Theory Base of Accounting

Definition

The Accounting Equation shows the relationship between the assets, liabilities, and capital of a business. It proves that everything a business owns was either financed by the owner or by outsiders (creditors).

The Formula

• Assets: What the business owns (Cash, Machinery, Buildings, Stock).
• Liabilities: What the business owes to outsiders (Bank loans, Creditors).
• Capital (Equity): The owner's investment in the business.

Examples

1. Starting a business: If you start a business with $10,000 cash:
   Assets ($10,000 Cash) = Liabilities ($0) + Capital ($10,000)
2. Buying on credit: If you buy a laptop for $1,000 on credit:
   Assets ($11,000) = Liabilities ($1,000) + Capital ($10,000)

Real-Life Connection

Imagine you want to buy a car worth $20,000. You have $5,000 in your pocket (Capital) and you take a loan of $15,000 (Liability). Your "Asset" is the car ($20,000). This is exactly how a company looks at its balance sheet!

A. Traditional Approach (Golden Rules)

This classifies accounts into three types:

• Personal Accounts: (Relating to persons/firms) $\rightarrow$ Debit the Receiver, Credit the Giver.
• Real Accounts: (Relating to assets/properties) $\rightarrow$ Debit what comes in, Credit what goes out.
• Nominal Accounts: (Relating to expenses, losses, income, gains) $\rightarrow$ Debit all expenses and losses, Credit all incomes and gains.

B. Modern Approach (The DEALER Rule)

Use the acronym DEALER to remember which accounts increase with a Debit or Credit:

Examples

• Paying Rent (Expense): Rent increases $\rightarrow$ Debit Rent; Cash decreases $\rightarrow$ Credit Cash.
• Receiving Commission (Revenue): Cash increases $\rightarrow$ Debit Cash; Commission increases $\rightarrow$ Credit Commission.

Meaning

• Capital Transactions: Long-term in nature; they affect the earning capacity of the business.
• Revenue Transactions: Short-term, day-to-day operational expenses or incomes.

A. Vouchers

A Voucher is documentary evidence of a transaction (like a bill, receipt, or invoice). Without a voucher, an accountant cannot record a transaction.

B. Books of Original Entry

1. Journal: The "Diary" of the business. Every transaction is recorded here first in chronological order.
   • Process: Transaction $\rightarrow$ Voucher $\rightarrow$ Journal Entry.
2. Ledger: The "Summary." Entries from the Journal are posted into individual accounts (e.g., Cash A/c, Sales A/c). This is called Posting.

C. Special Purpose Books (Subsidiary Books)

As businesses grow, they use specialized books to avoid clutter:

• Cash Book: Specifically for cash and bank transactions.
• Purchase Book: Only for credit purchases of goods.
• Sales Book: Only for credit sales of goods.
• Returns Books: Purchase Return and Sales Return books.

Meaning

A BRS is prepared to match the difference between the balance in the Cash Book (maintained by the business) and the Passbook/Bank Statement (maintained by the bank).

Common Reasons for Differences

• Timing Differences: Cheques issued but not yet presented for payment.
• Bank-only entries: Bank charges, interest credited, or direct deposits by customers.
• Errors: Mistakes made by either the accountant or the bank.

Numerical Illustration

Step-by-Step Solution:
1. Cash Book Balance:      $10,000
2. Add: Cheque issued but not presented: +$2,000
3. Less: Bank charges:      -$500
-------------------------------------------
Reconciled Balance:        $11,500
          

1. The Accounting Equation is:
   a) Assets = Liabilities - Capital
   b) Assets = Liabilities + Capital
   c) Capital = Assets + Liabilities
   Answer: (b)
2. Which of these is a Real Account?
   a) Salary A/c
   b) Bank A/c
   c) Ram's A/c
   Answer: (b)
3. Purchasing machinery is a ________ expenditure.
   a) Revenue
   b) Capital
   c) Deferred Revenue
   Answer: (b)
4. The process of transferring entries from Journal to Ledger is called:
   a) Balancing
   b) Journalizing
   c) Posting
   Answer: (c)
5. A Bank Reconciliation Statement is prepared by:
   a) The Bank
   b) The Account Holder (Business)
   c) The Auditor
   Answer: (b)
6. Which book records credit purchases of goods?
   a) Cash Book
   b) Purchase Book
   c) Purchase Journal (for assets)
   Answer: (b)
7. "Debit the receiver, Credit the giver" applies to:
   a) Real Accounts
   b) Personal Accounts
   c) Nominal Accounts
   Answer: (b)
8. Bank charges recorded in the Passbook but not in the Cash Book will:
   a) Increase Cash Book balance
   b) Decrease Cash Book balance
   c) Have no effect
   Answer: (b)
9. The first book of entry is:
   a) Ledger
   b) Journal
   c) Trial Balance
   Answer: (b)
10. Drawings are a type of:
    a) Asset
    b) Liability
    c) Reduction from Capital
    Answer: (c)

1. Q: Distinguish between Journal and Ledger.
   A: Journal is the book of original entry where transactions are recorded chronologically. Ledger is the book of final entry where transactions are classified into specific accounts.
2. Q: Why is the Accounting Equation always balanced?
   A: Because of the Dual Aspect Concept, which states that every transaction affects at least two accounts, ensuring that total resources (Assets) always equal total claims (Liabilities + Capital).
3. Q: What is a Voucher? Why is it important?
   A: A voucher is a written document that serves as evidence of a transaction. It is important for auditing and ensuring the authenticity of entries.
4. Q: Explain the Modern Approach to Debit and Credit.
   A: Use the DEALER rule: Increases in Assets, Expenses, and Drawings are Debited. Increases in Liabilities, Equity, and Revenue are Credited.
5. Q: How do you treat "Cheques issued but not presented" in BRS (starting from Cash Book balance)?
   A: Add them to the Cash Book balance because the bank has not yet deducted the money, making the bank balance higher.
6. Q: Give two examples of Revenue Expenditure.
   A: 1. Payment of wages to workers. 2. Repair and maintenance of machinery.
7. Q: What are Special Purpose Books?
   A: These are subsidiary books used in large businesses to record specific types of transactions (like Sales, Purchases, or Cash) to avoid cluttering the Journal.
8. Q: If Assets = $50,000 and Liabilities = $20,000, find Capital.
   A: Capital = Assets - Liabilities $\rightarrow$ $50,000 - $20,000 = $30,000.
9. Q: What is the difference between a Single Column Cash Book and a Double Column Cash Book?
   A: A Single Column Cash Book only records cash transactions. A Double Column Cash Book records both cash and bank transactions.
10. Q: Why does a Bank Reconciliation Statement sometimes show a difference?
    A: Due to timing differences (e.g., unpresented cheques) or omissions (e.g., bank charges) by either the business or the bank.

• Accounting Equation: Assets = Liabilities + Capital.
• DEALER Rule: Drawings, Expenses, Assets (Debit ↑) | Liabilities, Equity, Revenue (Credit ↑).
• Journal vs Ledger: Journal is chronological; Ledger is classified.
• BRS: Matches Cash Book with Bank Passbook.

Mnemonic for Golden Rules:
Personal $\rightarrow$ Person (Receiver/Giver)
Real $\rightarrow$ Real things (In/Out)
Nominal $\rightarrow$ Name of expense/income (Exp/Inc)