Chapter 1 Solutions: Theoretical Concepts of Book-Keeping and Accounting

Answers to the Chapter 1 exercises. Each answer is as long as its marks call for: a sentence or two for 1 mark, five clear points or a five-row table for 5 marks, and full working for numerical problems.

Group A: Very Short Answer Questions (1 Mark Each)

1. Define book-keeping in one sentence.

Book-keeping is the systematic identification, classification and recording of financial transactions in the books of original entry (Journals) and their posting into the Ledger in chronological order.

2. Who propounded the Double Entry System of book-keeping and in which year?

The Double Entry System was propounded by Luca Pacioli, an Italian Franciscan friar and mathematician, in 1494 AD, when he documented it in his book Summa de Arithmetica, Geometria, Proportioni et Proportionalita, published in Venice.

3. State any two limitations of financial accounting.

(1) It ignores non-monetary factors such as employee morale, managerial skill and market reputation, and (2) it records assets at their historical (original purchase) cost, ignoring the effect of inflation on their value.

4. Under which accounting concept is Capital treated as a liability of the business?

Under the Business Entity Concept. Because the business and its owner are treated as separate entities, the money invested by the owner is shown as Capital, an amount the business owes to the owner.

5. Mention the full form of NFRS and NAS.

NFRS: Nepal Financial Reporting Standards. NAS: Nepal Accounting Standards.

6. What is meant by the Matching Concept in accounting?

The Matching Concept means that, to find the true profit of an accounting period, all expenses incurred during that period, whether paid in cash or still outstanding, are matched against the revenues earned in the same period.

7. Distinguish between Trade Discount and Cash Discount in one point.

Trade Discount is a deduction from the list price allowed at the time of a bulk purchase or sale and is never recorded in the ledger accounts, whereas Cash Discount is a deduction allowed for prompt payment and is recorded in the books as an expense for the giver and an income for the receiver.

8. 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?

Owner’s Equity (Capital) = Assets - Liabilities = 4,50,000 - 1,20,000 = 3,30,000. The Owner’s Equity is Rs. 3,30,000.

Group B: Short Answer & Numerical Questions (5 Marks Each)

1. Define accounting and explain any four primary objectives of accounting.

Accounting is the broader discipline that begins where book-keeping ends. It covers designing the accounting system, recording and classifying financial transactions, summarizing them in the Trial Balance and the financial statements (Income Statement and Balance Sheet), and analyzing, interpreting and communicating the results to internal and external users for decision-making. According to the American Institute of Certified Public Accountants (AICPA), accounting is the art of recording, classifying and summarizing transactions and events of a financial character in terms of money, and interpreting their results.

Four primary objectives of accounting are:

1. Maintaining systematic records: Human memory is limited, and a business makes too many transactions for anyone to remember. Accounting keeps a complete, chronological and permanent record of every transaction in the Journal and the Ledger, which can be referred to at any time and used as evidence.
2. Ascertaining the operating result: At the end of the accounting period, the Income Statement (Trading and Profit & Loss Account) is prepared from the accounts. It shows whether the business has earned a Net Profit or suffered a Net Loss during the period.
3. Ascertaining the financial position: The Balance Sheet, prepared on the last day of the period, shows the assets the business owns, the liabilities it owes to outsiders and the owner’s equity. Owners, banks and creditors use it to judge how sound the business is.
4. Facilitating decision-making and tax compliance: Analyzed financial statements, budgets and ratios help management take rational decisions about costs, prices and expansion. The same records form the basis for filing VAT and Income Tax returns with the tax authorities.

Accounting also communicates audited results to shareholders, banks and regulators, and its documentary records help to detect errors and frauds.

2. Differentiate between Book-keeping and Accounting on any five bases.

Book-keeping is the recording phase of accounting, while accounting goes on to summarize, analyze and communicate the recorded data. They differ as follows:

The chapter adds a sixth basis, decision making: management cannot take strategic decisions from book-keeping records alone, whereas the analyzed statements and ratios that accounting provides are used directly for decisions.

3. Explain the Business Entity Concept, Going Concern Concept, and Money Measurement Concept with suitable examples.

These are three of the fundamental accounting concepts within GAAP, the common set of concepts, conventions and rules that make financial statements uniform, reliable and comparable.

1. Business Entity Concept: The business and its owner are treated as two completely separate accounting entities, and only the transactions of the business are recorded in its books. The capital invested by the owner is shown as an amount the business owes to the owner, and anything the owner takes out for personal use is charged to Drawings, not treated as a business expense.
   Example: Sita starts a shop with cash Rs. 5,00,000, so the shop records Cash A/c Dr. and Capital A/c Cr. When she later takes Rs. 10,000 from the shop to pay the rent of her house, the amount is debited to Drawings A/c, not to Rent A/c.
2. Going Concern Concept: It is assumed that the business will continue to operate in the foreseeable future and has no intention or need to close down. Because of this assumption, fixed assets are shown at historical cost less depreciation spread over their useful life, not at the price they would fetch if they had to be sold at once.
   Example: A machine bought for Rs. 2,00,000 might sell for only Rs. 1,20,000 if the business closed today, but it is still shown at its cost of Rs. 2,00,000 less depreciation, because the business expects to keep using it for years.
3. Money Measurement Concept: Only those transactions and events that can be expressed in money (Nepalese Rupees) are recorded in the books. Qualitative facts are left out, however important they are, because they cannot be measured in money.
   Example: A sale of goods for Rs. 50,000 is recorded, but a dispute between two managers, the skill of the staff or the good reputation of the shop is not recorded, even though each of them affects the business.

Together, these concepts decide whose transactions are recorded (the business’s own), what is recorded (only events measurable in money) and how assets are valued (as those of a continuing business).

4. Differentiate between Cash Basis and Accrual Basis of accounting.

Under the cash basis, revenues and expenses are recorded only when cash is received or paid; under the accrual (mercantile) basis, revenues are recorded when earned and expenses when incurred, whenever the cash moves. They differ as follows:

Example: If salary of Rs. 10,000 for the last month of the year is still unpaid at the year end, the cash basis records no expense for it. The accrual basis charges it as an expense of that year and shows Rs. 10,000 as Outstanding Salary, a liability, in the Balance Sheet.

5. 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).

In the Books of Everest Enterprise
Accounting Equation

Verification of Final Balances:

• Total Assets: Cash (Rs. 1,91,000) + Stock (Rs. 40,000) + Machinery (Rs. 60,000) = Rs. 2,91,000
• Capital + Liabilities: Capital (Rs. 2,47,000) + Creditors for Machinery (Rs. 40,000) + Outstanding Wages (Rs. 3,000) + Advance Commission (Rs. 1,000) = Rs. 2,91,000 (Verified).

Answer: Total Assets = Rs. 2,91,000; Capital = Rs. 2,47,000; Liabilities = Rs. 44,000.

Working notes:

• (b) Profit on sale: Cash rises by Rs. 38,000 and stock falls by Rs. 30,000. The difference, 38,000 - 30,000 = 8,000, is profit and increases Capital.
• (c) Machinery on part credit: Machinery is a fixed asset, so it is added to assets at its full cost of Rs. 60,000. Only Rs. 20,000 leaves the cash; the unpaid balance, 60,000 - 20,000 = 40,000, is owed to the supplier and is a liability (Creditors).
• (d) Wages: The whole wages of the period, 12,000 + 3,000 = 15,000, is an expense and reduces Capital, as the Matching Concept requires. Only Rs. 12,000 is paid in cash; the unpaid Rs. 3,000 becomes a liability (Outstanding Wages).
• (e) Commission: All Rs. 5,000 is received in cash, but only 5,000 - 1,000 = 4,000 is earned this year and increases Capital. The Rs. 1,000 received for next year is income received in advance, a liability until it is earned.
• Capital: 2,50,000 + 8,000 - 15,000 + 4,000 = 2,47,000.
• Cash: 1,80,000 + 38,000 - 20,000 - 12,000 + 5,000 = 1,91,000.