ACCOUNTING

DEFINITION

“Accounting is an art of recording, classifying and summarizing in a

significant manner and in terms of money, transaction and events, which

are in part at least of a financial character and interpreting the results thereof”.-AICPA

FUNCTIONS OF ACCOUNTING

Recording

Classifying

Summarizing

Deals with financial transactions

Interprets

OBJECTIVES OF ACCOUNTINGTo keep systematic recordsTo protect business propertiesTo ascertain the operational profit or lossTo ascertain the financial position of the

businessTo facilitate rational decision makingInforms

Accounting Principles

Accounting Concepts

Separate entity concept

Going concern concept

Money measurement concept

Cost concept

Dual aspect concept

Accounting period concept

Matching concept

Realization concept

Accounting Convention

Conservatism convention

Full discloser convention

Consistency convention

Materiality

Accounting Principles

Separate entity conceptIn accounting business is considered to be a separate entity from the proprietor[s].Thus when one person invest Rs. 10,000 into business. It will be deemed that the proprietor has given that such of money to the business which will shown as a ‘liability’ in the books of the business.

Going concern conceptAccording to this concept it is assumed that the business will continue for a fairly long time to come. There is neither the intention nor the necessity to liquidate the particular business venture in the foreseeable future.

Money measurement conceptAccounting records only monetary transactions. Events or transactions which cannot be expressed in money do not find place in the books of accounts though they may be very useful for the business.

Cost conceptThe cost concept does not mean that the asset will always be shown at cost but it become the basis for all future accounting for the assets. It means that asset is recorded at cost at the time of its purchase but it may systematically be reduced in its value by charging depreciation.

Dual aspect conceptThis is the basic concept of accounting as per this concept every business transaction has a dual effect.eg: if A started a business with a capital of Rs. 10,000. there are two aspect of the transaction. On the one hand the business has asset of Rs. 10,000 while on the other hand the business has to pay to the proprietor a sum of Rs. 10,000 which is taken as proprietor’s capital.

Accounting period conceptAccording to this concept, the life of the business is divided into appropriate segment. This is because though the life of the business is considered to be indefinite, the measurement of income and studying the financial position of the business after a very long period would not be helpful in taking proper corrective steps at the appropriate time. It is, therefore, absolutely necessary that after each segment or time interval the business man must ‘stop’ and ‘seek back’, how things are going. In accounting such a segment or time interval is called ‘accounting period.’ It is usually a year.

Matching conceptThe paramount objective of running a business is to earn profit. In order to ascertain the profit made by the business during the period, it is necessary that revenue of the period should be matched with the costs of that period. The term matching means appropriate association of related revenues and expenses.

Realization conceptAccording to this concept revenue is recognized when a sale is made. Sale is considered to be made at the point when the property in goods passes to the buyer and he becomes legally liable to pay.

Full discloser conventionAccording to this convention accounting reports should disclose fully and fairly the information they purport to represent. They should be honestly prepared and sufficiently disclose information which is of material interest to proprietors, present and potential creditors and investors.

Conservatism conventionIn the initial stages of accounting certain anticipated profits which were recorded,did not materialize. This resulted in less acceptability of accounting figures by theend users. On account of this reason the accountants follow the rule ‘anticipatedno profit but provide for all possible losses’, while recording business transaction.In other words, the accountant follows the policy of “playing safe”. On account ofthis convention, the inventory is valued at cost or market price whichever is less’.Similarly a provision is made for possible bad and doubtful debts out of currentyear’s profits.

MaterialityAccording to this convention the accountant should attach importance to material details and ignore insignificant details. This is because otherwise accounting will be unnecessarily overburdened with minute details. The question what constitutes a material detail is left to the discretion of the accountant. Moreover, an item may be material for one purpose while immaterial for another.

Consistency conventionAccording to this convention accounting practices should remain unchanged from one period to another. For example, if stock is valued at ‘cost or market price whichever is less’. This principle should be followed year to year.

Accounting EquationThe properties owned by a business are called assets. The rights to theproperties are called equities. Equities may be sub-divided into two principaltypes: the rights of the creditors and the rights of the owner. The equities ofcreditors represented debts of the business and are called liabilities. Theequity of the owners is called capital, or proprietorship or owner’s equity.Thus:

Assets = Liabilities + Capitalor

Assets – Liabilities = Capital

The accounting equation can be understood with the help of the following transaction:

A starts business with a capital of Rs. 10,000.There are two aspects of the transaction. The business has received cash of Rs. 10,000. It is its asset but on the other hand it has to pay a sum of Rs. 10,000, to A, the proprietor. Thus:

CAPITAL & LIABILITIES Rs. Assets Rs.CAPITAL 10,000 Cash 10,000

Accounting basics

1. Journal:- Recording of financial transactions

2. Ledger:- Classifying those financial transactions

3. Trial balance:- Final summary of the classified transactions

These are basic three steps of accounting before preparing any financial

report.

Let’s consider few financial transactions:-

a) Capital infused into the business 5,00,000

b) Purchase of land 1,00,000

c) Purchase of building 1,00,000

d) Goods purchased 1,00,000

e) Sales 5,00,000

These transactions hardly make any sense. So I will dedicate 1 page for each

type of transactions i.e. I will record these transactions and then will classify

these transactions. Then I will prepare the final summary of these

transactions. Once the final summary is prepared then I will prepare the

different financial reports.

Journal

S.N Date Particulars LF DR CR

1 Cash acc DrTo capital Acc

5,00,0005,00,000

2 Land acc DrTo Cash acc

1,00,0001,00,000

3 Building acc DrTo cash acc

1,00,0001,00,000

4 Goods acc DrTo cash acc

1,00,0001,00,000

5 Cash acc DrTo Sales acc

5,00,0005,00,000

Preparing Ledger or separate accounts for all the items in the financial transaction

One page for each item, let’s say I am preparing cash account, then I will

record all cash related transactions on a page. I will put cash that I received on

the left side and the cash which I paid on the right side.

Cash Ledger

Similarly different ledgers will be prepared (building account, Land account,

Sales account and goods account) and I will dedicate one page to all these

Ledgers. Event now I can not show this to my manager. What I need to do is to

prepare the finally summary of these transactions. So I will prepare the final

summary, i.e. the trial balance.

Debit credit

Capital inflow 5,00,000 Purchase of land 1,00,000

Sales 5,00,000 Purchase of building 1,00,000

Balance cash 7,00,000 Purchase of goods 1,00,000

Trial balance

Total amount of cash left and total amount of land, total amount of building

and total amount of goods left will be mentioned in the final summary. This

final summary would be shown to the manager. This is called the trial balance.

Then I will go to the financial statements.

Trial Balance can be defined as “a list of all balances standing in the Ledger

Accounts and Cash Book of a concern at any given time.

Advantages:

1. It is the shortest method of verifying the arithmetical accuracy of entries made in the Ledger. If the Trial balances agree, it is an indication that the Accounts are correctly written up; but it is not a conclusive proof.

2. It helps to prepare the Trading A/c, Profit & Loss a/c and Balance Sheet.

3. It presents to the businessman consolidated lists of all Ledger Balances.

Preparation:

• There are two methods for preparing the Trial Balance

Trial Balance

First Method:

• In this method, Ledger Accounts are not balanced. They are totaled. The debit side totals and the credit side totals are entered in a separate sheet. The grand total of Debit Column will be equal to the grand total of the Credit Column.

• Second Method:

• This method is more widely used. In this method, Ledger accounts are balanced. The brought down balances are then brought to a sheet as given bellow.

Financial statementsBalance sheet: a big box with two sides. On one side we will mention all the

liabilities the business will incur and on the other side I will mention all the assets .

The total of assets should be equal to the total of liabilities. In accounting terms it

is said that your balance sheet should tally. Both sides of the balance sheet should

tally. Why these two should tally? There are two explanation for this . One is

mathematical and another one is logical.

Mathematical reason is that for every transaction we make two entries one is

debit and another is credit and one part will go to the asset side and the another

part will go to the liability side so the balance sheet will tally. The other reason is

logical.

Logical reason:- to this liabilities we call them as sources of fund and to these

assets we call them as applications of fund. So there can not be a scenario that

your sources of fund and application of fund will differ.

Balance sheet is prepared on a particular date and is only true on a particular date.

BALANCE SHEET

Assets Liabilities

All of a firm’s identifiable assets and liabilities appear on the balance sheet, and the difference between a firm’s assets and its liabilities represents the value of the firm.

• Mirrors the Accounting Equation

Assets = Liabilities + Equity

Uses of funds = Sources of funds

• Assets are listed in order of liquidity

– Current and non-current

• Liabilities are listed in order of maturity

• Equity consists of Contributed Capital andRetained Earnings

To be reported on a balance sheet,an asset must:

1. Be owned or controlled by the company

2. Must possess expected future benefits

Most assets are recorded at historical costs

• Historical Cost is

– Objective

– Verifiable

– Therefore, not subject to bias

• However, historical cost is not particularly “relevant” to most readers of the balance sheet

• “Relevance vs. Reliability” is an important issue with accountants.

Liabilities are listed in order of maturity

Current Liabilities come due in less than a year.Noncurrent liabilities come due after a year.

Companies desire more current assets than current liabilities – this difference is called net working capital

Equity consists of:

– Contributed Capital (cash raised from the issuance of shares)

Earned Capital (retained earnings). Retained Earnings is updated each

period as follows:

Profit and loss account or income statement

Income statement is all about how much income is generated in a financial

Year. Income statement is prepared for a particular period and is true for a

particular period, let’s say for a financial year.

Statement of Cash flows

Cash flow statement is all about the cash generated in a particular period.

Through what sources we generated the cash. Cash flow is ultimately what

matters to a firm and its investors; therefore, it is not really necessary to worry

about the definition of earnings used in the preparation of the income

statement. Rather, one need only consider the sources and uses of cash as

reflected on the firm’s statement of cash flows.

• Statement of cash flows (SCF) reports cash inflows and outflows

• Cash flows are reported based on the three business activities of a company:

1. Operating activities: transactions related to the operations of the business.

2. Investing activities: acquisitions and divestitures of long-term assets

3. Financing activities: issuances and payments toward equity, borrowings, and long-term liabilities.

Capital 1,00,000

Bank loan 5,00,000

Purchase of material 3,00,000

Purchase of furniture 2,00,000

Prepare balance sheet for these transactions

Putting assets on right side and liabilities on the left side is just a convention.

In US assets are put on the left side and liabilities on the right side. There is

no logic behind this.

Our accounting system is based on double entry system. For every transaction

there would be corresponding transaction s of opposite effect i.e. debit and a

credit side entry.

Capital is a liability for the business, as soon as we will put capital in the

liability side its opposing effect would be increase in cash by the same amount

so we will write cash in the asset side. For the next transaction which is a bank

loan, it is again liability for the business and it would be mentioned on the left

Side with an opposing entry of similar amount of cash in the right side or in the

asset side, as cash will increase in the business and cash is an asset for the

Business.

Liabilities Assets

Cap 1,00,000 Cash (1+5-3-2) 1,00,000

Bank Loan 5,00,000 Purchase of mat 3,00,000

--------------------------------------------------------- Purchase of furniture 2,00,000

6,00,000 ------------------------------------------------------------

6,00,000

Next is purchase of material. This transaction will again has two entries as this will increase asset by 3 lakh but this will either reduce cash by 3 lakh or will create new liability of 3lakh to the business. Similarly for the next transaction purchase of Furniture will increase furniture asset by 2 lakh but it will either reduce cash asset by 2 lakh or it will create new liability to the business (if it is a credit sell). So ultimately the two sides will tally and the balance sheet will look like:-

So in the balance sheet both sides are equal.

1. Capital 5L

2. Bank loan 5L

3. Land & building 3L

4. Sales 10L

5. Expenses 4L

For these transactions prepare balance sheet and profit and loss account both.

Here for the first two transactions liability will increase by 10L and cash in the

asset side will increase in the assets side. For the 3rd transaction land and

building asset will increase at the same time considering it a cash purchase the

cash asset will decrease by the same amount. 4th transaction will increase cash

by 10Lin the asset side and the 5th transaction will reduce cash by 4L

Balance sheet will look like

Liabilities Assets

Cap 5 L&B 3

BL 5

Res 6 Cash 13

Total 16 Total 16

Expense income

Sal exp 4 Sales 10

Profit 6

Total 10 Total 10