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Module II

Introduction
Accounting is the art of recording, classifying, and summarizing the financial
transactions and interpreting the results therefore. Thus, accounting cycle involves the following
stages:
1. Recording of Transactions. This is done in the book termed as ‘Journal’.
2. Classifying the Transactions. This is done in the book termed as ‘Ledger’.
3. Summarizing the Transactions. This includes preparation of the trial balance, profit and
loss account and balance sheet of the business.
4. Interpreting the Result. This involves computation of various accounting ratios, etc., to
know about the liquidity, solvency and profitability of business.

JOURNALIZING
The journal records all daily transactions of a business into the order in which they occur.
A journal may therefore be defined as a book containing a chronological record of transactions.
It is the book in which the transactions are recorded foremost under the double entry system.
Thus, a journal is the book of original records. A journal does not replace but precedes the
ledger. The process of recording a transaction in a journal is termed as ‘Journalizing.’
A proforma of journal is given below:

Date Properties L.F Debit Credit

(Rs.) (Rs.)

1. Date: - The date on which the transaction was entered is recorded here.
2. Particulars: - the two aspects of transactions are recorded in this column, i.e., the details
regarding accounts which have to be debited and credited.
3. L.F.:- it means the Ledger Folio. The transactions entered into the journal are later on
posted to the ledger.
4. Debit: - in this column, the amount to be debited is entered.
5. Credit: - in this column, the amount to be credited is shown.

LEDGER
Ledger is a book which contains various accounts. In other words, ledger is a set of
accounts. It contains all accounts of the business enterprise, whether Real, Nominal or Personal.
It is usually prepared after the journal, and therefore it is a secondary or derived record.
Furthermore, it is the most important book for a businessman, as it is from the ledger that a trial
balance can be prepared and from the trial balance, the final accounts are prepared. Because of
the importance of the ledger, it is called the ‘King of Books of Accounts’.
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Posting
The term “Posting” means transferring the debit and credit items from the journal to their
respective accounts in the Ledger. It should be noted that the exact names of accounts used in the
Journal should be carried to the Ledger.
Posting may be done at any time. However, it should be completed before the financial
statements are prepared. It is advisable to keep the more active ac counts posted to date. The
examples of such accounts are the cash account, personal account of various parties etc.
The Ledger Folio (L.F) column in the journal is used at the time when debits and credits
are posted to the Ledger. The page number of the Ledger on which the posting has been done is
mentioned in the L.F. column of the Journal. Similarly, a folio column in the Ledger can also be kept
where the page from which posting has been done from the journal may be mentioned. Thus, there
are cross-references in both the Journal and the Ledger.

Form of Ledger Accounts

Dr. ----------------- Account Cr.

Date Particulars J.F Amount Date Particulars J.F Amount
(Rs.) (Rs.)

Relationship between Journal and Ledger

Both Journal and Ledger are the most important books used under the Double Entry
System of bookkeeping. Their relationship can be expressed as follows:
1. The transactions are recorded first of all in the Journal and then they are posted to the
Ledger. Thus, the Journal is the book of first or original entry, while the Ledger is the
book of secondary entry.
2. Journal records transaction in a chronological order, while the Ledger records transaction
in an analytical order.
3. Journal is more reliable in comparison to the Ledger since it is the book in which the
entry is passed first of all.
The process of recording transactions is termed as ‘Journalising’ while the process of recording
transactions in the Ledger is called ‘Posting’.

Balancing of an Account
The technique of finding out the net balance of an account, after the end of a
period (say a month, a quarter or a year), by considering the totals of both debits and credits
appearing in the account is known as ‘Balancing the Account’. The balance is put on the side of
the account which is smaller and a reference is given that it has been carried forward or carried
down (c/f or c/d) to the next period. On the other hand, in the next period a reference is given that
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the opening balance has been brought forward or brought down (b/f or b/d) from the previous
period.

TRIAL BALANCE
A Trial Balance is prepared usually at the end of a trading period, after balancing all the
ledger accounts and is made the basis for the compilation of final accounts. The sole object of
preparing a trial balance is the testing of the arithmetical accuracy of the various ledger accounts.
If posting, casting, carry forwards and balancing are done properly, the debit totals and the credit
totals of a trial balance must agree.
A Trial Balance, therefore, can be defined as a tabulated statement of the balances
standing at the debits and credits of the various accounts on a particular date prepared to test
the arithmetical accuracy of the accounts.

Objectives of Trial Balance

1. Checking of Arithmetical accuracy of the Accounting Entries: - Hence trial balance
represents a summary of all ledger balances, two sides of trial balance i.e., debit & credit
should tally.
2. Trial Balance forms the basis for financial statements i.e., for preparing P&L Account and
Balance Sheet.
3. Helps to locate errors in transactions
4. Position of a particular ledger account can be easily identified.

Suspense Account
It is an account opened temporarily, when the trial balance doesn’t tally. Whenever the
error is rectified, a rectification entry should be passed based on the suspense account, which will
be closed automatically. By helping in tallying the trial balance it avoids delay in the preparation
of final accounts.

TRADING ACCOUNT
The trading account shows the result of trading i.e., buying and selling. So a trading
account shows a gross profit or gross loss. As the trading account shows only trading results,
those transactions which are directly connected with purchases and sales are taken to this
account.
The items on the debit side of the trading account will be,
(i) Opening Stock
(ii) Purchase less returns
(iii) Direct expenses
On the credit side,
(i) Sales less returns
(ii) Closing stock

The balance of the trading account is gross profit or gross loss. If the credit side total of the
trading account is more than the debit side total, the difference is called Gross Profit. On the
other hand, if the debit side total is more than the credit side total, the difference is called Gross
Loss. The trading result i.e., gross profit or gross loss is transferred to Profit and Loss Account.
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PROFIT AND LOSS ACCOUNT

Profit and Loss account follows the Trading Account. It is prepared with a view to
finding out the net profit or net loss of a business for a particular trading period. All such
incomes & gains and losses & expenses which are not taken to trading account are taken to profit
and loss account before the profit or loss is ascertained.
The profit and loss account is first credited with gross profit or debited with gross loss as
ascertained in the trading account. Then all expenses and incomes are debited to it, which are not
debited to the trading account. Likewise, the incomes and gains which are not credited to trading
accounts are credited to profit and loss accounts.
The balance of profit and loss account is net profit or net loss. If the credit side of the
P&L account is more than the debit side, it is Net Profit. On the other hand, if the debit side of
the P&L account is more than the credit side, it is Net Loss. The resulting net profit or net loss is
transferred to the capital account of the proprietor

BALANCE SHEET
Balance sheet is a statement of assets and liabilities prepared with a view to ascertaining
the exact financial position of a business on a certain date.
According to Palmer, “The Balance Sheet is a statement at a given date showing on one
side the trader’s property and possession and on the other side his liabilities.”
According to American Institute of Certified Public Accountants, “Balance Sheet is a list
of balances of the assets and liability accounts. This list depicts the position of assets and
liabilities of a specific business at a specified point of time.”
Balance Sheet is prepared from the trial balance. The accounts that remain in the trial
balance after preparing the trading account and profit and loss account are either real accounts or
personal accounts. A debit balance in a personal account and real account represents an asset. A
credit balance in a personal account and real account represents a liability. All such assets and
liabilities are shown in the balance sheet. Assets are shown in the right hand side of a balance
sheet and liabilities on the left hand side.
The arrangement of assets and liabilities in the balance sheet is called “Marshalling” or
Grouping of Assets and Liabilities.
The assets and liabilities can be arranged in the balance sheet either:
1. In the order of liquidity, or
2. In the order of permanence.
1. If the order of liquidity is followed the arrangements of assets will be in the following
order:
(a) Liquid Assets
(b) Current Assets
(c) Fixed Assets.
On the liabilities side,
(a) Current Liabilities
(b) Fixed Liabilities

2. If the order of permanence is followed, the arrangement on the assets side will be,
(a) Fixed Assets
(b) Current Assets
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(c) Liquid Assets

On the liabilities side,
(a) Fixed Liabilities
(b) Current Liabilities

Features of a Balance Sheet

The salient features of a balance sheet are as follows:
1. The balance sheet is a statement and not an account.
2. It is prepared as on a particular date and not for a particular period
3. The balance sheet is prepared after the completion of trading and profit and loss account.
The trial balance and adjustments attached thereto help in the preparation of the balance
sheet.
4. The balance sheet has two sides – the left hand side being used for recording liabilities
and right hand side being used for recording assets.
5. The two sides of the balance sheet must agree i.e., assets must equal to liabilities.

Differences between Trial Balance and Balance Sheet

1. A Trial Balance is a list of all ledger balances on a given date, but a Balance Sheet is a list
of only real and personal accounts.
2. The aim of a Trial Balance is ascertaining the arithmetical accuracy of the books of
accounts. But the aim of a Balance Sheet is ascertaining the financial position of the
company.
3. The Balance Sheet shows the correct value of assets and liabilities but a Trial Balance
does not show it. This is because a Trial Balance does not record adjustments whereas the
Balance Sheet does record adjustments.

Differences between Trading and Profit & Loss Account and Balance Sheet
1. A Trading and Profit & Loss account as the name suggests is an account which is a
nominal account. But a Balance Sheet is only a statement.
2. A Trading and Profit & Loss account is prepared according to the double entry principle.
Closing journal entries are required for the preparation of Trading and Profit & Loss
account. But journal entries are not required for the preparation of the Balance Sheet.
3. All revenue items find their destination in either the Trading or Profit & Loss account. But
all capital items find their destination in the Balance Sheet.
4. The Trading and Profit & Loss account shows gross profit (or gross loss) and net profit (or
net loss) respectively. But the Balance Sheet shows assets and liabilities.
5. A Trading and Profit & Loss account is usually prepared for a year i.e., for a particular
period. But Balance Sheet is prepared as on a particular date.
6. The preparation of Trading and Profit & Loss account precedes the preparation of a
Balance Sheet.
7. In a Trading and Profit & Loss account, debit items are shown on the left hand side and
credit items are shown on the right hand side. But in Balance Sheet, debit balances are
shown on the right hand side and credit balances are shown on the left hand side.
8. Of course, both Trading and Profit & Loss account and Balance Sheet are prepared from
the Trial Balance. However, the account transferred to the Trading and Profit & Loss
account are finally closed while the accounts transferred to the Balance Sheet represent
those accounts whose balances are to be carried forward to the next year.
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Classification of Expenditure
Expenditure can be classified in to three categories:
1. Capital Expenditure
2. Revenue Expenditure
3. Deferred Revenue Expenditure

1. Capital Expenditure:-
It means an expenditure which has been incurred for the purpose of obtaining a
long term advantage for the business. Such expenditure is either incurred for acquisition of an
asset (tangible or intangible) which can later be sold and converted into cash or which result in
increasing the earning capacity of the business or which affords some other advantage to the
business.
Following are some of the examples of Capital Expenditure:
(a) Expenditure incurred in increasing the quality of fixed assets. (purchase of
additional furniture, plant, building for permanent use in the building)
(b) Expenditure incurred in increasing the quality of fixed assets.
(c) Expenditure incurred for substitution of a new asset for an existing asset.
(d) Expenditure incurred in connection with purchase, receipts, or erection of a fixed
asset
(e) Expenditure incurred for acquiring the right of carrying on a business. (Purchase
of patent rights, copy rights, goodwill etc.)

2. Revenue Expenditure:-
An expenditure that arises out of and in the course of regular business transactions of
concern is termed as revenue expenditure. It may simply be termed as “Expense”. Following are
few examples of revenue expenditure:
(a) Expenditure incurred in the normal course of running the business.
(b) Expenditure incurred to maintain the business. (Money spent for repairs of
existing fixed assets, cost of stores consumed, etc.)
(c) Cost of goods purchased or resale.
(d) Depreciation on fixed assets, interest on loans for the business.

Differences between Capital Expenditure and Revenue Expenditur

1. Capital Expenditure is incurred for acquisition of fixed assets for the business. While
revenue expenditure is incurred for day-to-day operation of the business.
2. Capital Expenditure is incurred for increasing the earning capacity of the business.
While revenue expenditure is incurred for maintaining the earning capacity of the
business.
3. Capital expenditure is of non-recurring nature while revenue expenditure is of a
recurring nature.
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4. The benefit of capital expenditure is received over a number of years and only a small
part of it, as depreciation is charged to the profit and loss account each year. The rest
appears in the balance sheet as an asset. While the benefit of revenue expenditure
expires in the year in which the expenditure is incurred and it is entirely charged to the
profit and loss account of the relevant year.

3. Deferred Revenue Expenditure:-

It is that class of revenue expenditure which is incurred during an account period, but is
applicable either wholly or in part to future periods. It can be classified into four distinct parts as
follows:
1. Expenditure wholly paid for in advance, where no service has yet been rendered,
necessitating its being carried forward i.e., the showing of such outlay as an asset in the
Balance Sheet as prepaid expenditure.
2. Expenditure partly paid in advance, where a portion of benefit has been derived within the
period under review, the balance being as yet “unused”, and therefore shown in the
Balance Sheet as an asset
3. Expenditure in respect of service rendered which for any should reason is considered as
an asset, or more properly, is not considered to be allocable to the period in question.
(e.g., development costs in mines and plantations, discount on debentures in limited
companies and cost of experiments.)
4. Amounts representing losses of an exceptional nature. (e.g., properly confiscated in a
foreign country, heavy loss of non-insured assets through, say, fire.)