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    Introduction to Accounting

    Accountancy is the process of communicating financial information about a business entity tousers such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and


    Accounting has been defined as:the art of recording, classifying, and summarizing in a significant manner and in terms ofmoney, transactions and events which are, in part at least, of financial character, andinterpreting the results thereof.(AICPA)

    Accountancy therefore encompasses the recording, classification, and summarizing of

    transactions and events in a manner that helps its users to assess the financial performance and

    position of the entity. The process starts by first identifying transactions and events that affect the

    financial position and performance of the company. Once transactions and events are identified,

    they are recorded, classified and summarized in a manner that helps the user of accounting

    information in determining the nature and effect of such transactions and events.

    Types of Accounting

    Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and

    varying needs of its users. Over the past few decades, accountancy has branched out into

    different types of accounting to cater for the diversity of needs of its users.

    Main types of accounting are as follows:

    Financial Accounting, or financial reporting, is the process of producing information for external

    use usually in the form offinancial statements. Financial Statements reflect an entity's past

    performance and current position based on a set of standards and guidelines known as GAAP

    (Generally Accepted Accounting Principles). GAAP refers to the standard framework of guideline

    for financial accounting used in any given jurisdiction. This generally includes accounting

    standards (e.g. International Financial Reporting Standards),accounting conventions, and rules

    and regulations that accountants must follow in the preparation of the financial statements.

    Management Accounting produces information primarily for internal use by the company's

    management. The information produced is generally more detailed than that produced for

    external use to enable effective organization control and the fulfillment of the strategic aims and

    objectives of the entity. Information may be in the form budgets and forecasts, enabling an

    enterprise to plan effectively for its future or may include an assessment based on its past

    performance and results. The form and content of any report produced in the process is purely

    upon management's discretion.

    Cost accounting is a branch of management accounting and involves the application of varioustechniques to monitor and control costs. Its application is more suited to manufacturing concerns.

    Governmental Accounting, also known aspublic accounting or federal accounting, refers to the

    type of accounting information system used in the public sector. This is a slight deviation from the

    financial accounting system used in the private sector. The need to have a separate accounting

    system for the public sector arises because of the different aims and objectives of the state

    owned and privately owned institutions. Governmental accounting ensures the financial position

    and performance of the public sector institutions are set in budgetary context since financial
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    constraints are often a major concern of many governments. Separate rules are followed in many

    jurisdictions to account for the transactions and events of public entities.

    Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules

    prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that

    govern the preparation of financial statements for public use (i.e. GAAP). Tax accountants

    therefore adjust the financial statements prepared under financial accounting principles to

    account for the differences with rules prescribed by the tax laws. Information is then used by taxprofessionals to estimate tax liability of a company and for tax planning purposes.

    Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of

    litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and

    criminal disputes that require an assessment of the financial effects of a loss or the detection of a

    financial fraud. Common litigations where forensic accountants are hired include insurance

    claims, personal injury claims, suspected fraud and claims of professional negligence in a

    financial matter (e.g. business valuation).

    Project Accounting refers to the use of accounting system to track the financial progress of a

    project through frequent financial reports. Project accounting is a vital component of project

    management. It is a specialized branch of management accounting with a prime focus on

    ensuring the financial success of company projects such as the launch of a new product. Project

    accounting can be a source of competitive advantage for project-oriented businesses such asconstruction firms.

    Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability

    Accounting, , refers to the process of reporting implications of an organization's activities on its

    ecological and social environment. Social Accounting is primarily reported in the form of

    Environmental Reports accompanying the annual reports of companies. Social Accounting is still

    in the early stages of development and is considered to be a response to the growing

    environmental consciousness amongst the public at large.

    Functions of Accounting:Learning Objectives:

    1. What are the important functions ofaccounting.

    Record Keeping Function:

    The primaryfunction ofaccountingis to keep a systematic record of financial transaction -journalisation, posting and preparation of final statements. The purpose of this function isto report regularly to the interested parties by means of financial statements.

    Protect Business Property:

    The second function ofaccountingis to protect the property ofbusinessfrom unjustifiedand unwanted use. Theaccountantthus has to design such a system ofaccountingwhich

    protect its assets from an unjustified and unwanted use.

    Legal Requirement Function:

    The third function ofaccountingis to devise such a system as will meet the legalrequirements. Under the provision of law, abusinessman has to file various statementse.g., income taxreturns,returnsforsales taxpurpose etc.Accountingsystem aims at fulfilling

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    the requirements of law.Accountingis a base, with the help of which variousreturns,documents, statements etc., are prepared.

    Communicating the Results:

    Accountingis the language ofbusiness. Various transactions are communicated

    throughaccounting. There are many parties - owners, creditors, government, employeesetc, who are interested in knowing the results ofthe firm. The fourth functionofaccountingis to communicate the results to interested parties. Theaccountingshows areal and true position ofthe firmof thebusiness.

    What is the accounting cycle?The accounting cycle is often described as a process that includes the following steps: identifying,

    collecting and analyzing documents and transactions, recording the transactions in journals,

    posting the journalized amounts to accounts in the general and subsidiary ledgers, preparing anunadjusted trial balance, perhaps preparing a worksheet, determining and recording adjusting

    entries, preparing an adjusted trial balance, preparing the financial statements, recording and

    posting closing entries, preparing a post-closing trial balance, and perhaps recording reversing


    Cycle and steps seem to be a carryover from the days of manual bookkeeping and accounting

    when transactions were first written into journals. In a separate step the amounts in the journal

    were posted to accounts. At the end of each month, the remaining steps had to take place in

    order to get the monthly, manually-prepared financial statements.

    Today, most companies use accounting software that processes many of these steps

    simultaneously. The speed and accuracy of the software reduces the accountants need for a

    worksheet containing the unadjusted trial balance, adjusting entries, and the adjusted trial

    balance. The accountant can enter the adjusting entries into the software and can obtain thecomplete financial statements by simply selecting the reports from a menu. After reviewing the

    financial statements, the accountant can make additional adjustments and almost immediately

    obtain the revised reports. The software will also prepare, record, and post the closing entries.

    Accounting cyclerefers to a complete sequence of accounting procedures which arerequired to be repeated in same order during each accounting period. Accounting

    cycle includes:


    First, all transactions should be recorded in the journal or books oforiginalentry known as

    subsidiary books as and when they take place.


    All entries in the journal of books oforiginalentry should be posted to the appropriateledger accounts to find out at a glance the total effect of all such transactions in aparticular account.

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    Last stage is to prepare the trial balance and final accounts with a view to ascertaining theprofit or loss made during a trading period and the financial position of thebusinessof aparticular date.

    Accounting Cycle

    What Is the Basic Accounting Equation and

    How Does It Help You Prepare Financial

    Statements?The accounting equation forms the basis for recording accounting transactions andreporting the company's financial results. Accounting students learn theaccounting equation near the beginning of their college careers and build their

    future education on this basis. The accounting equation also provides theframework for the balance sheet.

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    Basic Accounting Equation

    The accounting equation is: Assets = Liabilities + Owner's Equity.


    Assets refer to everything the company owns. Liabilities refer to everything thecompany owes to another entity and may consist of money, products or services.Owner's equity refers to the remaining net worth of the business after all liabilitiesare satisfied. Owner's equity can be calculated by subtracting the total liabilities fromthe total assets. An easy way to understand the accounting equation is to consider thepurchase of an automobile. The automobile is worth $20,000; the company pays$5,000 in cash and takes a loan out for $15,000. The automobile is the asset. Theloan is the liability. The accounting equation can be written as follows: 20,000(asset) = 15,000 (liability) + 5,000 (owner's equity).

    Expanded Accounting Equation

    An expanded form of the accounting equation breaks down the componentsof owner's equity. The value of owner's equity changes based on revenues, expensesand the owner's share. The expanded view of the accounting equation is written asfollows: Assets = Liabilities + Owner's Equity + Revenues - Expenses - Owner'sDrawing. Revenues refer to money earned by the company. Expenses refer to assetsused during the period. Owner's drawing refers to money the owner takes out of thecompany. The basic accounting equation considers revenue, expense and owner'sdrawing activity under the owner's equity title. The expanded version breaks downthese components since they are reported separately in the accounting records.

    Recording Transactions

    As the company's accountants record accounting transactions, eachtransaction must impact both sides of the accounting equation equally. If the assetsincrease, so must the liabilities or the owner's equity. If the assets decrease, so mustthe liabilities or the owner's equity. One asset may increase while another decreases,creating a net impact of zero. Transactions that impact revenues, expenses or owner'sdrawing are considered to impact owner's equity.

    Financial Reporting

    The balance sheet follows the format of the basic accounting equation. It lists

    each of the assets and calculates a total of all the assets. It also lists each of theliabilities and owner's equity accounts and calculates a total of the liability andowner's equity accounts. This total must equal the total assets. The income statementcan be created from the expanded accounting equation. The income statement listsall of the revenue accounts and calculates total revenue for the period. Next, theincome statement lists each of the expenses and calculates total expenses for theperiod. Net income is calculated by subtracting total expenses from total revenues.
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    Accounting Concept and Principles?

    Accounting Concepts and Principles are a set of broad conventions that have been devised to

    provide a basic framework for financial reporting. As financial reporting involves significant

    professional judgments by accountants, these concepts and principles ensure that the users of

    financial information are not mislead by the adoption of accounting policies and practices that go

    against the spirit of the accountancy profession. Accountants must therefore actively considerwhether the accounting treatments adopted are consistent with the accounting concepts and


    In order to ensure application of the accounting concepts and principles, major accounting

    standard-setting bodies have incorporated them into their reporting frameworks such as the IASB


    Following is a list of the major accounting concepts and principles:


    Information should be relevant to the decision making needs of the user. Information is relevant if

    it helps users of the financial statements in predicting future trends of the business (PredictiveValue) or confirming or correcting any past predictions they have made (Confirmatory Value).

    Same piece of information which assists users in confirming their past predictions may also be

    helpful in forming future forecasts.


    Information is reliable if a user can depend upon it to be materially accurate and if it faithfully

    represents the information that it purports to present. Significant misstatements or omissions in

    financial statements reduce the reliability of information contained in them.

    Money Measurement Concept in Accounting


    Money Measurement Concept in accounting, also known as Measurability Concept, means that

    only transactions and events that are capable of being measured in monetary terms are

    recognized in the financial statements.

    Timeliness of Accounting Information


    Timeliness principle in accounting refers to the need for accounting information to be presented

    to the users in time to fulfill their decision making needs.


    Timeliness of accounting information is highly desirable since information that is presented timely

    is generally more relevant to users while conversely, delay in provision of information tends to

    render it less relevant to the decision making needs of the users. Timeliness principle is therefore

    closely related to therelevance principle.

    Timeliness is important to protect theusers of accounting information from basing their decisions

    on outdated information. Imagine the problem that could arise if a company was to issue its
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    financial statements to the public after 12 months of the accounting period. The users of the

    financial statements, such as potential investors, would probably find it hard to assess whether

    the present financial circumstances of the company have changed drastically from those reflected

    in the financial statements.


    Financial statements of one accounting period must be comparable to another in order for the

    users to derive meaningful conclusions about the trends in an entity's financial performance and

    position over time. Comparability of financial statements over different accounting periods can be

    ensured by the application of similar accountancy policies over a period of time.

    A change in the accounting policies of an entity may be required in order to improve the reliability

    and relevance of financial statements. A change in the accounting policy may also be imposed by

    changes in accountancy standards. In these circumstances, the nature and circumstances

    leading to the change must be disclosed in the financial statements.

    Financial statements of one entity must also be consistent with other entities within the same line

    of business. This should aid users in analyzing the performance and position of one company

    relative to the industry standards. It is therefore necessary for entities to adopt accounting policies

    that best reflect the existing industry practice.


    Transactions and events must be accounted for and presented in the financial statements in a

    manner that is easily understandable by a user who possesses a reasonable level of knowledge

    of the business, economic activities and accounting in general provided that such a user is willing

    to study the information with reasonable diligence.

    Understandability of the information contained in financial statements is essential for its relevance

    to the users. If the accounting treatments involved and the associated disclosures and

    presentational aspects are too complex for a user to understand despite having adequate

    knowledge of the entity and accountancy in general, then this would undermine the reliability of

    the whole financial statements because users will be forced to base their economic decisions on

    undependable information.


    Information is material if its omission or misstatement could influence the economicdecisions of users taken on the basis of the financial statements (IASB Framework).

    Materiality therefore relates to the significance of transactions, balances and errors contained in

    the financial statements. Materiality defines the threshold or cutoff point after which financialinformation becomes relevant to the decision making needs of the users. Information contained in

    the financial statements must therefore be complete in all material respects in order for them to

    present a true and fair view of the affairs of the entity.

    Materiality is relative to the size and particular circumstances of individual companies.

    Going Concern

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    Going concern is one the fundamental assumptions in accounting on the basis of which financial

    statements are prepared. Financial statements are prepared assuming that a business entity will

    continue to operate in the foreseeable future without the need or intention on the part of

    management to liquidate the entity or to significantly curtail its operational activities. Therefore, it

    is assumed that the entity will realize its assets and settle its obligations in the normal course of

    the business.

    It is the responsibility of the management of a company to determine whether the going concern

    assumption is appropriate in the preparation of financial statements. If the going concern

    assumption is considered by the management to be invalid, the financial statements of the entity

    would need to be prepared on break up basis. This means that assets will be recognized at

    amount which is expected to be realized from its sale (net of selling costs) rather than from its

    continuing use in the ordinary course of the business. Assets are valued for their individual worth

    rather than their value as a combined unit. Liabilities shall be recognized at amounts that are

    likely to be settled.

    Accruals Concept

    Financial statements are prepared under the Accruals Concept of accounting which requires that

    income and expense must be recognized in the accounting periods to which they relate rather

    than on cash basis. An exception to this general rule is the cash flow statement whose main

    purpose is to present the cash flow effects of transaction during an accounting period.

    Under Accruals basis of accounting, income must be recorded in the accounting period inwhich it is earned. Therefore, accrued income must be recognized in the accountingperiod in which it arises rather than in the subsequent period in which it will be received.Conversely, prepaid income must be not be shown as income in the accounting period inwhich it is received but instead it must be presented as such in the subsequent accountingperiods in which the services or obligations in respect of the prepaid income have beenperformed.

    Expenses, on the other hand, must be recorded in the accounting period in which they are

    incurred. Therefore, accrued expense must be recognized in the accounting period in which it

    occurs rather than in the following period in which it will be paid. Conversely, prepaid expense

    must be not be shown as expense in the accounting period in which it is paid but instead it must

    be presented as such in the subsequent accounting periods in which the services in respect of

    the prepaid expense have been performed.

    Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an

    accounting period. Accruals concept is therefore very similar to the matching principle.

    Business Entity Concept

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    Financial accounting is based on the premise that the transactions and balances of a business

    entity are to be accounted for separately from its owners. The business entity is therefore

    considered to be distinct from its owners for the purpose of accounting.

    Therefore, any personal expenses incurred by owners of a business will not appear in the income

    statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the

    entity, it would be considered to be drawings for the purpose of accounting much in the same wayas cash drawings.

    The business entity concept also explains why owners' equity appears on the liability side of a

    balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for

    instance, represents a form of liability (known as equity) of the 'business' that is owed to its owner

    which is why it is presented on the credit side of the balance sheet.



    Going Concern


    Business EntityIn case where application of one accounting concept or principle leads to a conflict with another

    accounting concept or principle, accountants must consider what is best for the users of the

    financial information. An example of such a case would be the trade off between relevance and

    reliability. Information is more relevant if it is disclosed timely. However, it may take more time to

    gather reliable information. Whether reliability of information may be compromised to ensure

    relevance of information is a matter of judgment that ought to be considered in the interest of the

    users of the financial information.

    The Role of Accounting in Business ?Accounting is a process used by businesses for many reasons. The process of

    accounting consists of recording all transactions that occur within a business andsummarizing the information. An assortment of people then uses this information.

    Accounting can take place either manually or with computers using accountinginformation system software.


    Accounting is a system used by businesses to track financial information.Businesses then analyze and use the information to make business decisions.

    Accounting uses a double-entry method where accountants record transactions usingdebits and credits to individual accounts. The individual accounts are all part of thegeneral ledger, which is the place where a business keeps all accounts individually

    with balances.

    Financial Information

    Accounting plays a major role in businesses when it comes to the financialtransactions of a business. Financial accounting records all transactions andsummarizes the amounts on financial statements at the end of each month and year.Stakeholders of the business analyze the financial information. Stakeholders include
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    banks, stockholders, owners of the company and employees. Stakeholders use thisinformation to make lending and investing decisions.

    Managerial Information

    Managerial accountants also use accounting. Managerial accounting is an

    internal type of accounting. Managerial accountants analyze all financial informationand use it to make internal company decisions. These accountants make decisionsregarding plans for the business as well as budgets and forecasts.

    Cost Accounting

    Cost accounting is another important aspect of a companys bookkeepingrecords; it plays a large role in manufacturing and retail companies. Manufacturing

    businesses use cost accounting to determine the cost of goods manufactured, break-even points and on-hand inventory quantities. Retail companies use a form of costaccounting to keep track of inventory levels at all times.

    Tax Purposes Accounting also plays a large role for tax purposes. Recording consistent,

    accurate financial records leads to an easier calculation of income taxes. Thefinancial information transfers from the accounting information system to theappropriate tax forms. Accounting information is useful in paying other taxes,including sales taxes, payroll taxes and quarterly estimated taxes.

    Who Are Users of Accounting Information in a

    Business?Users of Accounting Information - Internal &


    Accounting information helps users to make better financial decisions. Users of financial

    information may be both internal and external to the organization.

    Internal users of accounting information include the following:

    Management: for analyzing the organization's performance and position and taking

    appropriate measures to improve the company results. Employees: for assessing company's profitability and its consequence on their future

    remuneration and job security.

    Owners: for analyzing the viability and profitability of their investment and determining

    any future course of action.

    Accounting information is presented to internal users usually in the form of management

    accounts, budgets, forecasts andfinancial statements.
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    External users of accounting information include the following:

    Creditor: for determining the credit worthiness of the organization. Terms of credit are

    set according to the assessment of their customers' financial health. Creditors include

    suppliers as well as lenders of finance such as banks.

    Tax Authourities: for determining the credibility of the tax returns filed on behalf of the


    Investors: for analyzing the feasibility of investing in the company. Investors want to

    make sure they can earn a reasonable return on their investment before they commit any

    financial resources to the company.

    Customers: for assessing the financial position of its supplier which is necessary for a

    stable source of supply in the long term.

    Regulatory Authorities: for ensuring that the company's disclosure of accounting

    information is in accordance with the rules and regulations set in order to protect the

    interests of the stakeholders who rely on such information in forming their decisions.

    External users are communicated accounting information usually in the form of financial

    statements. The purpose of financial statements is to cater for the needs of such diverse users of

    accounting information in order to assist them in making sound financial decisions.

    Accounting is a very dynamic profession which is constantly adapting itself to varying needs of its

    users. Over the past few decades, accountancy has branched out into different types of

    accountingto cater for the different needs of the users.

    Accounting information in business comes in a form of financial statements and is usedfor investment decisions by a variety of users who can be divided into three groups:equity investors, debt investors and stakeholders including operating management.

    Accounting information is also used by capital market players as an important basisfor judgments about company performance and future prospects for its stock priceor debt securities.

    Effective Financial Reporting SystemTo build an effective financial reporting system managers should recognize different

    users of information. Although financial reports are prepared primarily for owners,these reports are publicly available and read by interested parties seeking to assess

    performance of the company and its managers. Therefore, effective financial

    reporting should be based on recent numbers and contain four major financialstatements: the balance sheet, the income statement, the statement of shareholder'sequity and the cash-flow statement.

    Equity Investors

    Equity investors purchase shares to represent ownership interests in a company.Investors have a right to vote for company directors and receive dividends if they are paid.Investors use accounting information either themselves or through their representatives, such asfinancial and security analysts or stockbrokers. Financial information allows them to assess
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    company performance and see whether management is making wise business decisions. Iffinancial statements contain information that proves weak management performance, equityinvestors can exercise their rights to replace management by voting at the annual shareholders'meetings.

    Debt Investors

    Debt investors, often referred to as creditors, provide company with financing throughloans. Creditors have limited influence over the company apart from control tools described indebt contracts, such as collateral assets or debt restrictions aimed to reduce default risk. Thisgroup of investors use accounting information and financial statements for assessment of thedefault risks and ability to payback loans.

    Management and Other Users

    Management turn to financial statements to assess strengths and strategies of competingcompanies or prove reliability of potential business partners. Other users, such as governmentagencies base their regulatory decisions based on publicly available statements. Labor unions and

    employees are also known to use accounting information to negotiate better wages and healthbenefits.

    Capital Markets

    Publicly traded companies list their equity and debt securities on public exchanges and

    provide financial information to investors. Based on the information reflected in financialstatements capital market players decide whether to invest in a company or not and, therefore,move market prices for a company's equity and debt securities.

    What are Financial Statements

    Financial Statements represent a formal record of the financial activities of an entity. These are

    written reports that quantify the financial strength and performance of a company.

    Financial Statements reflect the financial effects of business transactions and events on the


    Types of Financial Statements

    The four main types of financial statements are:

    Statement of Financial Position (Balance Sheet)

    Income Statement (Profit and Loss Account)

    Cash Flow Statement

    Statement of Changes in Equity

    Statement of Financial Position

    Statement of Financial Position, or Balance Sheet, presents the financial position of an entity at

    any given date. A Statement of Financial Position has three main components:

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    Assets: Something a business owns or controls.

    Liabilities: Something a business owes to someone

    Equity: What the business owes to its owners. This represents the amount of capital that

    is left in the business after its assets are used to pay off its outstanding liabilities.

    Following is an Example of Statement of Financial Position (Balance Sheet):

    Statement of Financial Position as at 31st December 2011



    Property, Plant & Equipment 100,000

    Cash 10,000

    Inventory 10,000

    Receivable 5,000

    Total Assets 120,000


    Share Capital 80,000

    Retained Reserves 20,000

    Total Equity 100,000


    Payables 5,000

    Bank Loan 15,000

    Total Liability 20,000

    Assets of an entity may be financed from internal sources (i.e. share capital and profits) or from

    external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a business must be

    equal to the amount of capital invested by the owners (i.e. in the form of share capital and profits

    not withdrawn) and any borrowings, its no surprise that in the above example total Assets worth

    $120,000 equal to the sum of Equity ($100,000) and Liabilities ($20,000).

    This leads us to the Accounting Equation:Assets = Liabilities + Equity

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    The Equation may be re-arranged as follows:Equity = Assets LiabilitiesLiabilities = Assets - Equity

    Elements of the financial Statements

    There are five main elements of the financial statements:






    The first three elements relate to the statement of financial position while the latter two relate to

    income statements.


    Asset is a resource controlled by the entity as a result of past events and from which future

    economic benefits are expected to flow to the entity (IASB Framework).

    In simple words, asset is something which a business owns or controls to benefit from its use in

    some way. It may be something which directly generates revenue for the entity (e.g. a machine,

    inventory) or it may be something which supports the primary operations of the organization (e.g.

    office building).

    Assets may be classified into Current and Non-Current . The distinction is made on the basis of

    time period in which the economic benefits from the asset will flow to the entity.

    Current Assets are ones that an entity expects to use within one-year time from the reporting


    Non Current Assets are those whose benefits are expected to last more than one year from the

    reporting date.

    Following are the most common types of Assets and their Classification along with the economic

    benefits derived from those assets.

    Asset Classification Economic Benefit

    Machine Non-currentUsed for the production of goods forsale to customer.



    Provides space to employees for

    administering company affairs.

    Vehicle Non-currentUsed in the transportation ofcompany products and also forcommuting.

    Inventory CurrentCash is generated from the sale ofinventory.

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    Cash Current Cash!

    Receivables CurrentWill eventually result in inflow ofcash.


    According to IASB Frmework liability is defined as follows:

    A liability is a present obligation of the enterprise arising from past events, the settlementof which is expected to result in an outflow from the enterprise of resources embodyingeconomic benefits (IASB Framework).

    In simple words, liability is an obligation of the entity to transfer cash or other resources to

    another party.

    Liability could for instance be a bank loan, which obligates the entity to pay loan installments over

    the duration of the loan to the bank along with the associated interest cost. Alternatively, an

    entity's liability could be a trade payable arising from the purchase of goods from a supplier on


    Liabilities may be classified into Currentand Non-Current. The distinction is made on the basis of

    time period within which the liability is expected to be settled by the entity.

    Current Liability is one which the entity expects to pay off within one year from the reporting


    Non-Current Liability is one which the entity expects to settle after one year from the reporting


    Following are examples of some of the common types of liabilities along with their usual

    classification:Liability Classification

    Long Term Bank Loan Non-current

    Bank Overdraft current

    Short Term Bank Loan current

    Trade Payble current

    Debenture Non-current

    Tax Payble Current

    It may be appropriate to break up a single liability into their current and non current portions. For

    instance, a bank loan spanning two years and carrying 2 equal installments payable at the end of

    each year would be classified half as current and half as non-current liability at the inception of


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    Equity is the residual interest in the assets of the entity after deducting all the liabilities (IASB


    Equity is what the owners of an entity have invested in an enterprise. It represents what thebusiness owes to its owners. It is also a reflection of the capital left in the business after assets of

    the entity are used to pay off any outstanding liabilities.

    Equity therefore includes share capital contributed by the shareholders along with any profits or

    surpluses retained in the entity. This is what the owners take home in the event of liquidation of

    the entity.

    The Accounting Equation may further explain the meaning of equity:

    Assets - Liabilities = Equity

    This illustrates that equity is the owner's interest in the Net Assets of an entity.

    Rearranging the above equation, we have

    Assets = Equity + Liabilities

    Assets of an entity have to be financed in some way. Either by debt (Liability) or by share capital

    and retained profits (Equity). Hence, equity may be viewed as a type of liability an entity has

    towards its owners in respect of the assets they financed.

    Examples of Equity recognized in the financial statements include the following:

    Ordinary Share Capital

    Preference Share Capital (irredeemable)

    Retained Earnings

    Revaluation Surpluses


    Income is increases in economic benefits during the accounting period in the form of inflows or

    enhancements of assets or decreases of liabilities that result in increases in equity, other than

    those relating to contributions from equity participants (IASB Framework).

    Income is therefore an increase in the net assets of the entity during an accounting period except

    for such increases caused by the contributions from owners. The first part of the definition is quite

    easy to understand as income must logically result in an increase in the net assets (equity) of the

    entity such as by the inflow of cash or other assets. However, net assets of an entity may

    increase simply by further capital investment by its owners even though such increase in netassets cannot be regarded as income. This is the significance of the latter part of the definition of


    There are two types of income:

    Sale Revenue: Income earned in the ordinary course of business activities of the entity;

    Gains: Income that does not arise from the core operations of the entity.

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    For instance, sale revenue of a business whose main aim is to sell biscuits is income generated

    from selling biscuits. If the business sells one of its factory machines, income from the transaction

    would be classified as a gain rather than sale revenue.

    Following are common sources of incomes recognized in the financial statements:

    Sale revenue generated from the sale of a commodity.

    Interest received on a bank deposit.

    Dividend earned on entity's investments.

    Rentals received on property leased by the entity.

    Gain on re-valuation of company assets.

    Income is accounted for under the accruals principal whereby it is recognized for the whole

    accounting period in full, irrespective of whether payments have been received or not.

    As income is an element of the income statement, it is calculated over the entire accounting

    period (usually one year) unlike balance sheet items which are calculated specifically for the year

    end date.


    Expenses are the decreases in economic benefits during the accounting period in the form of

    outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other

    than those relating to distributions to equity participants (IASB Framework).

    Expense is simplya decrease in the net assets of the entity over an accounting period except for

    such decreases caused by the distributions to the owners. The first aspect of the definition is

    quite easy to grasp as the incurring of an expense must reduce the net assets of the company.

    For instance, payment of a company's utility bills reduces cash. However, net assets of an entity

    may also decrease as a result of payment of dividends to shareholders or drawings by owners of

    a business, both of which are distributions of profits rather than expense. This is the significance

    of the latter part of the definition of expense.

    Following is a list of common types of expenses recognized in the financial statements:

    Salaries and wages

    Utility expenses

    Cost of goods sold

    Administration expenses

    Finance costs


    Impairment losses

    Expense is accounted for under the accruals principal whereby it is recognized for the whole

    accounting period in full, irrespective of whether payments have been made or not.

    As expense is an element of the income statement, it is calculated over the entire accounting

    period (usually one year) unlike balance sheet items which are calculated specifically for the year

    end date.

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    Concept of Double Entry:

    Every transaction has two effects. For example, if someone transacts a purchase of a drink from

    a local store, he pays cash to the shopkeeper and in return, he gets a bottle of dink. This simpletransaction has two effects from the perspective of both, the buyer as well as the seller. The

    buyer's cash balance would decrease by the amount of the cost of purchase while on the other

    hand he will acquire a bottle of drink. Conversely, the seller will be one drink short though his

    cash balance would increase by the price of the drink.

    Accounting attempts to record both effects of a transaction or event on the entity's financial

    statements. This is the application of double entry concept. Without applying double entry

    concept, accounting records would only reflect a partial view of the company's affairs. Imagine if

    an entity purchased a machine during a year, but the accounting records do not show whether

    the machine was purchased for cash or on credit. Perhaps the machine was bought in exchange

    of another machine. Such information can only be gained from accounting records if both effects

    of a transaction are accounted for.

    Traditionally, the two effects of an accounting entry are known as Debit (Dr) and Credit (Cr).

    Accounting system is based on the principal that for every Debit entry, there will always be an

    equal Credit entry. This is known as the Duality Principal.

    Debit entries are ones that account for the following effects:

    Increase in assets

    Increase in expense

    Decrease in liability

    Decrease in equity

    Decrease in income

    Credit entries are ones that account for the following effects:

    Decrease in assets

    Decrease in expense

    Increase in liability

    Increase in equity

    Increase in income

    Double Entry is recorded in a manner that the Accounting Equation is always in balance.

    Assets - Liabilities = Capital

    Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or increase in liability or

    equity (Cr) and vice-versa. Hence, the accounting equation will still be in equilibrium.

    Examples of Double Entry1. Purchase of machine by cash

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    Debit Machine (Increase in Asset)

    Credit Cash (Decrease in Asset)

    2. Payment of utility bills

    Debit Utility Expense (Increase in Expense)

    Credit Cash (Decrease in Asset)

    3. Interest received on bank deposit account

    Debit Cash (Increase in Asset)

    Credit Finance Income (Increase in Income)

    4. Receipt of bank loan principal

    Debit Cash (Increase in Asset)

    Credit Bank Loan (Increase in Liability)

    5. Issue of ordinary shares for cash

    Debit Cash (Increase in Asset)

    Credit Share Capital (Increase in Equity)

    Ledger Accounts

    Accounting Entries are recorded in ledger accounts. Debit entries are made on the left side of the

    ledger account whereas Credit entries are made to the right side. Ledger accounts are

    maintained in respect of every component of the financial statements. Ledger accounts may bedivided into two main types: balance sheet ledger accounts and income statement ledger


    Balance Sheet Ledger Accounts

    Balance Sheet ledger accounts are maintained in respect of each asset, liability and equity

    component of the statement of financial position.

    Following is an example of a receivable ledger account:

    Receivable Account

    Debit $ Credit $

    Balance b/d 1 500Cash 3 500

    Sales 2 1000Balance c/d 4 1000

    1500 1500

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    1. Balance brought down is the opening balance is in respect of the receivable at the start ofthe accounting period.

    2. These are credit sales made during the period. Receivables account is debited because ithas the effect of increasing the receivable asset. The corresponding credit entry is madeto the Sales ledger account. The account in which the corresponding entry is made isalways shown next to the amount, which in this case is the Sales ledger.

    3. This is the amount of cash received from the debtor. Receiving cash has the effect ofreducing the receivable asset and is therefore shown on the credit side. As it can seen,the corresponding debit entry is made in the cash ledger.

    4. This represents the balance due from the debtor at the end of the accounting period. Thefigure has been arrived by subtracting the amount shown on the credit side from the sumof amounts shown on the debit side. This accounting period's closing balance is beingcarried forward as the opening balance of the next period.

    Similar ledger accounts can be made for other balance sheet components such as payables,

    inventory, equity capital, non current assets and so on.

    Income Statement Ledger Accounts

    Income statement ledger accounts are maintained in respect of incomes and expenditures.

    Following is an example of electricity expense ledger:

    Electricity Expense Account

    Debit $ Credit $

    Cash 1 1,000Income Statement 2 1,000

    1,000 1,000

    1. This is the amount of cash paid against electricity bill. The expense ledger is being

    debited to account for the increase in expense. The corresponding credit entry has beenmade in the cash ledger.

    2. This represents the amount of expense charged to the income statement. The balance inthe ledger has been recycled to the income statement which is being debited by the sameamount. Unlike balance sheet ledger accounts, there is no balance brought down orcarried forward. Instead, the income statement ledger is closed each accounting periodend with the balancing figure representing the charge to income statement.

    Accounting Equation

    Double entry is recorded in a manner that the accounting equation is always in balance:

    Assets = Liabilities + Equity

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    Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from internal

    sources of finance such as share capital and retained profits (i.e. Equity). Therefore, assets of an

    entity will always equal to the sum of its liabilities and equity.

    The accounting equation may be re-arranged as follows:

    Assets - Liabilities = Equity

    We may test the Accounting Equation by incorporating the effects of several transactions to see

    whether it still balances as theorized in the accountancy literature. For the purpose of this test, we

    may classify accounting transaction into the following generic types:

    1. Transactions that only affect Assets of the entity

    2. Transactions that affect Assets and Liabilities of the entity

    3. Transactions that affect Assets and Equity of the entity

    4. Transactions that affect Liabilities and Equity of the entity


    For all the examples on the next pages, it will be assumed that before any transaction, Assets of

    ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each.

    What is a Trial Balance?

    Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step

    towards the preparation of financial statements. It is usually prepared at the end of an accounting

    period to assist in the drafting of financial statements. Ledger balances are segregated into debit

    balances and credit balances. Asset and expense accounts appear on the debit side of the trial

    balance whereas liabilities, capital and income accounts appear on the credit side. If all

    accounting entries are recorded correctly and all the ledger balances are accurately extracted,the total of all debit balances appearing in the trial balance must equal to the sum of all credit


    Purpose of a Trial Balance

    Trial Balance acts as the first step in the preparation of financial statements. It is a

    working paper that accountants use as a basis while preparing financial statements.

    Trial balance ensures that for every debit entry recorded, a corresponding credit entry

    has been recorded in the books in accordance with the double entry concept of

    accounting. If the totals of the trial balance do not agree, the differences may be

    investigated and resolved before financial statements are prepared. Rectifying basic

    accounting errors can be a much lengthy task after the financial statements have been

    prepared because of the changes that would be required to correct the financial


    Trial balance ensures that the account balances are accurately extracted from accounting


    Trail balance assists in the identification and rectification of errors.

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    Following is an example of what a simple Trial Balance looks like:

    ABC LTDTrial Balance as at 31 December 2011

    Account TitleDebit Credit

    $ $

    Share Capital 15,000

    Furniture & Fixture 5,000

    Building 10,000

    Creditor 5,000

    Debtors 3,000

    Cash 2,000

    Sales 10,000

    Cost of sales 8,000

    General and Administration Expense 2,000

    Total 30,000 30,000

    1. Title provided at the top shows the name of the entity and accounting period end forwhich the trial balance has been prepared.

    2. Account Title shows the name of the accounting ledgers from which the balances havebeen extracted.

    3. Balances relating to assets and expenses are presented in the left column (debit side)whereas those relating to liabilities, income and equity are shown on the right column

    (credit side).4. The sum of all debit and credit balances are shown at the bottom of their respective


    Limitations of a trial balance

    Trial Balance only confirms that the total of all debit balances match the total of all credit

    balances. Trial balance totals may agree in spite of errors. An example would be an incorrect

    debit entry being offset by an equal credit entry. Likewise, a trial balance gives no proof that

    certain transactions have not been recorded at all because in such case, both debit and credit

    sides of a transaction would be omitted causing the trial balance totals to still agree. Types of

    accounting errors and their effect on trial balance are more fully discussed in the section on

    Suspense Accounts.

    How to prepare a Trial Balance

    Following Steps are involved in the preparation of a Trial Balance:

    1. All Ledger Accounts are closed at the end of an accounting period.

    2. Ledger balances are posted into the trial balance.

    3. Trial Balance is cast and errors are identified.

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    4. Suspense account is created to agree the trial balance totals temporarily until corrections

    are accounted for.

    5. Errors identified earlier are rectified by posting corrective entries.

    6. Any adjustments required at the period end not previously accounted for are incorporated

    into the trial balance.Closing Ledger Accounts

    Ledger accounts are closed at the end of each accounting period by calculating the totals of debit

    and credit sides of a ledger. The difference between the sum of debits and credits is known as

    the closing balance. This is the amount which is posted in the trial balance.

    How closing balances are presented in the ledger depends on whether the account is related to

    income statement (income and expenses) or balance sheet (assets, liabilities and equity).

    Balance sheet ledger accounts are closed by writing 'Balance c/d' next to the balancing figure

    since these are to be rolled forward in the next accounting period. Income statement ledger

    accounts on the other hand are closed by writing 'Income Statement' next to the residual amount

    because it is being transferred to the income statement as revenue or expense incurred for the


    The steps involved in closing a ledger account may be summarized as below:

    1. Add the totals of both sides of a ledger

    2. The higher of the totals among the debit side and credit side must be inserted at the endofBOTH sides.Closing balance is the balancing figure on the side with the lower balance.

    3. In case of ledger accounts of assets, liabilities and equity, 'balance c/d' is written next tothe closing balance whereas in case of income and expenses ledger accounts, 'IncomeStatement' is written next to the closing balance.

    4. The closing balances of all ledger accounts are posted into the trial balance.

    Next sections contain examples illustrating how the various types of ledger accounts are closed

    at the period end 31 December 2011.

    Posting Closing ledger balances into TrialBalance:

    Closing Balance of all ledger accounts are posted into the trial balance. It is important to

    remember that a debit closing balance in the ledger account appears on the credit side but in the

    trial balance it is presented in the debit column and vice versa.

    Posting of closing balances should be done carefully as many errors may occur during the

    posting process such as Posting Error, Transposition Errors and Slide error.

    Following is an example of a trial balance prepared from the closing balances of the ledgers

    detailed above.


    Trial Balance as at 31 December 2011

    Account TitleDebit Credit

    $ $

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    Share Capital 10,000

    Bank Loan 10,000

    Cash 30,000

    Salaries Expense 5,000Sales Revenue 15,000

    Total 35,000 35,000

    Bank Reconciliation?

    Bank reconciliation statement is a report which compares the bank balance as per company's

    accounting records with the balance stated in the bank statement.

    It is normal for a company's bank balance as per accounting records to differ from the balance as

    per bank statement due to timing differences. Certain transactions are recorded by the entity that

    are updated in the bank's system after a certain time lag. Likewise, some transactions are

    accounted for in the bank's financial system before the company incorporates them into its own

    accounting system. Such timing differences appear as reconciling items in the Bank

    Reconciliation Statement.

    The purpose of preparing a Bank Reconciliation Statement is to detect any discrepancies

    between the accounting records of the entity and the bank besides those due to normal timing

    differences. Such discrepancies might exist due to an error on the part of the company or the


    Importance of Bank Reconciliation Preparation of bank reconciliation helps in the identification of errors in the accounting

    records of the company or the bank.

    Cash is the most vulnerable asset of an entity. Bank reconciliations provide the

    necessary control mechanism to help protect the valuable resource through uncovering

    irregularities such as unauthorized bank withdrawals. However, in order for the control

    process to work effectively, it is necessary to segregate the duties of persons responsible

    for accounting and authorizing of bank transactions and those responsible for preparing

    and monitoring bank reconciliation statements.

    If the bank balance appearing in the accounting records can be confirmed to be correctby comparing it with the bank statement balance, it provides added comfort that the bank

    transactions have been recorded correctly in the company records.

    Monthly preparation of bank reconciliation assists in the regular monitoring of cash flows

    of a business.

    Preparing a Bank Reconciliation Statement

    Following is a sample Bank Reconciliation Statement:

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    Bank Reconciliation Statement as at 31 December 2011Balance as per corrected Cash Book 1 xxx


    Unpresented Cheques 2 xxx


    Deposits in Transit 3 (xxx)

    Errors in Bank Statement 4 (xxx)

    Balance as per Bank Statement xxx

    1. Balance as per corrected Cash Book:

    This is the starting point of a bank reconciliation. Corrected bank balance is calculated by

    adjusting the cash book ledger balance for transactions that are recorded by the bank but not by

    the entity as shown below:

    Balance as per Cash Book xxx


    Direct Credits 5 xxx

    Interest on Deposit 6 xxx


    Bank Charges 7 (xxx)

    Direct Debits 8 (xxx)

    Standing Order 9 (xxx)

    Errors in Cash Book 10 (xxx)

    Balance as per corrected Cash Book xxx


    Methods of depreciation

    There are several methods for calculating depreciation, generally based on either the passage of

    time or the level of activity (or use) of the asset.

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    [edit]Straight-line depreciation

    Straight-line depreciation is the simplest and most-often-used technique, in which the company

    estimates the salvage value of the asset at the end of the period during which it will be used to

    generate revenues (useful life) and will expense a portion oforiginal cost in equal increments

    over that period. The salvage value is an estimate of the value of the asset at the time it will be

    sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value

    orresidual value.

    Straight-line method:

    For example, a vehicle that depreciates over 5 years, is purchased at a cost ofUS$17,000,

    and will have a salvage value ofUS$2000, will depreciate at US$3,000 per year: ($17,000

    $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is

    the depreciable cost of the asset divided by the number of years of its useful life.

    This table illustrates the straight-line method of depreciation. Book value at the beginning of

    the first year of depreciation is the original cost of the asset. At any time book value equals

    original cost minus accumulated depreciation.

    book value = original cost accumulated depreciation Book value at the end of year

    becomes book value at the beginning of next year. The asset is depreciated until the book

    value equals scrap value.

    Book value atbeginning of year



    Book value atend of year

    $17,000 (original

    cost) $3,000 $3,000 $14,000

    $14,000 $3,000 $6,000 $11,000

    $11,000 $3,000 $9,000 $8,000

    $8,000 $3,000 $12,000 $5,000

    $5,000 $3,000 $15,000 $2,000 (scrap value)

    If the vehicle were to be sold and the sales price exceeded the depreciated value (net book

    value) then the excess would be considered a gain and subject todepreciation recapture. In

    addition, this gain above the depreciated value would be recognized as ordinary income by

    the tax office. If the sales price is ever less than the book value, the resulting capital loss is

    tax deductible. If the sale price were ever more than the original book value, then the gain

    above the original book value is recognized as a capital gain.

    If a company chooses to depreciate an asset at a different rate from that used by the tax

    office then this generates a timing difference in the income statement due to the difference

    (at a point in time) between the taxation department's and company's view of the profit.
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    [edit]Declining-balance method (or Reducing balance method)

    Depreciation methods that provide for a higher depreciation charge in the first year of an

    asset's life and gradually decreasing charges in subsequent years are called accelerated

    depreciation methods. This may be a more realistic reflection of an asset's actual expected

    benefit from the use of the asset: many assets are most useful when they are new. One

    popular accelerated method is thedeclining-balance method. Under this method the book

    value is multiplied by a fixed rate.

    Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year

    The most common rate used is double the straight-line rate. For this reason, this technique is

    referred to as the double-declining-balance method. To illustrate, suppose a business has

    an asset with $1,000 original cost, $100 salvage value, and 5 years useful life. First,

    calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straight-

    line depreciation rate equals (100% / 5) = 20% per year. With double-declining-balance

    method, as the name suggests, double that rate, or40% depreciation rate is used. The table

    below illustrates the double-declining-balance method of depreciation.

    Book value atbeginning of year




    Book value atend of year

    $1,000 (originalcost)

    40% $400 $400 $600

    $600 40% $240 $640 $360

    $360 40% $144 $784 $216

    $216 40% $86.40 $870.40 $129.60

    $129.60 $129.60 - $100 $29.60 $900 $100 (scrap value)

    When using the double-declining-balance method, the salvage value is not considered in

    determining the annual depreciation, but the book value of the asset being depreciated is

    never brought below its salvage value, regardless of the method used. The process

    continues until the salvage value or the end of the asset's useful life, is reached. In the last

    year of depreciation a subtraction might be needed in order to prevent book value from falling

    below estimated Scrap Value.

    Since double-declining-balance depreciation does not always depreciate an asset fully by its

    end of life, some methods also compute a straight-line depreciation each year, and apply the

    greater of the two. This has the effect of converting from declining-balance depreciation to

    straight-line depreciation at a midpoint in the asset's life.

    It is possible to find a rate that would allow for full depreciation by its end of life with the



    where N is the estimated life of the asset (for example, in years).
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    [edit]Activity depreciation

    Activity depreciation methods are not based on time, but on a level of activity. This could be

    miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life

    is estimated in terms of this level of activity. Assume the vehicle above is estimated to go

    50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost -

    $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then

    calculated by multiplying the rate by the actual activity level.

    [edit]Sum-of-years' digits method

    Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than

    straight line, but less than declining-balance method. Under this method annual depreciation

    is determined by multiplying the Depreciable Cost by a schedule of fractions.

    depreciable cost = original cost salvage value

    book value = original cost accumulated depreciation

    Example: If an asset has original cost of$1000, a useful life of5 years and a salvage valueof$100, compute its depreciation schedule.

    First, determine years' digits. Since the asset has useful life of5 years, the years' digits

    are: 5, 4, 3, 2, and 1.

    Next, calculate the sum of the digits. 5+4+3+2+1=15

    The sum of the digits can also be determined by using the formula (n2+n)/2 where n is equal

    to the useful life of the asset. The example would be shown as (52+5)/2=15

    Depreciation rates are as follows:

    5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year,

    and 1/15 for the 5th year.

    Book value atbeginning ofyear





    Book valueatend of year

    $1,000(original cost)

    $900 5/15$300 ($900 *5/15)

    $300 $700

    $700 $900 4/15$240 ($900 *4/15)

    $540 $460

    $460 $900 3/15$180 ($900 *


    $720 $280

    $280 $900 2/15$120 ($900 *2/15)

    $840 $160

    $160 $900 1/15$60 ($900 *1/15)

    $900$100 (scrapvalue)
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    [edit]Units-of-production depreciation method

    Under the units-of-production method, useful life of the asset is expressed in terms of the

    total number of units expected to be produced:

    Suppose, an asset has original cost $70,000, salvage value $10,000, and is expected

    to produce 6,000 units.

    Depreciation per unit = ($70,00010,000) / 6,000 = $10

    10 actual production will give the depreciation cost of the current year.

    The table below illustrates the units-of-production depreciation schedule of the asset.

    Book value atbeginning ofyear

    Units ofproduction

    Depreciationcost per unit



    Book valueatend of year

    $70,000(original cost)

    1,000 $10 $10,000 $10,000 $60,000

    $60,000 1,100 $10 $11,000 $21,000 $49,000

    $49,000 1,200 $10 $12,000 $33,000 $37,000

    $37,000 1,300 $10 $13,000 $46,000 $24,000

    $24,000 1,400 $10 $14,000 $60,000$10,000(scrap value)

    Depreciation stops when book value is equal to the scrap value of the asset. In the end,

    the sum of accumulated depreciation and scrap value equals the original cost.

    [edit]Units of time depreciation

    Units of time depreciation is similar to units of production, and is used for depreciation

    equipment used in mine or natural resource exploration, or cases where the amount the

    asset is used is not linear year to year.

    A simple example can be given for construction companies, where some equipment is

    used only for some specific purpose. Depending on the number of projects, the

    equipment will be used and depreciation charged accordingly.

    [edit]Group depreciation method

    Group depreciation method is used for depreciating multiple-asset accounts using

    straight-line-depreciation method. Assets must be similar in nature and have

    approximately the same useful lives.




    LifeDepreciationper year

    Computers $5,500 $500 $5,000 5 $1,000
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    [edit]Composite depreciation method

    The composite method is applied to a collection of assets that are not similar, and have

    different service lives. For example, computers and printers are not similar, but both are

    part of the office equipment. Depreciation on all assets is determined by using the

    straight-line-depreciation method.




    LifeDepreciationper year

    Computers $5,500 $500 $5,000 5 $1,000

    Printers $1,000 $100 $ 900 3 $ 300

    Total $ 6,500 $600 $5,900 4.5 $1,300

    Composite life equals the total depreciable cost divided by the total depreciation per

    year. $5,900 / $1,300 = 4.5 years.

    Composite depreciation rate equals depreciation per year divided by total historical

    cost. $1,300 / $6,500 = 0.20 = 20%

    Depreciation expense equals the composite depreciation rate times the balance in the

    asset account (historical cost). (0.20 * $6,500) $1,300. Debit depreciation expense and

    credit accumulated depreciation.

    When an asset is sold, debit cash for the amount received and credit the asset account

    for its original cost. Debit the difference between the two to accumulated depreciation.

    Under the composite method no gain or loss is recognized on the sale of an asset.

    Theoretically, this makes sense because the gains and losses from assets sold before

    and after the composite life will average themselves out.

    To calculate composite depreciation rate, divide depreciation per year by total historicalcost. To calculate depreciation expense, multiply the result by the same total historical

    cost. The result, not surprisingly, will equal to the total depreciation Per Year again.

    Common sense requires depreciation expense to be equal to total depreciation per year,

    without first dividing and then multiplying total depreciation per year by the same


    [edit]Tax depreciation

    Most income tax systems allow atax deduction for recovery of the cost of assets used in

    a business or for the production of income. Such deductions are allowed for individuals

    and companies. Where the assets are consumed currently, the cost may be deductedcurrently as an expense or treated as part ofcost of goods sold. The cost of assets not

    currently consumed generally must be deferred and recovered over time, such as

    through depreciation. Some systems permit full deduction of the cost, at least in part, in

    the year the assets are acquired. Other systems allow depreciation expense over some

    life using some depreciation method or percentage. Rules vary highly by country, and

    may vary within a country based on type of asset or type of taxpayer. Many systems that

    specify depreciation lives and methods for financial reporting require the same lives and
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    methods be used for tax purposes. Most tax systems provide different rules for real

    property (buildings, etc.) and personal property (equipment, etc.).

    [edit]Capital allowances

    A common system is to allow a fixed percentage of the cost of depreciable assets to be

    deducted each year. This is often referred to as a capital allowance, as it is calledin United Kingdom. Deductions are permitted to individuals and businesses based on

    assets placed in service during or before the assessment year.Canada's Capital Cost

    Allowance are fixed percentages of assets within a class or type of asset. Fixed

    percentage rates are specified by type of asset. The fixed percentage is multiplied by the

    tax basis of assets in service to determine the capital allowance deduction. The tax law

    or regulations of the country specifies these percentages. Capital allowance calculations

    may be based on the total set of assets, on sets or pools by year (vintage pools) or pools

    by classes of assets.

    [edit]Tax lives and methods

    Some systems specify lives based on classes of property defined by the tax authority.Canada Revenue Agency specifies numerousclasses based on the type of property and

    how it is used. Under the United States depreciation system, the Internal Revenue

    Servicepublishes a detailed guidewhich includes a table of lives based on types of

    businesses in which assets are used. The table also incorporates specified lives for

    certain commonly used assets (e.g., office furniture, computers, automobiles) which

    override the business use lives. U.S. tax depreciation is computed under the double

    declining balance method switching to straight line or the straight line method, at the

    option of the taxpayer.[7] IRS tables specify percentages to apply to the basis of an asset

    for each year in which it is in service. Depreciation first becomes deductible when an

    asset is placed in service.

    [edit]Additional depreciation

    Many systems allow an additional deduction for a portion of the cost of depreciable

    assets acquired in the current tax year. The UK system provides afirst year capital

    allowance of 50,000. In the United States, two such deductions are available.

    A deductionfor the full cost of depreciable tangible personal property is allowed up to

    $250,000. This deduction is fully phased out for businesses acquiring over $800,000 of

    such property during the year.[8] In addition, additional first year depreciation of 50% of

    the cost of most other depreciable tangible personal property is allowed as a deduction.[9] Some other systems have similar first year or accelerated allowances.

    [edit]Real propertyMany tax systems prescribe longer depreciable lives for buildings and land

    improvements. Such lives may vary by type of use. Many such systems, including the

    United States and Canada, permit depreciation for real property using only the straight

    line method, or a small fixed percentage of cost. Generally, no depreciation tax

    deduction is allowed for bare land. In the United States, residential rental buildings are

    depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and

    land improvements over a 15 or 20 year life, all using the straight line method. [10],,id=177054,00.html,,id=177054,00.html,,id=177054,00.html
  • 7/27/2019 Accounting & accounting cycle


    [edit]Averaging conventions

    Depreciation calculations can become complex if done for each asset a business owns.Many systems therefore permit combining assets of a similar type acquired in the sameyear into a pool. Depreciation is then computed for all assets in the pool as a singlecalculation. Calculations for such pool must make assumptions regarding the date of

    acquisition. The United States system allows a taxpayer to use a half year convention forpersonal property or mid-month convention for real property.[11]Under such a convention,all property of a particular type is considered acquired at the midpoint of the acquisitionperiod. One half of a full period depreciation is allowed in the acquisition period and inthe final depreciation period. United States rules require a mid-quarter convention forpersonal property if more than 40% of the acquisitions for the year are in the finalquarter.

    Accounting Ratios | Financial Ratios:

    Learning Objectives:

    1. Define and explain the term accounting ratios.

    2. What are advantages and limitations of using accounting orfinancial ratios.

    3. Howfinancial ratiosare classified.

    Ratios simply means one number expressed in terms of another. A ratio is astatistical yardstick by means of which relationship between two or various figures

    can be compared or measured.

    Definition of Accounting Ratios:The term "accounting ratios" is used to describe significant relationship between figuresshown on abalance sheet, in a profit and loss account, in a budgetary control system orinanyother part of accounting organization.Accounting ratiosthus shows the relationshipbetween accounting data.Ratios can be found out by dividing one number by another number. Ratios show howone number is related to another. It may be expressed in the form of co-efficient,percentage, proportion, or rate. For example the current assets and current liabilities ofabusinesson a particular date are $200,000 and $100,000 respectively. The ratio ofcurrent assets and current liabilities could be expressed as 2 (i.e. 200,000 / 100,000) or200 percent or it can be expressed as 2:1 i.e., the current assets are two times the currentliabilities. Ratio sometimes is expressed in the form of rate. For instance, the ratiobetween two numerical facts, usually over a period of time, e.g. stock turnover is threetimes a year.

    Advantages of Ratios Analysis:

    Ratio analysis is an important and age-old technique of financial analysis. The followingare some of the advantages / Benefits of ratio analysis: