THE MECHANICS OF ACCOUNTING

(all amounts in the illustration in INR 00,000)

The start of double accounting system was accompanied by the use of the accounting equation for making the balance sheet and profit and loss account. Prior to the industrial revolution, businesses were small and transactions few.  The following example would help you understand the mechanics of accounting as it used to be and as what it is today. Assume a business going through the following economic transactions in a financial period,

• Transaction number 1- the introduction of rupees 50 Lakhs as capital
• Transaction number 2 - the payment of rupees 3 Lakhs as advance rent  
• Transaction number 3  -the buying of machine, rupees 6 lakh, 50% of the payment being made in cash.
• Transaction number 4  -the buying of inventory worth rupees 15 lakhs, one third of the payment be made in cash
• Transaction number 5 - the sale of 50% of the above-mentioned inventory for rupees 20 lakh, 50% of the amount received in cash where as the balance 50% is promised to be paid later.
• Transaction no 6- the payment of power and fuel bill of rupees 6 lakh in cash.
• Transaction number 7 - the payment of  salary  equaling  rupees 6 lakh  being paid in cash  
• Transaction number 8- travelling expenditure of rupees 1 lakh paid in cash.

All of the above are explicit transactions, transactions accompanied with proof and the accountant, would record all these explicit transaction in the accounting equation as shown in Exhibit 1.

Note that the accountant is showing a negative balance of INR 50,000 in the Retained Earning column implying that the organization has suffered a loss ,which shall go into the form of reduction of the initial Capital contributed by the owners.

You may like to ponder over whether ‘change of Capital can be called Profit?’ However, coming back to the illustration , implicit transactions that have contributed towards the performance of the organization but not having being accounted by the junior accountant because of lack of evidence/proof should also be taken into account e.g. the use of the premises for one full year or the use of the machinery for one full year. Redrawing the Accounting Equation after these two adjustments results in details shown in

Exhibit 2.

The use of accounting equation was sufficed to keep account of a small number of transactions. However as the size of businesses grew, the writing and rewriting of the entire accounting equation after every explicit transaction was both tedious and prone to error .An easier way had to be identified in order to make the writing of accounts an easy exercise accompanied by a favorable cost benefit .It was decided that every asset and liability be accounted for separately using two pages, one on the left and the other on the right .An increase in an asset was decided to be recorded on the left hand page of the two pages ; the writing on the left hand page was to be called debit. The process of writing on the right hand page was decided to be called credit. This would obviously be done for increase in liabilities or a decrease in asset. Obvious because the entire language of accounting is based on an equation and if we devise one rule for the LHS, it would automatically be reversed for the opposite side.  Details in Exhibit 3 will show you the two sides or the two pages of every asset and liability, which occur, in the accounting equation of our example. Similar to what the accountant did in the accounting equation approach, totals of all Assets and Liabilities at the end of the financial period have been identified from the different two pages accounts. If the LHS is heavier, the balance is known as a Dr Balance , whereas , in case the RHS is heavier, the balance is known as Cr Balance. Of course, these balances will be the same as the balances arrived at by the use of an accounting equation. Why? The organized placement of all Dr and Cr balances results in a document called the Trial Balance.  The following shows the Trial Balance as extracted from the two pages accounts appearing in

Exhibit 3.

HEAVIER SIDE PLACEMENT

As with the Asset= Capital + Liabilities equation scenario, the adjustments relating to the utilization of rental premises and machine for one year each have not been provided for while writing the explicit transactions because of lack of proof. Hence, adjustments to the same need to be provided resulting in the following adjusted Trial Balance.

As mentioned earlier, two accounting heads viz Cash and Retained Earnings carry the maximum number of transactions. These accounts are of priority because of the necessity of liquidity and profits. Hence instead of drawing the Retained Earnings two page account, separate accounts for all revenue expenditure and revenues shall be maintained. Their balances would subsequently be transferred into the Retained Earning account . Therefore, the following two pages accounts would appear in this new analysis instead of the older Retained Earning two page account.

ACCOUNTS REPLACING THE RETAINED EARNINGS ACCOUNT

Note that there are 5 two pages accounts which we have drawn instead of the one two page account on retained earning . All these 5 accounts happened to be off revenue or revenue expenditure also known as expense. When we had drawn the retained earning account , we had incorporated the revenue on the right hand page and expenses on the left hand page  The balance of the retained earning was considered a liability and an our example, the negative amount  represented losses which the company suffered during the accounting period . Just as profits are a liability , losses may be considered as assets.Why?The drawing of all these 5 accounts separately, instead of the one retained earning account would change the trial balance in terms of the total and also the number of items appearing. This new trial balance shown in Exhibit 4 shell separately carry details of the revenue and revenue expenditure instead of the balance of retained earning.

Adjustments relating to the utilization of rental premises and machine for one year each have not been provided for while making the Trial Balance shown in Exhibit 4. The Trial Balance post adjustments would appear as follows,

A Profit & Loss Account and a Balance Sheet can now be extracted from the adjusted Trial Balance as follows,

EXHIBIT 3

THE WRITING OF EVERY EXPLICIT TRANSACTION ON TWO PAGES, THE LEFT AND THE RIGHT. (RULE - INCREASE IN ASSET ON THE LEFT).