Chapter 1 — Book Keeping and Accounting

Every business, whether it is a small kirana shop in a Telangana village or a large company in Hyderabad, deals with money every day. Goods are bought, goods are sold, wages are paid, rent falls due, cash comes in from customers and goes out to suppliers. No human memory can hold hundreds of such events for months together. So a businessman writes them down. That act of writing down business transactions in a proper set of books is called book keeping.

Formally, book keeping is the art and science of recording business transactions in a systematic manner in a set of books, so that the financial position of the business can be known at any time. The word systematic is important. Notes scribbled on the back of a bill are not book keeping. Book keeping means recording in a fixed order, in fixed books, following fixed rules, so that anyone trained in the method can read and check the records later.

The need for book keeping arises from several practical facts:

• Limited memory: a trader cannot remember what he owes to each supplier and what each customer owes him.
• Proof of transactions: written records serve as evidence in disputes with customers, suppliers, banks and tax officers.
• Knowing profit or loss: only from records can a trader find out whether the year ended in profit or loss.
• Knowing financial position: the records show what the business owns and what it owes on a given date.
• Legal requirement: the Companies Act and the Income Tax Act require businesses above certain limits to maintain proper books.
• Control: records help detect theft, waste and fraud by employees.

Book keeping is mainly clerical work. It involves identifying which events are financial transactions, measuring them in rupees, recording them in the journal or subsidiary books, and classifying them by posting to ledger accounts. The book keeper does not draw conclusions; that is left to the accountant. A helpful way to remember the difference is this: book keeping is the raw material and accounting is the finished product. Book keeping produces records; accounting produces information.

Historically, some form of record keeping has existed for thousands of years. Traders in ancient India kept records on palm leaves and in bahi khata books, a practice still visible in many old business houses. But the modern scientific system, the double entry system, was first explained in print by an Italian monk, Luca Pacioli, in the year 1494 in his book on arithmetic and geometry. That system spread across Europe with trade and later came to India, and it is the system taught throughout this course.

Book keeping stops at recording and classifying. Accounting goes further. It takes the classified records and summarises them into a trial balance, a trading and profit and loss account and a balance sheet; it analyses those statements; it interprets what they mean; and it communicates the results to the people who need them. Accounting is therefore a wider term that includes book keeping as its first stage.

The American Institute of Certified Public Accountants gives the classic definition: accounting is the art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. Every phrase of this definition teaches something.

• Recording means writing transactions in the journal or subsidiary books as they happen.
• Classifying means grouping transactions of the same nature under one head in the ledger, so that all rent payments come together and all sales to Ravi come together.
• Summarising means preparing the trial balance and the final accounts, which present the whole year's work in a few pages.
• In terms of money means only those events that can be expressed in rupees are recorded; the honesty of a manager or the loyalty of workers cannot be entered.
• Transactions and events of a financial character means that only dealings that change the money position of the business are covered.
• Interpreting the results means explaining to the owner what the figures say about profitability, liquidity and growth.

Another useful way of describing accounting is that it is the language of business. Just as language conveys thoughts from one person to another, accounting conveys the financial story of a business to its owners, lenders, government and public. A balance sheet read by a banker in Hyderabad tells the same story to a banker in Mumbai because both understand the same language.

Accounting today has several branches. Financial accounting records transactions and prepares final accounts for outsiders. Cost accounting finds out the cost of each product or service so that prices can be fixed and waste controlled. Management accounting gives managers the reports they need for planning and decision-making. This course deals with financial accounting, which is the base of the other two.

The process of accounting can be seen as a cycle that repeats every year: identify transactions, record them in the journal, post them to the ledger, prepare the trial balance, make adjustments, prepare final accounts, and finally communicate and interpret. The cycle starts again with the opening balances of the new year. Every chapter of this course fits somewhere on that cycle.

Students often use the two words as if they mean the same thing, and examiners often ask for the difference precisely because the two are related but not identical. The relationship is like that between a foundation and a building. Book keeping is the foundation; accounting is the complete building that stands on it. Without book keeping there can be no accounting, but book keeping alone gives no conclusions.

Take the example of a mobile phone shop in Nizamabad. The book keeper enters every sale, every purchase from the distributor, every salary and every electricity bill in the books, and posts them to the ledger accounts. That is his whole job. At the year end the accountant collects those ledger balances, prepares the trial balance, adjusts for closing stock and outstanding salaries, prepares the trading and profit and loss account, prepares the balance sheet, and then tells the owner that the gross profit ratio has fallen from 18 per cent to 14 per cent because the distributor raised prices while the shop did not. The book keeper produced data; the accountant produced knowledge.

It follows that a person who knows accounting can always do book keeping, but a person trained only in book keeping cannot do accounting. It also follows that errors in book keeping flow straight into the accounts, which is why the accountant must check the book keeper's work regularly. Both are essential, and in a small business the same person often does both.

Why does a business go to the trouble and expense of keeping accounts? The answer lies in the objectives of accounting. Each objective corresponds to a question that the owner or some other interested person keeps asking, and accounting exists to answer those questions with figures rather than guesses.

1. To maintain a systematic and permanent record. The first objective is to replace memory with writing. All transactions are recorded in the order in which they occur, with date, amount and parties, in books that are kept for years. The Income Tax Act, for instance, requires books to be preserved for several years after the relevant year.

2. To ascertain the profit or loss. The owner wants to know whether the year's effort was rewarded. Accounting answers this through the trading account, which shows gross profit, and the profit and loss account, which shows net profit after all expenses. A profit means the business has added to its wealth; a loss means it has eaten into it.

3. To ascertain the financial position. Profit alone does not tell the whole story. The owner also wants to know what the business owns (assets), what it owes (liabilities) and what his own stake is (capital). The balance sheet, prepared on the last day of the year, answers this.

4. To provide information to various users. Owners, managers, bankers, suppliers, tax authorities and employees all need information about the business. Accounting supplies it in a standard form that all of them can understand.

5. To help in decision-making. Should the business buy a new machine, raise prices, open a branch in Khammam, or borrow from a bank? Each decision needs figures on cost, revenue and cash, and accounting provides them.

6. To control assets and detect errors and fraud. When every rupee is recorded, missing cash or stock becomes visible. Comparing recorded stock with physical stock exposes shortages. Regular reconciliation with the bank exposes errors.

7. To meet legal requirements. Companies must file audited accounts with the Registrar of Companies; all businesses above a threshold must file income tax and GST returns based on their books. Accounting makes compliance possible.

8. To ascertain the amount owed to and by the business. By keeping a separate account for each customer and each supplier, the business knows exactly how much is receivable from debtors and payable to creditors on any date.

It is helpful to remember these objectives as the answers to five plain questions: What happened? Did we gain or lose? Where do we stand? What do others need to know? What should we do next? Every book and statement in accounting exists to answer one of these.

Accounting brings real benefits, but it also has boundaries that a careful reader of accounts must keep in mind. Examiners frequently ask for both sides.

Advantages of accounting

• Replaces memory: a complete written record means nothing is forgotten.
• Shows profit or loss: the profit and loss account tells the owner the result of the year's trading.
• Shows financial position: the balance sheet lists assets, liabilities and capital on a given date.
• Helps comparison: figures of this year can be compared with last year, or with other firms, to judge progress.
• Evidence in court: properly kept books are accepted as evidence in disputes over money.
• Helps in tax matters: income tax and GST assessments are based on the books; without them the assessing officer may estimate income at a higher figure.
• Helps raise loans: a bank asks for audited accounts before sanctioning a loan.
• Helps in selling the business: the price of a going business is fixed on the basis of its accounts.
• Controls expenses and detects fraud: every expense is visible and can be questioned; missing cash shows up.
• Settlement of accounts: amounts due to and from each party are known exactly.

Limitations of accounting

• Records only monetary transactions: the skill of the workforce, the goodwill of customers or a good location cannot be entered because they have no agreed rupee value, yet they affect profit greatly.
• Based on historical cost: assets are shown at the price paid, not at current market value. A building bought for Rs 10 lakh in 2005 still appears at Rs 10 lakh less depreciation even if it is worth Rs 1 crore today.
• Ignores price level changes: because the rupee does not have the same value every year, adding rupees of 2010 to rupees of 2026 gives a misleading total.
• Influenced by personal judgement: the rate of depreciation, the method of valuing stock and the provision for bad debts depend on the accountant's estimates, so two accountants may show different profits for the same firm.
• Can be manipulated: figures can be dressed up to show a better picture, a practice called window dressing.
• Deals with the past: financial accounts report what has already happened; they do not by themselves forecast the future.
• Not exact: profit is an estimate that depends on assumptions about the future life of assets and the collectability of debts.

The lesson is that accounting information is powerful but must be read with understanding. A balance sheet is a photograph, not a prophecy; it is taken from a particular angle, using particular conventions, and a wise reader knows what lies outside the frame.

Accounting is not done for the accountant's own pleasure. It is done because many people need to know about the business, and each of them looks at the accounts with a different question in mind. These people are called users of accounting information. They are divided into two groups: internal users, who are inside the business, and external users, who are outside it.

Internal users

• Owners: the proprietor or partners invest their money and want to know the return on it. They look at profit and at the growth of capital.
• Management: managers run the business daily and need reports on sales, costs, cash and stock to plan, control and decide. In a small firm the owner and the manager are the same person.
• Employees: workers are interested in the firm's profit because it affects the safety of their jobs, their bonus and their chances of a wage increase.

External users

• Investors and shareholders: people who have bought or are thinking of buying shares want to judge the safety and return of their investment.
• Creditors and suppliers: those who sell goods on credit want to know whether the business can pay its bills on time; they look at liquidity.
• Banks and lenders: before giving a loan, a bank studies the accounts to judge whether interest and principal can be repaid, and it keeps studying them while the loan is outstanding.
• Government and tax authorities: income tax, GST and other departments use the accounts to compute tax and to check compliance.
• Customers: a customer who depends on a supplier for continuous supply wants to know that the supplier is financially stable.
• Researchers and analysts: they study accounts of many firms to comment on industries and the economy.
• Public and regulatory agencies: the general public, consumer groups and bodies such as SEBI use accounts to see how companies affect the economy and whether rules are being followed.

Because the same set of statements must serve all these readers, accounting follows agreed principles so that the statements are comparable, reliable and understandable. A banker in Hyderabad and an investor in Delhi must read the same balance sheet and reach the same understanding. This is the reason for the accounting concepts and conventions dealt with later in this chapter. The needs of the users also explain the qualitative characteristics that good accounting information should have: reliability, relevance, understandability and comparability.

Accounting has its own vocabulary, and a student who is vague about these words will be vague about everything that follows. Each term below must be learnt with its exact meaning.

Business transaction: any dealing that involves the exchange of money or money's worth and changes the financial position of the business, such as buying goods, paying wages or receiving cash from a customer. An event that cannot be measured in money, such as appointing a manager, is not a transaction.

Capital: the amount invested by the owner in the business, in cash or in kind. From the business's point of view capital is a liability, because the business owes it to the owner. Capital increases with profit and additional investment and decreases with losses and drawings.

Drawings: cash or goods taken by the owner from the business for personal use. Drawings reduce capital.

Assets: the properties and possessions of the business that have money value. Fixed assets are held for long use, such as land, buildings, machinery and furniture. Current assets are held for conversion into cash within a year, such as stock, debtors, bills receivable, cash and bank balances. Fictitious assets are not real assets at all but deferred expenses shown on the asset side, such as preliminary expenses.

Liabilities: the amounts owed by the business to outsiders. Long-term liabilities are payable after more than a year, such as a term loan. Current liabilities are payable within a year, such as creditors, bills payable, outstanding expenses and bank overdraft.

Debtors: persons who owe money to the business, usually because goods were sold to them on credit. Creditors: persons to whom the business owes money, usually because goods were bought from them on credit.

Goods: the articles in which the business regularly deals. For a furniture shop, tables are goods; for a school, tables are assets.

Purchases: goods bought for resale, whether for cash or on credit. Sales: goods sold in the ordinary course of business. Buying a delivery van is not a purchase in this sense; it is the acquisition of an asset.

Purchase returns (returns outward): goods returned to suppliers. Sales returns (returns inward): goods returned by customers.

Stock or inventory: unsold goods on hand on a given date; opening stock at the start of the year and closing stock at the end.

Expenses: costs incurred to earn revenue, such as rent, salaries, wages, electricity. Income or revenue: the amount earned by selling goods or services and from other sources such as interest and commission received.

Discount: trade discount is a reduction from the list price given at the time of sale and is not recorded in the books; cash discount is allowed for prompt payment and is recorded.

Voucher: a written document, such as a bill, receipt or invoice, that supports a transaction. Entry: the record of a transaction in the books. Account: a summarised record of all transactions relating to one person, asset, expense or income.

Bad debts: amounts due from debtors that cannot be recovered. Insolvent: a person whose liabilities exceed his assets and who cannot pay his debts in full.

If every accountant recorded transactions according to his own ideas, no two sets of accounts could be compared and no reader could trust them. So the profession has developed a set of rules, assumptions and guidelines that everyone follows. Together they are called Generally Accepted Accounting Principles, or GAAP. They are usually divided into concepts, which are basic assumptions, and conventions, which are customs that have grown up in practice. The concepts are dealt with here.

1. Business entity concept. The business is treated as separate and distinct from its owner. The owner's personal house, car and bank account are not the business's assets; the money the owner puts in is shown as capital, a liability of the business to him; money he takes out is drawings. This is why a sole trader's books show his own capital as if he were an outsider.

2. Money measurement concept. Only transactions that can be expressed in money are recorded, and they are recorded in the currency of the country. A firm owns 2 buildings, 10 machines and 50 chairs; these cannot be added, but Rs 40 lakh, Rs 25 lakh and Rs 1 lakh can. The limitation is that non-monetary facts, however important, are left out.

3. Going concern concept. It is assumed that the business will continue for an indefinitely long time and is not about to be closed. Because of this, fixed assets are recorded at cost and depreciated over their useful life rather than shown at the price they would fetch if sold tomorrow, and expenses paid in advance are carried forward as assets.

4. Cost concept. An asset is recorded at the price actually paid for it, and that cost is the basis of all later accounting for the asset. Market value is ignored. This keeps records objective and verifiable, since the cost is supported by a document.

5. Dual aspect concept. Every transaction has two aspects, a receiving and a giving, and both are recorded. When goods are bought for cash, goods come in and cash goes out. This concept is the basis of the double entry system and of the accounting equation Assets = Liabilities + Capital.

6. Accounting period concept. Although the business is a going concern, its life is divided into equal periods, usually a year, so that profit can be measured and reported regularly. In India the accounting year normally runs from 1 April to 31 March.

7. Matching concept. The expenses of a period are matched against the revenues of the same period to find the profit of that period. Rent for March unpaid on 31 March is still charged to this year; insurance paid for next year is carried forward.

8. Realisation or revenue recognition concept. Revenue is treated as earned when goods are delivered or services rendered and the customer becomes liable to pay, not when the order is received and not necessarily when cash is received.

9. Accrual concept. Income and expenses are recorded when they are earned or incurred, not when cash changes hands. This concept, with matching, distinguishes the accrual basis from the cash basis of accounting.

10. Objectivity or verifiability concept. Every entry must be supported by evidence such as a bill or receipt, so that an independent auditor can verify it.

Conventions are customs and traditions that accountants have followed for so long that they now guide the preparation of accounts. They are not laws but practices accepted by common consent, and they modify the way concepts are applied. There are four main conventions.

1. Convention of consistency. Once a method has been chosen for a particular item, the same method should be followed year after year. If depreciation on machinery is charged at 10 per cent by the straight line method this year, it should not be switched to the written down value method next year without a good reason. The purpose is to make the figures of different years comparable. Consistency does not forbid change altogether; if a change is genuinely needed, it may be made, but the fact and the effect of the change must be disclosed.

2. Convention of full disclosure. Accounts must reveal all material information fully, fairly and honestly, so that users are not misled. This is why the balance sheet carries notes explaining the method of depreciation, contingent liabilities such as pending court cases, and events after the balance sheet date. Companies are required by law to disclose a great deal; even a sole trader should not hide facts that would change a reader's judgement.

3. Convention of conservatism or prudence. The accountant should anticipate no profit but provide for all possible losses. Where two values are equally acceptable, the lower value for assets and income and the higher value for liabilities and expenses should be chosen. This is why closing stock is valued at cost or market price, whichever is lower; why a provision for doubtful debts is created before a debt actually goes bad; and why an expected gain on a court case is not recorded until it is won. The aim is to prevent the profit from being overstated and the owner from withdrawing money that has not really been earned. Carried too far, prudence creates secret reserves and hides the true position, so it must be applied with judgement.

4. Convention of materiality. Only items that are significant enough to influence the decisions of a user need be treated strictly and disclosed separately; trivial items may be dealt with in the simplest way. A stapler costing Rs 150 will last for years, but nobody depreciates it; it is written off as stationery expense. What is material depends on the size of the business: Rs 10,000 is material to a small shop and immaterial to a large company.

These conventions work together with the concepts. Consider closing stock: the cost concept says record it at cost, prudence says use market value if lower, consistency says use the same method every year, and full disclosure says state the method in a note. Reading a set of accounts intelligently means recognising which principle has shaped each figure.

Beyond concepts and conventions, India now has formal Accounting Standards issued by the Institute of Chartered Accountants of India, which spell out how particular items such as depreciation, inventories and revenue should be treated so that all companies follow uniform practice. Standards give legal force to what the concepts and conventions express in general terms.

The dual aspect concept says every transaction has two sides. The accounting equation expresses this idea in a single line that holds true at every moment in the life of a business:

Assets = Liabilities + Capital

The logic is simple. Everything the business owns (assets) was paid for with money supplied by someone. That money came either from outsiders (liabilities) or from the owner (capital). So the total of what the business owns must always equal the total of the claims against it. The equation can be rearranged as Capital = Assets − Liabilities, which is the owner's net worth, or Liabilities = Assets − Capital.

Every transaction changes at least two items in the equation, but the equation itself stays balanced. There are only a few patterns:

• An asset increases and another asset decreases (buy furniture for cash).
• An asset increases and a liability increases (buy goods on credit).
• An asset increases and capital increases (owner brings in cash; or a profit is earned).
• An asset decreases and a liability decreases (pay a creditor).
• An asset decreases and capital decreases (owner withdraws cash; or an expense is paid).
• A liability increases and capital decreases (outstanding expense recorded).

Expenses and losses reduce capital; incomes and gains increase capital. That is why the full equation is sometimes written as Assets = Liabilities + Capital + Revenues − Expenses − Drawings.

Consider the following transactions of Kiran, who starts business on 1 April:

After the sixth transaction assets total 80,000 + 20,000 + 20,000 = 1,20,000, and liabilities plus capital total 20,000 + 1,00,000 = 1,20,000. The equation balances, as it must. In transaction 4 the profit of Rs 5,000 (sale 15,000 less cost 10,000) has increased capital; in transaction 5 the rent expense has reduced it.

The accounting equation is not merely an exercise. The balance sheet is nothing but the accounting equation written out in full on a particular date, with assets on one side and liabilities and capital on the other. A student who can keep the equation balanced through a series of transactions has already understood the heart of double entry.

The double entry system is the method of recording transactions in which the two aspects of every transaction are both recorded, one as a debit and the other as a credit, in two different accounts, for equal amounts. It follows directly from the dual aspect concept. If goods worth Rs 10,000 are bought for cash, the goods account receives the benefit and cash account gives it; purchases account is debited with Rs 10,000 and cash account is credited with Rs 10,000.

The system was first described systematically by Luca Pacioli in 1494, and it is used today by every business in the world, from a street vendor's accountant to the largest multinational, because it is complete, self-checking and scientific.

Features of the double entry system

• Every transaction affects two accounts, or more, but the total debited always equals the total credited.
• One account is debited and another is credited; there is no transaction with only one side.
• Both personal and impersonal accounts are maintained, so the system gives a complete picture.
• Because debits always equal credits, the arithmetical accuracy of the books can be tested by a trial balance.

Stages of the double entry system

• Recording in the journal or subsidiary books, transaction by transaction, in date order.
• Classifying by posting to ledger accounts, so that all entries about one account are together.
• Summarising by balancing the ledger accounts, preparing the trial balance and then the final accounts.

Advantages of the double entry system

• It provides a complete record of both aspects of every transaction.
• Arithmetical accuracy can be checked through the trial balance.
• Profit or loss can be found accurately from the profit and loss account.
• The financial position can be known from the balance sheet.
• Errors and frauds are easier to detect because every entry can be traced to its other half.
• Comparison between years and between firms becomes possible.
• It supplies full information about debtors, creditors, assets and expenses.
• It is accepted by courts, banks and tax authorities.

Disadvantages are few: the system needs trained persons, it is somewhat costly for a very small business, and it does not by itself detect errors of principle or compensating errors. These are dealt with in the chapter on rectification of errors.

The alternative is the single entry system, in which only personal accounts and a cash book are kept and the other aspect of many transactions is not recorded. It is incomplete, unscientific and cannot produce a trial balance, so profit has to be estimated from changes in capital. Small traders sometimes use it, but it is not accepted by tax authorities or by law for companies.

Before the rules of debit and credit can be applied, each account must be identified by type. Under the traditional or English approach, accounts are classified into two broad groups, personal and impersonal, and impersonal accounts are further divided into real and nominal.

1. Personal accounts are accounts of persons with whom the business deals. There are three kinds:

• Natural persons: accounts of human beings, such as Ravi's account, Sita's account.
• Artificial persons: accounts of bodies that the law treats as persons, such as a company, a bank, a firm, a club or a cooperative society: State Bank of India account, Andhra Cements Ltd account.
• Representative personal accounts: accounts that stand for a group of persons or represent an amount owed to or by persons, such as outstanding salaries account (which represents the employees to whom salary is due), prepaid insurance account, accrued interest account. Capital account and drawings account are also personal accounts because they represent the owner.

2. Real accounts are accounts of assets and properties of the business. They are of two kinds:

• Tangible real accounts: assets that can be seen and touched, such as cash, buildings, machinery, furniture, stock.
• Intangible real accounts: assets that cannot be touched but have value, such as goodwill, patents, trademarks, copyrights.

3. Nominal accounts are accounts of expenses, losses, incomes and gains. Examples are salaries, rent, wages, discount allowed, loss by fire, commission received, interest received, discount received. They are called nominal because they exist in name only; at the end of the year their balances are transferred to the profit and loss account and they start the new year at zero. Purchases and sales accounts are also treated as nominal accounts.

The modern or American approach classifies accounts into five groups based on the accounting equation: asset accounts, liability accounts, capital accounts, revenue accounts and expense accounts. Both approaches give the same debit and credit results; the traditional approach is followed in this course.

A few tricky cases

• Outstanding rent account is a representative personal account, not a nominal account, because it represents the landlord to whom rent is due.
• Bank account is a personal account (artificial person), but cash account is a real account.
• Bad debts account is nominal (a loss); a debtor's account is personal.
• Goodwill account is real, though intangible.
• Purchases account is nominal although goods are tangible, because it records an expense of the trading period.

A practical test: if the account name is that of a person, firm or body, or represents an amount due to or from persons, it is personal. If it names a thing the business owns, it is real. If it names an expense, loss, income or gain, it is nominal. Correct classification is the first step in every journal entry.

Every account has two sides. The left side is the debit side, abbreviated Dr, and the right side is the credit side, abbreviated Cr. To record a transaction, the book keeper must decide which account is debited and which is credited. The rules that decide this are called the golden rules of accounting, and there is one rule for each type of account.

Personal accounts: Debit the receiver, credit the giver. When a person receives something from the business, his account is debited; when a person gives something to the business, his account is credited. Sold goods to Ravi on credit: Ravi receives goods, so debit Ravi. Bought goods from Sita on credit: Sita gives goods, so credit Sita.

Real accounts: Debit what comes in, credit what goes out. When an asset comes into the business, its account is debited; when it goes out, its account is credited. Purchased machinery for cash: machinery comes in, so debit machinery; cash goes out, so credit cash.

Nominal accounts: Debit all expenses and losses, credit all incomes and gains. Paid rent: rent is an expense, so debit rent account. Received commission: commission is an income, so credit commission account.

Under the modern approach the same results are expressed in terms of increases and decreases: an increase in assets or expenses is a debit and a decrease is a credit; an increase in liabilities, capital or revenue is a credit and a decrease is a debit.

Applying the rules: a worked set

• Started business with cash Rs 1,00,000. Cash comes in (real): debit cash. The owner gives (personal): credit capital.
• Purchased goods for cash Rs 20,000. Goods are an expense of trading (nominal, purchases): debit purchases. Cash goes out (real): credit cash.
• Sold goods to Kumar on credit Rs 15,000. Kumar receives (personal): debit Kumar. Sales is an income (nominal): credit sales.
• Paid wages Rs 4,000. Wages is an expense (nominal): debit wages. Cash goes out (real): credit cash.
• Received interest Rs 1,000. Cash comes in (real): debit cash. Interest is an income (nominal): credit interest received.
• Kumar paid Rs 15,000. Cash comes in: debit cash. Kumar gives: credit Kumar.

Notice that in every case exactly one account is debited and one is credited with the same amount, which is what makes the trial balance agree. The word debit does not mean bad and credit does not mean good; they are simply the left and right sides of an account. With a little practice the rules become automatic, and the journal, which is the subject of the next chapter, becomes easy.

Two further distinctions complete the introduction: the system of book keeping a business uses, and the basis on which it recognises income and expenses.

Systems of book keeping

The double entry system, already described, records both aspects of every transaction and is the only complete and scientific system. The single entry system is really an incomplete double entry system. Under it a trader keeps a cash book and personal accounts of debtors and creditors but does not keep real and nominal accounts. Some transactions are recorded on both sides, some on one side and some not at all. It is cheap and simple, which is why very small traders use it, but it has serious defects: no trial balance can be prepared, arithmetical accuracy cannot be checked, profit cannot be found exactly and must be estimated by comparing opening and closing capital, the financial position cannot be shown reliably, and the records are not accepted by tax authorities or courts as full evidence. Whenever this course speaks of book keeping, it means double entry.

Bases of accounting

The basis of accounting refers to the point of time at which revenues and expenses are recognised. There are two bases.

Cash basis. Income is recorded only when cash is actually received and expenses only when cash is actually paid. Outstanding expenses, prepaid expenses, accrued income and income received in advance are ignored. The method is simple and is used by some professionals such as doctors and lawyers and by small non-trading bodies, but it does not match expenses with revenues and gives a distorted profit. A business that received Rs 2,00,000 in a year but performed services worth Rs 3,00,000 would show only Rs 2,00,000 as income.

Accrual or mercantile basis. Income is recorded when it is earned, whether or not cash has been received, and expenses are recorded when they are incurred, whether or not cash has been paid. Outstanding and prepaid items are adjusted. This basis follows the matching, accrual and realisation concepts, gives a true profit for the period and a true financial position, and is required by the Companies Act. It is the basis assumed throughout this course.

A hybrid basis, in which income is on cash basis and expenses on accrual basis, was once allowed for some taxpayers but is no longer recognised under Indian tax law; only cash or mercantile basis may be followed, and consistently.