Introduction to Accounting (B.Com Hons) Notes || Unit 1 || Sem - 1 Delhi University

Unit-I: Introduction to Accounting (Sem-1) Delhi University

Conceptual Framework

A Conceptual Framework in accounting refers to a structured theory that establishes the principles, assumptions, and rules guiding financial reporting and accounting practices. It provides a foundation for developing accounting standards and ensures consistency, comparability, and reliability in financial statements.

Key Components of the Conceptual Framework of Accounting

1. Objectives of Financial Reporting

The primary goal is to provide financial information that is useful for investors, creditors, and other stakeholders in making economic decisions.

2. Qualitative Characteristics of Financial Information

• Fundamental Qualities:
  • Relevance (usefulness for decision-making)
  • Faithful Representation (complete, neutral, and error-free)
• Enhancing Qualities:
  • Comparability (consistent across periods and entities)
  • Verifiability (can be checked for accuracy)
  • Timeliness (available when needed)
  • Understandability (clear and interpretable)

3. Elements of Financial Statements

• Assets (resources controlled by the entity)
• Liabilities (obligations of the entity)
• Equity (owner’s residual interest)
• Revenues (inflows from core operations)
• Expenses (outflows related to operations)

4. Principles of Accounting

• Accrual Principle: Recognize revenues and expenses when they are incurred, not when cash is received or paid.
• Going Concern Principle: Assume the business will continue operating indefinitely.
• Consistency Principle: Apply the same accounting methods over time for comparability.
• Matching Principle: Match revenues with related expenses in the same period.
• Prudence (Conservatism) Principle: Avoid overstating assets or income and understating liabilities or expenses.
• Materiality Principle: Consider the significance of financial information for decision-making.

5. Recognition, Measurement, and Disclosure

• Recognition: When to record assets, liabilities, income, and expenses.
• Measurement: How to value these elements (historical cost, fair value, etc.).
• Disclosure: What information should be presented in financial statements.

Importance of the Conceptual Framework

• Provides a foundation for accounting standards.
• Ensures consistency in financial reporting.
• Enhances comparability across businesses.
• Assists users in interpreting financial statements accurately.

Introduction to Accounting Standards (AS) & Indian Accounting Standards (Ind AS)

1. Introduction to Accounting Standards

What is an Accounting Standard?

Accounting Standards (AS) are a set of rules and guidelines issued by regulatory authorities to ensure consistency, reliability, and comparability in financial reporting. These standards help organizations maintain uniformity in their accounting practices and financial statements.

Need for Accounting Standards

Before the introduction of accounting standards, different businesses followed different accounting methods, which made financial statements difficult to compare. Accounting standards were introduced to:

1. Ensure uniformity in financial reporting.
2. Improve comparability of financial statements across different industries.
3. Increase transparency and reliability of financial data.
4. Ensure compliance with legal and regulatory frameworks.
5. Protect investors and other stakeholders by providing accurate information.
6. Facilitate international trade and investment by aligning with global accounting practices.

2. Development of Accounting Standards in India

Regulatory Bodies Governing Accounting Standards

• Institute of Chartered Accountants of India (ICAI): Develops and recommends Accounting Standards in India.
• Ministry of Corporate Affairs (MCA): Approves and notifies standards for implementation.
• National Financial Reporting Authority (NFRA): Ensures compliance with accounting and auditing standards.

Historical Background

• 1977: ICAI formed the Accounting Standards Board (ASB) to develop AS.
• 1991: Liberalization led to a need for global accounting standardization.
• 2006: The Government of India decided to converge Indian standards with IFRS, leading to the introduction of Ind AS.
• 2015: Ind AS was officially notified, replacing AS for large companies.

3. Indian Accounting Standards (Ind AS) and IFRS

What is Ind AS?

Indian Accounting Standards (Ind AS) are converged with International Financial Reporting Standards (IFRS) to ensure global consistency in financial reporting. These are principle-based standards that provide guidelines for the preparation and presentation of financial statements.

Why was Ind AS Introduced?

• To align Indian accounting practices with international standards (IFRS).
• To attract global investors and make Indian businesses more competitive.
• To ensure fair value accounting and transparency.
• To improve the credibility of financial statements.

Applicability of Ind AS

Category	Applicability
Listed Companies	Mandatory for all listed companies
Unlisted Companies	If net worth is ₹250 crore or more
Banks, NBFCs, Insurance Companies	As per RBI, SEBI, and IRDAI guidelines

4. Key Differences Between AS and Ind AS

Basis	Accounting Standards (AS)	Indian Accounting Standards (Ind AS)
Framework	Based on Indian GAAP	Based on IFRS
Approach	Rule-based	Principle-based
Fair Value Concept	Limited use of fair value	Extensive use of fair value
Consolidated Financial Statements	Not mandatory	Mandatory for holding & subsidiary companies
Financial Instruments	Limited guidelines	Comprehensive guidelines (Ind AS 109)
Component Accounting	Not required	Required for property, plant, and equipment (PPE)

5. List of Important AS and Ind AS

Major Accounting Standards (AS)

AS No.	Name
AS 1	Disclosure of Accounting Policies
AS 2	Valuation of Inventories
AS 3	Cash Flow Statements
AS 6	Depreciation Accounting
AS 9	Revenue Recognition
AS 10	Property, Plant & Equipment
AS 12	Accounting for Government Grants
AS 14	Accounting for Amalgamation
AS 22	Accounting for Taxes on Income

Major Indian Accounting Standards (Ind AS)

Ind AS No.	Name
Ind AS 1	Presentation of Financial Statements
Ind AS 2	Inventories
Ind AS 7	Cash Flow Statements
Ind AS 16	Property, Plant & Equipment
Ind AS 18	Revenue Recognition
Ind AS 21	Foreign Exchange Transactions
Ind AS 33	Earnings per Share
Ind AS 103	Business Combinations

6. Key Features of Ind AS

1. Fair Value Accounting: Assets and liabilities are measured at fair value instead of historical cost.
2. Principle-Based Approach: Provides flexibility while ensuring compliance with fundamental accounting principles.
3. Mandatory Consolidation of Financial Statements: Holding and subsidiary companies must prepare consolidated accounts.
4. Component Accounting: Each component of an asset must be depreciated separately.
5. Recognition of Revenue (Ind AS 115): Follows a five-step model to recognize revenue accurately.
6. Financial Instruments (Ind AS 109): Provides detailed guidelines for classification and measurement of financial instruments.

7. Benefits of Ind AS Implementation

• Enhances global credibility and trust in financial reports.
• Improves financial transparency and reduces fraud.
• Facilitates cross-border investments and mergers.
• Enables better financial analysis for investors.
• Aligns Indian businesses with international corporate practices.

8. Challenges in Implementing Ind AS

• Complexity: Requires a deep understanding of IFRS-based principles.
• High Implementation Cost: Companies need to upgrade their accounting systems and train staff.
• Valuation Issues: The fair value concept may lead to variations in financial reports.
• Regulatory Compliance: Companies need to comply with multiple regulatory requirements.

9. Conclusion

Accounting Standards (AS) and Ind AS play a crucial role in ensuring consistency, comparability, and transparency in financial reporting. While AS follows traditional Indian GAAP, Ind AS is aligned with IFRS, making Indian companies globally competitive. The transition from AS to Ind AS marks a significant improvement in the financial reporting system, benefiting investors, stakeholders, and the overall economy.

Accounting Process Overview

Definition & Objective
Accounting is the process of recording, classifying, summarizing, and interpreting financial transactions to provide useful information for decision making. Its primary objectives are to:

• Maintain a systematic record of financial transactions.
• Measure business performance (profit or loss).
• Ascertain the financial position (assets, liabilities, and equity).
• Communicate results to internal (management) and external (investors, creditors, regulatory authorities) stakeholders.

This process is often described as the “language of business” because it translates business events into financial information that can be analyzed and compared over time.

The Accounting Cycle (Process Steps)

The accounting cycle is a repeating series of steps that ensure accurate financial reporting for each accounting period. The cycle includes:

Step 1: Identification of Transactions

• Key Point: Recognize every financial event (sale, purchase, expense, etc.) that affects the business.
• Note: Only transactions that have a monetary impact and are supported by documentary evidence are recorded.

Step 2: Recording in the Journal (Book of Original Entry)

• Journal Entries: Every identified transaction is recorded as a journal entry using the double-entry system.

• Debits and Credits: Each transaction affects at least two accounts so that the total debits equal the total credits.

• Example: When inventory is purchased on credit, the Inventory account is debited and Accounts Payable is credited.

Step 3: Posting to the Ledger

• General Ledger: Journal entries are then posted to individual ledger accounts (also called “T-accounts”), where transactions are grouped by account.
• Purpose: This helps in tracking the changes in each account over the period.

Step 4: Preparing the Trial Balance

• Trial Balance: At the end of the period, the closing balances of all ledger accounts are listed to verify that total debits equal total credits.

• Error Detection: A balanced trial balance indicates (but does not guarantee) that transactions have been recorded correctly.

Step 5: Making Adjusting Entries

• Adjustments: Before finalizing the accounts, adjustments (for accruals, deferrals, depreciation, etc.) are made to reflect the true economic activity.
• Adjusted Trial Balance: These entries are posted and a new trial balance is prepared to ensure accuracy.

Step 6: Preparing Financial Statements

• Income Statement (Profit & Loss Account): Summarizes revenues and expenses to determine net profit or loss.

• Balance Sheet (Statement of Financial Position): Reports assets, liabilities, and equity as of a specific date.

• Cash Flow Statement: (if required) Reports cash inflows and outflows over the period.

Step 7: Closing the Books

• Closing Entries: Temporary (nominal) accounts (revenues, expenses, and drawings) are closed to a permanent account (typically retained earnings) to reset their balances for the next period.
• New Cycle: Once closed, the accounting cycle begins again for the new period.

3. Key Concepts and Underlying Principles

Double-Entry Bookkeeping

• Principle: Every transaction affects two accounts. For example, an increase in an asset must be matched by an increase in a liability or equity (or a decrease in another asset).
• Accounting Equation: $$\text{Assets} = \text{Liabilities} + \text{Equity}$$
• Debits and Credits:
  • Assets and Expenses: Increased by debits, decreased by credits.
  • Liabilities, Equity, and Revenues: Increased by credits, decreased by debits.
  
  

Fundamental Principles

• Accrual Concept: Revenues and expenses are recorded when they are earned or incurred, not necessarily when cash is exchanged.
• Matching Principle: Expenses should be recorded in the same period as the revenues they help to generate.
• Business Entity Concept: The business is treated as a separate entity from its owners.
• Going Concern: It is assumed that the business will continue to operate indefinitely.
• Consistency: Once an accounting method is chosen, it should be used consistently from period to period.

4. Types of Accounts and Their Treatment

• Real (Permanent) Accounts: Include assets and liabilities. Their balances are carried forward to the next period.
• Nominal (Temporary) Accounts: Include revenues, expenses, and gains/losses. They are closed at the end of each accounting period.
• Personal Accounts: Relate to individuals or organizations (e.g., accounts receivable, accounts payable).

Understanding these classifications helps in applying the proper debit and credit rules for each transaction.

5. Supporting Books of Account

• Subsidiary Books: These include special journals such as the sales book, purchase book, cash book, etc., which capture detailed transactions before summarizing them in the general ledger.
• Journals: Chronological records of all transactions.
• Ledgers: Organized accounts that compile all transactions by account.
• Trial Balance: A summary report that checks the arithmetic accuracy of ledger postings.

6. Summary

In summary, the accounting process (or cycle) involves:

1. Identifying and recording transactions in journals.
2. Posting these transactions to the appropriate ledger accounts.
3. Preparing a trial balance to verify the equality of debits and credits.
4. Making adjusting entries to account for accruals, deferrals, and depreciation.
5. Preparing financial statements that report the company’s performance and position.
6. Closing temporary accounts to start the new cycle.

Expenditure Categories

I. Expenditure in Accounting

1. Definition of Expenditure

An expenditure is the outflow of money or the cost incurred in acquiring goods or services. In a business context, expenditures are incurred to generate revenues and sustain operations.

2. Main Categories of Business Expenditures

A. Revenue Expenditure (Current or Operating Expenses)

• Characteristics:
  • Incurred in the day-to-day operations of the business.
  • Recurrent in nature; they do not lead to the creation of a lasting asset.
  • Fully charged against revenue in the accounting period.
• Examples:
  • Salaries and wages, rent, utilities, maintenance, repairs, and office supplies.
• Key Point:
  These expenditures maintain the current earning capacity of the business rather than expanding it.

B. Capital Expenditure (CapEx)

• Characteristics:
  • Spends money on acquiring or enhancing long-term assets.
  • Provides benefits over more than one accounting period.
  • Capitalized on the balance sheet and then depreciated (or amortized) over the asset’s useful life.
• Examples:
  • Purchase of machinery, land, buildings, equipment, or major renovations.
• Key Point:
  Capital expenditures are investments intended to increase the productive capacity of the business.

II. Expenditure in Public Finance

In public finance the concept of expenditure is broadened to include government spending on various functions. Such expenditure is crucial for economic planning, welfare, and development.

1. Definition of Public Expenditure

Public expenditure is the spending incurred by government (central, state, and local) to provide public goods, maintain the administration, and promote social and economic welfare.

2. Common Bases for Classifying Public Expenditure

A. By Benefit or Target Group

• Categories:
  • Expenditure benefiting the entire society (e.g., defence, public health, education).
  • Expenditure conferring special benefits to particular groups (e.g., targeted subsidies or welfare payments).

B. By Revenue Return

• Categories:
  • Expenditures with direct revenue return (e.g., fees, tolls).
  • Expenditures without any direct revenue return (e.g., pure public services like basic healthcare).

C. By Function of Government

• Categories:
  • Protection Functions: Defence, police, and judiciary.
  • Commercial Functions: Activities that support trade and industry (e.g., infrastructure and public enterprises).
  • Development Functions: Spending on education, healthcare, and social welfare.

D. By Importance and Necessity

• Categories:
  • Primary Expenditure: Essential spending on core functions (defence, law and order, administrative costs).
  • Secondary Expenditure: Spending on welfare and non-essential services (social security, education, and public recreation).

E. By Productivity

• Categories:
  • Productive Expenditure: Spending that directly contributes to long-term economic growth (investment in infrastructure).
  • Unproductive Expenditure: Spending that does not directly add to productive capacity (sometimes including high defence spending).

Expenditure Categories in Business Financial Statements

1. Operating vs. Non-Operating Expenses

• Operating Expenses:
  • Costs directly related to the primary business activities (similar to revenue expenditures).
  • Examples include rent, utilities, and salaries.
• Non-Operating Expenses:
  • Costs not tied directly to core business operations (e.g., interest expenses, losses from investments).
• Importance:
  Distinguishing these helps in understanding the performance of the business’s main operations versus peripheral activities.

2. Fixed vs. Variable Expenses

• Fixed Expenses:
  • Costs that remain relatively constant regardless of output (e.g., lease payments).
• Variable Expenses:
  • Costs that vary in direct proportion to business activity (e.g., raw material costs).

Why Understanding These Categories Matters

• Budgeting and Planning:
  Proper classification ensures accurate budgeting, effective resource allocation, and improved cost control.
• Financial Analysis:
  Investors and managers use these distinctions to analyze profitability, operating efficiency, and long-term investment quality.
• Taxation and Reporting:
  The treatment of revenue versus capital expenditures has significant implications for tax deductions and financial reporting.
• Public Policy:
  In the public sector, classifying expenditure appropriately is vital for assessing economic impact, ensuring accountability, and designing fiscal policies.

Summary

1. In Business Accounting:
   • Expenditures are primarily divided into revenue (operating) and capital (investment) expenditures.
2. In Public Finance:
   • Expenditures are classified on several bases (benefit, revenue return, function, importance, productivity) to determine their impact on economic development and social welfare.
3. Other Classifications:
• Operating vs. non-operating and fixed vs. variable expenses provide additional perspectives in both private and public sectors.

Preparation of Financial Statements for a Profit-Making Sole Proprietorship Trading Firm

I. Introduction

Purpose and Objectives
Financial statements are the end products of the accounting cycle. Their main objectives are:

• To measure the profitability (via the Income Statement) and financial position (via the Balance Sheet) of the firm.
• To provide useful information to internal users (owners, management) and external users (creditors, investors, tax authorities).
• To assist in decision-making and in evaluating the firm’s efficiency and solvency.

For a sole proprietorship trading firm—whose activities primarily involve buying and selling goods—the financial statements typically include:

• Income Statement: Comprising the Trading Account and the Profit & Loss (P&L) Account.
• Statement of Changes in Owner's Equity: Summarizing the effects of investments, withdrawals, and net income on the proprietor’s capital.
• Balance Sheet: Presenting the firm’s assets, liabilities, and owner’s equity at a specific date.

II. The Accounting Cycle Overview

1. Recording Transactions:
   Every business transaction is initially recorded in a journal by using the double-entry system.
2. Posting to Ledger:
   Journal entries are posted into ledger accounts to accumulate balances.
3. Trial Balance:
   A trial balance is prepared to verify the arithmetical accuracy of the postings. (Errors here must be corrected before moving forward.)
4. Adjusting Entries:
   Adjustments are made for accruals, prepayments, depreciation, closing stock, bad debts, etc., to ensure revenues and expenses are matched in the proper accounting period.
5. Preparation of Final Accounts:
   Finally, the Trading Account, Profit & Loss Account, Statement of Changes in Owner’s Equity, and Balance Sheet are prepared.

Key Financial Statements for a Sole Proprietorship Trading Firm

A. Trading Account & Profit & Loss Account (Income Statement)

Trading Account:

• Purpose: To record all transactions directly related to the trading activities (i.e., the purchase and sale of goods) and to determine the gross profit or loss.
• Structure:
  • Debit Side:
    • Opening Stock
    • Purchases (net of returns)
    • Direct expenses (e.g., carriage inwards, wages related to purchases)
  • Credit Side:
    • Sales (net of sales returns)
    • Closing Stock (often shown as a balancing figure in the Trading Account or separately in the Balance Sheet)
• Gross Profit:
  Calculated as:

Gross Profit=Net Sales−(Opening Stock+

Net Purchases+Direct Expenses−Closing Stock$$<span\; style="font-size:\; x-small;">)</span>$$

$$\text{Purchases}+\text{Direct Expenses}-\text{Closing Stock})$$ 

This figure is then carried forward to the Profit & 

Loss Account.

Profit & Loss Account:

• Purpose: To record indirect (operating) expenses and other incomes not directly involved in trading operations so that the net profit or loss for the period can be determined.
• Structure:
  • Debit Side:
    • Operating expenses (e.g., salaries, rent, utilities, advertising, depreciation of non-trading assets)
  • Credit Side:
    • Operating incomes (e.g., commission, discount received, other non-trading incomes)
  • Net Profit or Loss:
    The difference between total credits and total debits gives the net profit (if credits exceed debits) or net loss (if debits exceed credits). This result is subsequently transferred to the proprietor’s capital account.

B. Statement of Changes in Owner's Equity

• Purpose: To reconcile the opening capital with the closing capital by reflecting:
  • Additions: Additional investments and net profit.
  • Deductions: Drawings and net loss.

Format: $$\text{<span style="font-size: x-small;">Closing Capital</span>}<span\; style="font-size:\; x-small;">=</span>\text{<span style="font-size: x-small;">Opening Capital</span>}<span\; style="font-size:\; x-small;">+</span><span\; style="font-size:\; x-small;"><br></span>\text{<span style="font-size: x-small;">Investments</span>}<span\; style="font-size:\; x-small;">+</span>\text{<span style="font-size: x-small;">Net Profit</span>}<span\; style="font-size:\; x-small;">-</span>\text{<span style="font-size: x-small;">Drawings</span>}$$ This statement shows how the proprietor’s claim on the business resources has changed during the period.

C. Balance Sheet (Statement of Financial Position)

• Purpose: To present the financial position of the business at a specific date.
• Basic Equation: $$\text{Assets} = \text{Liabilities} + \text{Owner’s Equity}$$
• Format:
  • Assets:
    • Current Assets: Cash, accounts receivable, closing stock, prepaid expenses.
    • Non-Current Assets: Fixed assets (e.g., land, buildings, machinery) less accumulated depreciation.
  • Liabilities:
    • Current Liabilities: Outstanding expenses (e.g., wages, salaries, rent payable), creditors.
    • Non-Current Liabilities: Any long-term borrowings.
  • Owner’s Equity:
    Reflects the capital as adjusted by the net profit (or loss) and drawings.

IV. Detailed Preparation and Adjustments

A. Preparation of the Trading Account

1. Heading:
   The account must include the firm’s name, the title “Trading Account,” and the period covered.
2. Items on Debit Side:
   • Opening Stock
   • Purchases (net of purchase returns)
   • Direct expenses (e.g., carriage inwards, wages related directly to production)
3. Items on Credit Side:
   • Net Sales (Sales less Sales Returns)
   • Closing Stock (if not adjusted elsewhere)
4. Determination of Gross Profit or Loss:
   The difference between the credit and debit totals gives the gross profit (if positive) or gross loss.

B. Preparation of the Profit & Loss Account

1. Transfer of Gross Profit:
   The gross profit (or loss) from the Trading Account is brought down.
2. Recording of Indirect Expenses:
   Include expenses such as administrative expenses, rent, salaries (that are not directly linked to production), advertising, depreciation on office equipment, etc.
3. Other Incomes:
   Record items like interest received, commission received, etc.
4. Net Profit or Loss:
   The final difference after all adjustments provides the net profit (or loss) for the period.

C. Adjusting Entries

Adjustments are essential for ensuring that the final accounts reflect the true performance and position of the business. Common adjustments include:

• Closing Stock:
  • Adjust the Trading Account and show the closing stock in the Balance Sheet.
  • (For example, if closing stock is valued at cost or the lower of cost/market, it is added on the credit side of the Trading Account and shown as a current asset in the Balance Sheet.)
• Outstanding Expenses:
  • Expenses incurred but not paid are recorded by debiting the appropriate expense account and crediting an outstanding expense (or accrual) liability account.
• Prepaid Expenses:
  • Expenses paid in advance are adjusted by reducing the expense in the current period and recognizing them as an asset.
• Depreciation:
  • Depreciation expense is charged on fixed assets, debited to the P&L Account and deducted from the respective asset on the Balance Sheet.
• Bad Debts and Provisions:
  • Write off irrecoverable debts and create provisions for doubtful debts as needed to conform with the prudence concept.

D. Preparation of the Statement of Changes in Owner's Equity

• Format and Computation:
  As outlined earlier, the statement reconciles the opening capital with the closing capital by accounting for net profit and withdrawals.

E. Preparation of the Balance Sheet

1. Heading:
   Include the firm’s name, title “Balance Sheet” (or “Statement of Financial Position”), and the date.
2. Assets Section:
   • Current Assets: List cash, receivables, closing stock, prepaid expenses.
   • Non-Current Assets: List fixed assets at cost less accumulated depreciation.
3. Liabilities and Owner's Equity Section:
   • Liabilities: List current liabilities first (e.g., outstanding expenses, creditors), followed by any long-term liabilities.
   • Owner's Equity: Show the closing capital from the Statement of Changes in Owner's Equity.
4. Balancing:
   Ensure that the total assets equal the total of liabilities plus owner’s equity.

V. Format and Presentation Considerations

• Vertical vs. Horizontal Format:
  Financial statements can be presented in horizontal (T-account style) or vertical (single column) formats. Most modern financial statements use a vertical format for clarity.
• Headings and Dates:
  Clearly indicate the name of the business, the title of the statement, and the period or date covered.
• Consistency:
  Use consistent accounting policies (such as depreciation methods and inventory valuation techniques) to allow for period-to-period comparisons.

VI. Conclusion

Accurate preparation of financial statements for a profit‐making sole proprietorship trading firm is crucial. It requires:

• A thorough understanding of the accounting cycle,
• Proper classification and adjustment of transactions,
• Clear presentation of income (through the Trading and Profit & Loss Accounts) and financial position (through the Balance Sheet).

Preparation of Financial Statements for Not-for-Profit Organisations

1. Overview of Not‐for‐Profit Organisations

Not‐for‐profit organisations (NPOs) are established primarily to serve a social, charitable, educational, or religious purpose rather than to generate profit. Key characteristics include:

• Service orientation: Their main objective is to render a service or promote a social cause.
• No profit distribution: Any surplus (or “deficit”) is not distributed as dividends but is reinvested or added to the capital (general) fund.
• Funding sources: Revenues are derived mainly from donations, subscriptions/membership fees, grants, and legacies rather than sales of goods or services.

2. Principal Financial Statements in NPO Accounting

NPOs generally prepare three main statements to meet both legal and management reporting requirements. These are similar in concept to those prepared by profit-making entities but are adapted to reflect the service orientation and funding restrictions of NPOs.

2.1 Receipts and Payments Account

• Purpose:
  This account is essentially a summarized cash book that records all cash and bank transactions during an accounting period. It captures both revenue and capital transactions without differentiating the period to which they pertain.

• Features:

  • Prepared on a cash basis.
  • Includes opening balances (cash in hand and cash at bank) and a closing balance.
  • Records all receipts (on the debit side) and payments (on the credit side), regardless of whether they relate to the current, past, or future periods.
  • Does not record non-cash items such as depreciation.

• Limitations:

  • It does not show the accrual effects or the true “performance” (i.e. surplus or deficit) for the current period because it aggregates transactions irrespective of their timing.

2.2 Income and Expenditure Account

• Purpose:
  Comparable to the profit and loss account in a business entity, this account is prepared on an accrual basis to determine whether the organisation has achieved a surplus (excess of revenue over expenditure) or incurred a deficit for the current period.

• Features:

  • Revenue Items: Includes income from subscriptions, donations (only the general donations that are recurring), entrance fees, government grants (maintenance type), interest received, and other income items that relate solely to the current period.
  • Expense Items: Includes all revenue expenses such as salaries, rent, utilities, printing, stationery, and also non-cash adjustments (e.g. depreciation on fixed assets).
  • Adjustments:
    • Adjustments are made for items received in advance or outstanding. For example, if subscription receipts in the cash book include amounts for previous or future years, only the portion attributable to the current period is shown as income.
    • Prepaid expenses and outstanding liabilities (e.g. unpaid rent or salaries) are also adjusted.

• Outcome:
  The difference between the total income and the total expenditure is the period’s surplus (or deficit), which is then transferred to the capital fund on the balance sheet.

2.3 Balance Sheet

• Purpose:
  The balance sheet (or statement of financial position) for an NPO shows the organisation’s financial position at a specific date. Unlike a commercial business, instead of “shareholders’ equity” the balance sheet of an NPO features the capital (general) fund and any special purpose funds.

• Structure:

  • Assets:
    • Non-current assets: Fixed assets such as buildings, furniture, equipment, and intangible assets (if any).
    • Current assets: Cash and bank balances, receivables (e.g. outstanding subscriptions), stock (such as consumables).
  • Liabilities:
    • Include all current and non-current liabilities. Particular attention is given to liabilities arising from amounts received in advance (e.g. subscriptions received for future periods) which are shown on the liabilities side.
  • Capital Fund:
    • Represents the accumulated surplus (or deficit) from prior periods along with additional capital items like life membership fees, legacies, or specific donations that have been capitalised.

• Key Considerations:

  • The surplus (or deficit) from the Income and Expenditure Account is added to (or deducted from) the opening capital fund to arrive at the closing capital fund balance.
  • Adjustments for outstanding and prepaid items, as well as reclassification of certain receipts (e.g. specific donations that are meant for a particular purpose), are essential.

3. Steps in Preparing the Financial Statements

Step 1: Gather and Summarise Cash Transactions

• Prepare the Receipts and Payments Account:
  • Start with the opening cash and bank balances.
  • Record all receipts (e.g., subscriptions, donations, entrance fees) and all payments (e.g., salaries, rent, purchases) during the year.
  • Compute the closing cash and bank balance.

Step 2: Adjust for Accrual Accounting

• Prepare the Income and Expenditure Account:
  • For Income:
    • Extract revenue items from the Receipts and Payments Account but adjust for timing differences (e.g., exclude amounts received in advance and add outstanding subscriptions that relate to the current period).
  • For Expenditure:
    • Record all revenue expenses incurred during the period.
    • Make adjustments for prepaid expenses (deduct) and outstanding expenses (add).
    • Record non-cash items (e.g., depreciation) that do not appear in the cash account.
  • Determine the Surplus/Deficit:
    • The net result (excess of income over expenditure or vice versa) forms the surplus (or deficit) for the period.

Step 3: Prepare the Balance Sheet

• Assemble Asset and Liability Balances:
  • List all assets (both current and non-current) and liabilities as of the balance sheet date.
• Incorporate the Capital Fund:
  • Start with the opening capital fund, add the current period’s surplus (or subtract a deficit), and include any additional capital receipts (e.g., life membership fees) that are meant to be capitalised.
• Ensure Balancing:
  • Verify that total assets equal the sum of liabilities and the capital fund.

4. Adjustments and Special Considerations

4.1 Treatment of Subscriptions

• Outstanding Subscriptions:
  • Amounts due at the end of the period are added to the income side in the Income and Expenditure Account and shown as a current asset (subscriptions receivable) on the Balance Sheet.
• Subscriptions Received in Advance:
  • Amounts received for future periods are deducted from the current year’s income and shown as a liability on the Balance Sheet.

4.2 Treatment of Donations and Legacies

• General Donations:
  • If recurring and unrestricted, they are treated as revenue receipts and appear on the Income and Expenditure Account.
• Specific Donations or Legacies:
  • If the donation is for a specific purpose, it is treated as a capital receipt and credited directly to the capital or special fund on the Balance Sheet.

4.3 Non-Cash Adjustments

• Depreciation:
  • A systematic allocation of the cost of fixed assets is charged to the Income and Expenditure Account, reducing the asset’s book value on the Balance Sheet.

4.4 Other Adjustments

• Prepaid Expenses and Outstanding Liabilities:
  • Prepaid expenses (e.g., rent paid in advance) are deducted from expenses in the current period and shown as current assets.
  • Outstanding expenses (e.g., salaries unpaid at year-end) are added to the expense side and shown as current liabilities.

5. Summary

• Receipts and Payments Account provides a cash basis summary of transactions over the period but does not reveal the true performance of the organisation.
• Income and Expenditure Account converts cash data to accrual basis by making necessary adjustments for timing differences, thereby determining the surplus or deficit of the period.
• Balance Sheet shows the financial position at a point in time, including assets, liabilities, and the capital fund (which accumulates past surpluses/deficits and capital receipts).

These steps ensure that the financial statements not only satisfy statutory requirements but also provide stakeholders with a clear picture of how funds were acquired and used in furtherance of the organisation’s mission.