Basis, Accounting System & Accounting Equation

Introduction and Meaning

There are basically two systems of accounting followed for the recording of business transactions. These are:

1. Single Entry System
2. Double Entry System

Single Entry System

It denotes a system of accounting where a cash book is prepared and no other ledgers are prepared excepting personal accounts. The preparation of a cash book shows all receipts and payments of cash.

It is a system of accounting which does not follow the principles of the double entry system. It has been rightly said that the Single Entry System is nothing but an admixture of single entry, double entry, and no entry system because:

• For recording the cash book, one aspect (whether receipt or payment) is recorded.
• For recording transactions relating to personal accounts, the double entry system is followed.
• For internal transactions like depreciation on an asset, no entry is passed.

Conclusion: The single entry system of accounting is not at all a true system because it is not based on scientific principles of recording. As such, this method is sometimes called "accounts from incomplete records."

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Features of Single Entry

The following are some of the essential characteristics of the single entry system:

• A cash book is prepared showing receipts and payments of cash.
• No other ledgers excepting personal accounts are maintained.
• Personal accounts are maintained under a dual aspect basis.
• The cash book is recorded under a one aspect basis.
• There is no provision for entry for internal transactions.

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Ascertainment of Profit

There are basically two methods of calculating profit under this system. These are:

1. Statement of Affair Method (Traditional method)
2. Conversion Method

Generally, profit determination is made under the statement of affairs method. The following procedure is adopted for the calculation of profit:

Step 1: Calculate Opening Capital

Calculate the Opening capital by preparing an opening statement of affairs.

Statement of Affairs as on ........ (Opening)

Step 2: Calculate Closing Capital

Calculate the Closing capital by preparing a closing statement of affairs.

Statement of Affairs as on ........ (Closing)

Step 3: Calculation of Profit

After the calculation of closing capital and opening capital, the profit is calculated by the application of the following table:

1. Calculation of Profit

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Alternative Methods for Calculation of Profit (Single Entry System)

Depending on the information provided in a problem, profit can also be calculated using these expanded formats:

2. Calculation of Profit (When fresh capital is introduced)

3. Calculation of Profit (Comprehensive)

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Introduction and Meaning of Double Entry

The Double Entry System of accounting denotes a system where both aspects of a transaction are recorded in the books of accounts. This duality becomes the fundamental basis of the double entry system of accounting.

This system of accounting operates on the core belief that the totals of all debits must be equal to the totals of all credits. Because of this fundamental characteristic, this system of accounting is often compared with Newton's third law of motion, which states that for every action, there is always an equal and opposite reaction.

This method arranges accounts in such a way that the dual aspect (which is present in every single account transaction) is expressed by a debit amount and an equal, offsetting credit amount.

The double entry system is the system under which each transaction is regarded to have two-fold aspects, and both of these aspects are recorded to obtain a complete and accurate record of all dealings.

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Features of Double Entry System

What makes this system so universal? Here are its main features:

1. A transaction takes place only if there are two parties—one party receiving the benefit and the other party giving or parting with the benefit.
2. Each party is affected by the transaction in opposite directions, but with the exact same amount.
3. Each transaction affects at least two items in an accounting equation. (Remember, the accounting equation is composed of three elements: assets, liabilities, and capital).
4. Changes are recognized from the angle of the party in whose books the recording is being done.
5. Changes are recorded in two related accounts in the books of the party.
6. The account receiving the benefit is debited (recorded on the left-hand side) and the account rendering the benefit is credited (recorded on the right-hand side).
7. Each account has two sides—left (debit) and right (credit).
8. For each transaction, the debit amount is exactly equal to the credit amount.

So, the famous proverb "every debit has a corresponding credit and vice-versa" is entirely based on this system!

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Advantages of Double-Entry System

The double-entry system of bookkeeping is the global standard for a reason. It has a massive number of advantages:

• (i) Complete Record: It enables you to keep a complete, end-to-end record of all business transactions.
• (ii) Arithmetical Accuracy: It provides a built-in check on the arithmetical accuracy of the books of accounts based on the equality of debits and credits.
• (iii) Determines Profit/Loss: It clearly gives the results of business activities, calculating either profit or loss during the accounting period.
• (iv) States Financial Position: It states the exact financial position of the business at a point in time. Total resources of the business and the claims of outsiders are cleanly revealed by a statement known as the balance sheet.
• (v) Enables Comparison: It makes it possible to compare the current year's data with those of previous years, helping the owner manage the business on better lines.
• (vi) Reduces Errors: It drastically reduces the chances of errors creeping into the accounting records because of its core equality principle.
• (vii) Detailed Information: It helps you ascertain the details regarding any specific account easily and accurately.
• (viii) Cost of Production: It helps in ascertaining the cost of production by preparing a Manufacturing account (in the case of a manufacturing business).
• (ix) Granular Profit Disclosure: The profit disclosed is broken down under the headings of Gross Profit and Net Profit.
• (x) Effective Control: The distinction between gross and net profit heavily assists management in administering effective control systems.
• (xi) Tax Assessment: Financial statements prepared under this system are the reliable basis for determining the tax liability of the business.
• (xii) Insurance Claims: The calculation of abnormal loss (e.g., loss of stock due to fire, accidents) helps immensely in accurately filing claims with an insurance company.

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Disadvantages of Double-Entry System

In fact, there are arguably no true disadvantages to the double-entry system of bookkeeping as a concept. However, for the sake of argument and practical implementation, the following may be regarded as drawbacks:

1. Requirement of Expert Knowledge: It isn't something anyone can do intuitively. Nowadays, accounting is a complex profession and must be practiced by qualified professionals (like Chartered Accountants).
2. Lengthy & Cumbersome Process: The process of recording, classifying, analyzing, and interpreting is undeniably cumbersome and tedious.
3. Expensive: An accounting department needs to be staffed by qualified and trained personnel requiring high salaries. Therefore, it is expensive for very small business units, and it may not be economical for them to maintain a full-fledged accounting department.

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Classification of Accounts

Individual transactions of a similar nature are recorded at one place. Before knowing the rules of debit and credit, it is essential to have complete knowledge of the meaning and format of an account.

An account denotes a summary of business transactions relating to a person, asset, liability, expense, or income. The physical (or digital) place where relevant transactions are recorded is called an account.

An account is generally recorded in a 'T' shape where the left-hand side is the debit side (receiver of benefit) and the right-hand side is called the credit side (giver of benefit).

It is regarded as a well-organized statement and a summary of all transactions relating to a particular head.

Standard Format of an Account:

Name of the Account
(Dr.) (Cr.)

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Classification of Accounts: Two Approaches

The classification of accounts can be judged from two distinct approaches:

• Traditional approach (British approach)
• Modern approach (American approach)

1. Traditional Approach (British Approach)

Under this approach, accounts are mainly classified into the following three broad categories: Personal Account, Real Account, and Nominal Account.

A. Personal Account
Accounts relating to individuals, firms, clubs, hospitals, etc., are known as personal accounts.

B. Real Account
The properties and possessions owned by an enterprise are included under the purview of real accounts.

C. Nominal Account
Nominal accounts consist of expenses, losses, incomes, and gains.

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2. Modern Approach (American Approach)

Under the modern American approach, accounts are classified under the following functional heads:

• Assets: These include Cash, Bank, Bills Receivable, Debtors, Land, Goodwill, Patents, etc.
• Liabilities: These include Creditors, Bills payable, outstanding expenses, Bank loan, etc.
• Capital: This includes the capital account and the drawing account.
• Revenue: Commission received, Interest received, Dividend received, etc.
• Expenses & Losses: Salaries, wages, Carriage, postage, Bad debt, Loss on sale of asset, etc.
• Contra Accounts: Provision for bad debt, provision for discount on debtors, provision for depreciation, purchase return, sales return, etc.

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Basis of Accounting System

A basis of accounting is nothing more than a set of rules that the accountant follows when preparing financial reports.

(a) Accrual or Mercantile Basis
Revenues, costs, assets, and liabilities are reflected in the accounts in the specific period in which they accrue. All incomes and expenses belonging to the accounting period are recorded in the books, even if these are not transacted in cash during that period.

(b) Cash or Receipts Basis
Transactions are reflected in the accounts only in the period in which actual receipts or actual payments are made. Entries are made only when cash actually changes hands.

(c) Tax Basis
This means the provisions of income tax are used in deciding how to record transactions. For most companies, this is simply a modified version of the accrual basis.

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Rules/Principles of Double Entry System

The Rules of Debit and Credit (Traditional Approach)

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The Rules of Debit and Credit (Modern / Accounting Equation Approach)

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Distinction between Cash System and Mercantile System

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Accounting Equation

The 'Dual Concept' is the very basis of the accounting equation. Under this concept, the total sum of assets is always equal to the total sum of external and internal equities.

The Formula:

Capital + Liability = Assets

• Assets: Economic resources owned by an enterprise.
• External claims: Outsiders' equity (the liability of the business).
• Internal claims: Owners' equity (the capital of the business).

Key Takeaway: Capital increases with incomes/gains and additional investment. Capital decreases with expenses/losses and drawings.

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