INTRODUCTION TO ACCOUNTING

Definition
The American Institute of Certified Public Accountants (AICPA) had defined accounting as
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 financial character and interpreting the
results thereof.

Process (steps) of accounting

(1) Identifying financial transactions and events

• Accounting records only those transactions and events which are of financial nature.
• So, first of all, such transactions and events are identified.

(2) Measuring the transactions

• Accounting measures the transactions and events in terms of money which are
considered as a common unit.

(3) Recording of transactions

• Accounting involves recording the financial transactions inappropriate book of accounts

such as Journal or Subsidiary Books.

(4) Classifying the transactions

• Transactions recorded in the books of original entry – Journal or Subsidiary books are
classified and grouped according to nature and posted in separate accounts known as
‘Ledger Accounts’.

(5) Summarising the transactions

• It involves presenting the classified data in a manner and in the form of statements,
which are understandable by the users.
• It includes Trial balance, Trading Account, Profit and Loss Account and Balance Sheet.
(6) Analysing and interpreting financial data

• Results of the business are analyzed and interpreted so that users of financial
statements can make a meaningful and sound judgment.

(7) Communicating the financial data or reports to the users

• Communicating the financial data to the users on time is the final step of Accounting so
that they can make appropriate decisions.

Objectives of Accounting

• Maintenance of records of business transactions

Accounting is used for the maintenance of systematic record of all financial transactions. Even
the most brilliant manager cannot accurately remember the numerous transactions taking place
every day. Hence, proper and complete records of all business transactions are kept regularly.
Moreover, the recorded information enables verifiability and acts as an evidence.

• Calculation of profit and loss

The owners of the business are keen to know about net results of their business operations
periodically, i.e. whether the business has earned profits or incurred losses. The profit and
loss of the business can be calculated by preparing – trading and profit/loss account in the end
of the year. This is possible only when we have recorded the transaction in proper books of
accounts.

• Depiction of financial position

At the end of every accounting year, the financial position of the business is ascertained by
preparing a balance sheet. A proper record of resources/property owned by the business
(assets) and claims against such resources (liabilities) facilitates the preparation of a
statement, which is known as balance sheet/position statement.

• Providing accounting information to its users

The accounting information generated is communicated in the form of
reports, statements etc. to the users of accounting information. The two
main users are internal and external users.
a) Internal users –
i. Owners:- Owners are interested in knowing the profits earned or losses incurred
by the business besides the safety of their capital.
 ii. Management:- Includes management at all levels (lower, middle, higher) who need
timely information on cost of sales, profitability, etc. for planning, controlling and
decision-making.
iii. Employees & Workers:- Need to know if their dues towards EPF, insurance, end
of service etc are deposited with respective authorities.

b) External users – are those who have limited authority, ability and resources to obtain
the necessary information and have to rely on financial statements (Profit/loss account,
balance sheet). Some of the external users and their need are discussed below;
i. Investors and potential investors
They need Information on the risk and returns on investments.
ii. Lenders and financial institutions
They need information on the credit worthiness of the company and its ability to
repay loan and pay interest.
iii. Suppliers and creditors
They need information on whether amounts owed will be repaid when due and of
the continued existence of the business.
iv.Customers
They need information on the continued existence of the business and thus the
availability of a continued supply of products, parts and after sales service.
v.Government and tax authorities
They need information on the allocation of the resources and the compliance to
regulations.

Role of Accounting in Business

• Primary role of Accounting is to maintain systematic records of financial transactions
in order to ascertain profit or loss for the accounting period.
• Accounting provides assistance to management by providing financial information for its
affective functioning and rational decision making.
• Accounting help in comparing results from year to year and locate reasons for significant
changes.
• Accounting records are often accepted by codes as evidences.

Advantages of Accounting
• Replacing memory
Business transactions are innumerable, varied and complex as such it is quite impossible to
memorize each and every transaction. Accounting records these transactions in writing,
therefore it is not necessary for the businessman to memorize transactions taking place
every day.
• Assessing the performance of the business
Accounting keeps proper and systematic record of all business transactions. With the help
of recorded transactions, income statements are prepared to know the profit earned or
the loss suffered by the business.
• Assessing the financial status/position of the business
Financial position of the business is displayed through position statement, i.e. Balance
sheet. The position statement is prepared at the end of Accounting year and reflects the
true position of assets and liabilities of the business on a particular date.
• Documentary evidence
Accounting records can also be used as an evidence in the court of law to
substantiate/support the claim of the business. These records are based on documentary
proof.
• Preventing and detecting frauds
The proper accounting system and effective arrangement of internal check prevents
leakage of goods and cash. In case any fraud is committed, accounting helps in detection
of these frauds and also fixes the responsibility for it.

LIMITATIONS OF ACCOUNTING
• Incomplete information
Accounting records only those transactions which are financial in nature. It records only
quantitative aspects of the transactions. Transactions of non-financial nature do not find
place in accounting. For example, the competency of the management change in economic
and political situations, government policies, competition in the market and change in
consumer’s preferences, etc. are not recorded even though they affect the financial
health of the business.
• Inexactness
Accounting assesses profit or loss of the business on the basis of both real and assumed
estimates. Accountants make the evaluation of the stocks, determine the method of
depreciations and maintain various reserves and provisions in any way they like. Different
firms have their own different methods, so the results of the business will change with
the change in the practice.

• Showing valueless assets

There are certain assets which do not have real value but they are shown as assets in our
balance sheet. Few examples of these assets are Preliminary expenses, Goodwill, discount
on issue of shares or debentures, etc. Showing these assets in the book of accounts
make its results doubtful.

• Manipulation
 Accounting results are based upon the information supplied to it. The management is
biased and feeds manipulative information to prove its point of view. This may be done by
omitting certain accounts/transactions, under estimating or over estimating the value of
assets, etc.

Qualitative characteristics of accounting information

i) Reliability:- Accounting information must be reliable . Reliability of

information means it should be verifiable, free from bias and material error

ii) Relevance:- Accounting information must be relevant to the user .

Information is relevant if it meets the needs of the users in decision
making. Helping in prediction and feed back.

iii) Understandability: Understandability means that the information

provided through the financial statements must be presented in a manner
that the users are able to understand.

iv) Comparability:- The users should be able to compare accounting

information of an enterprise on year to year basis or with other enterprises
( Intra-Firm and Inter-Firm comparison)

Types of Accounting Information

a) Information relating to profit or surplus – A firm prepares Trading and Profit and
Loss Account as a part of Income statement which provides information about Gross
Profit or Gross Loss and Net Profit or Net Loss as a result of business operations.

b) Information relating to financial position- Balance Sheet makes available the

information regarding the financial Position of an entity. It provides information
regarding assets like fixed assets, amounts receivable, cash balance etc. Also it provides
information regarding liabilities like loans, creditors, bills payables, etc.

c) Information about cash flow- Cash flow statement shows the inflow and outflow of
cash during a specific period. It is of immense use as many decisions such as payment of
liabilities, dividend, and expansion of business etc. are based on availability of cash.
Basic Accounting Terminologies

i. Business transactions
Every activity of financial nature having documentary evidence, capable of being
presented in monetary term causing changes on assets, liabilities, capital, revenue and
expenses is termed as business transactions.eg. sale of goods, receipt from debtors,
payment for expenses etc.
ii. Capital
Capital is the amount invested by the owner in the business. It can be brought in the
form of cash or assets. Capital is an obligation so it is shown on the liabilities side of
the Balance Sheet.
iii. Assets
Valuable resources owned by a business which were acquired at a considerable money or
cost. Assets can be broadly classified into two categories Non-current Assets & Current
Assets.
a) Non-current assets – These assets are held as an investment to facilitate business
operations. They are held by the business from a longterm point of view. They include all
fixed assets (tangible & intangible) and non-current investments.
• Fixed Assets – these assets are acquired for long term use in the business. They are
not meant for sale. These assets increase the profit earning capacity of the business.
Few examples of fixed assets are land and building, plant and machinery, furniture and
fixture, motor vehicle, livestock, etc.
• Tangible assets – Assets having physical existence which can be seen and touched
are known as tangible assets. Eg : Land, plant, equipment, stock, etc.
• Intangible assets – Intangible Assets are those which do not have physical
existence. They are not normally purchased and sold in the open market, such as
goodwill and patents copyrights.
b) Current assets – These assets which are short term in nature. They are fluctuating
assets which change their value constantly. Current assets include cash in hand, cash at
bank, accounts receivables (bill receivable and debtors) prepaid expenses, accrued
income, etc.
iv. Liabilities
Liabilities are obligations or debts that an enterprise has to pay at some time in future.
• Long term liabilities / Non Current Liabilities - are to be paid after a period
of one year. E.g.: loans and debentures
• Short term liabilities/ Current Liabilities - are payable within a period of one
year. E.g.: creditors and bills payable.
v. Drawings
 The amount or goods withdrawn from the business for personal use by the owner is
called drawings. Example: Purchase of car for wife by withdrawing money from
business.

vi. Income /Revenues

These are the amounts which are earned (received or receivable) by the enterprise
by selling its products or providing services to its customers, called sales revenue.
Other items of revenue common to many business are commission, interest, dividends
, royalties, rent received etc. Revenue is also called as Income.
vii. Sales
Sales are total revenues from goods or services sold to customers, sales may be cash
sales or credit sales.
viii. Sales Return – When goods are returned from customer due to any reason
(defective) it is known as sales return or Return Inwards.
ix. Profit
The excess of revenues over its related expenses during an accounting year is profit.
x. Gain
A profit that arises from transactions which are incidental to business, such as sale
of fixed assets, winning a court case, appreciation in the value of an asset.
xi. Voucher
The documentary evidence in support of a transaction is known as voucher. For
example bills, cash memo, invoice, etc.
xii. Goods
It refers to the products in which the business unit is dealing, i.e. in terms of which
it is buying and selling or producing and selling.
xiii. Stock / Inventory :
A measure of something in hand for the purpose of sale or to use in the production of
goods meant for sale. : goods, spares and other items in a business.
xiv. Debtors
Debtors are persons or other entities who have to pay to an enterprise an amount
against credit sales of goods and services. It is shown on the asset side of balance
sheet.

Bills Receivable:
Bills Receivable means a bill of exchange accepted by a debtor, the amount of which
will be received on a specified date.
xv. Creditors
Creditors are persons or entities to whom the enterprise has to pay for credit
purchase of goods or services. It is shown on the liabilities side of balance sheet.
 Bills Payable:
Bills Payable means a bill of exchange accepted, the amount of which will be paid on
a specified date.

xvi. Discount
It is the deduction in the price of goods sold. There are two kinds of discounts:
a) Trade discount – Offering deduction of agreed percentage on list price, at the
time of selling is called trade discount. It is generally offered to promote bulk
purchases/sales.
b) Cash discount – when debtors are given certain percentage of deduction on
amount to be paid to encourage early payment is called cash discount. This
discount is given at the time of payment.
xvii. Purchases
Purchases are total amount of goods procured by a business on credit or on cash
basis for use in production or for re-sale.
xviii. Purchase Return – Goods purchased may be returned to the seller for any reason
say defective etc. are called purchase returns or Return Outwards.
xix. Loss
The excess of expenses over its related revenues is termed as loss.
xx. Expenditure
Spending money or incurring liability for some benefit, service or property received
is called expenditure. The two types of expenditure are revenue expenditure and
capital expenditure.
xxi. Capital expenditure
Expenses incurred in acquiring and increasing the value of fixed assets is termed as
capital expenditure. Eg - Purchase of Machinery, purchase of furniture, etc.
xxii. Revenue expenditure/ Expenses
Expenses which are incurred as routine business expense are known as revenue
expenditure. Salary, rent etc.

DISTINGUISH BETWEEN
Current Assets Vs. Non Current Assets

Current Asset Non Current Asset

Current assets are ones the company
Non Current assets are which are held on long
expects to convert or use in the
term basis, that is which are for more than
business within one year of the
one year
balance sheet date
Eg Cash ,Debtors, bills Receivable Eg land,building,plant and machinery

Capital Expenditure Vs. Revenue Expenditure

Basis Capital Expenditure Revenue Expenditure

Meaning Expenses incurred in
acquring and increasing the Expenses incurred as routine business
value of fixed assets are expenses are known as Revenue
termed as Capital Expenditure
Expenditure
Purpose These are incurred in These are incurred for conducting of
purchasing of fixed assets business affairs.
Where are These are shown at assets These are shown at the debit side of
they shown side of the Balance sheet trading profit and loss account
Period Its benefits extend to more Its benefits are restricted to only
than one year one year.

Capital Receipts Vs. Revenue Receipts

Basis Capital Receipts Revenue Receipts

Meaning The amount received in form The amount received mainly by selling
of capital introduced, loans of goods and services is
taken and sales proceeds of
fixed assets is known as
Capital Receipts
Nature These receipts are capital in
These receipts are Revenue in nature
nature
Where are These receipts are shown in These receipts are shown at the
these shown the liabilities side of Balance credit of either trading A/c or profit
Sheet Only and loss account