Accounting

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A business house must necessarily keep systematic record of what happens from day-to-day so that it can know where it stand and so that it can satisfy the ever increasing curiosity of the income-tax officer,if nothing else.Most of the business these days is run by join stock companies and these are required by law to prepare periodic, mostly annual, statements in proper form showing the state of financial affairs. A systematic record of the daily events of a business leading to presentation of a complete financial picture is known as Accounting.

The art of accounting has been practiced for long but it is only recently, more specifically in the late thirties, that the study of the theory of accounting has been taken up seriously. In this task,the American Institute of Certified Public Accountants (AICPA) has played a notable part.
This institute once defined accounting as "the art of recording,classifying and summarizing in a significant manner, and in terms of money transaction and events which are, in part at least,of a financial character, and interpreting the results thereof."

Accounting Conscepts

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Accounting is the language of business;affairs of a business unit are communicated to others as well as to those who own or manage it through accounting information which has to be suitably recorded, classified, summarized and presented. To make the language convey the same meaning to all people, as far as practicable and to make it full of meaning, accounting have agreed number of concepts which they try to follow.These are given below:

(1) Business Entity Concept. Accounting treat a business as distinct from the person who own it, then it become possible to record transactions of the business with the proprietor also. Without such distinction, the affairs of the the firm will not be available.

(2) Cost Concept. Transactions are entered in the book of accounts at the amounts actually involved. Suppose a firm purchase a piece of land for $5000 but considers it as worth $6000. The purchase will be recorded $5000 and not any more. This is one of the most important concepts----it prevents arbitrary values being put on transactions, chiefly those resulting in acquisition of assets. Another way of saying the same thing would be that the amount to be recorded is objectively arrived at--as a result of the mutual agreement of the two parties involved.
Of course,sometimes, accountants have necessarily to be satisfied with an estimate only- the amount of depreciation to be charged each year in respect of machinery is an example; the amount has to be an estimate since the future life of the machinery cannot be known precisely.

(3) Money Measurement Concept. Accounting records only those transactions which are expressed in monetary terms, though quantitative records are also kept. An event, even though important, like a quarrel between the production manager and the sale manager, will not recorded unless its monetary effect can be measured with a fair degree of accuracy.

(4) Going Concern Concept. It is assumed that the business will exist for a long time and transactions are recorded from the point of view. It is this that necessitates distinction between expenditure that will render benefit over a long period and that whose benefit will be exhausted quickly, say within the year. Of course, if if is certain that the concerned venture will exist only for a limited time, the accounting record will be kept accordingly.

(5) Dual-Aspect Concepts. Each transaction has two aspects; if a business has acquired an asset, it must have resulted in one of the following.
(a) some other asset has been given up; or
(b) the obligation to pay for it has arisen; or
(c) there has been a profit, leading to an the amount that the business owes to the proprietor; or
(d) the proprietor has contributed money for the acquisition of the asset.
So in accounting the two effects of an entry will be recorded.

(6) Realization Concept. Accounting is a historical record of transaction; it record what has happen. It does not anticipate events though anticipated adverse effect of events that have already occurred are usually recorded. This is of great importance in stopping business firms from their profits by recording sales and income that are likely to accrue. Unless money has been realized-----either cash has been received or a legal obligation to pay has been assumed by the customer----no sale can be said to have taken place and no profit or income can be said to have arisen.

(7) Accrual Concept. If an event has occurred or a transaction has been into, its consequence will follow. Normally all transactions are settled in cash but even if cash settlement has not yet taken place, it is proper to bring the translation or the event concerned into the books. Income or profit arises only out of business operations----when there has been an increase in the owner's share of the assets of the firm (called owner's equity) but not if the increase has resulted from money contributed by the owner himself. Any increase in the owner's equity is called revenue and anything that reduced the owner's equity is expense (or loss); profit result only when the total of revenue exceeds the total of expense or losses.

Branches of Accounting

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The accounting system , as developed originally, concerned only the financial state of the affairs and the financial results of operations.This is called "Financial Accounting"
It includes preparation of accounts, generally on historical basis, so as to enable the management to prepare the financial statements showing the results of operations and the financial state of affairs, to exercise full control over the property and assets of the firm or the institute concerned and to prepare returns and statements concerning
taxation.
Cost Accounting developed because of the limitation of financial accounting in respect of information relating to the cost of individual jobs,products,etc
This information is needed for the purpose of making numerous decisions(e.g. the prices to be quoted a special customer or the priority to be accorded to a product when resources are scares.etc.) and for exercising control over the costs being occurred. Cost Accounting basically involves estimating costs in advance and detailed analysis.

A third branch of accounting which has now developed is Management Accounting. It means such accounting as will enable management to discharge its functions properly, chiefly in respect of forecasting and budgeting, control over costs and revenues decisions, both routine and strategic.

The Practical System

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It will readily realized that the bulk of transactions of a business house relate to cash (and bank) and purchase and sale of goods. Such transaction will often even in a single day and therefore, journalising each one of these transactions singly involves good deal of labor. To avoid this labor, a separate register (or Book) suitably ruled for each group of transactions is kept.One has, therefore usually the Cash Book (To record both cash and bank transactions) the Purchases Book (or Purchases Day Book or Purchases Journal) to record credit purchases of goods dealt in by the business, and the Sale Book to record credit sales of goods. If other transactions are many , one can keep separate books for them also. For Example, if returns from customers are numerous, one can start a Sale Returns Book or Return Inwards Book.
These are really specialized journals. Transactions not capable of being entered in any of these specialized journals maintained will be entered in the Journal. The Journal, therefore, will be very light. This is know as the Practical System or the English System. The books mentioned above as Books of Original Entry or Subsidiary Books.

Cash Book:- The cash Book is meant to record all cash transactions----whichever be their nature. It is divided into two sides----one,the left hand side, for receipts of cash; and other, the right hand side, for payments. Since in a modern business, transaction with or through bank are even more numerous than strictly cash transactions, each side has two columns----one to record cash transactions and the other to record bank transactions----payments into bank being enterd on the left hand side and payment out of bank being enter on the right hand side. (The left hand side is known as the debit side and the right hand side is called the credit side)

Purchases and Sales Books:- Besides cash transactions, purchase and sale of goods account for the bulk of other transactions and, as such separate books or registers are used to record credit purchases and credit sales. It must be remembered that cash purchases must already have appeared in the Cash Book (Credit side) and, similarly, cash sales must have been debited in Cash Book. Therefore, only credit purchases and sales are recorded in the purchases and sales Books.
Another point to remember is that only the credit purchases of goods dealt in and sales of goods only will be entered in the Purchases and Sales Books. Purchases of office furniture or Office equipment, for example, will recorded elsewhere.

Retuns Books:- Quite often goods have to be returned to supplies and goods are received back the customers for various. If return are numerous, it will be better if separate register or books are maintained to record returns of purchases (Return Outwards) and return of sales (Return Inwards). The ruling for both of these Books---Return Outwards and Return Inwards----is exactly similar to the Purchase or Sale Book. Entries are also similarly made. The total of the Return Inwards Book for a month shows total return made by customers (which means diminution of sales) and the total of the Returns Outwards Book shows corresponding reduction in purchases.

Jurnal:- Transaction will be entered in various books as follows"
All cash transactions in Cash Book
Credit purchases of goods dealt in in Purchases Book
Credit sales of goods dealt in in Sales Book
Return Inwards in Return Inwards Book
Return Outwards in Return Outwards Book

Transactions, not covered by any of the above categories, will be journalised,But it should be noted that if any other class of transaction is bulky (quite often transactions relating to bills of exchange are numerous), one should have a separate register or book to record such transactions will not be journalised.

Accounts

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After recording transactions in the various subsidiary books, it is necessary to "process" the entries further and recast that all transactions of a kind for the whole period are brought together. Not until one knows at one glance what transactions have taken place with a particular person, can one ascertain what he owes or what is owed to him.
An example of such marshaling of transaction in the Cash Book itself where all transactions of cash (and Bank) have been classified, receipt put on one side and payments on the other. One can then ascertain how much cash one possesses or what balance there is at bank.
A statement which emerges after the marshaling of entries relating to a person, an asset or items of expenses or income for a particular period is know as account.

A Model for Processing Accounting Information

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The study of accounting information systems analyzes how events affecting an organization are recorded,summarized,and reported. These events are recorded using that organization's system of human and computer resources,summarized using accounting methods and objectives, and reported as information to interested persons both within ans outside of the organization.
The chapter describes a conceptual model for recording, processing, and reported these events to external parties. You should be familiar with this model from your introductory accounting course. If so, much of the material in this chapter will be a review. In the next chapter, you will see how this model is adapted for reporting within the organization. The remainder of this chapter details how this conceptual process is implemented.

Organizations

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Accounting Information System exist in many forms of organization, whether proprietorship, partnership, corporation,nonprofit foundations, or households. While the complexity of each accounting information system differs,each is similar in three important ways: each contains a similar structure (of human and computer resources), similar process (the use of accounting methods), and similar purpose (to provide information)
This book, like most accounting textbooks, uses as an example on type of organization: the profit-seeking,publicly owned corporation engaged in manufacturing and selling goods. The structure, process and the purpose of the accounting information systems are more complex in the manufacturing corporation than in the others. You can readily adapt what you learn about this type of corporation to the circumstances of the forms listed earlier.

Events Affecting an Organzation

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The events that effecting any organization are a result of its interaction with its environment, which includes economic, social, political, and regulatory entities.
Accounting Information systems recorded, summarized and report events arising from these entities. The events to be processed depend on the scope of the organization's accounting information system and the nature of the events.

Human and Computer Resources

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A system of human and computer resources records, process, and reports events from the organization's environment. When the system contains only human resources, it is a a manual system.
If it uses only computer resources, it is a computer-based system.
Most organizations today use computer-based accounting information system. However, both methods are important, because each organization's computer-based system has different mix system employ the same procedures. In these cases, understanding manual methods makes it easier to master computerized ones.

Accounting Methods and Objectives

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All accounting information system record, process, and report using accounting methods to achive accounting objectives. These objectives determine the system's scope, which in turn determines the nature of the events and the method of accounting. However, all system record events in money and use the same conceptual process.

Scope of the System and Nature of the Events

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For the publicly held corporations, the accounting information system's scope must comply with generally accepted accounting principles (GAAP).
GAAP is necessary to produce financial statements intended for parties external to the organization. With GAAP, any event that has a determinable monetary impact on the organization must be recognized as an accounting transaction. A system whose objective is to record, process and report past transactions in accordance with GAAP is a financial accounting information system.
Usually the scope of an organization's system for processing accounting data is broader than that required by GAAP. For example, when an accounting information system includes budgetary forecasting, it recognizes future transactions and estimates their monetary impact. Budgeting and other such systems intended primarily for use within the organization constitute managerial accounting information systems.
Because these systems share objectives and methods, financial accounting information system are example of managerial ones. Managerial accounting information system have both internal and external reporting objectives. For external reporting they use accounting methods required by GAAP; for internal reporting, they use those perfect by management. Management uses the information provides by both systems.
External parties, on other hand, rely on information provided by financial accounting information systems in accordance with GAAP (Generally Accepted Accounting Principles ).

The Accounting Process

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The accounting process begins with an economic event is recognized by an accounting information system, which records the economic event as an accounting transaction.
For financial accounting information system, the activities that process a transaction constitute the accounting cycle. Conceptually, the accounting cycle consists of the following six steps.

1:- Journalize. The first step in accounting cycle is recording the transaction. Some analysts the event, determines the accounts it effects, identifies wethere each account is debited or credited, and enters, the transactions chronologically in a journal.
Each organization has a chart of accounts (Lest of all the heads which are use in accounting like,Sales a/c,Purchases a/c,Sales return a/c etc....). In jouralizing an event, the accountant must choose from this list. An analyst establishes this list at the time the accounting information system are created.
You can see some of the basic heads which are use in Chart of Accounts.

2:- Post. In posting, the second step, an accounting information system transfers journal entries to ledgers. A ledger is a summary, by account, of all transactions affecting that account. Thus after posting. transactions are recorded by account rather than chronological sequence. This step makes it possible to summarize the effects of all the events affecting the organization.

3:- Prepare a Trail Balance. This is step three in the accounting cycle. During any accounting period, accounting information systems journalize and post a large number of transactions. Prior to producing accounting reports, the system summarize the effect of all the events in a trail balance.

4:- Prepare Adjusting Entries. The fourth step in the accounting cycle is the preparation of adjusting entries. When creating an accounting information system, an analyst identifies stranded or recurring journal entries. Which are adjusting entries. Sometimes and accountant also propose adjusting entries to correct previous adjusting entries, records them in the journal, and post them to the ledger. These alter the account balance shown in the trail balance.

5:- Prepare Accounting Reports. The fifth step in the accounting cycle is preparation the accounting reports. This is easier if the system prepares a second trail balance. Because its debit and credit totals reflect the adjustments made in step four, accountants call it the adjustment trail balance. From the adjusted trail balance, accountants prepare reports.
Income statement and Balance Sheet that, according to GAAP ( Generally Accepted Accounting Principles), must be produced by a financial accounting information system. Managerial accounting information system, which are broader in scope, produce additional reports.

6:- Close the Books. After preparation the accounting reports, accountants prepare the accounting records for the next reporting period. This includes the posting of closing and reversing journal entries.
Closing entries transfer balance from revenue and expense accounts into the income summary account. The balance in this, which equals Net expenses and revenues of the prior period are not included in those of the following period.

Why study Accounting Information System?

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In the past few decades the study of accounting information system has become important for all accountants. Prior to computerized processing, accounting system used manual technologies that were much easier to understand. Microcomputers, however, have made computer practical for even the smallest organization. Because almost every today uses computer to process accounting data, you must understand not only the conceptual process but also the technologies used in the process.
As an accountant, you will work with computerized accounting systems in one of three ways: if you become auditor, you must know how to review computer-based system and to plan and execute audit procedures using them. If you become a management accountant, you will work daily with computerized system and participate in project teams that develop new ones. Many accounting students also become management consultants or system analysts. Regardless of your career path you must understand both the process and the technology.This text makes it easy for you to achive this understanding.

Technology and Accounting Information System

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You should have just the accounting process in non technological terms. In older accounting system, journals and ledgers are bound volumes in which bookkeepers manually record journal and adjusting entries. An accountant then manually prepares trail balances and reports using large worksheet.
In modern system, journals and ladgers take the form of computer files. Computer programs post entries and prepare the accounting reports. Accountants control this process by providing inputs and by determining how these programs work.
Conceptually, the accounting process is identical regardless of the technology employed,which is why your introductory accounting course concentrated on journals and ledgers. This is actually a technology-independent view of the accounting process.

Opening entry

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Opening entry:- When a business starts the books of the new year, it has to make what is known as the opening entry in the journal. It is to record the opening balances of various accounts that are being transferred from the books of the previous year to the books of the new year. All those accounts which denote what the business possesses (assets) are debited and all the accounts showing amounts due by the business (liabilities) are credited. If capital (amount due by the business to the proprietor) is given, well and good, but if it is not, it can be easily found out by deducting liabilities from assets. Capital account will also be credited. An opening entry (with imaginary figures) looks like the following:-

Cash Account Dr 5,000
Cash at Bank Account Dr 43,000
Sundry Debtors (Customers) Dr 27,000
Stock Account Dr 40,000
Furniture Account Dr 15,000
Office Equipment Account Dr 20,000

To Sundry Creditor (Suppliers) 20,0000
To Capital Account 1,40,000

The opening entry is made in the journal. At the end of the trading period, closing entries are made, the object being to close books.

Trail Balance

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Trail Balance:- It has been seen how every amount that is placed on the debit side of an accounts has a corresponding entry on the credit side of some other account. This is but natural that the total of all the debit balances should agree with the total of all credit balances. In fact, all businesses periodically tabulate the debit and credit balances separately in a statement to see whether the total of debit balances ogress with the total of credit balances or not. Such a statement is known as Trail Balance.
The accountant heaves a sigh pf relief, when the total of the debit balance agrees with the total of credit balances, because it is quite a good proof that the ledger has been correctly written up. However, it is not a conclusive proof of accuracy.

Ledger

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Ledger:- The book which contains accounts is known as ledger. Since final information pertaining to the financial position of the business emerges only from accounts, the ledger is also called the Principle Book. Other books like the purchases Book or Sales Books or Journal merely facilitate the preparation of accounts or the ledger and hence are known as Subsidiary Books or Books of Original Entry. The Cash Book has a unique position. It is a subsidiary book because cash entries are first entered here and the other accounts are prepared. But the Cash Book contains the two accounts of Cash and Bank itself and hence it is a part and parcel of the ledger also. The Cash Book, therefore is both a Book of Original Entry and a Principle.

Accounting Terminology

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Accounting Terminology

Financial Statements: Represent the manner in which transactions are presenting once they have been analyzed. The four basic financial statements to become familiar with are the income statement, balance sheet, statement of owners equity and statement of cash flow.

Income Statement: The income statement represents a summary of an entity’s revenues and expenses for a specific period of time, such as a month or a year. The income statement also called the statement of earnings or statement of operations represents a financial picture of business operations during the period. From a business perspective, one of the most important pieces of information provided by the income statement is “net income” calculated as revenues minus expenses. A positive net income indicates that operations for the period were favorable while a negative net income represents an unfavorable operational position.

Statement of Owners Equity: Represents a summary of the changes that occurred in the entity’s owners equity during a specific time period, such as a month or a year. Increases to owners equity arise from investments by the owner and from net income earned during the period. Decreases result from owner withdrawals and from a net loss for the period. Net income or net losses come directly from the income statement, and owner investments are capital transactions between the business and its owner, so they do not affect the income statement.

Balance Sheet: List all of the entity’s assets, liabilities and owners equity as of a specific date, usually the end of a month or a year. The balance sheet is like a snap shot of the entity and for this reason it is also called the statement of financial position.

Statement of Cash Flows: Reports the amount cash coming in (cash receipts) and the amount of cash going out (cash payments, disbursements) during a period of time. The statement of cash flows shows the net increase or net decrease in cash over a period of time and the cash balance at the end of the period.
Account Payable – A liability backed by the general reputation and credit standing of the debtor.

Account Receivable – A promise to receive cash from a customer for whom goods and/or services have been provided by the activity.

Accrual Basis Accounting – Accounting that records the impact of a business event as it occurs, regardless of whether the transaction affected cash.

Accrued Expense – An expense the business has incurred but not yet paid.

Accrued Revenue - A revenue that has been earned but not yet collected in cash.

Adjusting Entry – Entry made at the end of the period to assign revenues to the period in which they are earned and expenses to the period in which they are incurred.

T-Account Basics: Accounting is based on a double entry system which means that we record the dual effects of a business transaction. Therefore, each transaction affects at least two accounts.

Debit: An entry affecting the left side of a T-Account.

Credit: An entry affecting the right side of a T-Account.

Increases in assets are recorded on the left side (debit) of the account.
Decreases in assets are recorded on the right side (credit) of the account.

Increases in liabilities and owners equity are recorded as a (credit).
Decreases in liabilities and owners equity are recorded as a (debit).

Asset – An economic resource that is expected to be of benefit in the future.

Book Value of an Asset – The assets cost minus accumulated depreciation.

Cash Basis Accounting – Accounting that records transactions only when cash is received or paid. This methodology excludes receivables, payables and depreciation in its computation.

Chart of Accounts – List of all the accounts and their account numbers in the ledger.

Current Asset – An asset that is expected to be converted to cash, sold, or consumed during the next 12 months, or within the business’s normal operating cycle.

Current Liabilities – A debt due to be paid with cash or with goods and services within one year or within the entity’s operating cycle if the cycle is longer than one year.

Current Ratio – Measures the ability to pay current liabilities with current assets. Therefore, the ratio calculation is generated by dividing current assets over current liabilities.

Debt Ratio – This ratio measures the ability to pay for both current and long term debts (total liabilities). This ration is calculated by dividing total liabilities over total assets, and a lower debt ratio is more desirable than a high figure. As a rule of thumb, a debt ratio below .60 is considered generally safe while a debt ratio above .80 is considered risky.

Generally Accepted Accounting Principles (GAAP) – Accounting guidelines formulated by the Financial Accounting Standards Board (FASB) that govern how accountants measure, process and communicate financial information.

Journal – The chronological accounting record of an entity’s transactions.

Liability – An economic obligation such as a debt payable.

Liquidity – Measure of how quickly an item can be converted to cash.

Matching Principle – The basis for recording expenses this methodology directs accountants to identify all expenses incurred during the period, to measure the expenses, and to match them against the revenues earned during that same span of time.

Net Income – Excess of total revenues over total expenses. Also called net earnings or net profit.

Net Loss – Excess of total expenses over total revenues.

Note Payable – A written promise of future payment.

Note Receivable – A written promise for future collection of cash.

Posting – Copying amounts from the journal to the ledger.

Revenue – Amounts earned by delivering goods or services to customers.

Transaction – An event that affects the financial position of a particular entity and can be recorded reliably.

Trial Balance – A list of all accounts with their balances taken from the ledger used to ensure that total debits equal total credits.

Unearned Revenue – A liability created when a business collects cash from customers in advance of doing work. The obligation is to provide a product or a service in the future. Also called deferred revenue.

Matching Principle

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Matching Principle:- According to this principle, the relevant expenses incurred should be correlated and matched so that a complete picture is available. Suppose a company, closing its books each year on March 31, producing a monthly journal, receives annual subscription in January,2007 and treats these as income. This will lead to distortion of the picture since nine issues in 2007-08 will have to be supplied without any further amount being received; the net effect is that the income of 2007-08 is being transferred to 2006-07. The proper thing to do is to treat 3 month' subscriptions as income for 2006-07 and 9 months' subscription should be carried forward to 2007-08 and shown in the Balance Sheet (as on March 31,2007) to indicate that these subscription have been received and will involve supply of nine issues. Similarly, to take another example, suppose a printing press inures cost totaling Rs.15,000 on jobs not yet complete and therefore not yet billed to the customers. To treat this amount as an expense will be to unduly deflate the current year's profits---properly this amount should be debited to the profit and loss Account next year when the income will also be credited.

Deferred Revenue Expenditure

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Deferred Revenue Expenditure:- In some cases, the benefit of a revenue expenditure may be available for period of two or three or even more years. Such expenditure is then known as "Deferred Revenue Expenditure" and is written off over a period of a few years and not wholly in the year in which it is incurred. For example, a new firm may advertise very heavily in the beginning to capture a position in the market. The benefit of this advertising campaign will last quite a few years. It will be better to write off the expenditure in there or four and not in the first year.
When loss of a specially heavy and exceptional nature is sustained, it can also treated as deferred revenue expenditure.But,it should be noted, loss resulting from transactions enterd into, such as speculative purchase or sale of a large quantity of a commodity, cannot be treated as a deferred revenue expenditure. Only loss arising from circumstances beyond one's control can be so treated.

Trading Account

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Trading Account:- At the end of the year, every business must ascertain its net profit (or loss). This is done in two stages:(1) finding out the gross profit (or gross loss) and then (2) finding out the net profit (or net loss). Gross Profit is the excess of net sales (that is,gross sales minus returns from customers) over the cost of good sold. Cost of goods sold involves an adjustment for stocks on hand. Thus, if in the first year of its existence, a business purchases goods (net,that is after deducting returns to suppliers) to the extent of Rs.1,00,000 and if , at the end of the year, goods worth R.s 15000 are still unsold, the cost of goods sold will be Rs.85,000. Suppose for the same firm, purchases next year amount to Rs.150,000 and value of the stock at the end of the next year is Rs.20,000, the cost of goods sold will be Rs.145,000. Thus
Rs.
Opening Stock 15,000
Add Purchases made during the year 1,50,000
-------------------
1,65,000
Less Stock of goods in hand at the 20,000
end of the year. ----------------------
Cost of goods sold 1,45,000
If the net sales amount to Rs.2,00,00, there is a gross profit of Rs.55,000. i.e Rs.2,00,000----Rs.1,45,000.
This profit is termed gross because the expenses must be deducted from it before the net profit or true profit can be ascertained. Gross Profit is the result of trading as such and throws in bold relief the main effect of buying and selling polices-----market conditions have a direct influence on gross profit. The usual way to ascertain gross profit is by means of an account, called the Trading Account.

Profit and Loss Account

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Profit and Loss Account:- The Profit and Loss Account starts with the credit from Trading Account in respect of gross profit (or debit if there is gross profit). Thereafter, all those expenses or losses which have not been debited to the Trading Account are debited or the Profit and Loss Account. If there is any income besides the gross profit, it will also be transferred to the credit of the Profit and Loss Account.
The fundamental principle for preparing the Trading and Profit and Loss Account is that the expenses and incomes for the full trading period, but only for the trading period,are taken to the Profit and Loss Account (and Trading Account). This must be created before the accounts can be said to show a true picture. All expenses accounts should be properly adjusted.

Bad Debts

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Bad Debts:- Some people fail to pay dues. They are known as bad debts and the amount which is irrecoverable is a loss. If a person fails a petition in bankruptcy, his creditors will generally write him off as a bad debt. The entry in the books of the creditors is
Bad Debts Account Dr.
To The Debtor's (by name) Account Cr.
The debtor's account is then closed and the bad debts account is transferred, at the end of the year, to the Profit and Loss Account (debit side).
Some time the amount is later on recovered wholly or partially. In this case the account to be credited is not the debtor;s personal account, but Bad Debts Recovered Account. This is a clear "Profit"
Provision for Bad Debts:- Suppose a person owes a Rs.500 and one is doubtful regarding his ability or (intention) to pay but one also does not want to written it off yet. The amount actually turns out to be bad and has to be written off. Is the loss next year's or this year's? Obviously this year's. Loss on this year's debtors is the year's loss even if the actual witting off is done next year. One should provide for the loss this year. Not knowing the actual amount that will have to be written off next year, one can only make a guess and fix an arbitrary figure. This year's profits are reduced by this figure and the amount is treated as provision thus created.
The entry for the creation of the provision is:
Profit and Loss Account (Dr)
To Provision for Bad and Doubtful Debts (Cr)
Provision for Discounts:- Some firms also maintain a Provision for Discounts----that is, a provision to meet discounts which may have to be allowed to present debtor. The procedure is the same as for provision for bad debts. First, the profit and Loss Account is debited and the Provision for Discounts Account credited.
This account is carried forward to the next year. Next year, the actual discounts allowed will be debited to this account and not to the Profit and Loss Account. The Profit and Loss Account will be debited to make up the required balance each year.If after providing the required balance, a surplus is left in the Provision for Discount Accounts, it should be transferred to the credit of Profit and Loss Account, just like the Provision for Bad Debts Account. But the provision required to be maintained for discount should be calculated on total debtors minus the provision for bad debts, since those who turn bad will not earn discount.