Unit – 2 Basic Accounting Procedures

Double Entry System

Double entry system of accounting is more than 500 years old. “Luca Pacioli” an Italian friar &
mathematician published “Summa de Arithmetica, Geometria, Proportioni, et Proportionalita”
(“Everything about Arithemetic Geometry and proportions”).
The first book that described a double entry accounting system. Double entry system of book-keeping
has emerged in the process of evolution of various accounting techniques. It is the only scientific
system of accounting. According to it, every transaction has two-fold aspects–debit and credit and
both the aspects are to be recorded in the books of accounts. Therefore, in every transaction at least
two accounts are effected.

For example, on purchase of furniture either the cash balance will be reduced or a liability to the supplier will arise.
and new asset furniture is acquired . This has been made clear already, the Double Entry System records both the
aspects. It may be defined as the system which recognizes and records both the aspects of transactions. This system
has proved to be systematic and has been found of great use for recording the financial affairs for all institutions
requiring use of money.

This system affords the under mentioned advantages:

(i) By the use of this system the accuracy of the accounting work can be established, through the device
of the trial balance.
(ii) The profit earned or loss suffered during a period can be ascertained together with details.
(iii) The financial position of the firm or the institution concerned can be ascertained at the end of
each period, through preparation of the balance sheet.
(iv) The system permits accounts to be kept in as much details as necessary and, therefore affords
significant information for the purposes of control etc.
(v) Result of one year may be compared with those of previous years and reasons for the change
may be ascertained.
It is because of these advantages that the system has been used extensively in all countries.

Concept of DEBIT AND CREDIT

We have seen that in T-accounts increase and decrease entries are made on the left and right side of
the accounts for assets respectively and vice-versa for liabilities. But, formally accountants use the term
Debit (Dr.) to denote an entry on the left side of any account and Credit (Cr.) to denote an entry on
the right side of any account.
We know that by deducting the total of liabilities from the total of assets the amount of capital is
ascertained, as is indicated by the accounting equation.

Assets = Liabilities + Capital

or
Assets – Liabilities = Capital
To understand the equation better , let us expand it:-
Assets = Liabilities + stockholders’ Equity

Assets = Liabilities + ( contributed capital + beginning retained earnings + revenue - expense -

dividends) Here,
Contributed capital = the original capital introduced by the owner.
Beginning retained earnings = previous earnings not distributed to the shareholders.
Revenue = generated from the ongoing activities of the business
Expenses = cost incurred for the operations of the company.
Dividends = earnings distributed to the shareholders of the company
We have also seen that if there is any change on one side of the equation, there is bound to be similar
change on the other side of the equation or amongst items covered by it or an opposite change on the
same side of the equation. This is illustrated below:

Transactions Total = Liabilities + Owner’s

Assets Rs. Capital
Rs. Rs.
(1) Started business with cash Rs.10,00,000 10,00,000 10,00,000
(2) Borrowed Rs.5,00,000 + 5,00,000 + 5,00,000
(3) Withdrew cash from business Rs.2,00,000 - 2,00,000 - 2,00,000
(4) Loan repaid to the extent of Rs.1,00,000 - 1,00,000 - 1,00,000
(5) Bought furniture worth Rs.3,00,000 with +3,00,000
Cash - 3,00,000
Balance 12,00,000 = 4,00,000 + 8,00,000
As has been seen previously, what has been given above is suitable only if the number of
transactions is small. But if the number is large, a different procedure of putting increases and
decreases in different columns will be useful and this will also yield significant information. The
transactions given above are being shown below according to this method.

Total Assets = Liabilities + Owner’s Capital

Decrease Decrease Increase Decrease Increase
Rs. Rs. Rs. Rs Rs.

(1) 10,00,000 10,00,000

(2) 5,00,000 5,00,000
(3) 2,00,000 2,00,000
(4) 1,00,000 1,00,000
Total 15,00,000 3,00,000 1,00,000 5,00,000 2,00,000 10,00,000
Balance 12,00,000 4,00,000 + 8,00,000

It is a tradition that:
(i) increases in assets are recorded on the left-hand side and decreases in them on the right-hand side; and
(ii) in the case of liabilities and capital, increases are recorded on the right-hand side and decreases on the
left-hand side.
When two sides are put together in T form, the left-hand side is called the ‘debit side’ and the right
hand side is ‘credit side’. When in an account a record is made on the debit or left-hand side, one says
that one has debited that account; similarly to record an amount on the right-hand side is to credit
it.
From the above, the following rules can be obtained:
 (i) When there is an increase in the amount of an asset, its account is debited; the account will be
credited if there is a reduction in the amount of the asset concerned : Suppose a firm purchases
furniture for
Rs. 8,00,000 the furniture account will be debited by Rs.8,00,000 since the asset has increased by this
amount. Suppose later the firm sells furniture to the extent of Rs 3,00,000 the reduction will be recorded by
crediting the furniture account by Rs.3,00,000.
FURNITURE

Increase Decrease
(1) 8,00,000 (2) 3,00,000
Balance 5,00,000
ii) If the amount of a liability increases, the increase will be entered on the credit side of the liability account,
i.e. the account will be credited: similarly, a liability account will be debited if there is a reduction in
the amount of the liability. Suppose a firm borrows ` 5,00,000 from Mohan; Mohan’s account will be
credited since ` 5,00,000 is now owing to him. If, later, the loan is repaid, Mohan’s account will be
debited since the liability no longer exists.
MOHAN

Decrease Increase
(2) 5,00,000 (1) 5,00,000
(i) An increase in the owner’s capital is recorded by crediting the capital account: Suppose the
proprietor introduces additional capital, the capital account will be credited. If the owner
withdraws some money, i.e., makes a drawing, the capital account will be debited.
(ii) Profit leads to an increase in the capital and a loss to reduction: According to the rule mentioned in
(iii) above, profit & incomes may be directly credited to the capital account and losses & expenses
may be similarly debited.
However, it is more useful to record all incomes, gains, expenses and losses separately. By doing so,
very useful information will be available regarding the factors which have contributed to the year’s
profits and losses. Later the net result of all these is ascertained and adjusted in the capital
account.
(iii) Expenses are debited and Incomes are credited: Since incomes and gains increase capital, the rule is
to credit all gains and incomes in the accounts concerned and since expenses and losses decrease
capital, the rule is to debit all expenses and losses. Of course, if there is a reduction in any
income or gain, the account concerned will be debited; similarly, for any reduction in an
expenses or loss the concerned account will be credited.
The rules given above are summarised below:
(i) Increases in assets are debits; decreases are credits;
(ii) Increases in liabilities are credits; decreases are debits;
(iii) Increases in owner’s capital are credits; decreases are debits;
(iv) Increases in expenses are debits; decreases are credits; and
 (v) Increases in revenue or incomes are credits; decreases are debits.
The terms debit and credit should not be taken to mean, respectively, favourable and unfavourable things.
They merely describe the two sides of accounts.
TRADITIONAL APPROACH
Under traditional approach of recording transactions one should first understand the term debit and credit
and their rules. The term debit and credit have already been explained in para 1.4 of this Unit.
Transactions in the journal are recorded on the basis of the rules of debit and credit only. For the purpose
of recording, these transactions are classified in three groups:
(i) Personal transactions. (Personal Account)
(ii) Transactions related to assets and properties. (Real Account)
(iii) Transactions related to expenses, losses, income and gains. (Nominal Account)
Classification of Accounts
(i) Personal Accounts: Personal accounts relate to persons, trade receivables or trade payables. Example
would be the account of Ram & Co., a credit customer or the account of Jhaveri & Co., a supplier of
goods. The capital account is the account of the proprietor and, therefore, it is also personal but
adjustment on account of profits and losses are made in it. This account is further classified into
three categories:
(a) Natural personal accounts: It relates to transactions of human beings like Ram, Rita, etc.
(b) Artificial (legal) personal accounts: For business purpose, business entities are treated to
have separate entity. They are recognised as persons in the eye of law for dealing with other
persons. For example: Government, Companies (private or limited), Clubs, Co-operative
societies etc.
(c) Representative personal accounts: These are not in the name of any person or organisation but
are represented as personal accounts. For example: outstanding liability account or prepaid
account, capital account, drawings account.
(ii) Impersonal Accounts: Accounts which are not personal such as machinery account, cash account,
rent account etc. These can be further sub-divided as follows:
(a) Real Accounts: Accounts which relate to assets of the firm but not debt. For example,
accounts regarding land, building, investment, fixed deposits etc., are real accounts. Cash in
hand and Cash at the bank accounts are also real.
(b) Nominal Accounts: Accounts which relate to expenses, losses, gains, revenue, etc. like
salary account, interest paid account, commission received account. The net result of all the
nominal accounts is reflected as profit or loss which is transferred to the capital account.
Nominal accounts are, therefore, temporary.
Golden Rules of Accounting
All the above classified accounts have two rules each, one related to Debit and one related to Credit
for recording the transactions which are termed as golden rules of accounting, as transactions are recorded
on the basis of double entry system.

Types of Account Account to be Debited Account to be Credited

Personal Account Receiver Giver
Real Account What comes in What goes out
Nominal Account Expense and losses Income and gains
Example:-
From the following information , state the nature of account and state which account will be debited
and which will be credited.
1. Started business with a capital of ` 50,00,000.
2. Wages and salaries paid ` 50,000
3. Rent received ` 2,00,000
4. Purchased goods on credit ` 9,00,000
5. Sold goods for ` 8,16,000 and received payment in cheque.

SOLUTION

Transaction ACCOUNTS NATURE DEBIT OR Journal Entry

INVOLVED CREDIT
Started business Bank account Personal Debit (Receiver) Bank A/c Dr.
with capital of Capital account Personal Credit (giver) To Capital
` 50,00,000 A/c
Wages and salaries Wages/salaries Nominal Debit (expense) Wages/ Salaries Dr.
paid Bank Personal Credit (giver) To Bank A/c
Rent received Ban Personal Debit (Receiver) Bank A/c
k Nomina Credit (income)
Rent l Dr. To Rent
A/c
Purchases made Purchases Nominal Debit (expense) Purchases A/c Dr.
on credit Creditor Personal Credit (giver) To Creditor A/c
Goods sold and Ban Personal Debit (Receiver) Bank A/c
payment received k Nominal Credit (gains)
in cheque Sales Dr. To Sales
A/c
 BBA I Semester - Accounting for Business

MODERN CLASSIFICATION OF ACCOUNTS

Real, nominal and personal accounts is the traditional classification of accounts. Now, let
us see the modern and more acceptable classification of accounts:-

Types of account Normal balance of Account to be debited Account to be credited

account when there is: when there is:
Asset account Debit Increase Decrease
Liabilities account Credit Decrease Increase
Capital account Credit Decrease Increase
Revenue account Credit Decrease Increase
Expenditure account Debit Increase Decrease
Withdraw account Debit Increase Decrease
Let us solve the same example with the modern approach now:-

Accounts involved Nature Debit/Credit Reason

Cash Asset Debit Increase
Capital Liability Credit Increase
Wages/salaries Expense Debit Increase
Cash Asset Credit Decrease
Cash Asset Debit Credit
Rent Revenue Credit Increase
Purchase Expense Debit Increase
Creditor Liability Credit Debit
Cash Asset Debit Increase
Sales Revenue Credit Increase

Manjula Devi P, Assistant Professor, GFGC Kanakapura