This article is written by Venkat Ramaiah Chavali who is pursuing a Diploma in Business Laws for In House Counsels from Lawsikho.

Introduction & Scope

Bookkeeping is to account what numbers are to arithmetic. Incidentally, bookkeeping too is numbers. In arithmetic, a given number means the same wherever it appears, but it is not so in bookkeeping; the interpretations differ. Confused? Let me explain, … maybe I am putting the cart before the horse; let me restart properly by addressing first things first. 

To understand ‘Basic Bookkeeping’ or any subject for that matter is to comprehend the intricacies and implications of it. It is not the same thing as learning a subject per se but having learnt the subject to realize and recognize the essence and relevance of what is learnt in each situation. Thus, to understand a subject, you need to know two aspects, the concepts of the subject and how when these concepts are applied in real life they alter or impact the results. So, to help understand Basic Bookkeeping, concepts are covered under the heading 2, “ Basic Concepts of Bookkeeping” and the impact under the heading 3, “How Does Law Impact Bookkeeping?”

The Layout

Matter Addressed	Bells and Whistles – The Spice
1. Introduction & Scope	To make this Article not only interesting but also useful, throughout this article real examples are given where can and where could not, hypothetical illustrations are provided.
2. Basic Concepts of Bookkeeping
3. How Does Law Impact Bookkeeping?
4. Summary and Conclusion
5. References —[numbers], given as superscript and details listed as endnotes; Where appropriate Hyperlinks are provided

This article is to alert the entrepreneurs who only understand and love their products and profits but have no inkling of how one misplaced posting in their books can jolt their business and turn their profits into losses. It is also to caution the junior accountants—who are normally tasked with the work of keying in the entries—to understand how uninformed posting under wrong head-of-account can result in unintended damage to their organization. 

Basic Concepts of Bookkeeping

Here only so much of the subject is covered and concepts explained that are necessary to understand the basic bookkeeping, plus to make sense out of what is covered under the heading 3, “How Does Law Impact Bookkeeping?”

What is Bookkeeping?

Bookkeeping is simply capturing and recording financial transactions. It is the starting point or the alpha of accounting and creation of ‘Database’ so to speak. 

What is Double-entry Bookkeeping?

A transaction implies two sides. Double-entry bookkeeping is where both sides of each transaction are captured and recorded, as against single entry bookkeeping where only the cash side of a transaction is recorded. The transaction is recorded as soon as it occurs in a book called the Journal. A Journal is also known as daybook, because in it a day’s transactions are entered chronologically as soon as one arises, so no financial information is lost.

Conventionally, the two affected entries in a double-entry system are known as Debit (Dr) and Credit (Cr). The system uses the ‘duality principle’ that for every debit entry there is always an equal and corresponding credit entry.

The 2 Sides of a Transaction, The 3 Types of Account and the Rules of Accounting

The two sides of a transaction i.e., the Debit and Credit are respectively posted in the two affected accounts which would be one or other of the following three types of accounts: 

1. Real Account – where tangible aspects like cash, goods etc. are the things/ transacted
2. Personal Account – where a person, group of persons or a legal entity is the affected party of transaction.
3. Nominal Account – represents income/ expense related to intangible things like rent, goodwill, etc.; or gains/ loss.

The credit and debit sides of a given transaction are posted in the affected account according to the rule specific to the type of account ( listed above). These are known as the ‘three golden rules of accounting’.

Golden Rule 1 – for Real Accounts: Debit what comes in and Credit what goes out.

Golden Rule 2 – for Personal Accounts: Debit the Receiver and Credit the giver.

Golden Rule 3 – for Nominal Accounts: Debit all expenses and losses and Credit all incomes and gains.

In a nutshell

TYPE OF ACCOUNT	GOLDEN RULE TO DECIDE DEBIT OR CREDIT
	DEBIT (Dr)	CREDIT (Cr)
Real Accounts	What comes in to business	What goes out of business
Personal Accounts	The person/entity receiving	The person/entity giving
Nominal Accounts	Expenses and Losses of business	Income and gains of business

Journal, Ledger & Head of Account

A ledger is an account where bookkeeping entries belonging to different affected accounts are segregated and posted. Ledgers are periodically processed for a company’s financial and managerial accounting as well as for statutory compliances. The data posted to ledgers is first validated by a Trial balance before it is further used. 

Head of Account or simply Account Head is a name under which transactions of a particular nature are grouped or recorded. For example, repair and maintenance expenses incurred on so many things so many times are all grouped under the head ‘Repairs & Maintenance’. Another example is conveyance expenses, which are grouped under the head ‘Conveyance Expenses’. All ledgers that come under a particular account-head are grouped together, for preparation of Balance Sheet and are therefore also at times referred to as ‘Ledger groups’.

The above concepts are illustrated using the following three transactions: 

Representative transactions of an office:

1. Furniture (tangible, so real account) is purchased with Rs. 20,000/- Cash (real account). Here furniture is coming in (Dr) cash is going out (Cr). Affected ledgers: Furniture (under head Capital Purchases) and Cash ledgers.
2. Rent (intangible, so nominal account) of Rs. 12,000/- is paid for the premises in cash (real account). Here rent is an expense (Dr) and cash is going out (Cr). Affected ledgers: Cash and Rent ledgers. 
3. Stationery items (real account) are purchased for Rs. 1,800/- on credit from Books & Pens store (personal account). Here stationery is coming in (Dr) and the Books & Pens store is the giver (Cr). Affected ledgers: General stores ledger and Books & Pens Store ledger (ultimately balances of all such short-term creditors are compiled under the account head ‘Sundry Creditors’). 

Format showing the recording of the above transactions in Double-Entry Bookkeeping Journal:

DATE (Year 2020)	Sl. No.	PARTICULARS	Ledger Folio	Dr	Cr
1, July	01	to Capital purchases (Furniture) by cash	1-103 1-100	20,000:00	20,000:00
1, July	02	To Rent By Cash	2- 109 1-100	12,000:00	12, 000:00
1, July	03	To General Stores (stationary) By Books & Pens Store	1- 108 3- 104	1,800:00	1,800:00

Systems of Bookkeeping

There are two systems of bookkeeping: the Mercantile system and the Cash system. Over a period, a third system, referred to as Hybrid system evolved.

Mercantile System of Bookkeeping

 This system is also known as the “book profits system of accountancy” or the “Complete double-entry bookkeeping” or more popularly “Accrual” method of accounting. Under this system the net profit or loss is calculated after taking into account all the income and all the expenditure relating to the period, whether such income has been actually received or not and, whether such expenditure is actually paid or not. The profit computed under this system is the profit truly earned, though not necessarily realized in cash, or the loss computed under this system is the loss truly sustained, though not necessarily paid in cash. This method of bookkeeping brings into credit what is due immediately as it becomes legally due and before it is actually received; and it brings into debit expenditure as soon as the amount for which a legal liability has been incurred, even before it is actually disbursed. 

Cash System of Bookkeeping

This system is opposite of the ‘mercantile system of bookkeeping’. Under this system only actual cash receipts and actual cash payments are recorded. Entries being made only when money is really collected or disbursed. 

Which System to adopt Mercantile or Cash?

A pertinent question that may arise here is what system to use? 

The Hon’ble Supreme Court in:

• Commissioner of Income Tax Vs A Krishna Swamy Mudaliar (1964) 53 ITR 122

Observed that in some cases, neither of the two systems mercantile system or cash system give a clear picture of the true profits earned and certainly not taxable profits.

What Is the Actual Business Practice, Mercantile or Cash?

In actual business practice however, the system of bookkeeping followed in many cases are such that they can neither be called “mercantile accountancy system” nor the “cash system of bookkeeping”. They are simply mixtures of the two systems and are styled as ‘hybrid systems of bookkeeping’[1]. 

Naturally, the dilemma or question that pops up in mind at this juncture is whether one can adopt different methods of accounting for different sources?

The answer is ‘Yes’. The Hon’ble Allahabad Hight court in:

• JK Bankers Vs Commissioner of Income Tax (1974) 94 ITR 

Held that there could be different methods of accounting for different sources of income. 

To further understand the impact and implications of law with respect to above referred case law, please see Commissioner of Income Tax Vs. Shrimati Shingari Bai on 23 February 1945 (AIR 1945 All 102), and what happened after that vide Finance Act, 1995; under sub-heading 3.2 of heading 3, “ How Does Law Impact Bookkeeping?”

How Does Law Impact Bookkeeping?

To live, money is needed and money transactions are intertwined with tax. Hence the saying that once a person is born two things are inevitable, death and tax; and the ramifications of tax are many. For the amateurs let me explain that under law, some terms used are specifically defined or interpreted in the Act. Some terms used in the Act are defined exhaustively. These cause minimum issues and are relatively easy to resolve. Some are defined inclusively; these terms are patently clear to understand but are latent minefields. And then there are terms that are not defined at all but are profusely used in the Act, these are the quagmires. One has to depend on their natural meaning and decided cases by courts to interpret them – higher the deciding court in the hierarchy the better.

It is impossible to cover everything that one needs to know in a single article like this. However, to kindle one’s interest to further pursue on one’s own, a hypothetical case is taken as a prop to explain what happens when an entry is misconstrued and booked. A few more aspects to know are touched upon under sub-heading 3.2.

Elucidation with a Hypothetical Example

Do you remember the quick retraction made at the start of introduction with the ‘cart before the horse’? Well, this is where the cart should come figuratively. 

This hypothetical example makes use of real case laws to convey the impact of law and lessons to draw from them.

Fictional Ltd. owns a single jet private airplane for business use. Owing to a freak short-circuit when it was standing on the ground, the engine burnt out. The maintenance engineers concluded that engine is beyond repair and replaced it by procuring a reconditioned engine from the manufacturer at a discount yet at a substantial price. The accountant routinely booked it under ‘Repairs & Maintenance’ head. The Income-Tax Officer, considering it a capital expense disallowed it and completed the assessment. 

The company, to arrive at the profit for tax computation deducted the cost of engine from earnings, ‘Repairs & Maintenance’ being a revenue expense. But because of the disallowance by the assessing officer the tax burden alone increased enormously, not to speak of the compounding charges the company was slapped with for misrepresenting capital expense as revenue expense. 

The problem arose because firstly, the terms capital expense and revenue expense are not defined under the Income tax Act, 1961; secondly, because the Income tax uses the term ‘capital expenditure’ for which no allowance is given to the assessee. The term ‘capital expenditure’ is used as contrasted with the term ‘revenue expenditure’ in respect of which the assessee is entitled to allowance of full deduction. 

The line of demarcation between capital expenditure and revenue expenditure is very thin and learned Judges in England have from time to time pointed out the difficulties besetting that task.

 Lord Macnaghten in Dovey v. Cory administered the following warning:

“I do not think it is desirable for any tribunal to do that which Parliament has abstained from doing- that is, to formulate precise rules for the guidance and embarrassment of business men in the conduct of business affairs. …”[2]

Justice Rowlatt in Countess Warwick Steamship Co. Ltd. v. Ogg observed, “It is very difficult, as I have observed in previous cases of this kind, following the highest possible authority, to lay down any general rule which is both sufficiently accurate and sufficiently exhaustive to cover all or even a great number of possible cases, and I shall not attempt to lay down any such rule.”[2]

As stated earlier, since the terms are not defined, one must depend upon:

1. its natural meaning, and
2. decided cases

The natural meaning comes from the nature of things. Explanation:

Since only revenue expenses can be deducted from taxable income for computing profits of a business under the Income Tax Act, it becomes essential to distinguish revenue expenditure from capital expenditure. The following tests can be applied for this purpose.

1. Nature of assets: Any expenditure incurred to acquire a fixed asset or in connection with the installation of a fixed asset is capital expenditure; whereas any expenditure incurred to purchase goods for resale along with other necessary expenses incurred in connection with such purchase are revenue expenses.
2. Nature of liability: A payment made by a person to discharge a capital liability is a capital expenditure. Whereas an expenditure incurred to discharge a revenue expenditure is revenue expenditure. 

For example, the amount paid to a contractor for cancellation of a contract to construct a factory building is capital expenditure. While the amount paid by a person as compensation for failing to supply goods as per the contract is a revenue expenditure as it is to discharge the revenue liability. 

1. Nature of transaction: An expense incurred to acquire a source of income like purchase of a patent for medicine to produce it and sell is a capital expenditure. whereas, expenditure incurred to earn income, say like salaries paid to the employees or advertisements or customer entertainment are revenue expenditure. 
2. Nature of purpose of transaction: If the amount is spent on increasing the earning capacity of an asset, it is capital expenditure. For example, redoing the décor of the reception lounge of a hotel to create an ambiance is capital expenditure, or fixing additional doors and windows in an industry is capital expenditure. While any expenditure incurred on keeping an asset in running condition is revenue expenditure. In the example just given periodic cleaning and changing the upholstery of the seating arrangement, painting of doors and windows periodically to protect from corrosion, wear and tear is revenue expenditure. 

Some principles gleaned from decided cases under the Income Tax Act are:

CAPITAL EXPENDITURE	REVENUE EXPENDITURE
Acquisition of Fixed Assets	Routine expenditure
Produces benefits for several years	Gets consumed in one year
Improves or increases earning capacity	Maintains the profit-making capacity of business
Non-recurring outlay	Recurring item
Normally it is a lump sum payment	Normally it is a periodic pay out.

A Few Other Aspects to Know

Returning to systems of bookkeeping (sub-headings 2.3.3&4) described under Heading 2 supra, in the case of:

• Commissioner of Income Tax Vs. Shrimati Shingari Bai on 23 February 1945 (AIR 1945 All 102),

the facts that led to the appeal in the Allahabad High Court were,

• Shrimati Shingari Bai, the assessee was a professional money lender

• she regularly kept her books according to “complete double-entry bookkeeping” or “mercantile system of accounting”

• for the accounting year 1933-34 she, the assessee has shown her income from money lending to be Rs. 1499/-

• only for the purpose of this return of 1933-34 she chose a cash method of accounting.

• When her accounts were scrutinized, according to which all her accounts were regularly kept, the interest account showed a credit of Rs.31,081/-

The question raised by the Commissioner of Income Tax (CIT) before the Court was, whether according to the law in force in respect of the assessment year 1934-35, the Income-Tax Officer was entitled to base his assessment of the profits on the ‘mercantile system” which was her own regular system, for the accounting year 1933-34 too; or whether she – the assessee – was entitled to insist on an assessment based only on actual receipts and actual expenditure, the  “cash system” of accounting, as per her tax-return? 

In his judgment Hon’ble Iqbal Ahmad, CJ held that the answer to the question referred is, “The Income-Tax Officer, on the facts set out in the case stated, … , entitled and bound, to compute the profits and gains of the assessee in accordance with the method of accounting regularly adopted by the assessee, that is to say, the mercantile method of accounting. …”

It can be inferred reading this judgement together with the subsequent judgement in case of JK Bankers of the same Allahabad High Court that, you may use different methods of accounting for different sources but you cannot use different methods in different years for the same source of income. 

Thankfully, the mix-ups that can be caused with multiple methods is reduced to a degree since April 1, 1997 vide amendment to Section 145 of the Income Tax Act, 1961, by outlawing the ‘hybrid system’ of accounting, as it was opined that it does not reflect the correct income. According to the amendment, income chargeable under the head “Profit & Gains of Business or Profession or Income from other sources” shall be computed only in accordance with either cash system or mercantile system of accounting. 

Examples abound under income tax alone on how a simple entry posted under one head but decided to be otherwise by the Assessing Officer led to so many litigations. The same gets no less complex with Goods and Services Tax (GST). Under which category of tax, a cashew sweet covered with a silver foil in an AC restaurant from the display case sold for take-away is to be charged? Think!

One cannot duck taking the plea that it was only a daybook entry; when it comes to scrutiny all books of account will be scrutinized. According to Section 2(12A) of the Income Tax Act, 1961 books or books of account, include ledgers, daybooks, cash books, account books and other books, whether kept in the written form or a printouts of data. The Hon’ble Income Tax Appellate Tribunal Delhi Bench, in Brij Lal Goyal V. Asst. CIT (2004) 88 ITD 413 held that the Books of Account mean those books of account whose main objects is to provide credible data and information to file the tax returns.[3]

All this is not intended to frighten but to alert, so one is careful about the legal mines and quagmires in their bookkeeping practices. Errors do occur and courts understand this. However, one needs to pay attention to major financial transaction(s) and prevent errors and omissions rather than face an unpleasant discovery later. 

The Hon’ble Supreme Court in Commissioner of Income Tax v. Padmachand Ramgopal (1970) 76 ITR 19 held that insignificant mistakes noticed in the book of account of one year, like one item of interest not brought into account or one item of receipt having been incorrectly recorded, cannot form the basis for rejection of books of account.[3] 

Summary & Conclusion

• Basic Bookkeeping is all about capturing and recording financial transactions. 
• If only the cash side of the transaction is captured it is called single-entry bookkeeping.
• If both sides of a financial transaction are captured (credit and debit sides) it is double-entry bookkeeping.
• There are three types of accounts namely, real, personal, and nominal accounts. The debit and credit entries are made according to the specific rule applicable to the type of account.
• Three different systems (Mercantile, Cash and Hybrid) were followed till March 31, 1997. But effective 1st April 1997 i.e. assessment year 1997-98 onwards, due to amendment in the Act, either Cash system or Mercantile system of accounting is allowed under Income tax laws, 

To conclude:

• • It is important to know that bookkeeping is not a mere recording of numbers but also determining the purpose of the financial transaction in real life situation and booking it in consonance with law under the appropriate account head.
  • Occasional errors may happen, it is not a matter to be worried about, but care is to be exercised if the financial transaction is of significant value to avoid litigation and loss. 
  • Law and facts of a case keep changing. So do not apply them ipso ditto.
  • It is essential to know the impact various tax laws can have on the business caused by bookkeeping. They not only affect the bottom line but often cause avoidable difficulties, and sometimes may overturn a business. 

In my opinion, it is preferable for accountants to know the tax implications to be accomplished. It is my opinion and advise especially for entrepreneurs and startups to acquire minimum necessary understanding of bookkeeping vis a vis tax laws. I would go one step further and suggest that if they have an in-house counsel to involve him/her proactively. No doubt the Chartered Accountants and auditors – in house and or statutory – do vet the accounts, but to rely on them blindly could prove costly. They have statements in their reports that professionally safeguard them, but eventually, it is for the entrepreneur to hold the baby, for law does not absolve them from facing the consequences. The idea is not to scare but to alert, because forewarned is forearmed. 

References

[1] Bookkeeping and Accounts Rupram Gupta (pages 269 and 270)

[2] Citations from the judgement of Assam Bengal Cement Co. Ltd Vs The Commissioner of Income Tax. (SC on 11 November 1954, Civil Appeal No. 162 of 1952 ) [Equivalent Citations: 1955 AIR 89, 1955 SCR (1) 876], Authored by Hon’ble Justice N H Bhagwati.

[3] Rejection of Books of Account by AO – A Study; by Sri. Prabhakar K S (Proprietor – Shree Tax Chambers) {used for explaining some concepts and citing examples}

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