businessman it is called
discount.
When some discount is allowed in
prices of goods on the basis of sales of the items, that is termed as trade discount, but when debtors are allowed
some discount in prices of the goods for quick payment, that is termed as cash discount or Settlement Discount.
Statement
of Financial Position A
statement that shows the financial position of a business at a particular point
in time. It records the assets, liabilities and capital of the business.
Income
Statement A statement reporting on the financial performance
of a business over a period of time. It records the income and expense of the
business.
Meaning of Debit
and Credit
The term ‘debit’ is supposed to
have derived from ‘debit’ and the term ‘credit’ from ‘creditable’.
For convenience ‘Dr’ is used for
debit and ‘Cr’ is used for credit.
Recording of transactions require
a thorough understanding of the rules of debit and credit relating to accounts.
Both debit and credit may represent either increase or decrease, depending upon
the nature of account.
Duality
Concept:
Every transaction that occurs
within a business has two equal and opposite effects on the accounting
equation.
Personal Accounts:
Accounts
recording transactions with a person or group of persons are known as personal
accounts. These accounts are necessary, in particular, to record credit
transactions. Personal accounts are of the following types:
(a) Natural
persons: An
account recording transactions with an individual human being is termed as a
natural persons’ personal account. eg., Kamal’s account,
Maria’s account. Both males and
females are included in it
(b) Artificial
or legal persons: An
account recording financial transactions with an artificial person created by
law or otherwise is termed as an artificial person, personal account, e.g.
Firms’ accounts, limited companies’ accounts, educational institutions’
accounts, Co-operative society account.
(c)
Groups/Representative personal Accounts: An account indirectly representing
a person or persons is known as representative personal account. When accounts
are of a similar nature and their number is large, it is better tot group them under
one head and open a representative personal accounts. e.g., prepaid insurance, outstanding
salaries, rent, wages etc.
When a person starts a business,
he is known as proprietor. This proprietor is represented by capital account
for all that he invests in business and by drawings accounts for all that which
he withdraws from business. So, capital accounts and drawings account are also
personal accounts.
The rule for personal accounts
is: Debit the receiver
Credit the giver
Real Accounts
Accounts relating to properties or assets are known
as ‘Real Accounts’, A separate account is maintained for each asset e.g., Cash
Machinery, Building, etc.,
Real accounts can be further
classified into tangible and intangible.
(a) Tangible
Real Accounts: These
accounts represent assets and properties which can be seen, touched, felt,
measured, purchased and sold. e.g. Machinery account Cash account, Furniture
account, stock account etc.
(b) Intangible
Real Accounts: These
accounts represent assets and properties which cannot be seen, touched or felt
but they can be measured in terms of money.
e.g., Goodwill accounts, patents
account, Trademarks account, Copyrights account, etc.
The rule for Real accounts is: Debit
what comes in
Credit what goes out
Nominal Accounts
Accounts relating to income,
revenue, gain expenses and losses are termed as nominal accounts. These
accounts are also known as fictitious accounts as they do not represent any
tangible asset. A separate account is maintained for each head or expense or
loss and gain or income. Wages account, Rent account Commission account,
Interest received account are some examples of nominal account
The rule for Nominal accounts is:
Debit all expenses and losses
Credit all incomes and gains
Invoice
While making a sale, the seller
prepares a statement giving the particulars such as the quantity, price per
unit, the total amount payable, any deductions made and shows the net amount
payable by the buyer. Such a statement is called an invoice.
Voucher
A voucher is a written document
in support of a transaction.
It is a proof that a particular transaction
has taken place for the value stated in the voucher. Voucher is necessary to
audit the accounts.
Solvent
A person who has assets with
realizable values which exceeds his liabilities is insolvent.
Insolvent
A person whose liabilities are
more than the realizable values of his assets is called an insolvent.
Journal
The journal is a record
containing details of non-routine double entry to the ledgers i.e. generally
those that don’t arise from other books of original entry.
Ledger Folio: This column is
meant to record the reference of the main Book.
SUB-DIVISION OF
JOURNAL
When innumerable number of
transactions takes place, the journal, as the sole book of the original entry
becomes inadequate. Thus, the number and the number and type of journals
required are determined by the nature of operations and the volume of transactions
in a particular business.
Books
of prime entry/ Books of Original entry
The books in which all
transactions are initially recorded.
1. Sales Day Book- to record all
credit sales.
2. Purchases Day Book- to record all
credit purchases.
3. Cash Book- to record all cash
transactions of receipts as well as payments.
4. Sales Returns Day Book- to
record the return of goods sold to customers on credit.
5. Purchases Returns Day Book- to
record the return of goods purchased from suppliers on credit.
6. Bills Receivable Book- to
record the details of all the bills received.
7. Bills Payable Book- to record
the details of all the bills accepted.
8. Journal Proper-to record all
residual transactions which do not find place in any of the aforementioned
books of original entry.
LEDGER
Ledger is a main book of account
in which various accounts of personal, real and nominal nature, are opened and
maintained.
General
ledger
It is the central storage system
where all accounting transactions are ultimately recorded.
It is, effectively, the
accounting equation in real life.
Personal
Ledger
It holds individual accounts for
each of the business’s credit customers and suppliers.
Kinds of Cash
Book: From
the above it can be observed that the Cash Book serves as a subsidiary books as
well as ledger. Depending upon the nature of business and the type of cash
transactions, various types of Cash books are used. They are:
a) Single Column Cash Book
b) Two Column Cash Book or Cash
Book with cash and discount columns.
c) Three Columnar Cash Book or
Cash Book with cash, bank and discount columns.
d) ‘Bank’ Cash Book or Cash Book
with bank and discount columns.
e) Petty Cash Book.
Trail
balance
is a statement containing the balances of all ledger accounts, as at any given
date, arranged in the form of debit and credit columns placed side by side and
prepared with the object of checking the arithmetical accuracy of ledger
postings.
Total Method
According to this method, debit
total and credit total of each account of ledger are recorded in the trail
balance.
Balance Method
According to this method, only
balance of each account of ledger is recorded in trail balance. Some accounts
may have debit balance and the other may have credit balance. All these debit
and credit balances are recorded in it. This method is widely used.
Operating
expenses: These
expenses are incurred to operate the business efficiently. They are incurred in
running the organization. Operating expenses include administration, selling,
distribution, finance, depreciation and maintenance expenses.
Non operating
expenses: These
expenses are not directly associate with day to day operations of the business
concern. They include loss on sale of assets, extraordinary losses, etc.
Operating
incomes: These
incomes are incidental to business and earned from usual business carried on by
the concern. Examples: discount received, commission earned, interest received
etc.
Non operating
incomes: These
incomes are not related to the business carried on by the firm. Examples are
profit on sale of fixed assets, refund of tax etc.
Types of Assets:
Assets are properties of
business. They are classified on the basis of their nature. Different types of
assets are as under:
(i) Fixed
assets: Fixed
assets are the assets which are acquired and held permanently and used in the
business with the objective of making profits. Land and building, Plant and
machinery, Furniture and Fixtures are examples of fixed assets.
(ii) Current
assets: The
assets of the business in the form of cash, debtors bank balances, bill
receivable and stock are called current assets as they can be realized within
an operating cycle of one year to discharge liabilities.
(iii) Tangible
assets: Tangible
assets have definite physical shape or identity and existence; they can be
seen, felt and have volume such as land, cash, stock etc.
Thus tangible assets can be both
fixed assets and current assets.
(iv) Intangible
assets: The
assets which have no physical shape which cannot be seen or felt but have value
are called intangible assets. Goodwill, patents, trademarks and licenses are
examples of intangible assets. They are usually classified under fixed assets.
(v) Fictitious
assets:
Fictitious assets are not real assets. Past accumulated losses or expenses
which are capitalized for the time being, expenses for promotion of
organizations (preliminary expenses), discount on issue of shares, debit
balance of profit and loss account etc. are the examples of fictitious assets.
(vi) Wasting
assets: These
assets are also called depleting assets. Assets such as mines, Timber forests,
quarries etc. which become exhausted in value by way of excavation of the
minerals, cutting of wood etc. are known as wasting assets. Such assets are
usually natural resources with physical limitations.
(vii) Contingent
assets: Contingent
assets are assets, the existence, value possession of which is based on
happening or otherwise of specific events. For example, if a business firm has
filed a suit for a particular property now in possession of other persons, the
firm will get the property if the suit is decided in its favor. Till the suit
is decided, it is a contingent asset.
Types of Liabilities
A liability is an amount which a
business firm is ‘liable to pay’ legally. All the amounts which are claims by
outsiders on the assets of the business are known as liabilities. They are
credit balances in the ledger. Liabilities are classified into four categories
as given below.
(1) Owner's
capital: Capital
is the amount contributed by the owners of the business. In addition to initial
capital introduced, proprietors may introduce additional capital and withdraw
some amounts from business over a period of time. Owner’s capital is also
called ‘net worth’. Net worth is
the total fund of proprietors on a particulars date. It consists of capital,
profits and interest on capital subject to reduction of drawings and interest
on drawings. In case of limited companies, capital refers to capital subscribed
by shareholders. Net worth refers to paid up equity capital plus reserves and
profits, minus losses.
(2) Long term
Liabilities:
Liabilities repayable after specific duration of long period of time are called
long term liabilities. They do not become due for payment in the ordinary ‘operating
cycle’ of business or within a short period of lime.
Examples are long term loans and
debentures. Long term liabilities may be secured or unsecured, though usually
they are secured.
(3) Current
liabilities: Liabilities
which are repayable during the operating cycle of business, usually within a
year, are called short term liabilities or current liabilities.
They are paid out of current
assets or by the creation of other current liabilities.
Examples of current liabilities are trade
creditors, bills payable, outstanding expenses, bank overdraft, taxes payable
and dividends payable.
(4) Contingent
liabilities: Contingent
liabilities will result into liabilities only if certain events happen. e.g. Bills
discounted and endorsed which may be dishonored.
Types of Errors in Accounting
Accounting errors can
occur in double entry bookkeeping for a number of reasons. Accounting errors
are not the same as fraud, errors happen unintentionally, whereas fraud is a
deliberate and intentional attempt to falsify the bookkeeping entries.
An accounting error can
cause the trial balance not to balance, which is easier to spot, or the error
can be such that the trial balance will still balance due to compensating
bookkeeping entries, which is more difficult to identify.
Accounting Errors that Affect
the Trial Balance
Errors that affect the trial balance are
usually a result of a one sided entry in the accounting records or an incorrect
addition.
As a temporary measure, to balance the trial
balance. the difference in the trial balance is allocated to a suspense
account, and a suspense account reconciliation is carried out at a later stage.
For example, suppose the trial balance showed
total debits of 84,600 but total credits of 83,400 leaving a difference of
1,200 as shown below.
|
Suspense Accounts – Trial Balance Difference
|
|
Account
|
Debit
|
Credit
|
|
Trial Balance Totals
|
84,600
|
83,400
|
|
Difference
|
|
1,200
|
|
Total
|
84,600
|
84,600
|
To make the trial balance balance a single
entry is posted to the accounting ledgers in a suspense account.
|
Suspense Account Posting
|
|
Account
|
Debit
|
Credit
|
|
Suspense account
|
|
1,200
|
When the accounting error is identified a
correcting entry is made. Suppose the difference was an addition error on the
rent account, then the correcting entry would be as follows:
|
Suspense Account Reconciliation Posting
|
|
Account
|
Debit
|
Credit
|
|
Suspense account
|
1,200
|
|
|
Rent
|
|
1,200
|
Errors Which do not Affect the
Trial Balance
Accounting errors that do not affect the
trial balance fall into one of six categories as follows:
1.
Error of Principle in Accounting
2.
Errors of Omission in Accounting
3.
Error of Commission
4.
Compensating Error
5.
Error of Original Entry
6.
Complete Reversal of Entries
Error of Principle in
Accounting
An error of principle in accounting occurs
when the bookkeeping entry is made to the wrong type of account. For example,
if a £1,000 sale is credited to the sundry expenses account instead of the
sales account, the correcting entry would be as follows:
|
Accounting Errors – Error of Principle in Accounting Example
|
|
Account
|
Debit
|
Credit
|
|
Sundry expenses
|
1,000
|
|
|
Sales
|
|
1,000
|
Errors of Omission in
Accounting
Errors of omission in accounting occur when a
bookkeeping entry has been completely omitted from the accounting records.
If the payment £2,000 to a supplier has been
omitted then the correcting entry would be as follows:
|
Accounting Errors – Errors of Omission in Accounting Example
|
|
Account
|
Debit
|
Credit
|
|
Accounts payable
|
2,000
|
|
|
Cash
|
|
2,000
|
Error of Commission
An accounting error of commission occurs when
an item is entered to the correct type of account but the wrong account. For
example is cash received of £3,000 from Customer A is credited to the account
of Customer B the correcting entry would be.
|
Accounting Errors – Error of Commission
|
|
Account
|
Debit
|
Credit
|
|
Accounts receivable – Customer
B
|
3,000
|
|
|
Accounts receivable – Customer
A
|
|
3,000
|
Compensating Error
A compensating error occurs when two or more
errors cancel each other out. For example, if the fixed assets account is
incorrectly totalled and understated by £600, and the rent account is
incorrectly totalled and overstated by £600, then the posting to correct the
error would be as follows:
|
Accounting Errors – Compensating Error
|
|
Account
|
Debit
|
Credit
|
|
Fixed assets
|
600
|
|
|
Rent
|
|
600
|
Error of Original Entry
An error of original entry occurs when an
incorrect amount is posted to the correct accounts.
A particular example of an error of original
entry is a transposition error where the numbers are not entered in the correct
order. For example, if cash paid to a supplier of £2,140 was posted as £2,410
then the correcting entry of £270 would be.
A good indicator for a transposition error is
that the difference (in this case 270) is divisible by 9.
|
Accounting Errors – Error of Original Entry
|
|
Account
|
Debit
|
Credit
|
|
Cash
|
270
|
|
|
Accounts payable
|
|
270
|
Complete Reversal of Entries
Complete reversal of entries errors occur
when the correct amount is posted to the correct accounts but the debits and
credits have been reversed. For example if a cash sale is made for £400 and
posted incorrectly as follows:
|
Accounting Errors – Incorrect posting
|
|
Account
|
Debit
|
Credit
|
|
Sales
|
400
|
|
|
Cash
|
|
400
|
Then to correct the accounting error the
original entry must be reversed and the correct entry made, this can be
achieved by doubling the original amounts as follows:
|
Accounting Errors – Complete Reversal of Entries
|
|
Account
|
Debit
|
Credit
|
|
Sales
|
|
800
|
|
Cash
|
800
|
|
The type of accounting errors that do not
affect the trial balance are summarized in the table below.
|
Summary of Accounting
Error Types
|
|
Accounting Errors
|
Description
|
|
Error of Principle in
Accounting
|
Correct amount, wrong type
of account
|
|
Errors of Omission in
Accounting
|
Entry missed from
accounting records
|
|
Error of Commission
|
Correct amount and
type of account but wrong account
|
|
Compensating Error
|
Two or more errors
balance each other out
|
|
Error of Original
Entry
|
Correct accounts,
wrong amounts
|
|
Complete Reversal of
Entries
|
Correct amount and
account, entries reversed
|
1. Business
Entity
A business is
considered a separate entity from the owner(s) and should be treated
separately. Any personal transactions of its owner should not be recorded in
the business accounting book, vice versa. Unless the owner’s personal
transaction involves adding and/or withdrawing resources from the business.
2. Going
Concern
It assumes that an
entity will continue to operate indefinitely. In this basis, assets are
recorded based on their original cost and not on market value. Assets are
assumed to be used for an indefinite period of time and not intended to be sold
immediately.
3. Monetary
Unit
The business
financial transactions recorded and reported should be in monetary unit, such
as US Dollar, Canadian Dollar, Euro, etc. Thus, any non-financial or
non-monetary information that cannot be measured in a monetary unit are not
recorded in the accounting books, but instead, a memorandum will be used.
4.
Historical Cost
All business
resources acquired should be valued and recorded based on the actual cash
equivalent or original cost of acquisition, not the prevailing market value or
future value. Exception to the rule is when the business is in the process of
closure and liquidation.
5. Matching
This principle
requires that revenue recorded, in a given accounting period, should have an
equivalent expense recorded, in order to show the true profit of the business.
6.
Accounting Period
This principle
entails a business to complete the whole accounting process of a business over
a specific operating time period. It may be monthly, quarterly or annually. For
annual accounting period, it may follow a Calendar or Fiscal Year.
7.
Conservatism
This principle
states that given two options in the valuation of business transactions, the
amount recorded should be the lower rather than the higher value.
8.
Consistency
This principle
ensures consistency in the accounting procedures used by the business entity
from one accounting period to the next. It allows fair comparison of financial
information between two accounting periods.
9.
Materiality
Ideally, business
transactions that may affect the decision of a user of financial information
are considered important or material, thus, must be reported properly. This
principle allows errors or violations of accounting valuation involving
immaterial and small amount of recorded business transaction.
10.
Objectivity
This principle
requires recorded business transactions should have some form of impartial
supporting evidence or documentation. Also, it entails that bookkeeping and
financial recording should be performed with independence, that’s free of bias
and prejudice.
11. Accrual
This principle
requires that revenue should be recorded in the period it is earned, regardless
of the time the cash is received. The same is true for expense. Expense should
be recognized and recorded at the time it is incurred, regardless of the time
that cash is paid.
A
negotiable instrument is a document guaranteeing the
payment of a specific amount of money, either on demand, or at a set time, with
the payer named on the document.
A
promissory note is a legal instrument, in which one
party (the maker or issuer) promises in writing to pay a determinate sum of
money to the other (the payee), either at a fixed or determinable future time
or on demand of the payee, under specific terms.
Bills
of Exchange
A bill of exchange is an
unconditional order in writing, addressed by one person to another, signed by
the person giving it, requiring the person to whom it is addressed to pay on
demand, or at a fixed or determinable future time, a sum certain in money to or
to the order of a specified person, or to bearer.
Parties
of bill of Exchange
A bill of exchange requires in its
inception three parties—the drawer, the drawee, and the payee. The person who
draws the bill is called the drawer.
He gives the order to pay money to the third party. The party upon whom the
bill is drawn is called the drawee.
One to whom money is paid is called the payee.
