ANNEXURE C. Although financial accounting systems had been a part and parcel of companies,

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1 ANNEXURE C C1. Principles of Accounting Although financial accounting systems had been a part and parcel of companies, engineers who are largely involved in management programs are seldom exposed to the methods of accounting. Hence it is thought necessary to describe briefly the traditional accounting procedures followed in companies in this section. Though there are various standards available throughout the world, proper book keeping forms the heart of any accounting system. The English method of book keeping of financial transactions is briefly illustrated here. Each financial transaction is posted in accounts following double entry method. According to this method each financial transaction is entered in two accounts. Further, all accounts will have two major columns. The left side column is called as debit column and the one at the right hand side is called as credit column. Fundamentally accounts are classified into three types namely Nominal, Personal and Real accounts. The nominal accounts are meant for accounting expenditure and gains. The personal accounts are used for accounting transactions involving individual persons. Financial transactions involving non-movable properties are accounted in real accounts. For posting the details in accounts, conventionally certain rules are followed which are presented in Table C1. After posting the details in accounts the extracts are drawn and checked whether the debit and credit sides tally. This process is known as trial balancing. Error if any is rectified while tallying. Nominal accounts Debit the expenses Credit the gains Personal accounts Debit the receiver Credit the giver Real accounts Debit what comes in Credit what goes out Table C1-Accounting Entry Rules (English Approach) Cl

2 After this process, trading, profit and loss accounts are prepared to identify whether the company has earned financial profit or lost financially. In the case of nonprofit organizations, instead of these accounts only Income and Expenditure Account is prepared. In both cases finally financial profit or loss is extracted. This will be utilized to develop Balance Sheet, which contains the details of liabilities on the left side and the assets on the right hand side. These form the final document of financial accounting which is meant to project the financial status of the company. The financial accounting documents do not reveal the value of apparent financial performances such as work culture, motivation, employee attitude, etc. The details of Income and Expenditure Account and Balance Sheet are presented in this chapter. C2. Income and Expenditure Account A Receipts and Payments account is a summary of cash transactions for a given period. It commences with the opening of cash in hand or at the bank, and debited with all sums actually received, and credited with all cash paid away during the period to which the account relates, whether or not they have accrued during that period, and whether they are of a capital or revenue nature. The final balance is the balance of cash in hand, or the credit or debit balance at the bank, as the case may be, at the end of the period. An Income and Expenditure Account is, in effect, the Profit and Loss Account of a non-trading concern. It contains only items of a revenue nature, being debited with all expenditure, and credited with all income, which relates to a particular period, whether or not it has actually been paid or received within that period. The final balance of an Income and Expenditure Account represents the excess of income over expenditure, or the excess of expenditure over income, as the case may be, for the period in question. This balance is analogous to the net profit or loss of a trading concern. Receipts and C2

3 Payments Accounts and Income and Expenditure Accounts are used commonly by such non-trading concerns such as social clubs, societies, etc., for the purpose of presenting their financial position to their members. The Profit and Loss account of a non-trading business, such as that of a professional firm, or of a property or investment company, is also often called an Income and Expenditure Account. It cannot be too strongly emphasized that a Receipts and Payments Account is not a proper substitute for an Income and Expenditure Account, since it deals only with cash transactions, and is not confined to those actually relating to the period covered by the account, or to transactions of a revenue nature, which alone must be considered in ascertaining the surplus or deficit of income accrued but outstanding at the end of the period, or of expenditure or liabilities due but unpaid. The final balance represents the balance of cash in hand or at the bank, or the amount of the bank overdraft, and nothing more. It will be appreciated that where, for example, fixed assets have been sold and the proceeds received, or revenue has been collected, but a considerable amount of expenses or other liabilities remains unpaid, there may be a substantial cash balance when, in fact, income for the period has been overspent. In order to prepare an Income and Expenditure Account from Receipts and Payments Account, it is merely necessary to post all items of a revenue nature appearing in the Receipts and Payments Account to the opposite sides of the Income and Expenditure Account, after making such adjustments as may be necessary to give effect to accruals and prepayments at the beginning and end of the period respectively. Thus, such items as subscriptions, entrance fees, income from investments, etc., which have been received in cash and debited to the Receipts and Payments Account, must be credited to the Income and Expenditure Account. Items of a capital nature appearing in the Receipts and Payments Account will be posted to the debit or credit, as the case C3

4 may be, of the relevant asset or liability accounts, and will not affect the Income and Expenditure Account. The Balance Sheet of a non-trading concern is prepared in the usual way, and contains particulars of all the assets and liabilities at the date as at which it is made up. The excess of the assets over liabilities is analogous to the capital of a trader, but is usually called the Accumulated Fund, or General Fund, since it is normally made up of the excess of income over expenditure which has been accumulated within the concern. Separate accounts should be kept for funds raised for special purposes. A variation of an Income and Expenditure Account is a Receipts and Expenditure Account. This is a revenue account similar in form to an Income and Expenditure Account, in which, however, credit is taken only for income actually received. Accrued income, which has not been received in cash, is ignored, although all expenditure for the period, whether paid or outstanding, is debited. Such an account is frequently prepared by professional business, such as those of solicitors, where it is desired to take no credit for income until it is actually realized, but at the same time to provide for all expenditure, whether paid or not. The balance of the account represents the most prudent estimate of the profit for the period. C3. Balance Sheet A Balance Sheet may be defined as a statement prepared with a view to measure the exact financial position of a business on a certain fixed date. It is prepared from the Trial Balance, after all the balances on Nominal Accounts are transferred to the Trading and Profit and Loss Account and the corresponding Accounts in the Ledger are closed. The balances now left in the Trial Balance and remaining open in the Ledger represent C4

5 either Personal Accounts or Real Accounts. In other words, they represent either Assets or Liabilities existing at the date of the financial close. All such Assets and Liabilities are set out in the Balance Sheet in a classified form. On the right-hand side are shown the various Assets or possessions of the business, and on the left-hand side, the various Liabilities, i.e. the amounts owing by the business. The excess of Assets over Liabilities then represents the then Capital of the owner. This figure of Capital must tally with the closing balance of the Capital Account in the Ledger after the net profit or loss has been transferred thereto. C3.1. Balance Sheet Includes Profit As the balance of profit and Loss Account is transferred to the Capital Account, and as the closing balance on the Capital Account is shown in the Balance Sheet, it is clear that the Balance Sheet shows the position inclusive of the profit or loss made during the trading period. C3.2. Balance Sheet Must Reflect True Position It is important to note that if the Balance Sheet is to reflect the true financial condition of a business, it must be drawn up most carefully. For this purpose, every Asset should be brought in at its true worth and every Liability properly inserted. Even the balance of Profit and Loss Account included therein should be correctly arrived at. It must be further understood that in as much as the figure of net profit or net loss as shown by the Profit and Loss Account ultimately finds its place in the Balance Sheet, both these statements of Final Accounts are closely inter-dependent on each other. It follows, therefore, that if any item of expense or income is omitted or is over or under stated, it will not only affect the correctness of the Balance Sheet. Similarly, if any Asset C5

6 or Liability is omitted to be shown in the Balance Sheet or is over or under-valued, not only would this affect the correctness of the Balance Sheet, but would equally falsify the net resultant Profit or Loss as disclosed by the Profit and Loss Account. C4. Types of Assets From the above, it is clear that all assets must be properly valued for the purpose of being included in a Balance Sheet. Assets are mainly divided into two classes, (1) Fixed Assets, and (2) Floating Assets. Fixed Assets are Assets that are held by way of equipment and not for the purpose of resale. They are of a permanent nature and it is by their help that the business is carried on. Examples are Land, Buildings, Plant, Machinery, Tools, Furniture, etc. Floating Assets are such as are required by the business for the purpose of resale, such as Stock-in-trade, or such assets as are constantly circulating and arise out of usual business dealings. They are held temporarily for subsequent conversion into money. These are Book Debts, Bills Receivable, and Cash at Bank, etc. C5. Form of Balance Sheet The Assets and Liabilities should be grouped together and properly classified under appropriate headings, so as to convey the information in a summarized form. The Debtors and Creditors need not be shown in the shape of individual balances, but must be set out in total. Further, the balances owing by customers must be shown separately under the heading of Trade Debtors' or 'Book Debts' and must not be mixed up with Debtors for Loans or Prepaid Expenses. Similarly, Trade Creditors must be C6

7 distinguished from Creditors for Loans, or from Liabilities for Expenses. In fact, the whole of the Assets and Liabilities must be disclosed in a manner as would present a clear view of the true state of affairs to any one reading the Balance Sheet. No definite rules can be laid down as to the correct order in which the Assets and Liabilities shall appear in the Balance Sheet. It is usual, however, to start with the Fixed Assets, and follow on with the Floating Assets in the order in which they are more difficult of realization. Similarly, the Fixed Liabilities are stated first and are followed by Floating Liabilities. There are concerns, however, which prefer to reverse this order, and in Partnership Accounts, usually the assets are shown in the natural order of their realisation and the liabilities in the order in which they are payable. C7

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