BASIC UNDERSTANDING OF ACCOUNTING
Lesson Objectives
On completion of this lesson, you will be able to understand
Principles and concepts of Accounting
Double Entry System of Accounting
Financial Statements
1.1 Introduction
Accounting is a process of identifying, recording, summarising and reporting economic information to
decision makers in the form of financial statements. Financial statements will be useful to the following parties:
Suppliers
Customers
Employees
Banks
Suppliers of equipments, buildings and other assets
Lenders
Owners
1.1.1 Types of Accounts
There are basically three types of Accounts maintained for transactions :
Real Accounts
Personal Accounts
Nominal Accounts
Real Accounts
Real Accounts are Accounts relating to properties and assets, which are owned by the business concern.
Real accounts include tangible and intangible accounts. For example,
Land
Building
Goodwill
Purchases
Cash
Personal Accounts
Personal Accounts are Accounts which relate to persons. Personal Accounts include the follow- ing.
Suppliers
Customers
Lenders
Nominal accounts
Nominal Accounts are Accounts which relate to incomes and expenses and gains and losses of a business
concern. For example,
Salary Account
Dividend Account
Sales
Accounts can be broadly classified under the following four groups.
Assets
Liabilities
Income
Expenses
The above classification is the basis for generating various financial statements viz., Balance Sheet, Profit &
Loss A/c and other MIS reports. The Assets and liabilities are taken to Balance sheet and the Income and
Expenses accounts are posted to Profit and Loss Account.
1.1.2 Golden Rules of Accounting
Personal A/C : Debit the Receiver
Credit the Giver
Real A/C : Debit What Comes in
Credit What Goes out
Nominal A/C : Debit all Expenses & Looses
Credit all Incomes & Gains
1.1.3 Accounting Principles, Concepts and Conventions
The Accounting Principles, concepts and conventions form the basis for how business transac- tions are
recorded. A number of principles, concepts and conventions are developed to ensure that accounting
information is presented accurately and consistently. Some of these concepts are briefly described in the
following sections.
Revenue Realization
According to Revenue Realisation concept, revenue is considered as the income earned on the date, when it
is realised. As per this concept, unearned or unrealised revenue is not taken into account. This concept is
vital for determining income pertaining to an accounting period. It reduces the possibilities of inflating incomes
and profits.
Matching Concept
As per this concept, Matching of the revenues earned during an accounting period with the cost associated
with the respective period to ascertain the result of the business concern is carried out. This concept serves
as the basis for finding accurate profit for a period which can be distributed to the owners.
Accrual
Under Accrual method of accounting, the transactions are recorded when earned or incurred rather when
collected or paid i.e., transactions are recorded on the basis of income earned or expense incurred
irrespective of actual receipt or payment. For example, a seller bills the buyer at the time of sale and treats
the bill amount as revenue, even though the payment may be received later.
The cash basis of accounting is a method wherein revenue is recognized when it is actually received, rather
than when it is earned. Expenses are booked when they are actually paid, rather than when incurred. This
method is usually not considered to be in conformity with accounting principles and is, therefore, used only in
select situations such as for very small businesses.
Going Concern
As per this assumption, the business will exist for a long period and transactions are recorded from this point
of view.
Accounting Period
The users of financial statements required periodical reports to ascertain the operational and the financial
position of the business concern. Thus, it is essential to close the accounts at regular intervals. viz., 365 days
or 52 weeks or 1 year is considered as the accounting period.
Accounting Entity
According to this assumption, a business is considered as a unit or entity apart from its owners, creditors and
others. For example, in case of a Sole Proprietor concern, the proprietor is treated to be separate and
distinct from the business, which he controls. The proprietor is treated as a creditor to the extent of his
capital and all the business transactions are recorded in the books of accounts from the business stand point.
Money Measurement
In accounting, only business transactions and events of financial nature are recorded. Only trans- actions that
can be expressed in terms of money are recorded.
1.1.4 Double Entry System of Book Keeping
As per Double Entry System of book-keeping, all the business transactions recorded in accounts have two
aspects - Debit aspect (receiving) and Credit aspect (giving). For example, when a business acquires an
asset (receiving) and pays cash (giving) for it. This accounting technique records each transaction as debit
and credit, where every debit has a corresponding credit and vice versa.
Features of Double Entry System of Book Keeping
The Double entry system of book keeping comprises of the following features :
Every business transaction affects two accounts
Each transaction has two aspects, i.e., debit and credit
Maintains a complete record of all business transactions
Helps to check the accuracy of the accounting transactions, by preparation of trial balance Helps ascertaining
profit earned or loss occured during a period, by preparation of Profit & Loss Account
Helps ascertaining financial position of the concern at the end of each period, by prepara- tion of Balance
Sheet
Helps timely decision making based on sufficient information
Minimizes the possibilities of fraud due to its systematic and scientific recording of business transactions The
following chart explains the way in which accounting transactions are recorded in the Double Entry system
and financial statements are prepared.
Figure 1.1 Double Entry System
1.1.5 Mode of Accounting
Accounting process begins with identifying and recording the transactions in the books of accounts i.e., the
first step in the Accounting Process is recording of transactions in the books of accounts. Accounting
identifies only those transactions and events which involves money and is sorted based on various source
documents.
The following are the most common source documents.
Cash Memo
Invoice or Bill
Vouchers
Receipt
Debit Note
Credit Note
Voucher
A voucher is a document in support of a business transaction, containing the details of such trans- action.
Receipt
When a trader receives cash from a customer against goods sold by him, issues a receipt con- taining the
name of such customer, details of amount received with date.
Invoice or Bill
When a trader sells goods to a buyer, he prepares a sales invoice containing the details of name and address
of buyer, name of goods, amount and terms of payments and so on. Similarly, when the trader purchases
goods on credit receives a Invoice/bill from the supplier of such goods.
Journals and Ledgers
A journal is a record in which all business transactions are entered in a chronological order. A record of a
single business transaction is called a journal entry. Every journal entry is supported by a voucher,
evidencing the related transaction.
Account
An account is a statement of transactions affecting any particular asset, liability, expense or income.
Ledger
A Ledger is a book which contains all the accounts whether personal, real or nominal, which are entered in
journal or subsidiary books.
Chart of Accounts
A chart of accounts is a list of all accounts used by an organization. The chart of accounts also displays the
categorization and grouping of its accounts.
Posting
Posting is the process of transferring the entries recorded in the journal or subsidiary books to the respective
accounts opened in the ledger i.e., grouping of all the transactions relating to a par- ticular account to a single
place.
Accounting Period
Generally, the financial statements are generated for a regular period such as a quarter or a year, for timely
and accurate ascertainment of operating and financial position of the organization.
Trial Balance
Trial balance is a statement which shows debit balances and credit balances of all Ledger accounts. As per
the rules of double entry system, every debit should have a corresponding Basics of Accounting credit, the
total of the debit balances and credit balances should agree. A detailed trial balance has columns for
Account name
Debit balance
Credit balance
1.1.6 Financial Statements
Financial statements are final result of accounting work done during the accounting period. Financial
statement serves a significant purpose to users of accounting information in knowing about the profitability
and financial position of the organisation. Financial statements normally include
Trading
Profit and Loss Account
Balance Sheet
Trading Account
Trading refers to buying and selling of goods. The trading account displays the transactions per- taining to
buying and selling of goods.
The difference between the two sides of the Trading Account indicates either Gross Profit or Gross Loss. If
the credit side total is in excess of the debit side total, the difference represents Gross Profit. On the other
hand, if the total of the debit side is in excess of the credit side total, the difference represents Gross Loss.
Such Gross Profit / Gross Loss is transferred to Profit & Loss Account. The Gross Profit is expressed as :
Gross Profit = Net Sales – Cost of Sales
Profit and Loss Account
The profit and loss account helps to ascertain the net profit earned or net loss suffered during a particular
period. after considering all other incomes and expenses incurred over a period. This helps the company to
monitor and control the costs incurred and improve its efficiency. In other words, the profit and loss
statement shows the performance of the company in terms of profits or losses over a specified period.
The Net Profit is expressed as :
Net Profit = (Gross Profit + Other Income) – (Selling and Administrative Expenses + Depre-
ciation + Interest + Taxes + Other Expenses)
A key element of the Profit and Loss Account, and one that distinguishes it from a balance sheet, is that the
amounts shown on the statement represent transactions over a period of time, while the items represented on
the balance sheet show information as on a specific date. All revenue and expense accounts are closed once
the profit and loss account is prepared. The Revenue and Expenses accounts will not have an opening
balance for the next accounting period.
Balance Sheet
The balance sheet is a statement that summarises the assets and liabilities of a business. The excess of
assets over liabilities is the net worth of a business. The balance sheet provides infor- mation that helps in
assessing
A company’s Long-term financial strength
A company’s Efficient day-to-day working capital management
A company’s Asset portfolio
A company’s Sustainable long-term performance
The balances of all the real, personal and nominal (capital in nature) accounts are transferred from trial
balance to balance sheet and grouped under the major heads of assets and liabilities. The balance sheet is
complete when the net profit/ loss is transferred from the Profit and Loss account.
1.1.7 Transactions
A transaction is a financial event that takes places in the course or furtherance of business and effects the
financial position of the company. For example, when you deposit cash in the bank, your cash balance
reduces and bank balance increases or when you sell goods for cash, your cash balance increases and your
stock reduces.
Transactions can be classified as follows :
Receipts – cash or bank
Payments – cash or bank
Purchases
Sales
1.1.8 Recording Transactions
The important aspect of accounting is to record transactions promptly and correctly to ascertain the financial
status of a company as on a particular date.
Generally, the business transactions may be of the folowing nature :
Purchase of goods either as raw materials for processing or as finished goods for resale Payment of
expenses incurred towards business
Sale of goods or services
Receipts (in Cash or by Cheques)
Payments (in Cash or Cheques)
Lesson Objectives
On completion of this lesson, you will be able to understand
Principles and concepts of Accounting
Double Entry System of Accounting
Financial Statements
1.1 Introduction
Accounting is a process of identifying, recording, summarising and reporting economic information to
decision makers in the form of financial statements. Financial statements will be useful to the following parties:
Suppliers
Customers
Employees
Banks
Suppliers of equipments, buildings and other assets
Lenders
Owners
1.1.1 Types of Accounts
There are basically three types of Accounts maintained for transactions :
Real Accounts
Personal Accounts
Nominal Accounts
Real Accounts
Real Accounts are Accounts relating to properties and assets, which are owned by the business concern.
Real accounts include tangible and intangible accounts. For example,
Land
Building
Goodwill
Purchases
Cash
Personal Accounts
Personal Accounts are Accounts which relate to persons. Personal Accounts include the follow- ing.
Suppliers
Customers
Lenders
Nominal accounts
Nominal Accounts are Accounts which relate to incomes and expenses and gains and losses of a business
concern. For example,
Salary Account
Dividend Account
Sales
Accounts can be broadly classified under the following four groups.
Assets
Liabilities
Income
Expenses
The above classification is the basis for generating various financial statements viz., Balance Sheet, Profit &
Loss A/c and other MIS reports. The Assets and liabilities are taken to Balance sheet and the Income and
Expenses accounts are posted to Profit and Loss Account.
1.1.2 Golden Rules of Accounting
Personal A/C : Debit the Receiver
Credit the Giver
Real A/C : Debit What Comes in
Credit What Goes out
Nominal A/C : Debit all Expenses & Looses
Credit all Incomes & Gains
1.1.3 Accounting Principles, Concepts and Conventions
The Accounting Principles, concepts and conventions form the basis for how business transac- tions are
recorded. A number of principles, concepts and conventions are developed to ensure that accounting
information is presented accurately and consistently. Some of these concepts are briefly described in the
following sections.
Revenue Realization
According to Revenue Realisation concept, revenue is considered as the income earned on the date, when it
is realised. As per this concept, unearned or unrealised revenue is not taken into account. This concept is
vital for determining income pertaining to an accounting period. It reduces the possibilities of inflating incomes
and profits.
Matching Concept
As per this concept, Matching of the revenues earned during an accounting period with the cost associated
with the respective period to ascertain the result of the business concern is carried out. This concept serves
as the basis for finding accurate profit for a period which can be distributed to the owners.
Accrual
Under Accrual method of accounting, the transactions are recorded when earned or incurred rather when
collected or paid i.e., transactions are recorded on the basis of income earned or expense incurred
irrespective of actual receipt or payment. For example, a seller bills the buyer at the time of sale and treats
the bill amount as revenue, even though the payment may be received later.
The cash basis of accounting is a method wherein revenue is recognized when it is actually received, rather
than when it is earned. Expenses are booked when they are actually paid, rather than when incurred. This
method is usually not considered to be in conformity with accounting principles and is, therefore, used only in
select situations such as for very small businesses.
Going Concern
As per this assumption, the business will exist for a long period and transactions are recorded from this point
of view.
Accounting Period
The users of financial statements required periodical reports to ascertain the operational and the financial
position of the business concern. Thus, it is essential to close the accounts at regular intervals. viz., 365 days
or 52 weeks or 1 year is considered as the accounting period.
Accounting Entity
According to this assumption, a business is considered as a unit or entity apart from its owners, creditors and
others. For example, in case of a Sole Proprietor concern, the proprietor is treated to be separate and
distinct from the business, which he controls. The proprietor is treated as a creditor to the extent of his
capital and all the business transactions are recorded in the books of accounts from the business stand point.
Money Measurement
In accounting, only business transactions and events of financial nature are recorded. Only trans- actions that
can be expressed in terms of money are recorded.
1.1.4 Double Entry System of Book Keeping
As per Double Entry System of book-keeping, all the business transactions recorded in accounts have two
aspects - Debit aspect (receiving) and Credit aspect (giving). For example, when a business acquires an
asset (receiving) and pays cash (giving) for it. This accounting technique records each transaction as debit
and credit, where every debit has a corresponding credit and vice versa.
Features of Double Entry System of Book Keeping
The Double entry system of book keeping comprises of the following features :
Every business transaction affects two accounts
Each transaction has two aspects, i.e., debit and credit
Maintains a complete record of all business transactions
Helps to check the accuracy of the accounting transactions, by preparation of trial balance Helps ascertaining
profit earned or loss occured during a period, by preparation of Profit & Loss Account
Helps ascertaining financial position of the concern at the end of each period, by prepara- tion of Balance
Sheet
Helps timely decision making based on sufficient information
Minimizes the possibilities of fraud due to its systematic and scientific recording of business transactions The
following chart explains the way in which accounting transactions are recorded in the Double Entry system
and financial statements are prepared.
Figure 1.1 Double Entry System
1.1.5 Mode of Accounting
Accounting process begins with identifying and recording the transactions in the books of accounts i.e., the
first step in the Accounting Process is recording of transactions in the books of accounts. Accounting
identifies only those transactions and events which involves money and is sorted based on various source
documents.
The following are the most common source documents.
Cash Memo
Invoice or Bill
Vouchers
Receipt
Debit Note
Credit Note
Voucher
A voucher is a document in support of a business transaction, containing the details of such trans- action.
Receipt
When a trader receives cash from a customer against goods sold by him, issues a receipt con- taining the
name of such customer, details of amount received with date.
Invoice or Bill
When a trader sells goods to a buyer, he prepares a sales invoice containing the details of name and address
of buyer, name of goods, amount and terms of payments and so on. Similarly, when the trader purchases
goods on credit receives a Invoice/bill from the supplier of such goods.
Journals and Ledgers
A journal is a record in which all business transactions are entered in a chronological order. A record of a
single business transaction is called a journal entry. Every journal entry is supported by a voucher,
evidencing the related transaction.
Account
An account is a statement of transactions affecting any particular asset, liability, expense or income.
Ledger
A Ledger is a book which contains all the accounts whether personal, real or nominal, which are entered in
journal or subsidiary books.
Chart of Accounts
A chart of accounts is a list of all accounts used by an organization. The chart of accounts also displays the
categorization and grouping of its accounts.
Posting
Posting is the process of transferring the entries recorded in the journal or subsidiary books to the respective
accounts opened in the ledger i.e., grouping of all the transactions relating to a par- ticular account to a single
place.
Accounting Period
Generally, the financial statements are generated for a regular period such as a quarter or a year, for timely
and accurate ascertainment of operating and financial position of the organization.
Trial Balance
Trial balance is a statement which shows debit balances and credit balances of all Ledger accounts. As per
the rules of double entry system, every debit should have a corresponding Basics of Accounting credit, the
total of the debit balances and credit balances should agree. A detailed trial balance has columns for
Account name
Debit balance
Credit balance
1.1.6 Financial Statements
Financial statements are final result of accounting work done during the accounting period. Financial
statement serves a significant purpose to users of accounting information in knowing about the profitability
and financial position of the organisation. Financial statements normally include
Trading
Profit and Loss Account
Balance Sheet
Trading Account
Trading refers to buying and selling of goods. The trading account displays the transactions per- taining to
buying and selling of goods.
The difference between the two sides of the Trading Account indicates either Gross Profit or Gross Loss. If
the credit side total is in excess of the debit side total, the difference represents Gross Profit. On the other
hand, if the total of the debit side is in excess of the credit side total, the difference represents Gross Loss.
Such Gross Profit / Gross Loss is transferred to Profit & Loss Account. The Gross Profit is expressed as :
Gross Profit = Net Sales – Cost of Sales
Profit and Loss Account
The profit and loss account helps to ascertain the net profit earned or net loss suffered during a particular
period. after considering all other incomes and expenses incurred over a period. This helps the company to
monitor and control the costs incurred and improve its efficiency. In other words, the profit and loss
statement shows the performance of the company in terms of profits or losses over a specified period.
The Net Profit is expressed as :
Net Profit = (Gross Profit + Other Income) – (Selling and Administrative Expenses + Depre-
ciation + Interest + Taxes + Other Expenses)
A key element of the Profit and Loss Account, and one that distinguishes it from a balance sheet, is that the
amounts shown on the statement represent transactions over a period of time, while the items represented on
the balance sheet show information as on a specific date. All revenue and expense accounts are closed once
the profit and loss account is prepared. The Revenue and Expenses accounts will not have an opening
balance for the next accounting period.
Balance Sheet
The balance sheet is a statement that summarises the assets and liabilities of a business. The excess of
assets over liabilities is the net worth of a business. The balance sheet provides infor- mation that helps in
assessing
A company’s Long-term financial strength
A company’s Efficient day-to-day working capital management
A company’s Asset portfolio
A company’s Sustainable long-term performance
The balances of all the real, personal and nominal (capital in nature) accounts are transferred from trial
balance to balance sheet and grouped under the major heads of assets and liabilities. The balance sheet is
complete when the net profit/ loss is transferred from the Profit and Loss account.
1.1.7 Transactions
A transaction is a financial event that takes places in the course or furtherance of business and effects the
financial position of the company. For example, when you deposit cash in the bank, your cash balance
reduces and bank balance increases or when you sell goods for cash, your cash balance increases and your
stock reduces.
Transactions can be classified as follows :
Receipts – cash or bank
Payments – cash or bank
Purchases
Sales
1.1.8 Recording Transactions
The important aspect of accounting is to record transactions promptly and correctly to ascertain the financial
status of a company as on a particular date.
Generally, the business transactions may be of the folowing nature :
Purchase of goods either as raw materials for processing or as finished goods for resale Payment of
expenses incurred towards business
Sale of goods or services
Receipts (in Cash or by Cheques)
Payments (in Cash or Cheques)
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