Essential Concepts in Financial Accounting
Single vs. Double Entry Accounting Systems
What is the Single Entry System?
The Single Entry System is an accounting method characterized by the following:
- It is an incomplete and unscientific method of accounting.
- Only one aspect of a transaction (usually a cash or personal account) is recorded.
- It is commonly used by small businesses.
- It does not provide a complete financial picture.
What is the Double Entry System?
The Double Entry System is a more robust accounting method:
- It is a scientific and systematic method of accounting.
- Both aspects of every transaction are recorded: a debit and a credit.
- It maintains full records of all assets, liabilities, income, and expenses.
- It provides accurate financial statements.
Key Financial Statements and Concepts
What is a Statement of Affairs?
A Statement of Affairs is a summary statement of assets and liabilities. Key points include:
- It is prepared under the single entry system to determine the capital of a business.
- It is often used to estimate profit or loss by comparing opening and closing capital.
- It is not as reliable as a balance sheet because it may include estimated figures.
What is a Statement of Profit and Loss?
Also known as the Income Statement, this is a financial statement showing the revenues and expenses for a specific period. It is used to determine the net profit or net loss. Its key elements are:
- Revenue
- Cost of Goods Sold (COGS)
- Gross Profit
- Operating Expenses
- Net Profit
Fundamental Accounting Terms and Principles
Equity
Equity refers to the owner’s residual interest in the business after deducting liabilities from total assets.
Assets and Liabilities
Assets are valuable resources owned by a business that provide future economic benefits and are controlled by the entity. Liabilities are present obligations owed to external parties to transfer resources.
Income Recognition
Under the accrual concept, income is recognized when it is earned and collectible, regardless of when cash is received.
The Accounting Cycle
The first event of the accounting cycle is identifying and analyzing financial transactions relevant to the business.
Invoices
Invoices are generated by the seller at the time of a credit sale to demand payment from the buyer.
Credit and Debit Notes
Credit notes are issued for sales returns. Debit notes are issued by buyers for returned goods or disputed charges.
Vouchers
A voucher is a written document that serves as proof of a business transaction for accounting records.
Internal Transactions
Two examples of internal transactions are the depreciation of machinery and internal stock transfers between departments.
Modern Account Types
The four modern account types are Assets, Liabilities, Equity (Capital), and Income/Expense accounts.
Key Accounting Concepts
The Money Measurement Concept
This concept states that only transactions measurable in monetary terms are recorded in accounts.
The Money Fund Concept
This refers to maintaining separate accounting for specific funds, like capital or donation funds.
The Entity Concept
This concept treats the business as a separate accounting unit from its owners or stakeholders.
The Propriety Concept
This concept ensures that all accounting decisions are made ethically and in the owner’s best interest.
The Going Concern Concept
This concept assumes that the business will continue operating indefinitely unless stated otherwise.
The Realization Concept
This concept dictates that revenue is recorded only when it is earned and measurable.
Objectives of Financial Accounting
Two primary objectives of financial accounting are to provide useful financial information and to help users make informed decisions.
Accounting Information
Accounting information is processed financial data used for analysis, planning, and decision-making.
IFRS and GAAP
IFRS (International Financial Reporting Standards) is a set of global accounting standards issued by the IASB for consistent financial reporting across countries. GAAP (Generally Accepted Accounting Principles) are a set of accepted accounting rules that govern how financial transactions should be reported.
Purpose of Accounting Standards
Accounting standards are needed to ensure uniformity, transparency, and comparability in financial reporting.
Revenue (AS-9)
As per AS-9, revenue is the gross inflow of benefits from ordinary business activities during an accounting period.
Capital and Income
Capital is the owner’s investment in the business. Income adds to that capital unless it is withdrawn.
Revenue vs. Receipts
Revenue is income earned through business operations, whereas receipts are the actual cash inflows from any source.
Errors Not Affecting the Trial Balance
Errors that do not affect the trial balance include errors of omission, principle, and compensating errors, all of which require rectification.
Inventory Accounting
Accounting for inventory involves recording, valuing, and reporting stock using specific valuation methods.
Consignment and Account Sale
Consignment is a business arrangement where goods are sent by the consignor to the consignee for sale. Ownership remains with the consignor until the goods are sold. In a sale, ownership transfers immediately. An account sale is a detailed statement sent by a consignee to the consignor about the goods sold and proceeds received.
Provisions, Reserves, and Funds
A provision is a charge against profit for a known liability. A reserve is an appropriation of profit set aside for future needs or contingencies. A reserve fund is an amount set aside from profits to meet unforeseen future liabilities or purposes.
Receipts and Payments Account
This is a summary of all cash and bank transactions (both capital and revenue) during a period, irrespective of the period to which they belong.
Capitalized Expenditure
Capitalized expenditure is spending on assets that provide long-term benefits, such as buying a building.
Proforma Invoice
A proforma invoice is a preliminary bill sent before a sale, often used for customs or pre-sale agreements.
Depreciation Measurement
The measurement of depreciation considers the cost, useful life, residual value, and depreciation method of the asset.
Bad Debt Recovery
Bad debt recovery occurs when a previously written-off unpaid amount from a customer is later collected.
Common Types of Accounting Errors
Error of Omission
This occurs when a transaction is completely or partially omitted from the books of accounts.
Example: A cash sale of ₹10,000 is not recorded at all.
Error of Commission
This happens when a transaction is recorded but with incorrect details, such as the wrong amount, wrong account, or on the wrong side.
Example: A payment of ₹8,000 to Mr. X is correctly recorded in the cash book but posted to Mr. Y’s account.
Error of Principle
This occurs when a transaction is recorded in violation of accounting principles, especially regarding capital and revenue classification.
Example: Buying machinery (a capital expenditure) is recorded as repairs and maintenance (a revenue expenditure).
Error of Misposting
An error of misposting occurs when an entry is recorded in the wrong ledger account or posted to the wrong side (debit or credit) of the correct account.
Example: A payment of ₹2,000 to Mr. A is wrongly posted to Mr. B’s account.
Error of Original Entry
This is an error made in the initial recording of a transaction with the wrong amount or figure.
Example: A sale of ₹5,400 is incorrectly recorded as ₹4,500 in the sales journal.