Financial and Management Accounting Unit 3 Page No.: 38 Unit 3 Double Entry Accounting Structure: 3.1 Introduction 3.2 Meaning of double entry accounting 3.3 Cash and mercantile system of double entry system 3.4 Accounting trail 3.5 Transactions and events 3.6 Preparation of vouchers 3.7 Financial statements and their nature 3.8 Accounting equation 3.9 Effect of transactions on accounting equation 3.10 Meaning and rules of debit and credit 3.1 Introduction The dual aspect concept of accounting is a full-proof system of recording, having the advantage of internal checking. The very fact that every transaction is recorded of its debit and credit aspects indicates that the final accounts of an organization takes into consideration every small or big transaction and the impact is every account is absorbed in the preparation of final financial statements. Double entry book keeping is definitely an improvement and more systematically designed than single entry system, where only a few personal and real accounts are considered. In this unit, the process of accounting – recording, journalizing, posting, ledger balancing, preparation of trial balance, preparation of final statements of accounts – is described along with the effect of every transaction on accounting equation. The rules of debit and credit as applicable to various types of accounts are also discussed.
Transcript
Financial and Management Accounting Unit 3
Page No.: 38
Unit 3 Double Entry Accounting
Structure:
3.1 Introduction
3.2 Meaning of double entry accounting
3.3 Cash and mercantile system of double entry system
3.4 Accounting trail
3.5 Transactions and events
3.6 Preparation of vouchers
3.7 Financial statements and their nature
3.8 Accounting equation
3.9 Effect of transactions on accounting equation
3.10 Meaning and rules of debit and credit
3.1 Introduction
The dual aspect concept of accounting is a full-proof system of recording,
having the advantage of internal checking. The very fact that every
transaction is recorded of its debit and credit aspects indicates that the final
accounts of an organization takes into consideration every small or big
transaction and the impact is every account is absorbed in the preparation
of final financial statements. Double entry book keeping is definitely an
improvement and more systematically designed than single entry system,
where only a few personal and real accounts are considered. In this unit, the
process of accounting – recording, journalizing, posting, ledger balancing,
preparation of trial balance, preparation of final statements of accounts – is
described along with the effect of every transaction on accounting equation.
The rules of debit and credit as applicable to various types of accounts are
also discussed.
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Learning Objectives:
After studying this unit, you should be able to understand the following:
1. To know what double entry book keeping means.
2. To understand the process of accounting, known as accounting trail.
3. To know the nature of financial statements.
4. To formulate an Accounting equation basing on debits and credits.
5. To know practically the impact of each transaction on the Accounting
Equation.
6. To summarize the rules of debit and credit as applicable to different
types of accounts.
The students should be able to appreciate the double entry system and
know the accounting process.
3.2 Meaning of Double Entry Accounting
We have learnt that the dual aspect recording is the most important
accounting concept. According to the concept, every business transaction
involves receiving aspect and giving aspect. If capital is brought in by the
owner of the business unit, the owner is the giver of the benefit and the
business unit is the receiver of the benefit. It is a liability to the business unit
and it is equally balanced by an asset in the business unit, in the form of
cash received towards capital. Therefore every liability is represented by an
asset. This is also expressed as every debit has an equivalent credit.
The logic adopted in double entry accounting can well be understood by an
illustration. We shall consider five transactions and show how they are
accounted for in the books of the business.
a. Mr. Abhi brings Rs.100000 cash as capital into his business.
b. He purchases furniture to his shop Rs.10000
c. He buys goods for cash Rs.50000
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d. He sells goods worth Rs.30000 for Rs.40000 on credit to Arjun
e. He pays wages to servants Rs.1000
In the first transaction, the business receives capital in cash and so capital
account and cash account are affected. Capital is a liability and cash is an
asset to the business.
Capital Rs.100000 (Liability) = Cash Rs.100000 (Asset)
In the second transaction, Furniture is purchased for cash and so furniture
account and cash account are affected. This transaction can be reflected as
under
Capital Rs.100000 Cash Rs. (100000- 10000) 90000
Furniture 10000
100000 100000
The third transaction is buying goods for cash, which means that stock of
goods are received and cash balance is reduced and this can be reflected in
the statement as under.
Capital Rs.100000 Cash Rs (90000 – 50000) 40000
Furniture 10000
Stock of goods 50000
100000 100000
The fourth transaction is a credit transaction of selling goods for Rs40000,
the cost of which is only Rs. 30000 to Arjun. So the accounts affected are
goods account, Arjun account and profit account. Since the profit belongs to
the owner and it is fair to add it to the owner’s capital. The effect of this
transaction can appear on the statement as shown below:
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Capital Rs. 100000 Cash 40000
Profit 10000 Furniture 10000
Stock of goods(50000-30000) 20000
Arjun (Debtor) 40000
110000 110000
The fifth transaction is payment of wages, which means that cash account is
affected and profit is reduced as a result of the expenditure(wages account).
This changes the statement as shown below:
Capital Rs. 100000 Cash (40000 – 1000) 39000
Profit (10000-1000) Furniture 10000
9000 Stock of goods 20000
Arjun 40000
109000 109000
From the above illustration, it is clear that every transaction has dual effect
and recording these two aspects which are known as debit and credit
aspects is the fundamental idea behind double entry system of book
keeping. So the meaning of double entry system is that every transaction is
recorded by identifying the two or more accounts affected therein and
suitably reflect them in the financial statements. This is a system where
internal cross checking is ensured.
Self Assessment Questions 1:
1. The system of recording transactions based on dual aspect concept is
called
i) Double account system
ii) Double entry system
iii) Single entry system
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2. Show the dual aspect effect of the following transactions on the assets
and liabilities of business.
a. Purchased goods for cash Rs.80000
b. Purchased delivery van on credit for Rs.400000
c. Paid Rs.5000 to a supplier of goods on credit
d. The proprietor withdrew Rs.20000 from the bank account of
business for Personal expenses.
3.3 Cash and mercantile system of double entry system
There are two systems of double entry book keeping namely cash system
and mercantile system. In case of cash system, transactions are recorded
only if cash is received or paid. Government accounting is done basing on
this system. On the other hand, mercantile system is one where both cash
and credit transactions are recorded. Besides, outstanding expenses or
incomes also find place in the mercantile system. It is fair enough to adopt
mercantile system because when an event takes place, it gets recorded
irrespective of its immediate impact on the cash position. In case of credit
transactions, cash does not flow immediately but it takes place at a future
point of time. Transactions like sales or purchases on credit, salary
payable, rent receivable, interest accrued but not received, depreciation
provided etc., influence on the financial position of the business unit and
therefore they should be recorded. Mercantile system facilitates this. Hence
double entry recognizes the fact that every transaction, whether cash or
credit, influences at least two accounts – one representing debit aspect and
another credit aspect.
Self Assessment Questions 2:
1. The two systems of double entry book keeping are ________ and
__________ .
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2. Government accounting is based on mercantile system. True or false?
3. All credit transactions come under mercantile system. True or False?
4. Interest receivable, rent receivable, dividend receivable are recorded in
cash system of book keeping. True or False?
5. Profit as per cash system and mercantile system of double entry show
different figures. True or False
3.4 Accounting Trail
Accounting trail is the process of identifying the transactions or events,
preparation of vouchers, recording them as journal entries, preparation of
ledger accounts, balancing the ledger accounts, incorporating all
adjustments, preparation of a trail balance and finally preparing the financial
statements and balance sheet. It is a sequential order in which the
accounting process flows. All transactions are recorded first in a book called
journal. The transactions are posted to the respective accounts, maintained
in a separate book called ledger. Later, all adjustments such as opening
entries, closing entries, adjusting entries are made in a book called journal
proper and there from, the ledger balances are summarized to form a trial
balance. From trial balance, trading account, profit and loss account and
balance sheet are prepared.
The identification of the accounts affected in the transactions is a major
task. There are three types of accounts, namely personal accounts, real
accounts and nominal accounts. An account is a summary of transactions
pertaining to a particular head.
Personal accounts include accounts of natural persons, such as Abhi
account, Mohan’s account, Sonali account etc; artificial personal accounts
such as Syndicate Bank account, X Co. Ltd account, a club account etc;
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representative personal account like outstanding rent account, salaries
payable account etc.
Real accounts are those which may be tangible real accounts and intangible
real accounts. Tangible real accounts relate to things that can be touched,
felt, physically measurable. Building account, furniture account, stock
account, cash account etc are tangible real accounts. Intangible real
accounts are such that they can not be seen or touched. They can be
measured in terms of money such as goodwill, patent rights etc.
Nominal accounts are also known as impersonal accounts. They are in the
form of expenses or losses, incomes or gains. They do not really exist in
physical form, but behind every nominal account cash is involved. For
example, salary account is a nominal account and when salary is paid, the
reality is the cash goes out and there is nothing salary in physical form.
Therefore salary account is regarded as nominal account. Similarly all
expenses and losses and all incomes and gains accounts are regarded as
nominal accounts.
Self Assessment Questions 3:
1. Accounting trial is a process starting from identifying the transactions or
events to preparation of final statement of accounts. True or False
2. There are three types of accounts namely ____________ and
________________.
3. A trial balance is the summarized form of ledger balances. True or False
4. Classify the following accounts into personal, real and nominal
i) Bank of Baroda Account ii) Printing and stationery expenses
Machinery Outstanding salary iii) Copy Rights iv) Sock of goods v) Loan
given to Krishna vi) Loan from Bank vii) Dividend received
viii) Discount Account
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3.5 Transactions and Events
A transaction is a business activity involving transfer of money or money’s
worth. It may be cash transaction or credit transaction. In cash transaction
cash flows immediately where as in credit transaction cash will be paid or
received at future date. Assets acquired or sold, liabilities incurred or paid,
expenses paid or payable, incomes received or receivable – are all business
transactions. But there are events which are neither cash nor credit
transactions but it has an impact on the financial position of a business.
These events may include provision for bad debts, provision for repairs,
depreciation, taxation, transfer of profit towards reserve fund or sinking fund
or investment fluctuation fund, etc., Events happen as a result of internal
policies or external needs. In accounting, transactions and events have
equal relevance and they must be recorded to arrive at the financial results
of the business concern.
Self Assessment Questions 4:
1. A transaction is a business activity where there is transfer of money or
money’s worth. True or False
2. An event happens as a result of internal policy of an organization. True
or False
3. Business transactions and events have equal importance in finding the
financial results of the business concern. True or False?
4. Identify the following as transactions or events as the case may be.
i) Depreciation of assets ii) Tax rates iii) Acquisition of assets iv) Selling
an asset v) Transfer of profits to Reserve Fund
3.6 Preparation of Vouchers
A voucher is a document in support of a business transaction. It may be a
receipt, a counterfoil of a receipt, an invoice or even correspondence with
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the concerned parties. Usually in large organizations, voucher system is
adopted to record payments. Some organizations will have printed voucher
book and each voucher contains the number of voucher, date, the name of
payee to whom the payment is made, the amount, the purpose for which
payment is made, signature of the person authorized to pay and the person
who receives the payment. For instance, Ram has supplied to us goods
worth Rs5000, for which he has given an invoice. This invoice itself can be
regarded as voucher, against which the payment is made. If carriage
charges of Rs100 are paid, we prepare a voucher and take the signature of
the person who receives it. When we pay cash, the receiver will give us a
receipt, that itself becomes a voucher. Vouchers are often prepared basing
on the invoices received or goods received returns. The actual payment
may be made partially or completely and it may be made in course of time.
In such cases, they are entered in Voucher register. The payment of a
voucher is recorded in cheque register. The system has the following
advantages:
1. It safeguards all cash disbursements
2. Total amount payable to creditors can be found out with the help of
unpaid
3. vouchers.
4. Internal check is ensured
5. Information about future cash requirements can be found out.
However, the system is not suitable for small organizations because it
involves personnel and the cost of maintenance.
Self Assessment Questions 5:
1. Voucher system is adopted to record payments. True or False?
2. Voucher system is suitable for small organizations. True or False?
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3. Voucher is a document showing the__________for which payment is
made.
4. Voucher system ensures internal check . True or False?
3.7 Financial statements and their nature
Financial statements are prepared to find out the profit or loss at the end of
an accounting period. In a trading concern, trading account and profit and
loss account are prepared. The purpose of preparing trading account is to
find out the gross profit / loss. Similarly, profit and loss account is prepared
to find out net profit / loss. Both these accounts are revenue accounts. In
other words, all revenue receipts and revenue payments are considered.
Revenue expenses are those which are incurred in day to day business
activities. Examples may include wages, carriage expenses, insurance
premium paid on stocks, salaries, printing, stationary, administrative
expenses, selling expenses and so on. Revenue receipts are called
incomes and the examples include rent received, sales made, interest
compensation received etc. More details about trading and profit and loss
account are given in Unit 7.
After preparing final accounts, a balance sheet is prepared containing
capital and liabilities on one side and assets on the other side of a
statement. Balance sheet is a statement of affairs and not an account.
Liabilities of a business include trade creditors, bills payable, bank over
draft, loans payable, outstanding expenses, pre-received incomes etc.
Capital of the owner, which is called equity, is added with liabilities on the
left side of the balance sheet. Assets of a business include fixed assets like
buildings, plant, machinery, furniture etc; current assets like sundry debtors,
bills receivable, closing stock of materials, outstanding incomes, prepaid
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expenses, cash in hand, cash at bank etc., Trading account or profit and
loss account and balance sheet are prepared at the end of a particular
accounting period, say one year. In Unit 7, details about balance sheet
preparation are given.
Self Assessment Questions 6:
1. Trading account and Profit and loss account are revenue accounts. True
or False?
2. What is the purpose of preparing Trading Account?
3. What is the end result of preparing profit and loss account?
4. Is balance sheet an account? What is it otherwise?
5. What items are shown on the left hand side of balance sheet?
6. Assets are shown on which side of balance sheet?
7. What is the purpose of preparing a balance sheet?
3.8 Accounting equation
The preparation of balance sheet is the final step in accounting process.
The accounting equation indicates that the sources of funds should be equal
to uses of funds. In other words, proprietor’s equity and liabilities to
outsiders should be equal to assets.
Sources of Funds = Application of funds OR
Owner’s equity = Asset OR
Owner’s equity + outside liabilities = Assets OR
L + P = A, where L is liabilities, P is
proprietor’ equity and A means assets. From this equation, the following
expressions can be obtained
L = A – P
P = A – L
A – L – P = Zero
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Self Assessment Questions 7:
1. Liabilities plus Equity is equal to ____________________________.
2. Assets minus liabilities to outsiders is equal to __________________.
3. If assets are Rs.5 lakhs, liabilities are Rs.3 lakhs, find out equity.
4. If Owner’s equity is Rs3 lakhs, Outsider liabilities are Rs.2 lakhs,
Owner’s share of profit is Rs.1 lakhs, find out the total value of assets.
5. Every transaction influences balance sheet and it is shown by
accounting equation True or False?
3.9 Effect of Transactions on Accounting Equation
As said earlier, every transaction has its effect on the balance sheet
equation. This has been amply illustrated while discussing the meaning of
double entry. The dual aspect of a transaction is reflected on the balance
sheet, ultimately making liabilities side equal to asset side of a balance
sheet. The following are the possible sets of transactions that can change
the values of assets and liabilities but the changes are equal on both sides
of balance sheet.
1. Increase in one asset with a decrease in another asset. For example,
goods are purchased for cash. It affects cash balance to come down
and stock balance increases and both of them are assets.
2. An increase in one asset with an equal amount of increase in liability.
For example, a building is purchased for business for Rs500000 by
raising a loan from bank. Here an asset is created and a loan is also
raised and the balance sheet tallies.
3. An increase in asset with an equivalent rise in the proprietor’s equity.
When an additional capital is obtained in cash, Cash account on the
asset side increases and capital account on the liabilities side also
increases with the same amount.
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4. An increase in a liability causing an equal amount of decrease in
another liability. Ex: A bank’s overdraft is paid out of debenture amount
collected. Here debenture liability increases with an equal amount of
decrease in bank’s overdraft.
5. Increase in a liability, followed by decrease in proprietor’s equity. If
debentures are issued for the purpose of paying redeemable preference
shares, the owner’s equity gets reduced and an additional liability of
debentures is added up.
6. Decrease in an asset and equivalent decrease in a liability. For instance,
bills payable are paid out by cheque. The bank balance which is an
asset is decreased and correspondingly the liability of bills payable is
also decreased.
7. Decrease in an asset and corresponding decrease in owner’s equity. If
capital is paid out for any reason, cash to that extent is decreased on the
asset side and the capital is reduced to that extent on the liabilities side.
Self Assessment Questions 8:
1. The principle of accounting equation is that the total of assets should be
equal to total of liabilities side. True or False.
2. Show how the accounting equation is affected in the following
transactions
a. Lal started business with Rs20000 cash
b. He purchased goods on credit Rs.80000
c. He sold goods costing Rs.25000 for Rs.30000 on cash.
d. He purchased furniture for cash Rs14000
e. He sold goods to Hari costing Rs500 for Rs.800
f. He received dividend on securities Rs.2000
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3.10 Meaning and rules of debit and credit
Debit and credit are the two words basic for accounting. Debit represents
receiving aspect and credit represents giving aspect. However the meaning
of debit and credit depends upon the classification of accounts. An account,
as we have understood is a summary of transactions pertaining to a
particular head. The account may be personal, real and nominal. Before
grasping the rules of debit and credit as applicable to various classes of
accounts, it is necessary to know how an account appears in the books of
accounts. An account is recorded in a ‘ T ‘ form, the left side indicating the
debit of the account and the right side representing the credit of the account.
On the left side of an account the columns are - date, particulars, ledger
folio and amount and similarly on the right side (credit side), the columns are
date, particulars, ledger folio and amount. The following illustration may be
observed:
CASH ACCOUNT
Debit Side Credit Side
Date particulars Ledger Amount
Folio (Rs)
Date Particulars Ledger Amount
Folio (Rs)
2005 2005
Jan. 1 To Balance brought down 20000 Jan 05 By salaries 10900
Jan15 To Joseph 35 10900 Jan 25 By Furniture 123 6000
Jan 28 To Sales 18 108900 Jan 30 By purchases 19 58800
Jan 31 By Rent 298 7500
By balance c/d 56600
139800 139800
Feb 1 To balance b / d 56600
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Observe from the above form of an account the following:
1. The balance brought down is the closing balance of the last month,
December, 2004
2. The amount received from Joseph is Rs.10900 and his account is
prepared in the in the page number 35 of the ledger. Similarly from sales
and its account is found in the ledger folio (page) 18.
3. The credit side contains payment of cash towards salary, furniture,
purchase of goods and rent respectively on different dates.
4. The balance carried down is the closing balance on the last day of
January, 2005 and it is brought down as opening balance on Feb,1
5. On the debit side, ‘To’ and credit side ‘By’ are the prefix used for every
entry as a matter of convention.
There is a standard form of drawing a ledger account. It is similar to that of a
pass book issued by a bank. The above illustration is shown in the standard
form.
CASH ACCOUNT
Date Particulars Post. Ref. Debit Credit Balance
2005 LF Rs Rs Rs
Jan 1 Opening balance b /d 20000 20000
Jan 5 Salaries 10900 9100
Jan 15 Joseph 35 10900 20000
Jan 25 Furniture 123 6000 14000
Jan 28 Sales 18 108900 122900
Jan 30 Purchases 19 58800 64100
Jan 31 Rent 298 7500 56600
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The rules of debit and credit for different classes of accounts are the
following
1. In respect of personal accounts : Debit the receiver and credit the giver
2. In respect of real accounts : Debit what comes in and credit what
goes out
3. In respect of nominal accounts : Debit all expenses and losses and
credit all incomes and gains.
The following steps should be remembered to apply debit and credit
principles
a) Identify the accounts affected in a transaction from business point of
view
b) If a personal account is involved, find whether the person is receiver or
giver of benefit
c) If the real account is affected, find whether it is coming in or going out
d) If the account is nominal account, find out if it is expenditure or income
or loss or gain.
e) Apply the suitable principle to debit or credit the respective affected
account.
Illustration: Show what accounts are affected in the following transactions.
Also show the accounting equation for the transactions
1. Madan commenced business with cash Rs. 70000
2. Purchased goods on credit 14000
3. Withdrew for private use 3000
4. Goods purchased for cash 12000
5. Paid wages 5000
6. Paid to creditors 10
7. Sold goods on credit (cost price Rs18000) 22000
8. Sold goods for cash (Cost price Rs.3000) 6000
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9. Purchased furniture for cash 5000
10. Received from debtors 11000
Solution:
Transaction No
Accounts affected in the books of the business
Account to be debited and account to be credited
01 Capital account and cash account
Cash account being real account is debited and Capital account being personal account is credited
02 Goods account and creditors account
Goods account being real account is debited and creditor’s account being personal account is credited
03 Personal drawings account and cash account
Drawings account being personal account is debited and cash account being real account is credited
04 Goods account and cash account
Goods account being real account is debited and cash account being real account is credited
05 Wages account and cash account
Wages account being nominal account is debited and cash account being real account is credited
06 Cash account and creditors account
Creditor’s account being personal account is debited and cash account being real account is credited
07 Goods account, Debtor’s account and profit account
Debtor’s account being personal account is debited, profit transferred to capital account being personal account is credited and goods account being real account is also credited
09 Furniture account and Cash account
Furniture account being real account is debited and cash account being real account is credited
10 Cash account and debtor’s account
Cash account being real account is debited and debtor’s account being personal account is credited.
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Accounting equations for the transactions
Transaction Assets = Liabilities + Owners Equity
Cash + Goods + Debtors + Furniture + =
Creditors + Madan’s capital
01 70000 70000
02 14000 14000
03 - 3000 -3000
04 - 12000 +12000
05 - 5000 -5000
06 -10000 -10000
07 -18000 22000 +4000
08 +6000 - 3000 +3000
09 -5000 5000
10 +11000 - 11000
End equation
52000+ 5000 + 11000 + 5000 + 4000 + 69000
73000 73000
Self Assessment Questions 9:
1. Rules of debit and credit are different for different types of accounts.
True or False?
2. Debit the receiver and _______________ the giver.
3. Debit all assets and credit all ________________.
4. Debit _____________________ and credit what goes out.
5. All expenses are ___________________ type of accounts.
6. Incomes and gains are always _________ as per principle of debit and
credit for nominal accounts.
7. Capital is ____________________ when it is withdrawn.
8. When cash is received from debtors, debtor’s account is ______ .
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Terminal Questions
1. The accounting equation is Assets = _______________ +
_______________.
2. State the meaning of double entry book keeping.
3. State the remarkable difference between cash system and mercantile
system of double entry.
4. State the important accounting trail.
5. Classify the following accounts as personal, real and nominal
a. Land account b. outstanding expenses account
c. capital account
d. ABC co Ltd., account e. Discount received account
f. salaries account
6. A voucher is a document which _______________ cash
disbursement.
7. What is a trading account?
8. The result of a trading account is ____________ or
_______________.
9. Net profit or net loss is the result of ____________________account.
10. Give a list of any four items of assets.
11. Name any four items that appear on the liabilities side of balance
sheet.
12. Balance sheet is a ________________________ of affairs of a
business.
13. Find the value of the following:
a. If the total assets are Rs87000 and the liabilities are Rs47000, find
out the amount of capital.
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b. If the capital of proprietor is Rs400000 and the total assets are
Rs600000, what is the amount of liabilities to outsiders?
c. If creditors are Rs56000, bank overdraft is Rs100000 and
outstanding expenses are Rs.8000, what is the total amount of
assets?
d. Fixed assets are Rs.70000 and current assets are Rs.100000 and
the creditors are Rs.30000. What is capital?
14. Show the effect of the following transactions on assets, liabilities and
owner’s
Equity of the business:
i. Ganesh started business with a capital of Rs.40000
9. He purchased stock of goods Rs.30000
10. Sold goods on cash Rs.40000, cost of which is Rs25000
11. Bought goods on credit Rs.10000
12. Sold goods on credit for Rs18000, the cost of which being
Rs10000
13. Paid Sales commission Rs.5000
14. Received cash discount Rs3000
15. Purchased furniture Rs.10000.
16. Received cash from debtors Rs.15000
17. Paid cash to creditors Rs.6000.
Answer for Self Assessment Questions
Self Assessment Questions 1:
1. Double entry system
2. a. Stock of goods increases and cash balance is reduced
b. Delivery Van is an asset and the supplier of the delivery van
becomes a creditor and it appears as liability
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c. Creditor’s balance is reduced on liabilities side and cash paid brings
down the cash balance on the asset side
d. The bank balance comes down on asset side and capital account is
reduced by the amount of drawings on the liabilities side.
