Process and Bases of Accounting

 

 

Accountancy (Class-XI) CHAPTER-4

Process and Bases of Accounting

(A)     Process of Accounting

The accounting process begins with the identification of business transactions which can be measured in terms of money. These transactions are then recorded in the books of accounts, classified and finally summarized by preparing trial balance and financial statements (i.e., preparation of profit and loss account and balance sheet. Thus, steps involved in the process of accounting are:

Process of Accounting

¯

Identification of Financial Transactions

¯

Preparation of Vouchers

¯

Recording transactions in the Books of Accounts

¯

Posting to Ledger

¯

Preparation of Trial Balance

¯

Preparation of Financial Statements (i)         Trading and Profit & Loss Account (ii)        Statement of Profit and Loss in case of companies (ii)    Balance Sheet

These steps of accounting process are discussed as under:        

1. Identification of financial transactions : As we know that accounting deals with business transactions that can be measured in terms of money. These transactions must be supported by documentary evidences such as cash memos, purchase invoice, sales invoice, pay-in-slip, payment vouchers, bank pass book, etc. These documents act as evidence, that a transaction has taken place and as such, these are called source documents.
2. Preparation of Vouchers : On the basis of source documents, vouchers are prepared. Usually, vouchers are printed forms containing name of our own firm, column of date, voucher number. It is further divided into debit (Dr.) and credit (Cr.) with amount columns along with column of signature where the clerk who prepares it will sign. Format of the voucher is as under.

 

Received Rs. _____________________________ _____________________________    Revenue _____________________________      Stamp _________________________________________	KANYA BOOK DEPOT Voucher No. ______________                              Date. ____________
	Dr. Purchases A/c	(`)
	Cr.       Shyama Paper Mart Bill No. ______________	(`)
	Signature of clerk

 

Vouchers are prepared from the source documents and they give direction as to which accounts are to be debited and credited. The documentary evidences are attached with each voucher. Thus, they are verifiable. In case of petty expenses like payment of Auto fare where no source document is available, voucher also acts as a source document. The vouchers are kept in serial order and are kept in a file for future reference and for verification by the auditor.

3. Recording of entries in the books of original entry : All the transactions are recorded from the vouchers in the books of accounts. Books of accounts in which transactions are recorded first are known as ‘Books of Original Entry.’ ‘Journal’ is one of the original entry in which all the transactions are recorded date wise as per the rules of ‘double entry system’. When the volume of transactions increase with the increase in the size of the business, journalist further sub-divided into several books called as ‘Subsidiary Books’ for simplification of recording of business transaction. Thus, all cash transaction are recorded in the Cash Book, all credit purchases of goods are recorded in ‘Purchases Book’, all credit sales are recorded in the ‘Sales Book’. Other similar books used for recording are Purchases Return Book, Sales Return Book, Bills Receivable Book, Bills payable book and journal proper.

                   Recording of transactions in the subsidiary books is also called as system of book-keeping. The system makes the process of classification of transactions easier.

4. Posting to Ledger : All the transactions recorded in the ‘Journal’ or in the ‘Subsidiary Books’ are transferred to respective accounts in the ledger. The process of transfer of entries from Journal or Subsidiary Books to ledger is called as posting. All the transactions pertaining to same party are posted in the same party in chronological (date wise) order. Thus, separate accounts are opened for each customer, each supplier, for each assets, each liabilities, purchases, sales etc. Similarly, separate accounts are opened in the ledger for each expense and income. The book in which above stated accounts are opened and kept is called ledger and it is also called as principal books of accounts. Ledger posting enables us to know the amount of total purchaser, total sales, total of each assets separately, total of each creditor and each debtor separately.
5. Preparation of Trial Balance : After posting the recorded transactions in the ledger, all the accounts are balanced and closed at the end of the accounting period or even earlier as well. A Trial Balance is then prepared by placing all the accounts having debit balance on the debit side and by placing all the accounts having debit balance on the debit side and by placing all the credit balances on the credit side. Thus, total of debit side should agree with the total of the credit side of the Trial Balance as accounts are kept on the dual aspect concept. The agreement of both the sides of Trial Balance ensures the arithmetical accuracy of the posting and balancing of ledger accounts. If there is a difference in the Trial Balance, steps are taken to locate the errors and these are rectified. Financial Statements are thereafter, prepared with the help of the Trial Balance.
6. Preparation of the Financial Statements : The preparation of Trial Balance merely confirms that recorded transactions have been corrected posted to ledger and correct balancing of each ledger accounts. It fails to point out the operating performance and financial soundness of the business entity. Thus, financial statements are prepared annually on the basis of Trial Balance to know the profitability and position of assets and liabilities of the business entity. Financial statements include preparation of:

(i)       Trading and Profit & Loss Account–reveals profitability position

(ii)      Balance Sheet–reveals financial soundness of the business entity

 

Accounting system at a glance

Source Documents	Cash Memo, Purchase Invoice, Sales Invoice, Invoice of Assets, Pay-in-slip, Bank Pass Book, etc.
¯
Recording of Transactions	Books of Original Entry Journal or Subsidiary Books Cash Books, Purchases Book, Sales Book, Purchases Return Book, Sales Return Book, Bills Receivable Book, Bills Payable Book, Journal Proper
¯
Posting of Transactions	Ledger Account
¯
Trial Balance	Check Arithmetical accuracy of accounts
¯
Financial Statements or Final Accounts	(i)  Trading and Profit & Loss Account (ii) Balance Sheet

 

Bases of Accounting

The basic objective of accounting is to ascertain the profit earned or loss caused to business equity at the end of each accounting period. Thus, we have two bases for ascertaining profit or loss of the business entity, namely.

(i)      Cash Basis and

(ii)     Accrual Basis

(i)      Cash Basis : Under this system of recording, all the financial transactions are recorded only when cash is received or cash is paid. Thus, credit transactions are not recorded in this system. It means revenue is recognized only on the receipt of cash and expense is recognized on its payment. Hence, outstanding expenses, prepaid expenses, income accrued and income received in advance are not considered. The difference between total receipts and total expenses represent either profit/surplus or loss/deficit. Generally, this system of accounting is adopted by the non-trading concerns like school, college, club, charitable trusts or by professionals like lawyers, doctors, architects, chartered accountants etc.

Advantages

(a)     Method is simple to understand and follow.

(b)     Technique is suitable in those enterprises where almost all transactions are recorded on cash basic.

(c)      No adjustment for outstanding and prepaid expenses is required. Similarly, no adjustment for accrued income and income received in advance is made.

(d)     The method is not affected by the personal biasness of the accountant or management.

Disadvantages

(a)      Cash basis of accounting is not based on the principle of matching concept so all income and all expense shown not relate to the same accounting period.

(b)      No distinction is made between capital and revenue items so the profit or losses are not comparable over a period of time.

(c)      System is not scientific so profit/loss exhibited can be easily manipulated as payment of expenses or income may be deferred to show wrong picture of the entity.

(d)      Moreover, the system is not recognized by the Indian Companies Act, 1956 which is subject to audit by the independent auditor who must be a practicing chartered account.

(e)      The system of cash basis of accounting does not reveal a true and fair view of profit or loss and financial position of an entity as it is not based on principle of matching concept and principle of accrual basis.

          (ii)     Accrual Basis of Accounting : The system of accrual basis of accounting is considered as most scientific system of accounting as it is based on principle of recognition and on principle of matching concept. Under accrual basis of accounting, income is recognized when a sale is made or service is rendered rather than when cash is received. Similarly, expense is recognized when an asset or service has been used to generate revenue irrespective of the fact that expense is paid or not. Thus, credit sales are treated as a part of total sales of the accounting period irrespective of the cash is received. Similarly, credit purchases will be considered as part of total purchase of goods.

Under Accrual Basis of Accounting, net profit of the firm is ascertained on the principle of matching concept. Accordingly, following points be observed:

(a)      Rent or salary outstanding for the March, 2014 will be considered as expense of March, 2014 and not of April, 2014 when these expenses are paid.

(b)      Salary paid in March, 2014 for the month of April, 2014 will be considered for the accounting year 2014-15 and not for accounting year 2013-14 as expense is prepaid and does not relate to current accounting period.

(c)      Similarly, interest on investment accrued on 31^st March, 2014 is an income of 2013-14 even though cash has not been received.

Thus, under accrual basis of accounting, net profit is ascertained by matching the revenue realized and cost incurred during the accounting period. Accordingly, outstanding expenses, prepaid expenses, income accrued and income received in advance are adjusted so as to arrive at the net income of the accounting period. All trading and profit making concerns including companies follow this system of accounting as it is most scientific and is based on double entry system of accounting.

Advantages

(a)      Accrual basis of accounting is based on double entry system of accounting and is most scientific system of accounting. Hence, this system is preferred and followed all over the world by the accountants.

(b)      It follows principles of recognition and principle of matching concept so the system discloses correct and true profit for the accounting period and also exhibits true and fair view of the financial position of the enterprise through Balance Sheet.

(c)      the system maintains distinction between capital and revenue item. Thus, system depicts a true and fair view of profit or loss of the firm during accounting period.

(d)      This system of accounting makes the inter-period and inter-firm comparison possible so it is mostly used by the accountants all over the world. Moreover, system is based on generally accepted accounting principles (GAAP).

Disadvantages

(a)      Accrual basis of accounting is not as simple as the cash basis accounting system is.

(b)      The system is based on matching concept and accrual basis so adjustments for outstanding expenses, prepaid expenses, accrued income and unearned income are to be made. The makes the system complicated so quick appraisal of financial statements is not feasible.

(c)      The system requires personal judgment of the accountant/management in respect of valuation of stock, selection of a method of charging depreciation, creation of provision for doubtful debt. Thus, true profit may not be ascertained due to personal biasness of the accountant/management.

 

Distinction between Cash basis and Accrual basis of Accounting

Basis	Accrual Basis of Accounting	Cash Basis of Accounting
1. Basis of Recording	All transactions whether cash or credit-are recorded in this system.	The transactions are recorded on cash basis.
2. Recording of Incomes	Incomes are recorded on accrual basis i.e., income must relate to accounting period irrespective of the fact whether cash is received or not.	All incomes are recorded on cash basis irrespective of the fact whether they relate to current accounting period or not.
3. Recording of Expenses	Expenses are recorded on accrual basis i.e., expenses must relate to current accounting period whether cash is paid for them or not.	All expenses are recorded on cash basis whether they relate to current accounting period or not.
4. Capital and revenue items	System keeps distinction between capital and revenue items.	This system makes no distinction between capital item and revenue item.
5. Users	This system of accounting is generally followed by business entities whose objective is to earn profit.	This system of accounting is suitable for not for profit organizations and professionals.
6. Possession of technical knowledge	The accounts are maintained on accrual basis so adjustments for outstanding and prepaid expenses; and accrued and income received in advance is needed. Thus, accountant must possess technical knowledge.	The system of accounting is simple so it does not require technical knowledge.
7. Uses of GAAP & Accounting Standards	The system is based on Generally Accepted Accounting Principles (GAAP) and accounting standards issued by ICAI.	The system violates the requirements of GAAP and accounting standards.
8. Legal Position	This system is recognized under Companies Act, 1956.	The system is not recognized under Companies Act, 1956.
9. Reliability of Accounts	This system is reliable as it depicts true and fair view of profitability and financial position of the business entity.	Only cash transactions are recorded so true profit cannot be ascertained. Hence, the system is not reliable.