In this series of articles we will also discuss:
1. Balance Sheet Explained
2. Trading and Profit and Loss Account
3. Adjustments of Final Accounts
Previously while discussing the basic accounting equation it was noted that A - L = P, where A represents assets (property and possession) owned by the business; L represents liabilities (claims against the business of the creditors) and P represents the proprietor's funds (equity) in the business.,
Accounting Concept of Income
The concept of 'income' is different to the economists and accountants. Economists concept of income is that of 'real income' meaning thereby the increase-in real terms of the ownership funds between two points of time.
In accounting the term income is known as 'net profit'. It was stated earlier :
Sales - Merchandising cost = Gross profit and Gross profit - Expenses of doing business = Net profit
In other words, Revenue - Expenses = Net profit.
These terms are explained below:
It is the monetary value of the products sold or services rendered to the customers during the period. It results from sales services and source like interest, dividend and commission etc. For example, sales affected by the business and charge made for services rendered by the business constitutes revenue. However, all cash receipt may nott be revenue.
Thus, money borrowed leads to cash receipt but it does not constitute revenue. Similarly additional capital brought in increases proprietor's funds but it is not revenue.
Expenses/Cost of (doing business)
Expenditure incurred by the business to earn revenue is termed as expense or cost of doing business. Examples of expenses are raw materials consumed, salaries, rent, depreciation, advertisement etc.
Cash v/s Accrual Basis of Accounting
Small business, individual professionals and non-trading concerns usually adopt cash basis of accounting. Under this system, incomes are considered to have been earned only when received ill cash and expenses are considered to have been incurred only actually paid. Hence, under this system the profit or loss of an accounting period is the difference between incomes received and the expenses paid. Though the cash basis of accounting is simple (no adjustment is required) but il loses its comparability.
Under accrual basis all incomes are credited to the period in which earned irrespective of the fact whether received or not. Similarly, all expenses are debited to the period in which incurred irrespective of the fact whether paid or not. It is a scientific basis of accounting, though a bit difficult.
Matching Concept. Requires that expenses should be matched to the revenues of the appropriate accounting period. So we must determine what are the revenues earned during a particular accounting period and the expenses incurred to earn these revenues.
It is the matching concept which justifies accrual basis of accounting.
Accruals and Deferrals
Accounting is expected to measure or ascertain the net income of the business during the accounting period. Normally, it is the calendar year (1st January to 31st December) but in other cases it may be Financial year (Ist April to 31st March) or any other period according to the convention of the business community of the area.
The combined impact of matching concept and the accounting period concept on accounting has resulted in accruals and deferrals.
Accrued or Outstanding expenses
It is the term which denotes that expenditure has been incurred during the accounting period but the same has not been paid in cash e.g. Salary, Rent, Wage etc. becoming due but not paid.
Deferred or pre-paid expenses
It is the term which denotes that payment in cash has been made "in advance but the full benefit of this payment has not been reaped by the current accounting period, e.g., Insurance paid in advance.
Accrued or outstanding Income
It is the term which denotes that the income has been earned but the cash has not been received against the same. Income has accrued due but not received e.g. Interest on investments etc.
Differed or Received in-advance Income
It is the term which denotes income which has been received (in cash) in advance but it has not been earned so far e.g. rent received in advance. All the accruals and deferrals arc not be adjusted at the end of the accounting period (end-period adjustments) in order to find out the income of the business during the period under review. The procedure of ascertaining (i) business income and (ii) financial position is being described, in detail below:
In fact, these arc two most important of many objectives of book-keeping. In order to know the profits earned by him he prepares a trading and loss account and in order to know the financial position of his business on the last day of the financial period he prepares a balance sheet.
Such accounts are called 'Final Accounts'. Preparation of final accounts is the concluding step of accounting cycle. In fact, final accounts include a number of accounts (i) Manufacturing/ Production account, (ii) Trading account, (iii) Profit and loss account and (iv) Balance sheet.
Practically balance sheet is a statement but for accounting purposes here it is treated as a part vital accounts.
The preparation of above all or any of the above accounts depends upon the nature of the business being carried on by the business concerned. In case of a manufacturing business manufacturing account, trading account, profit and loss account and balance sheet form the parts of final accounts whereas in case of trading business all other accounts are prepared with the exception of manufacturing account. Each of these accounts provide a specific vital information to businessman to help to control and organize the business activities in a batter way.