Compound means a thing that is composed of two or more separate components. Similarly, when used in accounting, a compound journal entry means a journal entry which includes multiple accounts that are either debited or credited, unlike a simple journal entry which only includes 1 debit and 1 credit.
In other words, an entry which has more than one account in debit, credit, or both is termed as a compound journal entry.
Explanation with Example
On January 7, YYYY, 9,500 received in cash from Unreal Pvt Ltd. as the full and final settlement of their account worth 10,000. (Allowed a discount of 500)
Date
Particulars
LF.
Debit
Credit
Type of Account*
Rule Applied*
7 Jan YYYY
Cash A/C
9500
Real A/C
Dr. What comes in
Discount Allowed
500
Nominal A/C
Dr. All losses
To Unreal Pvt Ltd.
10,000
Personal A/C
Cr. The giver
*Used for the explanation purposes.
In the above example of a compound journal entry, there are 2 accounts being debited and 1 account being credited. There are other examples of such entry where you will find more debits than credits or multiple accounts being credited and debited at the same time and so on. It all depends on the complexity of a transaction.
As per the accounting cycle, preparing a trial balance is the next step after posting and balancing ledger accounts. It is a statement of debit and credit balances that are extracted on a specific date.
It is made as an attempt to prove that the total of ledger accounts with a debit balance is equal to the total of ledger accounts with a credit balance. As the name suggests, it is an actual “trial” of the debit and credit balances, they should be equal.
A journal and a ledger are maintained according to the double-entry concept of accounting. In a trial balance, the sum of debits and credits must match.
It acts as a base to create the final accounts of a business such as an Income statement, a Trading A/C, and a Balance Sheet.
To prepare a trial balance it is important to ensure the arithmetic conceptual accuracy. Due to the dual aspect of accounting, the sum of total credits should be equal to the sum of total debits.
Due to its accuracy, tallied Trial Balances offer significant peace of mind regarding the accuracy of ledger balances.
It acts as a summarized form of all ledger balances, in case the debit and credit balances do not match then it is concluded that there is some error and the difference is temporarily transferred to a “Suspense A/C” and corrected afterwards.
Auditors may decide to use it and transfer the account balances onto their auditing software. They can then perform various different kinds of inspections.
Debit and Credit Accounts
In order to provide a summary statement view of the balances of various accounts, the trial balance is prepared. This also indicates the correct nature of the balances of different accounts. A general rule to follow here is;
Assets & Expenses shall have a Debit Balance.
Liabilities & Incomes shall have a Credit Balance.
The reason or logic behind the above rule is to keep the accounting equation in balance and this is the convention commonly followed. The accounting equation is A = L + E, or assets equal liabilities plus equity. The concept is based on the understanding that all assets of a business are either the financial right of the creditors (liabilities) or the owner (equity) in different proportions.
To balance the equation, a double-entry system with debits and credits is used. A debit increases the asset balance while a credit increases the liability or equity. This is required because they are on different sides of the accounting equation. This results in the majority of asset accounts having debit balances, and the majority of liability and equity accounts having credit balances.
Also, expenses cause the owner’s equity to decrease. Since the owner’s equity’s normal balance is a credit balance, an expense must be recorded as a debit. Similarly, incomes cause the owner’s equity to increase, and hence an income is recorded as a credit.
The following are a few examples of different accounts and their natural balance. Items that appear on the debit side of the trial balance:
Land and Buildings
Plant and Machinery
Furniture and Fixtures
Office Tools and Equipment
Cash at Bank
Cash in Hand
Motor Van
Loss from the sale of fixed assets
Travelling charges
Printing and postage expenses
Items that appear on the credit side of the trial balance:
Capital Account
Sundry Creditors
Bank Overdraft/Loan
Bills Payables
Sales (Revenue)
Purchase Returns
Common stock
Un-earned revenues
Retained earnings
Interest Received
Trial Balance and Balance Sheet
A Trial balance is a summary of balances of all accounts recorded in the ledger. It is prepared at the end of a particular period to indicate the correct nature of the balances of various accounts. A balanced trial balance ascertains the arithmetical accuracy of financial records.
A balance sheet is a statement that represents the financial position of a business on a particular date. All assets and liabilities are presented in the balance sheet in a classified form. Thus, it is a summary of the complete accountancy record. A balance sheet helps the user quickly get a handle on the financial strength and capabilities of the business along with its weaknesses.
Both the trial balance and the balance sheet are very crucial to the financial statements as a whole as they serve different purposes. A Trial balance is used-
To check the arithmetical accuracy of the ledger accounts
To locate errors in recording
To provide a basis for preparing the financial statements
A Balance sheet is used-
To know the actual financial standing of a business on a given day
To ascertain and identify the trends in a business
To project and make provisions for future probable setbacks
A trial balance and a balance sheet may seem similar as they both are the description of accounts and not the accounts themselves. Both are statements and are prepared at a particular point in time. But, they are actually very different as explained in the following table:
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When a business is small there is only one general ledger that is maintained. As the size of the business increases, the number of accounts also grow along with that. New subledgers are created under the general ledger accounts, these subsets of the general ledger are called subledger.
Similar types of accounts are grouped together and their representative account is shown in the general ledger. Few examples include accounts receivable,accounts payable, property, etc.
Example
Let’s take an example of the general ledger control account “Accounts Receivable”, which is made up of the following individual debtors of the business:
(AR1) + (AR2) = Accounts Receivable A/C (To be shown in GL)
So, one can imagine a big multinational corporation where hundreds and thousands of debtors, creditors, etc. are not uncommon. It becomes almost impossible to maintain one single ledger.
Hence, creating such subsets is the best possible option to not only maintain the data efficiently but also for calculations and quick access to information on an individual level.
It is also known as the principal book of accounts as well as the book of final entry. It is a book in which all ledger accounts and related monetary transactions are maintained in a summarized and classified form. All accounts combined together make a ledger and form a permanent record of all transactions.
It is the most important book of accounting as it helps in the creation of trial balance which then acts as a base for the preparation of financial statements.
Example:An account can be either an Asset, Liability, Capital, Revenue or an Expense account. Few examples of each are Furniture, Cash, Creditors, Bank Loan, Capital, Drawings, Sales, Rent, etc.
It is shown in “T” format and divided into 2 columns: the left-hand side represents the debit side and the right-hand side represents the credit side.
The process of transferring a transaction from a journal to a ledger account is called Posting. It is an essential task as it summarizes all transactions related to that account at one place.
Posting is made to accounts from journal entries and various subsidiary books.
Account Types and their Balances
Type of Account
Normal Balance
Assets
Debit
Liabilities
Credit
Capital
Credit
Revenue
Credit
Expenses
Debit
Drawings
Debit
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Liabilities are obligations a business owes to external or internal parties. As per the accounting equation liabilities are equal to the difference between assets and capital. For example, if Business A sells goods to Business B on credit, the amount owed by B to A is treated as a liability.
Internal Liability – All obligations which a business has to pay back to internal parties such as promoters (owners), employees etc. are termed as internal liabilities. Examples – Capital, Salaries, Accumulated profits, etc.
External Liability – All obligations which a business has to pay back to external parties i.e. lenders, vendors, etc. are termed as external liabilities. Example – Borrowings, Creditors, Taxes, Overdrafts, etc.
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Journal is the primary book of accounting where daily records of business transactions are first recorded in chronological order, i.e. in the increasing order of dates.
In case of a large business where the number of transactions is substantially more, it is divided into various subsidiary books; such as cashbook, sales book, purchase book, B/R book, B/P book, etc.
It is also called the book of original or first entry. It is a preliminary record where business transactions are first entered into the accounting system. This stage is also known as the original record stage & marks the beginning of a double-entry accounting system.
Sample Format & Template
Recording a transaction in a journal using an accounting entry is called Journalizing. It records both the debit and credit side of a business transaction.
The entry of a business transaction recorded in the journal is called a Journal Entry. It shows details of a transaction in a summarized form.
The act of transferring an accounting entry from a journal or a subsidiary book into a ledger account is called Posting.
Nowadays, for businesses and big corporations the entries carry over several pages, hence the totals are mentioned at the end of each page in front of the debit and credit columns.
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Both bookkeeping and accounting are used interchangeably in the financial world, however, there is a notable difference between bookkeeping and accounting. Bookkeeping is a part of accounting whereas accounting itself is a wider concept.
Definition of Bookkeeping – Literally, it means the activity of keeping (or maintaining) financial books, i.e. recording financial transactions & events. The books referred to, in this context, are the books of accounts. This involves extensive data input. Few activities under book-keeping are;
The input of invoice and voucher details into ERP systems.
Receiving and recording payments by customers.
Making and recording payments to vendors.
Efficiently processing payroll information, etc.
Definition of Accounting – Accounting, on the other hand, is the process that includes recording, classifying, summarizing, and interpreting the financial information of an economic unit. The economic unit is considered as a separate legal entity. Accounting information is widely used by various types of parties for several different reasons. Few activities under accounting are;
Preparation of a trial balance, ledger accounts, etc.
Difference between Bookkeeping and Accounting (Table)
Bookkeeping
Accounting
Definition
1. Bookkeeping is mainly related to the process of identifying, measuring, recording, and classifying financial transactions.
1. Accounting is the process of summarizing, interpreting, and communicating financial transactions that were classified in the ledger account as a part of bookkeeping
Stage
2. It is the beginning stage and acts as a base for accounting
2. Accounting begins where bookkeeping ends.
Management Decisions
3. Management can not make decisions based on bookkeeping.
3. Management can make decisions based on accounting.
Objective
4. The objective of bookkeeping is to keep proper and systematic records of financial transactions.
4. The objective of accounting is to ascertain the financial position and further communicate the information to the relevant parties.
Financial Statements
5. Financial statements are not prepared during bookkeeping.
5. Financial statements are prepared on the basis of records obtained through bookkeeping.
Skill Level
6. Bookkeeping doesn’t require any special skills as it is mechanical in nature.
6. Accounting, on the other side, requires special skills due to its analytical and somewhat complex nature.
Duties of a Bookkeeper & Accountant
In light of the above discussion, it can be established that there is a usual overlapping between the roles of a bookkeeper and an accountant. It can be hard at times to clearly distinguish the two but the generally accepted convention is that the bookkeeper contributes to the early stages of the common accounting cycle, while an accountant contributes to the latter stages.
Duties of a Bookkeeper
To look out for financial data and identify economic transactions for a business.
To distinguish between material economic activities and immaterial economic activities.
To record events measured in monetary terms, in an orderly manner in a journal or other subsidiary books.
To properly maintain the required books of original entry.
To produce required bills and invoices with reference to transactions.
To post all debits and credits in the general ledger.
To classify all transactions in a systematic manner.
To balance and reconcile all the accounts in the books of accounts.
To summarize the balances in an accurate trial balance.
To prepare the bank reconciliation statement.
To follow and report on budgetary compliance.
To follow due diligence in following the generally accepted conventions of recording and maintaining books of accounts.
Duties of an Accountant
To examine the recorded transactions in order to check the efficiency of the records.
To suggest adjustment entries if any error is present in the bookkeeping process.
To analyze the trial balance in order to prepare the financial statements.
To prepare the Trading as well as Profit and Loss account to capture the profitability of the business.
To prepare the Balance Sheet to reflect the financial position of the business.
To estimate the cost of operations and revenue generated for the business.
To gauge the income tax and other compliance-related requirements of the company.
To interpret the financial statements in a way that can be useful for business decision making by the owners and other stakeholders.
To communicate necessary accounting information to the internal as well as the external users.
To provide consultation and insights to the owners to help them make an informed decision.
The most accepted definition of an audit is given as an evaluation of a personal organization, process, system, or business. The term is most ordinarily used with respect to audits in accounting, and sometimes in project management, legal departments, and financial management also. In other words, an audit is a necessarily unbiased analysis or examination of an organization’s statements. The audit can be both internal as well as external.
Auditing vs Bookkeeping
Auditing starts after the accounting cycle is completed. It is not a part of traditional bookkeeping and/or accountancy. Bookkeeping and auditing are similar in the way that both of them deal with the financial records of the business involved. Also, the utmost care and due diligence is the way to go for both a bookkeeper as well as an auditor. The Bookkeeper works for the organization, while an auditor can be external or internal.
Despite all this, auditing is a completely different process when compared to bookkeeping. The basic difference between the two lies in the tasks involved and the objective of performing the two activities.
Bookkeeping is the process of maintaining the records of the business and making sure that all requirements are fulfilled. On the other hand, auditing involves doing analytical and backtesting on the records to establish authenticity.
Bookkeeping is done with the simple purpose of recording all material economic activities of a firm in a uniform manner so that it can form the base for decision making. On the other hand, auditing is performed with the objective of evaluating the truthfulness and fairness of the records.
Accountancy vs Accounting vs Auditing
Accountancy and accounting are used interchangeably. In-depth analysis shows that while accounting refers to the steps in the accounting process like recording, classifying, summarizing, etc, accountancy is used to denote the overall duties or functions performed by an accountant.
Accountancy and auditing are also related in the same fashion. Accountancy starts where bookkeeping ends while auditing is performed after accountancy is complete. Both of them are similar in a way that they both have to rely on the records as maintained by the bookkeeping. Both accountancy and auditing are analytical in nature and are performed to make the most of the financial records. The techniques and tools are different in both cases, however.
Accountancy involves summarizing and interpreting financial data to facilitate informed decision making. Auditing is the process of checking and ensuring that financial records are reliable.
Accountancy is very detailed and generally tries to not miss any detail. If a detailed audit is not being performed, an auditor will usually rely on random samples of financial information.
Accountancy is governed by accounting standards while auditing is governed by legal acts that are not very flexible in their approach.
An accountant is generally appointed by the management and will be paid a salary. An auditor on the other hand may be appointed by some external authority also and will be paid a specific fee.
Difference Between Bookkeeping and Accounting (PDF)
Download PDF to see the comparison between bookkeeping and accounting.
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Petty Cash Book is an accounting book used for recording cash expenses which are small and of little value, for example, stamps, postage and handling, stationery, carriage, daily wages, etc.
These are expenses which are incurred day after day; usually, petty expenses are large in quantity but insignificant in value. To record such expenses, a different book known as a petty cash book is maintained. It may be maintained by ordinary or by the imprest system.
Ordinary system
As part of the normal process of petty cash management, the petty cashier receives an appropriate amount of money.
When the petty cashier spends the amount, he or she submits the account to the head cashier for approval.
Imprest system
The word “imprest” means – A fund that a business uses for small expenditures and usually restores to a fixed amount after a period of time. Imprest system refers to paying an advance at the start and reimbursing the amount spent from time to time.
An Imprest system is where an estimate is made of the amount required to cover small expenses for a given period (for example, a month, quarter, etc.) and the same amount is advanced to the petty cashier as the opening balance.
It is then used by him/her to manage all petty expenses and make the required payments. At the beginning of a new period, the money is replenished when it has been spent. This amount is called imprest money.
Advantages of the Imprest System
Better Accuracy: At regular intervals, the cashier checks the petty cash book to ensure that any mistakes are quickly corrected.
Expense Management: Because petty cash cannot be spent beyond the available petty cash, petty expenses are kept within the limits of imprest.
Fraud Management: As the petty cashier is prohibited from drawing cash as and when we desire, misuse of cash can be minimized.
Type 1 – Simple Petty Cash Book
This type of book is maintained just like a cash book. Any cash, which the petty cashier receives, will be recorded on the debit side (left) cash column of the book and any cash which he pays out will be recorded on the credit side (right) cash column of the book.
Considered the most beneficial method of recording petty cash payments. In the analytical version, a separate column is used for each commonly occurring item of expenditure such as stamps, postage & handling, stationery, wages etc.
A column for “sundries” is usually added for miscellaneous payments. When a petty expense is recorded on the right-hand side of the book, the same amount is also recorded in the proper expense column.
Simple Petty Cash Book Vs Analytical Petty Cash Book
Simple Petty Cash Book
Analytical Petty Cash Book
There is no separate record for each type of petty expense.
In the analysis column, each item of expense that occurs frequently is listed.
It is difficult to determine the total expenses under different headings at the end of the period.
It is easy to determine expenses under different headings at the end of the period.
In a similar way to a cash book, each page is divided down the middle.
A large portion of the page is provided for expenses, with separate columns for expenses incurred on a regular basis.
Advantages of the Petty Cash Book
Efficiency: This book helps to save the time of the chief cashier.
Control: Managing small payments is easier with the help of this book.
Reduces Effort: As these entries are not recorded in the cash book and posted into the ledger, redundant and extra work is saved.
Ledger Accounts Prepared Easily: Only the totals are taken and posted in the ledger. Information that is unnecessary & trivial is omitted which helps in direct posting to the ledger.
Balancing of a petty cash book is done at the end of an accounting period. The columns for “payments” and “expenses” are totalled and it equals the total in the “Total Payment” column.
In the analytical type petty cash book, the closing balance (balance c/d) then becomes the opening balance (balance b/d) of the next period.
Petty Cash Journal Entry
(Entry 1) – When the amount is advanced to the petty cashier
Petty Cash A/c
Debit
Debit the increase in asset
To Cash A/c
Credit
Credit the decrease in asset
(Entry 2) – When petty cashier submits expense accounts
Expense 1 A/c
Debit
Debit the increase in expense
Expense 2 A/c
Debit
Debit the increase in expense
Expense 3 A/c
Debit
Debit the increase in expense
To Petty Cash A/c
Credit
Credit the decrease in asset
(Each expense is debited with its respective amount)
Posting
Each item in the book of petty expenses is posted in the ledger accounts at the end of a specific period which is pre-decided (usually – weekly, bi-weekly, monthly, or quarterly)
Ledger entry for each expense is not directly posted instead a petty cash account is maintained in the firm’s ledger.
In the ledger book, each petty expense account is kept separately.
Example to Show Ledger Posting
The petty cashier submitted the below expenses with their respective amounts for the current period amounting to 900. The cashier was advanced 1,000 as petty cash for the period. Post appropriate entries into individual ledger accounts.
Jan 3 – Entry at the start of the period when cash is handed over to the petty cashier,
Petty Cash A/c
1,000
To Cash A/c
1,000
The chief cashier records petty cash advances to the petty cashier on the credit side of the cash book as “By Petty Cash A/c”. In this case, the entry would for 1,000.
Jan 9 – Entry for each expense at the time of submission of accounts by the petty cashier,
Stationery A/c
500
Cartage A/c
300
Postage A/c
100
To Petty Cash A/c
900
To pass the journal entry for total expenses paid, individual petty expenses are debited and credited to Petty Cash Account. A separate account is maintained for each petty expense.
(Solution)
Stationery A/c
Date
Particulars
Amount
Date
Particulars
Amount
Jan 9
To Petty Cash A/c
500
Journal entry posted in the Stationery account on the debit side by writing “To Petty Cash A/c”.
Cartage A/c
Date
Particulars
Amount
Date
Particulars
Amount
Jan 9
To Petty Cash A/c
300
Journal entry posted in the Cartage account on the debit side by writing “To Petty Cash A/c”.
Postage A/c
Date
Particulars
Amount
Date
Particulars
Amount
Jan 9
To Petty Cash A/c
100
Journal entry posted in the Postage account on the debit side by writing “To Petty Cash A/c”.
Petty Cash A/c
Date
Particulars
Amount
Date
Particulars
Amount
Jan 3
To Cash A/c
1,000
Jan 9
By Stationery A/c
500
Jan 9
By Cartage A/c
300
Jan 9
By Postage A/c
100
Jan 9
By Balance c/d
100
1,000
1,000
Jan 10
To Balance b/d
100
Jan 10
To Cash A/c
900
Journal entries for each receipt and payment are posted in the Petty Cash Account on the debit & credit sides.
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A Cash Book is a type of subsidiary book where cash (or) bank receipts and cash (or) bank payments made during a period are recorded in a chronological order. Receipts are recorded on the debit – the left hand side, and payments are recorded on the credit – right hand side.
Entries are recorded just like a ledger account with the help of “To” and “By“. The number of cash transactions in a business is generally large, hence it is convenient to have a separate cash book to record such transactions.
In case a transaction affects both the cash and the bank account, a contra entry is recorded. There are 3 types of a cash book.
Single Column Cash Book
Also known as a simple cash book or a one column cash book, a single column cash book has one relevant column on each side which shows the simple “receipts” and “payments” of cash. Receipts are shown on the left side and the right side is for payments.
Sample Format of One Column Cash Book
Date
Particulars
LF.
Cash
Date
Particulars
LF.
Cash
Receipt Side
Receipt Side
Receipt Side
Receipt Side
Payment Side
Payment Side
Payment Side
Payment Side
Receipt Side
Receipt Side
Receipt Side
Receipt Side
Payment Side
Payment Side
Payment Side
Payment Side
Balancing
Just like any other account, it is balanced at the end of a period. The total of receipts should always be greater than the payments. The difference is mentioned on the credit side as “Balance c/d”. The balance on the debit side is then written with “To Balance b/d”, this is the beginning cash balance of a business for the next period.
Double Column Cash Book
Also known as a two column cash book, a double column cash book is the one which has a “Bank” column in addition to the regular “Cash” column. Just like the other type of books, it records receipts from cash and bank on the left side and payments – on the right side.
Sample Format of Two Column Cash Book
Date
Particulars
Cash
Bank
Date
Particulars
Cash
Bank
Triple Column Cash Book
Also called a three column cash book, a triple column cash book has “Cash”, “Bank” and “Discount Allowed” on the receipt on the left side and “Cash”, “Bank”and“Discount Received” on the payments are on the right side of the cash book. Cash discount is recorded, when payments are made in cash or by check.
Sample Format of Three Column Cash Book
Date
Particulars
Discount
Cash
Bank
Date
Particulars
Discount
Cash
Bank
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Also known as a B/P book, bills payable book is a subsidiary or secondary book of accounting where all bills of exchange, which are payable by the business, are recorded. The total value of all the bills payable for an accounting period is transferred to the books of accounts.
In a mid to large sized business where the number of bills exchanging hands is large in number, it is tough to journalize all bills drawn. All such bills are entered in an accounting ERP or a register depending on the business, furthermore, all these entries are transferred to the respective ledger accounts at a regular interval, often monthly.
A bill receivable for a “drawer” is a bill payable for a “drawee”. Bills payable account will usually have a credit balance, as it is supposed to be paid at maturity, it acts as a liability for the business. Generally, every bill has a 3-day grace period.
Sample Format of a B/P Book
The person, who draws the bill of exchange, is called a “drawer” and the customer, on whom it is drawn, is called a “drawee” or an “acceptor”.
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Also known as a B/R book, bills receivable book is a subsidiary or secondary book of accounting, where all bills of exchange, which are receivable for the business, are recorded. The total value of all the bills receivable for an accounting period is transferred to the books of accounts.
In a mid to large sized business where the number of bills exchanging hands is large in number, it is tough to journalize all receipt of bills. All the bills are entered in an accounting ERP or a register depending on the business, furthermore, all these entries are transferred to the respective ledger accounts at a regular interval.
Bills receivable account will usually have a debit balance. As a bill receivable is supposed to be received at maturity, it acts as a current asset for the business. Generally, every bill has a 3 day grace period.
Sample Format of the B/R Book
A person who draws the bill of exchange is called a “drawer” and a customer on whom it is drawn is called a “drawee” or an “acceptor”. A bill receivable for a “drawer” is a bill payable for a “drawee”.
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Journal Proper is mainly used for original records of a transaction which due to their importance or rareness of occurrence do not find a place in any of the subsidiary books of accounting. It is also known as a Miscellaneous Journal and it looks much like any other journal.
Sample Format of a Journal Proper
Types of entries that are entered in the journal proper:
As the name suggests, opening entries are recorded at the beginning of a financial period. The balances mentioned in the balance sheet of the previous year are brought forward by recording the liabilities, capital, and assets from the previous year.
Example
The rule to be applied to make an opening entry is
Assets A/C
Debit
To Liabilities A/C
Credit
To Capital A/C
Credit
Sample Format of an Opening Entry in a Journal Proper
Date
Particulars
LF.
Debit
Credit
mm/dd
Cash A/C
35,000
Furniture A/C
15,000
To Sundry Creditors A/C
24,000
To Capital A/C
26,000
All amounts mentioned in the sample format are the closing balances of the previous year balance sheet.
Closing Entries
Almost the opposite of the opening entries, they are recorded at the end of a financial period; closing entries are related to nominal accounts. These accounts are closed by transferring their balances to trading and profit and loss accounts. A record is not included in the ledger without a journal entry, so closing entries are recorded with the help of a journal proper and then recorded in the ledger.
Example
Profit & Loss A/C
Debit
To Salaries A/C
Credit
At the end of a period Salary account is closed by transferring its balance to profit and loss account.
Rectification Entries
In the world of accounting erasing or removing a journal entry once recorded is a strict NO!. Mistakes should only be corrected by passing another entry in the journal.
Example
Purchase for 10,000 was omitted by mistake, it belonged to Unreal Pvt Ltd.
Rectification entry, in this case, will be
Purchase A/C
10,000
To Unreal Pvt Ltd.
10,000
Transfer Entries
In simple terms, the transfer entry is used to transfer an item from one account into another. All such transfers are made with the help of journal entries.
Example
Let us take an example where a general reserve is created for a business by transferring 5,00,000 from the profits.
Date
Particulars
LF.
Debit
Credit
mm/dd
Profit & Loss A/C
5,00,000
To General Reserve
5,00,000
Adjustment Entries
The amount of expenses or incomes may need to be adjusted for advances paid or received at the end of a financial period, these types of adjustments are made with the help of a journal entry. They are very common at the end of an accounting period. Adjustment entries are mainly used for accrual or depreciation related entries.
Example
There are outstanding wages of 50,000 which need to be accounted for
Date
Particulars
LF.
Debit
Credit
mm/dd
Wages A/C
50,000
To Outstanding Wages A/C
50,000
Miscellaneous or Other Entries
In addition to the above entries, there are other entries that can be recorded in a journal proper. They are:
Discount allowed and received
Purchase or sale of items on credit other than goods
Effects of accidents such as losses due to fire
Consignment and joint venture transactions
Endorsement and dishonour of bills of exchange
Transaction for goods distributed as samples
Sale of obsolete assets
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When a business sends the ordered goods back to a vendor it is recorded in the sales return book. At times the buyer may return goods due to poor quality, inaccurate quantity, untimely delivery or other reasons. It is also called returns inwards and an appropriate sales return or a returns inward book is maintained.
All returns are primarily recorded in the sales return book unless the returns are not that frequent, in which case they are recorded in the journal.
Sample Format of Sales Return Book
Date
Particulars
Credit Note No.
LF.
Currency
Amount
Note: A column for “Remarks” can also be added to the Sales return book which would include a brief description of the reason why the goods were returned.
When the goods are returned by the customer, a credit note will be prepared and sent out to his name. A duplicate copy is kept for recording and reference purposes. The returns inward book is totalled at the end of each month.
How to Post Entries from Sales Return Book into Ledger?
After the sales return book is properly updated and all transactions are entered into it, the total of the items is transferred to the ledger in an account called the “Sales returns account”
At the end of the day, each entry is posted to the credit side of the appropriate individual’s account in the Debtors’ledger as this helps the account to remain up to date.
At the end of the month, the total of the “Amount” column is posted to the general ledger with the help of following journal entry.
Let’s assume that total sales returns made at the end of a month are 50,000.
Returns made by A are 30,000.
Returns made by B are 20,000.
These 4 different ledger accounts will be updated from the sales returns book.
Sales Return A/C
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
To Sundry Debtors A/C
50,000
Sundry Debtors A/C
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
By Sales Returns A/C
50,000
A’s Account
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
By Sales Returns A/C
30,000
B’s Account
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
By Sales Returns A/C
20,000
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At times it may be necessary to return few goods back to a supplier when an order is received, this may be due to poor quality, inaccurate quantity, untimely delivery or other reasons. Purchase returns are also called returns outward and an appropriate purchase returns/returns outward book is maintained.
All returns are primarily recorded in the purchase returns book unless the returns are not that frequent, in which case they are recorded in the journal.
Sample Format of Purchase Returns Book
Date
Particulars
Debit Note No.
LF.
Details
Amount
Note: A column for “Remarks” can also be added to the purchase book which would include a brief description of the reason for why the goods were returned.
When the goods are returned, a debit note will be sent along with them and a debit note number is mentioned in the purchase returns book. In return, the supplier is expected to send a credit note. The returns outward book is totalled at the end of each month.
How to Post Entries from Purchase Returns Book into Ledger?
After the purchase returns book is properly updated and all transactions are entered into it, the total of the items is transferred to the ledger in an account called the “Purchase returns account”.
At the end of the day, each entry is posted to the debit side of the appropriate individual’s account in the creditor’s ledger as this helps the account to stay up to date.
At the end of the month, the total of the “Amount” column is posted to the general ledger with the help of the below-mentioned journal entry.
Journal entry for purchase returns
Creditor A/C
Debit
To Purchase Returns A/C
Credit
Example:Let’s assume that the total purchase returns made at the end of a month are for 50,000.
Returns made to A are 30,000.
Returns made to B are 20,000.
These 4 different ledger accounts will be updated from the purchase returns book.
Purchase Returns A/C
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
By Sundry Creditors A/C
50,000
Sundry Creditors
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
To Purchase Returns
50,000
A’s Account
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
To Purchase Returns
30,000
B’s Account
Date
Particulars
Amt
Date
Particulars
Amt
mm/dd
To Purchase Returns
20,000
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Sales book records all credit sales made by a business. It is one of the secondary book of accounts and unlike cash sales which are recorded in cash book, sales book is only to record credit sales. The amount entered in the sales book is on behalf of invoices supplied to purchasers, however, a copy remains with the firm.
Sales book is also called a Sales Journal or Sales Day Book.
After all the transactions are posted in sales book the business needs to post them to the related ledger accounts. Following are the steps that need to be followed to post the amounts from sales book to the ledger,
Each entry is posted to the debit side of appropriate individual account in the debtor’s ledger at the end of the day, this keeps the accounts up to date.
The column for “Total” is then summed at the end of each month & posted to the ledger.
Journal Entry for Credit Sale
Debtor’s A/C
Debit
To Sales A/C
Credit
Example
Let’s say total sundry debtors at the end of a month are 50,000 where credit sales made from A is 30,000 & B is 20,000 during the period.
Here are the 4 ledger entries that will be recorded,
Sales Account
Date
Particulars
Currency
Date
Particulars
Currency
mm/dd
By Sundry Debtors per Sales Book
50,000
Sundry Debtors Account
Date
Particulars
Currency
Date
Particulars
Currency
mm/dd
To Sales A/C
50,000
A’s Account
Date
Particulars
Currency
Date
Particulars
Currency
mm/dd
To Sales A/C
30,000
B’s Account
Date
Particulars
Currency
Date
Particulars
Currency
mm/dd
To Sales A/C
20,000
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It is also known as a Purchase journal, Invoice book or Purchase daybook. A purchase book is a special-purpose subsidiary book prepared by a business to record all credit purchases. Nowadays all these recordings occur in ERPs and only small firms resort solely to notebooks or MS Excel.
A few things to note are,
Purchases recorded are only for goods or items related to core business operations of a company i.e. goods procured for resale.
Example – If a grocery business purchases office furniture it will not be posted in the purchases book as it is considered as a “purchase of an asset” and not goods.
Cash purchases are recorded in the cash book and credit purchases are recorded in the purchase book.
A reduction granted by a supplier of goods/services on list or catalogue price is called a trade discount. This is done due to business consideration such as trade practices, large quantity orders, etc.
It is not separately shown in the books of accounts; entries recorded in purchase book or sales bookare recorded as the net amount, i.e. Gross Amount – Trade Discount.
It is mainly provided to increase the volume of sales attained by a supplier. It is also known as a functional discount.
Example
Let’s assume that 100 keyboards are sold for the list price of 300 each with a trade discount of 10%.
100 Keyboards X 300 each
30,000
Less 10% of 30,000
30,000 – 3000 = 27,000 (Net Amt)
It is not shown separately instead Net amount is used in the financials.
It is generally recorded in the purchases or sales book, but it is not entered into ledger accounts and there is no separate journal entry. However, here is an example demonstrating how a purchase is accounted in case of trade discount.
Let’s assume that 10 tables are purchased from Unreal Pvt Ltd. at the list price of 3000 per item and 10% discount (trade) is allowed. Accounting for the transaction will happen as follows:
Total list price = 10 x 3000 = 30,000
Less (T.D) = 10% of 30,000 = 3000
Amount to be recorded = list price – discount = 30,000 – 3000 = 27,000
Purchase A/C
27,000
To Unreal Pvt Ltd.
27,000
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A cash discount is a deduction allowed by the supplier of goods or by the provider of services to the buyer from the invoice price. This is done as an incentive in return for paying a bill within a specified time.
Usually, the supplier will reduce the amount owed by a small percentage, e.g. 2%. It can be used by a business to improve the Days Sales Outstanding (DSO). It is not necessary for the supplier to offer a cash discount.
It is shown as an expense in the income statement (profit and loss account)
Few Benefits of Cash Discount
A cash discount is beneficial to the supplier as it allows him to have access to cash much sooner and therefore ensure liquidity to the business.
If used efficiently, a cash discount is beneficial to the buyer as not a mere tool to save some money, but also as a means of maintaining a healthy credit line and a good relationship with the supplier.
Common terms are 2/10, Net 30 (or) 2%/10 days, Net 30. This payment term means that the buyer has an option to avail a 2% cash discount from the invoice price if the payment is made within the first 10 days of receiving the invoice.
If the cash discount is not availed, the net amount due is to be paid within Net 30 days. The payment terms can be modified depending on the supplier’s needs.
Let’s say that 100 keyboards are sold for the invoice price of 300 each and the payment terms are 1/10, Net 30 days.
It means that the buyer will get a 1% cash benefit from the total invoice price if the payment is made within the first 10 days of receipt of the invoice. (Assuming there is no trade discount)
Amount due as per Invoice
30,000
Less Cash Discount 1%
300
Cash to be paid within 10 days
29,700
The buyer has a choice to not avail the discount. In this case, the total amount due will be 30,000 which can be paid within 30 days.
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A document that serves as evidence for a business transaction is called a Voucher. Sometimes, mistakenly seen as just a bill or receipt; it can have many other forms.
It is not the appearance of it that matters it just needs to act as evidence of a transaction. When a transaction is entered, the evidence of that transaction is also confirmed. A voucher helps in recording expenses or liability and further helps in its payment.
They are also called source documents as they help in identifying the source of a transaction. A few examples of vouchers include bill receipts, cash memos, pay-in-slips, checks, an invoice, a debit or credit note.
Documents which are created at the time when a business enters into a transaction are called source vouchers, for example, rent receipts, bill receipts at the time of cash sales, etc.
They are expected to contain complete details of a transaction duly signed by the maker and act as evidence of the transaction.
Accounting Vouchers
This type of a voucher basically analyzes a business transaction from the accounting standpoint and is used for recording purposes.
These are commonly prepared by accountants on the basis of supporting vouchers and approved by a different individual. They are further subdivided into two, cash and non-cash vouchers.
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It wouldn’t be wrong to say that this equation is the basis of all accounting. The Accounting Equation is based on the dual aspect concept of accounting, which says that every transaction has two aspects, debit and credit, and for every debit, there is equal and opposite credit.
This equation is also called the Balance Sheet Equation. It helps to prepare a balance sheet, which is the most vital step in creating financial statements.
This relationship between Assets, Capital and Liabilities is called the Accounting Equation or the Balance Sheet Equation. In general, the expression Assets = Capital + Liabilitiesis termed as the Accounting Equation, but you can use any of the above relationships till the time you understand the fundamentals of the equation.
Therefore, at any point, the total number of assets of a firm is equal to the total number of liabilities. That is because the equation indicates that sources of funds are equal to the uses of funds. In other words, the equation means that capital and liabilities together are equal to assets at all times.
Key Highlights
The accounting equation acts as a basis for accounting and uses the dual aspect principle of accounting.
It is also known as the Balance Sheet Equation.
According to the balance sheet equation, total assets are always equal to the sum of capital and external liabilities.
Application and Integrity of the Accounting Equation
In the below-mentioned example, we will deal with 2 different transactions that took place in a newly started business called Unreal Pvt Ltd. This example will help you clearly understand how a transaction affects the variables involved in an accounting equation and still maintains the integrity of the equation.
1. Unreal Pvt Ltd. startsa business with 1,000,000 cash (1 Million)
Variables Affected
Net Effect of Transaction
Accounting Equation
Capital & Assets
Assets & Capital Both Increase
Assets = Liabilities + Capital
1,000,000 (cash) = 0 + 1,000,000
Starting a business with 1 million means that the business owner introduced capital or in other words owner’s equity is 1M, which, in this case, was brought inside the business in the form of cash. Therefore, their cash increased by 1M and capital also increased simultaneously by the same amount.
2. They purchase raw material for 50,000 cash
Variables Affected
Net Effect of Transaction
Accounting Equation
Only Assets
Raw material (Asset) increases and Cash (Asset) decreases by 50k
Assets = Liabilities + Capital
1M + 50k – 50k (Cash) = 0 + 1M
Unreal Pvt Ltd began operations by purchasing raw material for their business for 50,000 in cash. This transaction ultimately reduced 50k worth of cash and added 50k worth of raw material to the business.
Similarly, when other more complex transactions take place in business, the accounting equation will get affected each time, but it would still maintain its basic fundamental of assets being equal to the sum of capital and liabilities.
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In accounting, an account is a specific header created for grouping similar transactions. It is maintained in a T-shaped tabular format with multiple columns containing matching transactions that are recorded together. Following the traditional approach, there are three types of accounts in accounting: Real, Personal, and Nominal.
They are journalized as per the golden rules of accounting. After that, the balance is transferred in a T-shaped table that contains all debit transactions on the lef, and the right-hand side includes all credit transactions.
Different types of financial statements are created using transactional information from accounts. A company’s financial position, operational performance, etc., are all represented using the same data.
As per the two accounting approaches i.e. the traditional (aka English approach) and the modern (aka American or the Accounting Equation approach) the accounts are classified into 2 major groups as shown below:
It is important to know what type of account are you dealing with because if you fail to identify an account correctly as either a real, personal or nominal account, in most cases, you will get end up recording incorrect journal entries.
A company’s financial data becomes unreliable when debit and credit rules are incorrectly applied. The golden rules are dependent on the accurate classification of the account.
Three Types of Accounts
1. Real Accounts
All assets of a firm, which are tangible or intangible, fall under the category of ‘Real Accounts’. (Except debtors)
Tangible real accounts are related to things that can be touched and felt physically. A few examples of tangible real accounts are building, furniture, equipment, cash in hand, land, machinery, stock, investments, etc.
Intangible real accounts are related to things that can’t be touched and felt physically. A few examples of such real accounts are copyrights, intellectual property, customer data, goodwill, patents, trademarks, broadcasting rights, logos, etc.
The golden rule for real accounts
Debit What Comes in
Credit What Goes Out
Example of Real Accounts
The transaction below shows the interaction of two different accounts: one is ‘Furniture’ and the other is ‘Cash’.
Furniture – Real Account (tangible) & Cash in Hand – Real Account (tangible)
Purchased furniture for 10,000 in cash
Accounts Involved
Debit/Credit
Rule Applied
Furniture A/C
10,000
Real A/C – Dr. what comes in
To Cash A/C
10,00
Real A/C – Cr. what goes out
Important to know about Real Accounts – In spite of the fact that “debtors” are assets for the company, they continue to be classified as personal accounts. This is because ‘debtors’ belong to individuals or entities and personal accounts specifically serve the purpose of calculating balances due to or due from such 3rd parties.
Second among three types of accounts are personal accounts which are related to individuals, firms, companies, etc. A few examples are debtors, creditors, banks, outstanding accounts, prepaid accounts, accounts of customers, accounts of goods suppliers, capital, drawings, etc.
Natural personal accounts: All of God’s creations are included in these types of personal accounts. Accounts that belong to individuals fall into this category e.g. Kumar’s A/c, Adam’s A/c, Unreal Co. A/c, etc.
Artificial personal accounts:Personal accounts which are created artificially by law, such as corporate bodies and institutions, are called artificial personal accounts. E.g. private companies, LLCs, LLPs, clubs, schools, sole proprietors, public limited companies, one-person companies, cooperative societies, etc.
Representative personal accounts: These are accounts that directly or indirectly represent a particular person or a group of people.
Consider the example of an employee whose wages are paid in advance to him/her, a prepaid wages account will be opened in the books of accounts. This wages prepaid account is a representative personal account indirectly linked to the person.
A few other examples that are related are as follows: prepaid insurance account, unearned interest account, rent received account, accrued commission account, prepaid rent account, outstanding rent, etc.
The golden rule for personal accounts
Debit the receiver
Credit the giver
Example of Personal Accounts
The transaction below demonstrates the interaction between two accounts: one is a ‘Private Limited Company’ and the other is a ‘Bank’.
Private Ltd Co. – Personal Account (artificial) & Bank – Personal Account (artificial)
Accounts which are related to expenses, losses, incomes or gains are called Nominal accounts.
The dictionary meaning of the word ‘nominal’ is “existing in name only“ and the meaning is absolutely true in the accounting terms as well. There is no physical existence of nominal accounts, but money is involved behind every such account even though they have no physical form.
Example – Purchases, Sales, Salaries,Commission Received, Bad Debts, Telephone Bills, etc. The final result of all nominal accounts is either profit or loss which is then transferred to the capital account.
The golden rule for nominal accounts
Debit all expenses and losses
Credit all incomes and gains
Example of Nominal Accounts
The transaction below shows the interaction between two accounts: one is a ‘Purchase’ and the other is ‘Cash’.
*Persons – Our use of the word “persons” mirrors the usage found in the financial world. In this context, it can refer to individuals, firms, companies, etc.
It is nearly impossible to provide a complete list of accounts therefore we tried to provide you with the most often used accounts along with a general understanding of how similar types of accounts may look like.
We have created a printer-friendly PDF version of the above table that can be instantly downloaded, for free. Those who use the three types of accounts in accounting and apply the legacy rules of debit and credit regularly should print or save this on their desktop.
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Practice
This section is dedicated to the practice of the three types of accounts in accounting. Practising this will help you gain a better understanding of the subject.
Question – Identify the accounts involved and their types. Also, state whether they should be debited or credited.
1. Paid rent for 30,000 in cash.
Accounts Involved – Rent Expense A/c & Cash A/c
Type – Rent Expense is a Nominal account & Cash is a Real account
Debit & Credit – Rent Expense A/c will be debited by 30,000 (Dr. all expenses & losses) whereas Cash A/c will be credited by 30,000 (Cr. what goes out)
2. Mary started the business with 95,000 in cash.
Accounts Involved – Cash A/c & Capital A/c
Type – Cash is a Real account & Capital A/c is a Personal account
Debit & Credit – Cash A/c will be debited by 95,000 (Dr. what comes in) whereas Capital A/c will be credited by 95,000 (Cr. the giver)
Capital A/C and Mary’s Capital A/C both can be used in the above question.
3. Sold goods on credit to Unreal Company for 25,000
Type – Unreal Company’s A/c is a Personal account & Sales is a Nominal account
Debit & Credit – Unreal Company’s A/c will be debited by 25,000 (Dr. the receiver) whereas Sales A/c will be credited by 25,000 (Cr. all incomes & gains)
4. Purchased goods on credit from Kumar for 50,000
Type – Purchases A/c is a Nominal account & Kumar’s A/c is a Personal account
Debit & Credit – Purchases A/c will be debited by 50,000 (Dr. all expenses & losses) whereas Kumar’s A/c will be credited by 50,000 (Cr. the giver)
5. 40,000 cash withdrawn by the proprietor for personal use
Accounts Involved – Drawings A/c & Cash A/c
Type – Drawings A/c is a Personal account & Cash A/c is a Real account
Debit & Credit – Drawings A/c will be debited by 40,000 (Dr. the receiver) whereas Cash A/c will be credited by 40,000 (Cr. what goes out)
6. Paid 2,000 as carriage inwards by cheque (inventory purchase)
Accounts Involved – Carriage Inwards A/c & Bank A/c
Type – Carriage Inwards A/c is a Nominal account & Bank A/c is a Personal account
Debit & Credit – Carriage Inwards A/c will be debited by 2,000 (Dr. all expenses & losses) whereas Bank A/c will be credited by 2,000 (Cr. the giver)
“Purchases account” is also debited (equal to the amount of purchase), however, it is not necessary to show that in the above practice example. Carriage inwards is treated as a direct operating expense since the product is intended for operational use.
7. Commission received 80,000 in cash
Accounts Involved – Cash A/c & Commission Received A/c
Type – Cash A/c is a Real account & Commission Received A/c is a Nominal account
Debit & Credit – Cash A/c will be debited by 80,000 (Dr. what comes in) whereas Commission Received A/c will be credited by 80,000 (Cr. all incomes & gains)
8. Paid 15,000 by the bank for trademark registration
Accounts Involved – Trademark A/c & Bank A/c
Type – Trademark A/c is a Real account & Bank A/c is a Personal account
Debit & Credit – Trademark A/c will be debited by 15,000 (Dr. what comes in) whereas Bank A/c will be credited by 15,000 (Cr. the giver)
Although a trademark may seem like an expense, it is an intangible asset and should not be viewed as a nominal account.
Type – Depreciation A/c is a Nominal account & Furniture A/c is a Real account
Debit & Credit – Depreciation A/c will be debited by 15,000 (Dr. all expenses & losses) whereas Furniture A/c will be credited by 15,000 (Cr. what goes out)
Depreciation is a non-cash expense and should be viewed as a nominal account. The amount debited & credited should be equal to the depreciation expense.
14. Received 7,000 as interest on drawings from Neel (Proprietor)
Accounts Involved – Drawings A/c & Interest on Drawings A/c
Type – Drawings A/c is a Personal account & Interest on Drawings A/c is a Nominal account
Debit & Credit – Drawings A/c will be debited by 7,000 (Dr. the receiver) whereas Interest on Drawings A/c will be credited by 7,000 (Cr. all incomes & gains)
Due to the fact that interest on drawings is an income for the company, it is added to the company’s interest account, thereby increasing its income. Actual cash is not received, instead, adjustments are made within relevant accounts.
15. 9,500 received in cash from Unreal Co. as the full and final settlement of their account worth 10,000.
Cash is a Real account so Dr. what comes in (9,500), Discount Allowed A/c is a Nominal account so Dr. all expenses/losses (500), and Unreal Co. A/c (Debtor) is a Personal account so Cr. the giver (10,000).
Type – Cash A/c is a Real account, Discount Allowed A/c is a Nominal account, and Unreal Co. A/c (Debtor) is a Personal account.
Debit & Credit – Cash A/c will be debited by 9,500 (Dr. what comes in), Discount Allowed A/c will be debited by 500 (Dr. all expenses & losses) whereas Unreal Co. A/c will be credited by 10,000 (Cr. the giver)
Accounts are broken down into 2 major categories based on their type, according to the traditional approach: Personal, and Impersonal. Personal accounts come in three types. Impersonal accounts are further broken down into two: Real & Nominal.
Due to its more holistic approach, the modern classification of accounts (assets, liabilities, revenue, expenses & capital) has gained more followers than the traditional classification (real, personal & nominal).
As far as we are concerned, using modern rules and classifications is easier and more convenient than using traditional rules.
There are some tricky cases where a person might incorrectly identify an account and we would like to identify them explicitly.
Accrued Income – is a personal account whereas the related income account is a nominal account. Any income or expense with a prefix such as prepaid, outstanding, accrued, received in advance, etc. shall be classified as a personal account.
Bank – It is easy to get confused because a bank account may seem like an asset therefore it should be a real account, No! Due to the fact that the bank account belongs to a legal entity, it is considered a personal account & treated accordingly.
Capital or Equity – It is a personal account as equity/capital is provided to the company by a person i.e. individual, firm, company, etc.
Goodwill – At the time of comparing tangible and intangible assets, it is easy to forget that assets are both physical and non-physical therefore, all intangible assets like goodwill, copyright, patents, investments, etc. are categorized as real accounts.
Drawings – Drawings refer to withdrawals of cash or goods for personal use by the owners of a business. Since the owner is a separate entity from the business, it is seen as a personal account.
Debtors – It’s easy to get confused because debtors are receivables, which are assets, so it should be treated as a real account, No! Due to the fact that debtors are an external third party (a separate entity), they are treated as personal.
The debit and credit rules are applied correctly when the type of account is accurately identified. By doing this, all financial events of a business are accurately recorded and accounted for. As a result, in the light of the accounting equation, debits are always equal to credits and the balance sheet is always a match.
Due to the fact that both internal and external users of accounting information rely on financial data, the accounts identified and the resulting rules applied should be accurate at all times.
In the general sense of the English language, something described as “Golden” means prime quality. In the context of accounting, the golden rules are the main rules used to record financial transactions at the time of their inception. These rules determine which accounts should be debited and credited.
A journal entry is the foundation of the financial statements of a company. Financial data becomes unreliable when debit and credit rules are incorrectly applied. Financial statements, for example, are based on trustworthy accounting data that is backed up by this rule and other accounting principles.
Each accounting entry is recorded chronologically in “the book of original entry” (journal or subsidiary books) according to the 3 golden rules of accounting.
Source documents are used to support the entry of transactions in the books of account. For example; invoices, cheques, receipts, debit notes, credit notes, etc.
After the activity has been recorded the next step is to ‘post’ the entry i.e. transfer it to the appropriate ledger account.
What is an account? – It is kind of a table in “T” form where transactions are recorded under specific headings. The data is not only used to track the amount of a transaction but also its effect and direction as well.
On the left-hand side, you will find all the debit transactions, and on the right-hand side, you will see all the credit transactions.
Debit & Credit – According to the nature of an account, it could mean either an increase or a decrease. Debits and credits are governed differently depending on the account type.
Debit – It means an increase in the value of an asset or expense or a decrease in the value of liability (including equity) or revenue.
Credit – It is the opposite of debit and it means a decrease in the value of an asset or expense or an increase in the value of liability (including equity) or revenue.
These rules are used to prepare an accurate journal entry that forms the basis of accounting and acts as a cornerstone for all bookkeeping.
They are also known as the traditional rules of accounting or the rules of debit and credit.
Easy Interpretation of 3 golden rules of accounting
Real Account
If the item (real account) is coming into the business then – Debit
If the item (real account) is going out of business then – Credit
Personal Account
If the person (or) legal body (or) group is receiving something – Debit
If the person (or) legal body (or) group is giving something – Credit
Nominal Account
If it is an expense or loss for the business – Debit
If it is an income or gain for the business – Credit
While making a journal entry there are essentially three types of accounts i.e. Real, Personal and Nominal. Each account has a specific rule that needs to be applied and it is of utmost importance to identify the account correctly for accurate journalisation.
When recording a journal entry, one must adhere strictly to the golden rules of accounting in order to ensure that the entry is accurately recorded. The following steps are used to register an entry in the primary book of accounting:
Identify the accounts involved
Determine the type of accounts
Apply the golden rules of accounting
Record the Transaction
Here is an example to help you understand. This example shows a business receiving cash and making a sale.
Cash A/c
Debit
Real – Debit what comes in
To Sales A/c
Credit
Nominal – Credit all income/gain
Step 1 – The first step of a journal entry is to identify the accounts involved in a transaction. A minimum of two such accounts shall be identified. According to the above example, the two accounts affected are “Cash” and “Sales”.
Step 2 – After identifying the type of accounts in step 1, the next step is to determine their type (real, personal, or nominal). According to the above example, the two accounts affected are “Cash” which is a real account and “Sales” which is a nominal account.
Step 3 – The highlight of our topic is the application of golden rules. It should be done correctly after determining the type of accounts.
As per the three rules of debit and credit (shown below) “Cash A/c” (Real) should be treated as per the 1st rule since cash is coming into the business “Debit what comes in”.
Similarly, “Sales A/c” should be treated as per the 3rd rule since the sale is an income for the business “Credit all incomes & gains”.
Rules of Debit and Credit According to Modern Approach
If you are posting an entry in the journal, you may use the Modern Accounting Approach instead of the three golden rules of accounting.
You should try to use the American or modern rules of accounting to compare and find out which one suits your learning style and is easy to apply. It is true that some people find the modern approach easier than the traditionally used three golden rules of accounting.
Example – Modern Rules of Accounting
Received cash 3,000 as rent from Unreal Pvt Ltd.
Accounts Involved
Debit/Credit
Modern Rule Applied
Cash A/C
3,000
Asset A/C – Dr. the increase
To Rent A/C
3,000
Revenue A/C – Cr. the increase
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Practice
This section is dedicated to the practice of the three golden rules in accounting. Practising this will help you gain a better understanding of the subject.
Question – For 1 to 10, give the nature of each account as well as the relevant rule to be applied. From 11 to 15, identify the accounts involved, along with their nature and the respective rules.
1. Cash
Type & Rule – Real A/c, Rule – Dr. what comes in and Cr. what goes out
Cash is an asset for the business and all assets (tangible and intangible are real accounts)
2. Loco Pvt Ltd. (Debtor)
Type & Rule – Personal A/c, Rule – Dr. the receiver and Cr. the giver
It is important to understand that a debtor is not categorized as a real account even though it is an asset to the business, however, it is classified as a personal account because it belongs to an individual or entity. A personal account is used to determine a person’s or organization’s balance due.
3. Goodwill
Type & Rule – Real A/c, Rule – Dr. what comes in and Cr. what goes out
It is treated as a real account since it is an asset to the business.
4. Purchases
Type & Rule – Nominal A/c, Rule – Dr. all expenses and losses & Cr. all incomes and gains
Purchases are an expense for the business therefore it is a nominal account.
5. Bank
Type & Rule – Personal A/c, Rule – Dr. the receiver and Cr. the giver
It is easy to confuse the Bank as a real account whereas it is actually categorized as a personal account because it belongs to an entity.
6. Inventory
Type & Rule – Real A/c, Rule – Dr. what comes in and Cr. what goes out
As a business asset, it is treated as a real account.
7. Salaries
Type & Rule – Nominal A/c, Rule – Dr. all expenses and losses & Cr. all incomes and gains
Salaries are an expense for the business therefore it is a nominal account.
8. Outstanding Salaries
Type & Rule – Personal A/c, Rule – Dr. the receiver and Cr. the giver
Salaries are an expense for the business whereas outstanding salaries are related to a worker or several workers which means the o/s salary account becomes a personal account. The thumb rule in the case of a prefix or suffix (outstanding, prepaid, accrued, etc.) is the type of account changes from nominal to personal.
Type & Rule – Real A/c, Rule – Dr. what comes in and Cr. what goes out
A leaseholder has the right to use the property for a specified period of time according to a lease agreement. An extremely low down payment is made by the lessee to acquire and use the property. Such a property is treated as a real account since it is a business asset.
10. Bad Debts Written Off
Type & Rule – Nominal A/c, Rule – Dr. all expenses and losses & Cr. all incomes and gains
The write-off of bad debts is the act of writing off receivables which the company now considers irrecoverable. It should be shown on the income statement and removed from the books of accounts. Since it is a loss for the business, it is treated as a nominal account.
11. Sold goods for cash 50,000
Accounts Involved – Cash A/c & Sales A/c
Type and Rules – Cash is a Real account so Dr. what comes in (50,000), Sales is a Nominal account so Cr. the income (50,000).
Type and Rules – Unreal Co. A/c is a personal account so Dr. the receiver (11,000), Sales is a Nominal account so Cr. the income (11,000).
It is important to note that in the above question the business is dealing with another entity. The account will be categorized as personal even though it is an asset for the firm.
13. Purchased Equipment for 10,000 (paid by Cheque)
Accounts Involved – Equipment A/c & Bank A/c
Type and Rules – Equipment A/c is a real account so Dr. what comes in (10,000), Bank is a personal account so Cr. the giver (10,000).
In many cases, a bank account is mistaken for a real account, when in fact it is a personal account because it belongs to a separate business entity.
14. Paid Salaries of 90,000 (Direct Deposit from Bank)
Accounts Involved – Salaries A/c & Bank A/c
Type and Rules – Salaries A/c is a nominal account so Dr. all expenses (90,000), Bank is a personal account so Cr. the giver (90,000).
15. 9,500 received in cash from Unreal Co. as the full and final settlement of their account worth 10,000. (Compound Journal Entry)
When many accounts are debited or credited, it is called a compound journal entry. As opposed to a simple journal entry that only includes a maximum of 1 debit and 1 credit. Usually, such an entry has 3 or 4 affected accounts.
Type and Rules – Cash is a Real account so Dr. what comes in (9,500), Discount Allowed A/c is a Nominal account so Dr. all expenses/losses (500), and Unreal Co. A/c (Debtor) is a Personal account so Cr. the giver (10,000).
We have created a printer-friendly PDF version of the rules. For those who use the golden rules of accounting regularly, it is highly recommended that they print this page and stick it on their desk or wall.
The three golden rules of accounting ensure that all the financial events of a business are accounted for and done accurately. As a result, in the light of the accounting equation, debits are always equal to credits and the balance sheet is always a match.
To ensure maximum financial transparency and accountability, businesses should ensure the implementation of these accounting principles and standards.
The customer accounts (debtors) who owe money to a business for purchasing goods on credit are called accounts receivable. When the money is received within the same accounting period it becomes part of the company’s operating revenue, however, if not received in the same year it becomes “trade debtors” which is another name for accounts receivable. It is also commonly abbreviated as “AR”. The entire life-cycle is termed as “O2C” (Order to Cash).
In layman terms, the total amount which is yet to be collected by debtors as per a firm’s sales book is known as accounts receivables. Large firms using ERP packages replace traditional sales book with sales ledger control account.
The buyer can be a sole trader, a partnership firm, a private company, etc. It is a short-term addition, hence an asset that is supposed to be received from the customers. Accounts receivables are shown on the asset side under the head current assets (right-hand side of a horizontal balance sheet).
Let us assume that you sold goods worth 10,000 to one of your buyers who is supposed to pay you within 45 days of receipt of invoice. Now, you send the customer a bill for 10,000. In this case, the amount acts as “dues to be received” and shall be booked in your records as accounts receivable.
It is similar to the situation where your mobile phone company generates an invoice on the 1st day of a month and gives you 30 days to pay the bill. It is an account receivable for the mobile phone company.
Key Highlights
They are created when a business sells goods on credit.
They should be collected from the customers within the agreed period.
If goods are returned by the buyer during the allowed time limit then a credit note is sent by the seller to notify the buyer that he has been provided appropriate credit. This cancels out his payment & results in a reduction of total accounts receivable.
Journal Entries Related to Accounts Receivable
Below are the two main scenarios linked to accounts receivable cycle where, in the first case, credit sale is recorded and the customer is assumed to be billed, and, in the second case, cash proceeds from the customer is recorded in books of accounts.
At the time of recording a credit sale and billing the customer
Accounts Receivable A/C
Debit
To Sales (on credit) A/C
Credit
(This can also be recorded at a particular customer level subledger wise, in that case, the customer who is billed will be debited)
(This can also be recorded at a particular customer level subledger wise, in that case, the customer paying for the goods/services will be credited)
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Accounts payable are obligations of a business that originate because of purchases made on credit (e.g. for raw material, finished goods etc.), the money is yet to be paid for these transactions. Accounts payable account can be created by anyone who buys goods or services on credit and promises to pay for them later. It can be a sole trader, a partnership firm or a full-fledged business.
It is a short-term liability and in simpler terms total amount which is yet to be paid by the business to its creditors as per the purchase book. Large firms using ERP packages replace traditional purchase book with purchase ledger control account.
It is also known as trade creditors, “AP” & “P2P” (Procure to Pay). Accounts payable are shown on the liability side under the head current liabilities (the left-hand side of a horizontal balance sheet).
Let us say a supplier extends credit to your business Unreal Pvt Ltd. and agrees that your business will be making a payment within 45 days of the date you are billed.
Now, you are billed 1,00,000 for goods bought on credit. The amount will be considered as dues to be paid or, in other terms, an “account payable” by your business till the supplier is paid. It is similar to the situation when a person has received his latest electricity bill where he is allowed to pay within the next 30 days. Now, it acts as payable for the individual until the time it is actually paid.
Key Highlights
Accounts payable are created when you buy goods on credit.
Accounts payable should be paid back to the suppliers within the agreed period of time.
They act as short-term debt, hence shown on the liability side under the head “current liabilities” of the balance sheet.
Journal Entries Related to Accounts Payable
Below are two main scenarios linked to the accounts payable cycle, where, in the first case, the credit purchase is recorded, and, in the second case, the cash paid to the supplier is recorded in the books of accounts.
At the time of recording an invoice
Purchase A/C
Debit
To Accounts Payable A/C
Credit
(This can also be recorded at a particular vendor level subledger wise, in this case, the vendor who has raised the invoice will be credited)
At the time of paying an invoice
Accounts Payable A/C
Debit
To Cash or Bank A/C
Credit
(This can also be recorded at a particular vendor level subledger wise, in this case, the vendor paid will be debited)
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The accounting cycle is a chronological order in which an accounting process flows. It is a step by step process followed to achieve the ultimate goals of accounting.
Firstly, the information is recorded in a book or accounting software (in the modern scenario) called a Journal. Then it is adjusted and moved to a ledger. Ledger balances are then summarized to make a trial balance. Finally, from trial balance financial statements such as an income statement, a trading account, and a balance sheet are prepared.
Accounting Cycle Steps
Identification – This is the origin of the accounting cycle. This step means identifying events that are to be recorded. It involves observing activities and selecting those events that are – considered to be evidence of economic activity and are relevant to the business organization. So, Events that are relevant and can be quantified in monetary terms are considered for the recording.
Prepare Evidence – When a financial transaction occurs, it gives rise to a source document. This supply document is proof that describes all the fundamental facts of the transaction in question, as the amount, which parties are involved, the aim of the transaction, and the transaction date. Thus, documents such as; a receipt, an invoice, a depreciation schedule, and a bank statement, a debit note, a credit note, etc. produce proof that an economic event has actually occurred.
Record a Journal Entry – Once the economic events are identified and quantified, this step involves recording transactions in chronological order and a systematic manner. According to double-entry accounting, each transaction should be recorded as both a credit and debit in separate journals. Sometimes, transactions are recorded in the books of original entries also.
Prepare a Ledger – Ledger accounts keep track of a company’s entire financial activity. Record of the journal and other subsidiary books is input for the ledger. Under this step, posting is done in the ledger in various accounts, on the basis of Journal entries.
Balance the Ledger – Each account like cash, accounts payable, investments, inventory, etc are balanced at the end of a certain period. If the total of the debit side is more than that of the credit side, the balance is called Debit Balance and is written on the credit side. In the same way, when the total of the credit side of an account is more than that of the debit side total, the balance is called Credit Balance. The difference amount is written on the debit side of the account. So, these balances are the output of this step.
Execute Adjustments – At the end of the period, adjustments are made. These are the result of rectifications made in the books of accounts and the results from the passage of time. For example, an adjusting entry may include advance payment of rent or insurance. So, this step requires the usage of the matching principle to organize company transactions into the appropriate financial periods.
Prepare Trial Balance– Balances from the ledger are brought to the trial balance. This is done so that any mathematical errors that may have occurred during the initial stages of the accounting cycle, can be identified. A trial balance matches if the total of debit is equivalent to the total of credit for the business.
Prepare Financial Statements – The last step of the Accounting cycle allows the organization of relevant financial data into appropriate categories in the financial statements of the business. Record of the trial balance is the input for this step. It involves summarizing transactions into Trading Account, Profit & Loss Account, and Balance sheet based on their nature.
Example of Accounting Cycle
PepsiCo bought a new processing plant for 10 Million, which was shown on the balance sheet as an asset. We will study the possible accounting trail related to this transaction.
Step 1
Transaction for buying the building is identified.
Analysis – Buying a new plant is both relevant for the business and can be quantified in monetary value. So, this is an economic activity.
Step 2
Evidence such as a legal ownership document is prepared.
Analysis – The ownership deed is the source document that will be evidence for the above financial transaction. It will disclose the parties involved, amount and time of transfer of payment, etc.
Step 3
Journal entry to purchase the building is recorded in books.
Analysis – A Journal entry to record the transaction will be passed. PepsiCo now has more plant than before. The plant is an asset, which is increasing on the debit side for 10 million. If a Bank transfer is done to pay for it, the bank balance is an asset, decreasing on the credit side.
Step 4
A ledger account such as a “Plant & Equipment account” is created.
Analysis – PepsiCo will go through each transaction and transfer the account information into the debit or credit side of that ledger account being affected. In the Plant & Equipment Account, there will be a debit of Bank by 10 million.
Step 5
Ledger account for the Plant & Equipment is then balanced.
Analysis – If there are no further transactions, the Ledger account is balanced and shows a debit balance.
Step 6
All adjustments, if any, are incorporated.
Analysis – If there is a requirement for rectifications, adjustment entries will be passed.
Step 7
The amount is treated as an asset and moved to trial balance.
Analysis – The balance of the Ledger account is the nature and output for the Trial Balance. The plant is treated as an asset and the ledger balance is its historical value.
Step 8
The amount is then shown on the asset side of the balance sheet.
Analysis – Since the above transaction involves two assets (Plant & Bank balance) only, it will reflect in the balance sheet. The Balance sheet will show an enhanced value of plant and reduced value of bank balance by 10 million.
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