Chapter 1: Theoretical Concepts of Book-Keeping and Accounting
1.1 Book-Keeping and Accounting
1.1.1 Meaning and Definition of Book-Keeping
Book-keeping is the foundational phase of accounting concerned with the systematic identification, classification, and recording of financial transactions in the books of original entry (Journals) and posting them into secondary books (Ledgers) in chronological order.
- J.R. Batliboi: “Book-keeping is the art of recording business dealings in a set of books.”
- R.N. Carter: “Book-keeping is the science and art of correctly recording in books of account all those business transactions that result in the transfer of money or money’s worth.”
Objectives of Book-Keeping:
- Permanent & Systematic Record: To maintain a chronological, permanent record of monetary transactions for future reference.
- Ascertainment of Financial Effect: To show the cumulative effect of transactions on individual accounts (assets, liabilities, incomes, and expenses).
- Detection of Errors and Frauds: To provide verifiable documentary trails that minimize clerical errors and misappropriation.
- Determination of Debtors and Creditors: To track exact receivables from customers and payables to suppliers at any date.
1.1.2 Meaning and Definition of Accounting
Accounting is a broader discipline that begins where book-keeping ends. It encompasses designing the accounting system, recording, classifying, summarizing financial transactions via Trial Balance and Financial Statements (Income Statement and Balance Sheet), analyzing and interpreting financial results, and communicating them to internal and external users for informed decision-making.
- American Institute of Certified Public Accountants (AICPA): “Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.”
- American Accounting Association (AAA): “Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.”
1.1.3 Evolution of Accounting
- Ancient Period: Early records of taxes, grain, and trade existed in Babylonia, Egypt, Greece, and during the Kautilya (Arthashastra) era in South Asia.
- Emergence of Double Entry (1494 AD): Luca Pacioli, an Italian Franciscan friar and mathematician, published “Summa de Arithmetica, Geometria, Proportioni et Proportionalita” in Venice in 1494 AD, which formally documented the Double Entry System (De Computis et Scripturis), earning him the title “Father of Modern Accounting.”
- Industrial Revolution & Corporate Era (18th–20th Century): Growth of joint-stock companies separated ownership from management, giving rise to statutory auditing, cost accounting, and management accounting.
- Harmonization & Digital Era (21st Century): Adoption of International Financial Reporting Standards (IFRS) globally and Nepal Financial Reporting Standards (NFRS) in Nepal, alongside computerized ERP and cloud accounting.
1.1.4 Objectives, Functions, Scope, Advantages, and Limitations of Accounting
| Dimension | Key Points |
|---|---|
| Objectives | 1. Maintain systematic records. 2. Ascertain operating result (Net Profit or Net Loss) via Income Statement. 3. Ascertain financial position (Assets, Liabilities, Equity) via Balance Sheet. 4. Facilitate rational decision-making and statutory tax compliance (VAT, Income Tax). |
| Functions | 1. Stewardship Function: Recording, classifying, and safeguarding business assets. 2. Managerial Function: Providing budgets, ratios, and variance data to management. 3. Legal & Compliance Function: Filing VAT returns, Income Tax returns under Income Tax Act 2058, and Company Registrar filings. 4. Communication Function: Publishing audited reports for shareholders, banks, and regulators. |
| Scope | Applicable to Trading Concerns (sole traders, partnerships, companies), Non-Profit Organizations (clubs, hospitals, NGOs, schools), Government Offices (ministries, departments, local levels), and Professionals/Individuals. |
| Advantages | Replaces human memory limitations; assists in obtaining bank loans; serves as legal evidence in courts; aids in business valuation during admission, retirement, or sale; enables inter-period and inter-firm comparisons. |
| Limitations | 1. Ignores Non-Monetary Factors: Employee morale, managerial skill, and market reputation are excluded. 2. Historical Cost Bias: Assets are recorded at original purchase price, ignoring inflation. 3. Personal Judgment & Estimates: Depreciation rates and bad debt provisions involve subjective estimates. 4. Window Dressing Risk: Manipulation of accounts to show an artificially favorable position. |
1.1.5 The Accounting Process (Accounting Cycle)
The Accounting Cycle is the complete sequence of accounting procedures repeated during each accounting period (in Nepal, typically 1 Shrawan to the last day of Ashadh):
- Identification of Financial Transactions (from source documents: invoices, receipts, vouchers)
- Journalizing (recording in primary books: Journal and Subsidiary Books)
- Posting to Ledger (classifying into individual ledger accounts and balancing them)
- Preparation of Unadjusted Trial Balance (testing arithmetical accuracy)
- Passing Adjustment Entries (recording accruals, prepayments, depreciation)
- Preparation of Adjusted Trial Balance
- Preparation of Financial Statements (Trading, P&L / Income Statement, and Balance Sheet)
- Closing Entries & Post-Closing Trial Balance
1.1.6 Difference Between Book-Keeping and Accounting
| Basis of Difference | Book-Keeping | Accounting |
|---|---|---|
| 1. Scope | Narrow scope; restricted to identifying, journalizing, and posting to ledgers. | Wide scope; includes book-keeping plus summarizing, analyzing, interpreting, and communicating. |
| 2. Stage | Primary stage of the accounting process. | Secondary stage; begins where book-keeping ends. |
| 3. Objective | To maintain systematic and chronological records of financial transactions. | To ascertain net profit/loss, financial position, and communicate results to stakeholders. |
| 4. Nature of Job | Routine, clerical, and repetitive in nature. | Analytical, executive, and interpretive in nature. |
| 5. Skill Required | Performed by junior staff (Book-keepers) with basic accounting knowledge. | Performed by senior professionals (Accountants / Chartered Accountants) with specialized expertise. |
| 6. Decision Making | Management cannot take strategic decisions directly from book-keeping records alone. | Provides analyzed financial statements and ratios directly used for management decision-making. |
1.1.7 Branches of Accounting and Ethical Considerations
- Financial Accounting: Focuses on recording historical transactions and preparing general-purpose financial statements (Income Statement, Balance Sheet, Cash Flow Statement) primarily for external users (investors, creditors, tax authorities, banks).
- Cost Accounting: Focuses on ascertaining, analyzing, and controlling the per-unit and total cost of manufacturing goods or rendering services (material, labor, and overhead costs).
- Management Accounting: Focuses on providing tailored financial and operating information (budgets, CVP analysis, ratio analysis, cash flow projections) to internal management for planning, controlling, and decision-making.
Ethical Considerations in Accounting:
Accountants must uphold five core ethical principles (aligned with the ICAN Code of Ethics):
- Integrity: Being straightforward, honest, and truthful in all financial reporting; refusing to falsify records or evade taxes.
- Objectivity: Remaining impartial and free from conflict of interest or undue bias.
- Professional Competence and Due Care: Maintaining up-to-date knowledge of NAS, NFRS, and tax laws.
- Confidentiality: Respecting the privacy of client/employer financial information unless legally required to disclose.
- Professional Behavior: Complying with relevant laws and avoiding any action that discredits the accounting profession.
1.2 Generally Accepted Accounting Principles (GAAP), NAS, and NFRS
1.2.1 Meaning of GAAP
Generally Accepted Accounting Principles (GAAP) refer to the common set of accounting concepts, conventions, standards, and rules that govern how financial transactions are measured, recorded, and reported so that financial statements are uniform, reliable, and comparable across organizations.
1.2.2 Fundamental Accounting Concepts
| Accounting Concept | Core Meaning & Practical Application in Nepal |
|---|---|
| 1. Business Entity Concept | The business and its owner(s) are treated as two completely separate accounting entities. Therefore, money invested by the owner is recorded as a liability of the business (Capital), and personal withdrawals are charged to Drawings. |
| 2. Money Measurement Concept | Only transactions and events capable of being expressed in monetary terms (e.g., Nepalese Rupees — NPR) are recorded in the books. Qualitative facts (like a dispute between managers or quality of staff) are omitted. |
| 3. Going Concern Concept | Assumes the business will continue operating for the foreseeable future and has no intention or necessity of liquidating. Hence, fixed assets are recorded at historical cost less depreciation rather than immediate liquidation value. |
| 4. Accounting Period Concept | The indefinite life of a going concern is divided into uniform time intervals (typically 12 months; in Nepal, the fiscal year runs from 1 Shrawan to the last day of Ashadh) to measure periodic profit and financial position. |
| 5. Historical Cost Concept | An asset is recorded in the books at the actual price paid to acquire it (acquisition cost + installation), and this cost forms the basis for subsequent depreciation. |
| 6. Dual Aspect Concept | Every business transaction has a two-fold effect (receiving a benefit and giving a benefit of equal value). This forms the bedrock of Double Entry and the Accounting Equation: Assets = Capital + Liabilities. |
| 7. Revenue Recognition (Realization) Concept | Revenue is recognized when goods are transferred or services are rendered to the customer (when legal right to receive payment arises), regardless of when actual cash is collected. |
| 8. Matching Concept | To determine accurate periodic profit, all expenses incurred during an accounting period (whether paid in cash or outstanding) must be matched against the revenues earned during that same period. |
1.2.3 Accounting Conventions
| Accounting Convention | Core Meaning & Application |
|---|---|
| 1. Convention of Consistency | Accounting policies and methods (e.g., Straight Line vs. Diminishing Balance depreciation, FIFO vs. Weighted Average inventory valuation) must remain unchanged from year to year unless a change is required by law or NAS for fairer presentation. |
| 2. Convention of Conservatism (Prudence) | “Anticipate no profit, but provide for all possible losses.” Closing stock is valued at lower of cost or net realizable value (NRV), and provision is made for doubtful debts, whereas unrealized gains are ignored. |
| 3. Convention of Materiality | Accountants should disclose all material facts that could influence the decisions of a reasonable user, while insignificant items (e.g., a Rs. 50 stapler) may be expensed immediately rather than capitalized as fixed assets. |
| 4. Convention of Full Disclosure | Financial statements and accompanying notes must honestly and transparently disclose all relevant financial information, including contingent liabilities (e.g., pending lawsuits) and accounting policies. |
1.2.4 Nepal Accounting Standards (NAS) and Nepal Financial Reporting Standards (NFRS)
- Accounting Standards Board (ASB) Nepal: Formed by the Government of Nepal in 2002 AD through an amendment to the Nepal Chartered Accountants Act, 1997, ASB formulates accounting standards in line with IAS/IFRS.
- Institute of Chartered Accountants of Nepal (ICAN): Regulates the accounting profession and pronounces mandatory compliance with NAS and NFRS.
- Nepal Accounting Standards (NAS) & NFRS: Establish mandatory rules for recognition, measurement, presentation, and disclosure of financial elements. For instance, NAS 01 (Presentation of Financial Statements) prescribes the structure of the Statement of Financial Position (Balance Sheet) and Statement of Profit or Loss, NAS 02 governs Inventories, and NAS 16 governs Property, Plant and Equipment (Fixed Assets).
1.3 Basic Accounting Terminologies
| Term | Clear Definition & Example |
|---|---|
| 1. Business Transaction | An economic event involving the exchange of goods, services, or money between two parties that changes the financial position of the business (Cash Transaction vs. Credit Transaction). |
| 2. Capital (Owner’s Equity) | The amount invested by the proprietor or partners in the business in the form of cash or assets. (Capital = Assets - Liabilities). |
| 3. Drawings | Cash or goods withdrawn by the owner from the business for personal or domestic use. It reduces Capital. |
| 4. Assets | Economic resources owned or controlled by a business that yield future economic benefits. • Non-Current (Fixed) Assets: Held for long-term use (>1 year), including Tangible Assets (Land, Building, Machinery, Furniture) and Intangible Assets (Goodwill, Patents, Trademarks, Software). • Current Assets: Cash or assets convertible into cash within 12 months (Cash in hand, Cash at bank, Inventory/Stock, Debtors, Bills Receivable, Prepaid Expenses). |
| 5. Liabilities | Financial obligations or debts payable by the business to outsiders. • Non-Current (Long-Term) Liabilities: Payable after 1 year (Debentures, Long-term Bank Loans, Mortgage Loans). • Current (Short-Term) Liabilities: Payable within 12 months (Creditors/Accounts Payable, Bills Payable, Bank Overdraft, Outstanding Expenses). |
| 6. Receipts | Cash inflows received by a business. • Capital Receipts: From sale of fixed assets, owner’s capital contribution, or long-term loans. • Revenue Receipts: From routine sale of goods/services, commission, or interest received. |
| 7. Expenses | Costs incurred in the process of generating revenue during an accounting period (e.g., Salary, Rent, Wages, Depreciation, Electricity). |
| 8. Income / Revenue | Gross inflow of economic benefits arising from ordinary operating activities (e.g., Sales revenue, Service fees, Interest earned, Commission received). |
| 9. Profit and Gain | Profit is the excess of operating revenue over operating expenses (Revenue - Expenses). Gain is an incidental profit from non-operating events (e.g., profit on sale of land). |
| 10. Loss | Excess of total expenses over total revenues, or an unintended reduction in value without receiving benefit (e.g., loss of goods by fire or theft). |
| 11. Purchases & Purchase Return | Purchases refer strictly to buying goods meant for resale or raw materials for production (not fixed assets). Purchase Return (Return Outward) is the return of defective/excess goods to suppliers. |
| 12. Sales & Sales Return | Sales refer to selling goods in which the business deals (Cash Sales + Credit Sales). Sales Return (Return Inward) is the return of sold goods by customers. |
| 13. Stock (Inventory) | Unsold goods lying in the warehouse at the beginning (Opening Stock) or end (Closing Stock) of an accounting year. Categorized into Raw Materials, Work-in-Progress (WIP), and Finished Goods. |
| 14. Debtors (Accounts Receivable) | Persons or entities who owe money to the business for goods sold or services rendered on credit. |
| 15. Creditors (Accounts Payable) | Persons or suppliers to whom the business owes money for goods purchased on credit. |
| 16. Bills Receivable (B/R) & Bills Payable (B/P) | Bills Receivable: A written bill of exchange accepted by a debtor promising to pay a specified sum on a future date (Current Asset). Bills Payable: A bill accepted by the business payable to a creditor on a future date (Current Liability). |
| 17. Discount | Trade Discount: Deduction from catalog/list price allowed by seller at the time of bulk purchase/sale (never recorded in ledger accounts; deducted directly on invoice). Cash Discount: Deduction allowed for prompt/timely payment of cash (recorded in books as an expense for the giver and income for the receiver). |
| 18. Solvent vs. Insolvent | Solvent: A person or firm whose assets equal or exceed liabilities (able to pay debts in full). Insolvent: A person or firm whose liabilities exceed assets (unable to pay debts in full). |
1.4 Double Entry System and Bases of Accounting
1.4.1 Double Entry Book-Keeping System
The Double Entry System is a scientific and complete system of recording financial transactions based on the principle that every business transaction affects at least two accounts in opposite directions—one account receives the benefit (Debited / Dr.) and another account yields the benefit (Credited / Cr.) of an equal monetary amount.
Features of Double Entry System:
- Dual Effect: Every transaction affects two sides—Debit and Credit—with equal amounts.
- Scientific Rule-Based Recording: Governed by explicit rules of debit and credit rather than arbitrary entries.
- Complete Record: Records Personal, Real, and Nominal accounts comprehensively.
- Arithmetical Verification: Total Debits always equal Total Credits, verified through a Trial Balance.
1.4.2 Bases of Accounting: Cash Basis vs. Accrual Basis
| Basis of Comparison | Cash Basis of Accounting | Accrual (Mercantile) Basis of Accounting |
|---|---|---|
| 1. Recognition Timing | Revenues and expenses are recorded only when actual cash is received or paid. | Revenues are recorded when earned and expenses when incurred, regardless of when cash moves. |
| 2. Outstanding & Prepaid Items | Ignores outstanding expenses, prepaid expenses, accrued income, and unearned income. | Adjusts for all outstanding expenses, prepaid expenses, accrued incomes, and unearned incomes. |
| 3. Accuracy of Profit | Does not reflect true periodic profit or loss because matching principle is violated. | Reflects true and fair periodic profit/loss and financial position in compliance with GAAP and NFRS. |
| 4. Legal Recognition | Not recognized under Nepal Company Act or NFRS for corporate financial reporting (used mainly by small cash-based professionals or traditional government accounts). | Mandatory for companies and commercial enterprises under NAS/NFRS and Nepal Income Tax Act (for corporate entities). |
1.5 Accounting Equation
1.5.1 Meaning and Formula
The Accounting Equation is a mathematical expression of the Dual Aspect Concept showing that the total economic resources (Assets) of a business are always equal to the total claims against those resources by outsiders (Liabilities) and the owner (Capital).
Assets (A) = Capital (C) + Liabilities (L)
Derived relationships:
- Capital (C) = Assets (A) - Liabilities (L)
- Liabilities (L) = Assets (A) - Capital (C)
- Effect of Revenue & Expenses on Capital:
- Incomes / Revenues / Profits → Increase Capital (+)
- Expenses / Losses / Drawings → Decrease Capital (-)
1.5.2 Summary of Transaction Effects on the Accounting Equation
| Transaction Type | Effect on Assets (A) | Effect on Capital (C) | Effect on Liabilities (L) |
|---|---|---|---|
| 1. Started business with cash & furniture | + Cash, + Furniture | + Capital | No effect (0) |
| 2. Purchased goods on credit | + Stock (Goods) | No effect (0) | + Creditors |
| 3. Sold goods costing Rs. 10,000 for Rs. 13,000 cash | + Cash (13,000), - Stock (10,000) | + Profit (3,000) | No effect (0) |
| 4. Paid salary or rent in cash | - Cash | - Expense | No effect (0) |
| 5. Outstanding salary (unpaid expense) | No effect (0) | - Expense | + Outstanding Salary |
| 6. Prepaid rent paid in cash | - Cash, + Prepaid Rent | No effect (0) | No effect (0) |
| 7. Paid Rs. 9,500 to creditor of Rs. 10,000 in full settlement | - Cash (9,500) | + Discount Gain (500) | - Creditors (10,000) |
| 8. Owner withdrew cash/goods for personal use | - Cash / - Stock | - Drawings | No effect (0) |
1.5.3 Worked Numerical Example (NEB 5-Mark / 8-Mark Standard)
Illustration 1.1:
Prepare an Accounting Equation from the following transactions of Bagmati Traders, Kathmandu:
- Started business with cash Rs. 2,50,000 and furniture Rs. 50,000.
- Purchased goods on credit from Pokhara Suppliers Rs. 80,000 and for cash Rs. 40,000.
- Sold goods costing Rs. 50,000 on credit to Janakpur Store for Rs. 65,000.
- Paid house rent Rs. 15,000 and salary Rs. 20,000; a further Rs. 5,000 of salary is still outstanding.
- Settled the account of Pokhara Suppliers of Rs. 80,000 by paying Rs. 78,000 in cash.
- Goods costing Rs. 8,000 were withdrawn by the proprietor for personal use.
Solution:
In the Books of Bagmati Traders, Kathmandu
Accounting Equation
| S.N. | Transactions | Assets (Cash + Furniture + Stock + Debtors) Rs. | = | Capital Rs. | + | Liabilities (Creditors + O/S Salary) Rs. |
|---|---|---|---|---|---|---|
| 1. | Started business with cash & furniture | 2,50,000 (Cash) + 50,000 (Furn.) = 3,00,000 | = | 3,00,000 | + | 0 |
| 2. | Purchased goods on credit Rs. 80,000 & cash Rs. 40,000 | -40,000 (Cash) + 1,20,000 (Stock) = +80,000 | = | 0 | + | +80,000 (Creditors) |
| New Equation | 3,80,000 (2,10,000 + 50,000 + 1,20,000) | = | 3,00,000 | + | 80,000 | |
| 3. | Sold goods costing Rs. 50,000 for Rs. 65,000 on credit | -50,000 (Stock) + 65,000 (Debtors) = +15,000 | = | +15,000 (Profit) | + | 0 |
| New Equation | 3,95,000 (2,10,000 + 50,000 + 70,000 + 65,000) | = | 3,15,000 | + | 80,000 | |
| 4. | Paid rent Rs. 15,000, salary paid Rs. 20,000 & O/S Rs. 5,000 | -35,000 (Cash) | = | -40,000 (Exp.) | + | +5,000 (O/S Salary) |
| New Equation | 3,60,000 (1,75,000 + 50,000 + 70,000 + 65,000) | = | 2,75,000 | + | 85,000 | |
| 5. | Paid Rs. 78,000 to Pokhara Suppliers in full settlement of Rs. 80,000 | -78,000 (Cash) | = | +2,000 (Disc. Gain) | + | -80,000 (Creditors) |
| New Equation | 2,82,000 (97,000 + 50,000 + 70,000 + 65,000) | = | 2,77,000 | + | 5,000 | |
| 6. | Goods withdrawn by owner for personal use Rs. 8,000 | -8,000 (Stock) | = | -8,000 (Drawings) | + | 0 |
| Final Equation | 2,74,000 | = | 2,69,000 | + | 5,000 |
Verification of Final Balances:
- Total Assets: Cash (Rs. 97,000) + Furniture (Rs. 50,000) + Stock (Rs. 62,000) + Debtors (Rs. 65,000) = Rs. 2,74,000
- Capital + Liabilities: Capital (Rs. 2,69,000) + Outstanding Salary (Rs. 5,000) = Rs. 2,74,000 (Verified).
1.6 NEB Board Exam Practice Questions
Group A: Very Short Answer Questions (1 Mark Each)
- Define book-keeping in one sentence.
- Who propounded the Double Entry System of book-keeping and in which year?
- State any two limitations of financial accounting.
- Under which accounting concept is Capital treated as a liability of the business?
- Mention the full form of NFRS and NAS.
- What is meant by the Matching Concept in accounting?
- Distinguish between Trade Discount and Cash Discount in one point.
- If total assets of a business are Rs. 4,50,000 and external liabilities are Rs. 1,20,000, what is the amount of Owner’s Equity?
Group B: Short Answer & Numerical Questions (5 Marks Each)
- Define accounting and explain any four primary objectives of accounting.
- Differentiate between Book-keeping and Accounting on any five bases.
- Explain the Business Entity Concept, Going Concern Concept, and Money Measurement Concept with suitable examples.
- Differentiate between Cash Basis and Accrual Basis of accounting.
- Numerical Problem: Prepare an Accounting Equation from the following transactions of Everest Enterprise:
- (a) Commenced business with cash Rs. 1,80,000 and stock of goods Rs. 70,000.
- (b) Sold goods costing Rs. 30,000 for Rs. 38,000 in cash.
- (c) Purchased machinery for Rs. 60,000 paying Rs. 20,000 in cash and the balance on credit.
- (d) Paid wages Rs. 12,000 and wages still outstanding Rs. 3,000.
- (e) Received commission Rs. 5,000 (including Rs. 1,000 received in advance for next year). (Ans: Total Assets = Rs. 2,91,000 [Cash Rs. 1,91,000 + Stock Rs. 40,000 + Machinery Rs. 60,000]; Capital = Rs. 2,47,000; Liabilities = Rs. 44,000 [Creditors for Machinery Rs. 40,000 + O/S Wages Rs. 3,000 + Advance Commission Rs. 1,000])
Worked answers to these exercises are in Chapter 1 Solutions.