There were three friends Rancho, Raju and Farhan. They dropped out of engineering college to pursue a business idea. Their idea was to buy T-shirts from wholesalers and sell them on the beaches of Goa to tourists.
They estimated that they would require a capital of Rs. 40,000 to start. They had Rs. 10,000 each which they pooled together. They were still falling short of Rs. 10,000. So they decided to go to the Director of their former Engineering college – Virus to request him to lend them Rs. 10,000. Virus was very happy that these guys have left the college and readily gave them Rs. 10,000.
So Raju, Rancho and Farhan had their capital now. Rs. 30,000 of Owners Capital and Rs. 10,000 as borrowed funds or loans or debt. They decided to name their firm – ‘ 3 Idiots & Co’.
They decided that the business will have a separate identity which will be different from the owners. [Finances of Business are always different from the owners]
The Firm – 3 Idiots & Co will have its own books of accounts.
The amount owed to others is called – ‘Liability’. The things, the firm owns are called – ‘Ássets’. Technically any firm from an accounting perspective is an fictitious entity and will have nothing of its own. All the Owner’s Capital (Read: Equity) also is a liability for 3 Idiots & Co. Also, the profits generated or loss incurred will also belong to the owners.
Balance Sheet refers to the status of the business as on a particular date. It tells us about the Assets, Liabilities and Equity. Balance Sheet of 3 Idiots & Co when they are about to start
In the end, ‘3 Idiots & Co’ – the firm will own nothing of its own. The amount of money owed by the firm to its owners is called Equity.
ASSETS = LIABILITIES + EQUITY
EQUITY = ASSETS – LIABILITIES
These guys have started the business. The business is doing very well. Their T shirts are a hit with tourists. Raju has been asked by the other two to maintain the books of accounts. He maintains a dairy. He records all the cash inflow and outflows in various accounts. For example, for a sale of Rs. 200 he adds Rs. 200 to Sales Account and Cash Account.
As the business has grown manifold. Raju is facing an issue. If he commits an error, it is difficult to detect. Instead of a ‘+’ if a ‘-’ is done, it is not easy to detect that a mistake has happened. “+/-” system lacks internal consistency. Therefore, it is easy to get something wrong and be completely unaware that something has gone amiss.
Raju discusses the issue with the other two and they go to meet Virus. Virus tells them about ‘Double Entry system of Book Keeping’. Tells them that the Debit/Credit system has internal consistency…
Debits and credits (abbreviated “dr” and “cr”) – unique accounting tools – describe the change in a particular account that is necessitated by a transaction. Instead of saying that cash is “increased” or “decreased,” it is said that cash is “debited” or “credited.”
In this system – In every transaction: Amount of Debit = Amount of Credit.
- We would know something is wrong if total Debit is not equal to the total Credit.
- The debit/credit rules are built upon an inherently logical structure.
Laws of Accounting Mechanics
- There is no such thing as one sided journal entry. There has to be Debit as well as credit.
- For every journal entry for every transaction – Debit Amount = Credit Amount. Therefore, Total Debits = Total Credits.
Every Transaction must adjust at least two accounts.
Matching Principle & Accrual Accounting
- A company will report an expense on its Income Statement (Profit and Loss Statement) in the year in which the related revenues are earned.
- For eg: If 3 Idiots & Co buys 3,000 T-Shirts in their first year but sell only 2500 T shirts, then in their P&L they will account for the cost of only 2500 T-Shirts.
- If the expense is not directly tied up to Revenue, then it should be reported on the Income Statement in the accounting period in which it expires or is used up.
- Eg: The rent the company pays for its premises. Irrespective of what Sales they do they need to pay rent periodically. Thus, it will be charged periodically in the Profit & Loss Statement.
Accrual System of Accounting vs Cash System of Accounting
Accrual accounting is an accounting method where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made. The method follows the matching principle, which says that revenues and expenses should be recognized in the same period.
Imagine your business needs to pay a salary of Rs. 100,000 every year. There can be three scenarios.
- Where the business paid the entire Rs. 100,000
- Paid Rs. 200,000. Which along with this year’s salary also included a one-year advance salary of Rs. 100,000
- The business was short of cash and paid just Rs. 50,000. Rest of the amount is due.
Salary Expense in all the three cases is going to be Rs. 100,000 only irrespective of how much cash was paid.
Another example of Accrual Accounting: Sales/Income recognition:
Lets say the business did sales of around Rs. 100,000.
When it comes down to collection of cash, let’s say there can be three scenarios:
- Cash received was Rs. 100,000
- Customer gave us Rs. 150,000. Rs. 50,000 as advance for more future purchases.
- Customer paid us Rs. 50,000. And Rs. 50,000 is due from the customer.
No matter how much cash we collect, amount of sales or income to be recognized in Profit and Loss Statement is Rs. 100,000.
Raju has doubt and ask the Virus when to know when to debit or credit an account. Virus tells them about the Golden rules of accounting. Where you first determine if any account falls under an of the three categories – Real Accounts, Personal Account or Nominal Account and then apply the rules.
- Real Accounts – an account dealing with the material assets of a business, eg: property.
- Personal Accounts – account types related to a person
- Nominal Accounts – these are general accounts which are closed at the end of the year eg: Expenses, gains, Revenue etc
But Farhan and Raju are finding the Golden Rule way a little difficult and ask Virus if there is an easy way for this. Virus tells them about the D-E-A-D & the R-E-L-I-C rule.
D-E-A-D: Debits increase Expenses, Assets & Dividends
Assets, Expenses and Dividends accounts each follow the same set of debit/credit rules.
Debits increase these accounts and credits decrease these accounts.
These accounts normally carry a debit balance.
D-E-A-D = debits increase expenses, assets, and dividends.
R-E-L-I-C: Revenues, Equity and Liabilities are Increased with Credits
Liability, Revenue, and Equity accounts each follow rules
Credits increase liabilities, revenues, and equity, while debits result in decreases.
These accounts normally carry a credit balance.
R-E-L-I-C = Revenues, Equity and Liabilities are Increased with Credits.
TOTAL DEBITS = TOTAL CREDITS
No that we know that every journal entry will have debit amount = credit amount, the total debits = total credits. The Balance sheet will always need to tally.
Sources of Funds (Liability) = Application of Funds (Assets)
After having told them about the debit and credit approach of recording transactions, Virus tells the 3 Idiots about the 3 important Financial Statements – Balance Sheet, Income Statement and Cash Flow Statements.
Balance Sheet – Shows the total assets and liabilities of a firm as on a particular date. Balance sheet is a static concept. It tells us about the situation as on a particular date.
Income Statement – Shows the total Income, expenses and thereby the total profit or loss the firm had during a particular period. Income Statement is a flow concept wherein it tells you the performance for a particular period eg: a quarter (i.e. 3 months) or annual (i.e. a year) etc.
Cash Flow Statement – records all the cash inflow and outflow during a particular period. Cash Flow Statements don’t follow accrual accounting but are made according cash accounting principles. We will discuss Cash Flow Statements in details in later write-ups.
Accounting System – The Process
- Classify/characterise the accounts involved in a transaction.
- Pass the journal entries
- Prepare ledger Accounts.
- Prepare a trial balance.
- Prepare financial Statements – Income Statements, Balance Sheets and Cash Flow Statements.
3 Idiot & Co – Transactions for the 1st Three Months:
Let us look at the transactions that 3 Idiots & Co did for the 1st Three months and how the transactions are reported all the way up-to preparation of the Financial Statements.
- Purchased 250 T Shirts @ Rs. 100 Each – Rs. 25,000.
- Sold 250 T-Shirts @ 300 Each – Collected Cash – Rs. 75,000
- Expenses paid in cash – Rs. 15,000
- Paid interest to Virus – Rs. 300 ( 10,000 * 12% *3/12)
Let’s see the journal entries and Ledger entries for the transactions:
- Purchased 250 T Shirts @ Rs. 100 Each – Rs. 25,000. After the journal entries, the respective ledger accounts are updated. In this transaction it is Purchases and Cash Account.
2. Sold 250 T-Shirts @ 300 Each – Collected Cash – Rs. 75,000. After the journal entries, the respective ledger accounts are updated. In this transaction, it is Sales and Cash Account.
3. Expenses paid in cash – Rs. 15,000. After the journal entries, the respective ledger accounts are updated. In this transaction, it is Expenses and Cash Account.
4. Paid interest to Virus – Rs. 300 ( 10,000 * 12% *3/12). After the journal entries, the respective ledger accounts are updated. In this transaction, it is interest and Cash Account.
After a particular period, trial balance is prepared to detect any mathematical or recording error in ledgers. Trial Balance just notes down all the ledgers and their Debit & Credit balances.
Preparation of the Profit & Loss Account:
The Profit and Loss Account records all the Sales and expenses. Sales/Income – Expenses = Profit.
After preparing the Profit and Loss Statement we will prepare the Balance Sheet as on that day. The Profit or loss is transferred to the Liability side of the Balance Sheet. (Profit or loss belongs to the owners of the business. Profit is a liability for the business, payable to the owners of the business).
Thus in this manner, the 3 Idiots & Co prepare their Profit and Loss as well as a Balance sheet for the 1st Three months of running their business.