Unit 11 Solutions: Basic Accounting Concepts & Systems
Answers to the Unit 11 exercises. Each answer is as long as its marks call for: a sentence or two for 1 mark, four explained points for 4 marks, and an introduction, explained points and a conclusion for 8 marks.
A. Very Short Answer Questions (1 Mark Each)
1. State the Accounting Equation.
Assets = Capital + Liabilities. It follows from the Dual Aspect Concept: the resources owned by a business are always equal to the claims of the owner and outsiders against those resources.
2. Under which accounting concept is the proprietor treated as a creditor of the business for their capital?
Under the Business Entity Concept. Because the business is treated as separate from its owner, the capital invested by the proprietor is shown as an amount the business owes to the owner.
3. What is meant by a Fiscal Year?
A Fiscal (Financial) Year is a continuous 12-month period adopted for closing the accounts and preparing financial statements; in Nepal, it runs from Shrawan 1 to the end of Ashadh (roughly mid-July to mid-July).
4. Define Fictitious Assets with two examples.
Fictitious assets are deferred revenue expenditures or accumulated losses shown temporarily on the asset side of the Balance Sheet until they are written off against future profits; they have no resale value. Examples: Preliminary Expenses and Discount (Loss) on Issue of Shares or Debentures.
5. What is Bad Debt?
Bad debt is the amount due from a debtor that cannot be recovered because the debtor has become insolvent or dishonest, so it is written off as a loss.
B. Short Answer Questions (4 Marks Each)
1. Differentiate between Single Entry System and Double Entry System on any four bases.
| Basis | Single Entry System | Double Entry System |
|---|---|---|
| Dual aspect | Records only one aspect of a transaction, or omits both aspects for non-cash real and nominal items | Records both aspects (debit and credit) of every transaction |
| Accounts maintained | Only the personal accounts of debtors and creditors and the Cash Book; real and nominal accounts are not opened | All three classes of accounts: personal, real and nominal |
| Trial Balance | Cannot be prepared, so the arithmetical accuracy of the books cannot be checked | Prepared regularly to check that total debits equal total credits |
| Profit or loss | Only an estimated profit or loss, found by comparing opening and closing capital | Exact gross and net profit or loss, found by preparing the Trading and Profit & Loss Account |
| Balance Sheet | A true Balance Sheet cannot be prepared, because real asset accounts are not kept | A true Balance Sheet is prepared, showing exact assets, liabilities and capital |
| Legal and tax recognition | Not accepted by the Inland Revenue Department, banks or courts of law | Accepted everywhere by tax authorities, auditors, banks and courts |
The unit adds one more basis, suitability: the single entry system suits only very small petty traders, while the double entry system suits every type of organization.
2. Explain the Business Entity Concept, Money Measurement Concept, Going Concern Concept, and Matching Concept.
- Business Entity Concept: The business is treated as a separate and distinct unit from its owner. Only the transactions of the business are recorded in its books, and the owner’s private dealings are kept out. For example, when the proprietor invests Rs. 5,00,000 in the business, the business shows it as Capital, an amount owed to the owner. When the owner takes Rs. 10,000 for household expenses, it is recorded as Drawings, not as a business expense.
- Money Measurement Concept: Only those transactions and events that can be expressed in money (Nepalese Rupees) are recorded in the books. Events that cannot be measured in money, such as a quarrel between two managers or the high skill of a worker, are not recorded, even if they affect the business.
- Going Concern Concept: It is assumed that the business will continue to operate in the foreseeable future and has no intention of closing down. For this reason, fixed assets are recorded at historical cost and depreciated over their useful life, instead of being valued at the price they would fetch if the business were closed and the assets sold at once.
- Matching Concept: To find the true profit or loss of an accounting period, the revenue earned in that period is matched against all the expenses incurred to earn it, whether paid or still outstanding. For example, salary for the last month of the year that is still unpaid is treated as an expense of that year, not of the year in which it is paid.
3. Differentiate between Trade Discount and Cash Discount.
| Basis | Trade Discount | Cash Discount |
|---|---|---|
| Meaning and purpose | A deduction on the catalogue or list price allowed by a manufacturer or wholesaler to encourage bulk purchases | A deduction allowed by a creditor to a debtor to encourage prompt payment within a stated time |
| When allowed | At the time of buying or selling goods, for cash or on credit | Only at the time of making or receiving payment in cash or by cheque |
| Shown in the invoice | Deducted on the face of the invoice; entries are made at the net amount | Not deducted in the invoice; calculated at the time of settlement |
| Recording in the books | Never recorded separately in the Journal or Ledger | Always recorded in the Journal and Cash Book as Discount Allowed A/c (Dr., expense) or Discount Received A/c (Cr., income) |
| Basis of the rate | Depends on the quantity bought | Depends on how early the payment is made |
| Profit & Loss Account | Not shown as an expense or income | Discount allowed is shown as a loss and discount received as a gain |
Example: Goods with a list price of Rs. 10,000 are sold at 10% trade discount, so the invoice and the entry are for Rs. 9,000 only. If the buyer pays early and gets a 2% cash discount, the seller receives Rs. 8,820 and records Rs. 180 as Discount Allowed.
4. Distinguish between: (a) Fixed Assets and Current Assets, and (b) Debtors and Creditors.
(a) Fixed Assets and Current Assets
| Basis | Fixed Assets | Current Assets |
|---|---|---|
| Meaning | Assets acquired for long-term use in the business, not for resale | Cash and assets expected to be converted into cash within one accounting year |
| Period | Used for more than one year | Held for less than one year |
| Purpose | To run the business and earn income over many years | For day-to-day operations and for paying short-term debts |
| Depreciation | Charged on tangible fixed assets (except land) | Not charged |
| Examples | Land & Building, Plant & Machinery, Furniture, Vehicles | Cash in hand, Cash at bank, Sundry Debtors, Bills Receivable, Closing Stock, Prepaid Expenses |
(b) Debtors and Creditors
| Basis | Debtors (Accounts Receivable) | Creditors (Accounts Payable) |
|---|---|---|
| Meaning | Persons or firms to whom the business has sold goods on credit | Persons or suppliers from whom the business has bought goods on credit |
| Amount | Money is receivable from them | Money is payable to them |
| Nature | Current asset | Current liability |
| Ledger balance | Their accounts show a debit balance | Their accounts show a credit balance |
| Cash discount | The business allows discount to them (Discount Allowed) | The business receives discount from them (Discount Received) |
C. Long Analytical Questions (8 Marks Each)
1. What is the Double Entry System of bookkeeping? Explain its features, objectives, and advantages in detail.
Meaning: The Double Entry System is the modern, scientific, complete and universally accepted system of bookkeeping, set out by Luca Pacioli in 1494 A.D. It recognizes that every financial transaction has two equal and opposite aspects: a receiving aspect (Debit) and a giving aspect (Credit). For every debit there must be a credit of an equal amount. According to J.R. Batliboi, “Every business transaction has a two-fold effect and that affects two accounts in opposite directions, and if a complete record were to be made of each such transaction, it would be necessary to debit one account and credit another account.”
Features:
- Two aspects of every transaction: Each transaction has a receiving aspect and a giving aspect. When Ramesh starts a business with cash Rs. 2,00,000, Cash A/c is debited and Capital A/c is credited.
- At least two accounts affected: Every transaction affects at least two accounts in opposite directions. When furniture worth Rs. 40,000 is bought on credit from Koshi Furniture, Furniture A/c is debited and Koshi Furniture A/c is credited.
- Equal debit and credit: The amount debited is always equal to the amount credited, so the total of all debits equals the total of all credits.
- All classes of accounts kept: Personal, real and nominal accounts (or assets, liabilities, capital, revenue and expenses) are all maintained.
- Fixed rules of debit and credit: Every entry follows set rules (the golden rules or the modern accounting-equation rules), so all accountants record a transaction in the same way.
- Self-balancing and verifiable: Because debits equal credits, a Trial Balance can be prepared to test the arithmetical accuracy of the books.
Objectives:
- To keep a complete, systematic and permanent record of every financial transaction.
- To find the exact profit or loss of the business for each fiscal year.
- To show the true financial position of the business on a particular date.
- To check the arithmetical accuracy of the books and to prevent and detect errors and frauds.
- To provide reliable information to owners, managers, banks, investors and the tax office.
Advantages:
- Complete and scientific record: Both aspects of every transaction are recorded, so the books give a full picture of the business.
- Check on arithmetical accuracy: The Trial Balance shows at once whether total debits equal total credits.
- Exact profit or loss: The Trading and Profit & Loss Account can be prepared, because all expense and income (nominal) accounts are kept.
- True financial position: A Balance Sheet can be prepared from the real and personal accounts, showing exact assets, liabilities and capital.
- Information about debtors and creditors: Personal accounts show at any time how much is receivable from each customer and payable to each supplier.
- Prevention of errors and frauds: Regular balancing and the Trial Balance make it hard for mistakes and fraud to go unnoticed.
- Comparison and decision making: Results of different years can be compared, which helps management plan budgets and policies.
- Legal and tax recognition: Books kept on this system are accepted as authentic evidence by the Inland Revenue Department, auditors, banks and courts of law.
Conclusion: The Double Entry System overcomes all the weaknesses of the single entry system. It records transactions completely, proves their accuracy through the Trial Balance and makes it possible to prepare the final accounts. That is why it is used by small, medium and large businesses, companies and banks, and also forms the basis of Nepal’s New Accounting System for government offices.