Unit-I: Introduction to Accounting
Definition of Accounting
Accounting is the process of identifying, recording, classifying, summarizing, interpreting, and communicating financial information. It helps stakeholders make informed decisions about the financial status and performance of an organization.
Features of Accounting:
(1) Accounting is an Art as well as Science : Accounting is both an art and a science. As an art, it involves recording, classifying, and summarizing transactions to determine a business’s net profit and financial position.
As a science, it is an organized body of knowledge based on established principles and standards.
(2) Recording of Financial Transactions Only : Accounting records only those events and transactions that have a financial component. Since so many of these are determined and expressed in monetary terms, they won't be recorded.
(3) Recording in Terms of money :Each Transaction is recorded in the books in term of money.
(4) Classifying: Classification is the process of grouping the transactions of one nature at one place, in a separate accounts. The book in which various accounts are opened is called "Ledger" (e.g., assets, liabilities, income, expenses).
(5) Summarizing: Summarising is the art of presenting the classified data in a manner which is understandable and useful to management and other users of such data.
With the goal to help stakeholders quickly understand a company's financial situation, summarizing involves incorporating information into important financial statements (such as income statements and balance sheets).
Recording, Classifying, and Summarising are also termed as 'Process of Accounting or Accounting Cycle
Add Picture of accounting Cycle
Interpreting: Analyzing financial data to determine a company's performance is known as interpretation. It entails examining the data to determine the organization's overall performance and financial health.
Communicating: Sharing financial information means providing important money-related details to people who need them, like investors, banks, or the company's management. This helps them make informed decisions—whether it’s about investing, lending, or running the business.
Accounting Principles
1. Accrual Principle: In accounting, accrual basis is used for recording of revenues and expenses.
2. Consistency Principle:
This concept states that accounting principles and methods should remain consistent from one year to another. These should not be changed from year to year,"
→ Ensures comparability of financial statements over time.
If a firm adopts different accounting principles in two accounting periods, the profits of the current period will not be comparable with the profits of the preceding period."
→ Consistency helps in accurate financial analysis.
3. Going Concern Principle:
- It is assumed that the business will continue to exist for a long period in the future
- Transactions are recorded in the books of the business on the assumption that it is a continuing enterprise.
- Assets and liabilities are accounted for as if the business will keep operating.
- We record fixed assets at their original cost and depreciation is charged on these assets without reference to their market value
- Businesses spread costs over time instead of treating large purchases as immediate expenses.
- All expenses incurred during an accounting period should be matched with the revenues recognized during that period
- This means that expenses related to a specific revenue should be recorded in the same period as that revenue.
- According to this concept, revenue for an accounting period should be recognized on an accrual basis
- This concept is fundamental in preparing an income statement and ensures that net profit is correctly determined.
- Without this principle, profits may be overstated or understated, leading to inaccurate financial results.
These are basic assumptions upon which accounting is based. Some key concepts include:
1. Business Entity Concept
According to this concept, business is treated as a unit separate and distinct from its owners, creditors, managers, and others. In other words, the owner of a business is always considered as distinct and separate from the business he owns. Business unit should have a completely separate set of books and we have to record business transactions from firm’s point of view and not from the point of view of the proprietor."
"The proprietor is treated as a creditor of the business to the extent of capital invested by him in the business. The capital is treated as a liability of the firm because it is assumed that the firm has borrowed funds from its own proprietors instead of borrowing it from outside parties."
Example: The owner's personal expenses are not recorded in the business accounts.
2. Money Measurement Concept
The Money Measurement Concept states that only transactions measurable in monetary terms are recorded in accounting. Events like strikes or competitor activities, though impactful, are not recorded unless expressed in money. This concept ensures uniformity by converting diverse business elements—cash, raw materials, finished goods—into a common unit of measurement: money.
Example: Employee morale is not recorded because it cannot be expressed in money.
3. Dual Aspect Concept
The Dual Aspect Concept states that every transaction has two aspects, affecting two or more accounts. This principle forms the basis of Double Entry System, ensuring the accounting equation remains balanced:
Assets = Liabilities + Capital
For example, if a business starts with ₹20 lakh in cash and takes a loan of ₹5 lakh, the equation remains balanced when the money is used for assets, machinery, etc. This concept ensures accurate financial records by recording both sides of a transaction.
4. Cost Concept
Example: A building bought for ₹5,00,000 will be recorded at ₹5,00,000 even if its market value is now ₹8,00,000.
5. Matching Concept
- All expenses incurred during an accounting period should be matched with the revenues recognized during that period
- This means that expenses related to a specific revenue should be recorded in the same period as that revenue.
- According to this concept, revenue for an accounting period should be recognized on an accrual basis
- This concept is fundamental in preparing an income statement and ensures that net profit is correctly determined.
- Without this principle, profits may be overstated or understated, leading to inaccurate financial results.
6. Accounting Period Concept
The Accounting Period Concept states that a business's financial results should be measured at regular intervals instead of waiting until it is completely wound up. This helps proprietors, managers, and investors assess performance and take corrective actions.
Financial statements are prepared for specific periods, such as a month, quarter, or year.
Accounting Conventions
An accounting convention may be defined as a custom or generally accepted practice which is either by general agreement or common consent among accountants.
1. Full Disclosure:
- Contingent Liabilities – Pending legal claims should be disclosed to avoid misleading financial statements.
- Changes in Accounting Policies – Any change in stock valuation methods, depreciation, or provision for doubtful debts should be mentioned in footnotes.
- Market Value of Investments – Should be disclosed separately in footnotes.
2. Materiality: Only items that are significant enough to influence the decision-making of users should be included in the financial statements.
3. Prudence: Financial statements should be prepared with caution, ensuring that assets and income are not overstated.
4. Substance Over Form: Transactions should be accounted for based on their economic substance rather than their legal form.
5. Uniformity: Similar transactions should be treated consistently across reporting periods.
Journal in Accounting
The Journal is the primary book of accounting where all financial transactions are initially recorded in chronological order. It is often referred to as the "Book of Original Entry" because it serves as the first point of documentation for business transactions.
Key Features of a Journal
1. Chronological Order: Transactions are recorded in the order in which they occur.
2. Double Entry System: Every transaction has a debit and a credit aspect.
3. Systematic Recording: Each entry is supported by a narration explaining the transaction.
4. Basis for Ledger Posting: The journal serves as the foundation for transferring entries to the ledger accounts.
Format of a Journal
| Date | Particulars | Debit (₹) | Credit (₹) |
|---|---|---|---|
| YYYY-MM-DD | Account Name Dr. | Amount | |
| To Account Name | Amount | ||
| (Narration) | Explanation of the transaction |
Date: The date of the transaction.
Particulars: Details of the accounts affected (debit and credit).
L.F. (Ledger Folio): The page number of the ledger where the account is posted.
Debit (₹): The amount debited to the account.
Credit (₹): The amount credited to the account.
Narration: A brief explanation of the transaction.
Rules for Journal Entries (Golden Rules)
1. Personal Accounts
Debit: The receiver.
Credit: The giver.
Example: Paid ₹5,000 to a creditor.
Journal Entry:
Creditor A/c Dr. ₹5,000
To Cash A/c ₹5,000
(Being payment made to creditor)
2. Real Accounts
Debit: What comes in.
Credit: What goes out.
Example: Bought furniture for ₹10,000.
Journal Entry:
Furniture A/c Dr. ₹10,000
To Cash A/c ₹10,000
(Being furniture purchased)
3. Nominal Accounts
Debit: All expenses and losses.
Credit: All incomes and gains.
Example: Paid salary of ₹8,000.
Journal Entry:
Salary A/c Dr. ₹8,000
To Cash A/c ₹8,000
(Being salary paid)
Advantages of Maintaining a Journal
- Provides a chronological record of transactions.
- Helps in detecting errors early.
- Serves as the basis for ledger preparation.
- Provides a clear explanation (narration) for each transaction.
Cash Book
The Cash Book is a financial journal that records all cash and bank transactions of a business in chronological order. It serves as both a journal and a ledger for cash and bank accounts.
Types of Cash Books
1. Single Column Cash Book:
Records only cash transactions (receipts and payments).
2. Double Column Cash Book: Records both cash and bank transactions.
3. Triple Column Cash Book:
Records cash, bank, and discount transactions.
4. Petty Cash Book:
Used for small or petty expenses.
Key Features
Debit Side: Records cash inflows (receipts).
Credit Side: Records cash outflows (payments).
Contra Entries: Transactions affecting both cash and bank (e.g., cash deposited into the bank).
Daily Balancing: Shows cash and bank balances daily.
Advantages
1. Tracks all cash and bank transactions.
2. Saves time by combining journal and ledger functions.
3. Simplifies error detection and auditing.
Example (Double Column Cash Book Format)
Subsidiary Books
Subsidiary Books are specialized journals where specific types of transactions are recorded before being posted to the ledger. They help divide accounting work and reduce the workload of the general journal.
Key Features
Classification of Transactions: Each subsidiary book records a specific category of transactions.
Time-Saving: Eliminates repetitive entries in the journal.
Clarity and Accuracy: Simplifies recording and reduces errors.
Foundation for Ledger Posting: Entries are directly posted to the respective ledger accounts.
Types of Subsidiary Books
1. Purchases Book:
Records all credit purchases of goods.
Cash purchases are recorded in the Cash Book.
Format:
| Date | Invoice No. | Name of Supplier | Details (Goods Purchased) | Ledger Folio (L.F.) | Amount (₹) |
|---|---|---|---|---|---|
| YYYY-MM-DD | 12345 | Supplier Name | Description of goods | Reference to Ledger | Total Amount |
2. Sales Book
Records all credit sales of goods.
Cash sales are recorded in the Cash Book.
Format:
| Date | Invoice No. | Customer Name | Ledger Folio | Details (₹) | Amount (₹) |
|---|---|---|---|---|---|
| YYYY-MM-DD | Invoice Number | Name of the Customer | LF Reference | Description of goods sold | Total Amount |
3. Purchases Returns Book (Returns Outward Book):
Records goods returned to suppliers.
Format:
| Date | Name of Supplier (Particulars) | Debit Note No. | Ledger Folio (L.F.) | Amount (₹) |
|---|---|---|---|---|
| YYYY-MM-DD | Name of Supplier and Details | Relevant number | Reference to Ledger | Amount |
4. Sales Returns Book (Returns Inward Book) :
Records goods returned by customers.
Format:
| Date | Name of Customer | Credit Note Number | Details (e.g., quantity, description) | Total Amount (₹) | Remarks |
|---|
5. Cash Book: Records all cash and bank transactions.
Bills Receivable Book
Records bills received from customers promising future payment.
Format:
| Date | Particulars | L.F. | Amount (Dr.) | Date | Particulars | L.F. | Amount (Cr.) |
|---|---|---|---|---|---|---|---|
| YYYY-MM-DD | Cash Received (Dr.) | Ledger Folio | ₹ Amount | YYYY-MM-DD | Cash Paid (Cr.) | Ledger Folio | ₹ Amount |
6. Bills Payable Book
Records bills issued by the business promising future payment.
Format:
| Date | Bill No. | Particulars (Creditor’s Name) | Amount (₹) | Due Date | Discount | Remarks |
|---|---|---|---|---|---|---|
| 2024-11-01 | 001 | Mr. Sharma | 5,000 | 2024-12-01 |
Advantages of Subsidiary Books
Specialization: Transactions are categorized, improving efficiency and clarity.
Time Efficiency: Reduces time spent recording transactions.
Error Reduction: Minimizes errors in classification and posting.
Simplified Ledger Posting: Entries are directly transferred to the respective ledgers.
Easy Division of Work: Facilitates delegation among accounting staff.
Ledger
The Ledger is the principal book of accounts where all transactions from the journal are classified and summarized under specific account headings. It is also known as the "Book of Final Entry."
Format of a Ledger
| Date | Particulars | L.F. (Ledger Folio) | Debit (₹) | Credit (₹) |
|---|---|---|---|---|
| yyyy-mm-dd | Details of transaction | Page no. or reference | Amount debited | Amount credited |
| yyyy-mm-dd | Details of transaction | Page no. or reference | Amount debited | Amount credited |
Date: The date of the transaction.
Particulars: The corresponding account involved in the transaction.
L.F. (Ledger Folio): The page number of the journal from which the entry is posted.
Debit/Credit: The transaction amount under the respective column.
Steps to Prepare a Ledger:
1. Identify the accounts involved from the journal.
2. Post the debit and credit entries to their respective accounts.
3. Write the date, particulars, and amount in the relevant columns.
4. Balance the ledger by subtracting the smaller total from the larger total.
Balancing the Ledger
Add the debit and credit sides.
[The difference (if any) is written as the balance c/d (carried down) on the shorter side.]
The balance is brought forward as balance b/d (brought down) in the next period.
Importance of Ledger
1. Provides a complete record of all accounts.
2. Helps determine the financial position of the business.
3. Aids in preparing the trial balance and financial statements.
4. Facilitates error detection and correction.
Example of a Ledger (Cash Account)
Balance c/d: ₹65,000 on the credit side.
Capital Expenditure and Revenue Expenditure
Expenditures are the amounts spent by a business to acquire goods, services, or assets. They are classified into Capital Expenditure and Revenue Expenditure based on their nature and benefit.
1. Capital Expenditure
Definition:
Capital expenditure refers to the spending incurred to acquire, upgrade, or improve fixed assets that provide long-term benefits to the business.
Characteristics:
1. Creates or enhances fixed assets (e.g., buildings, machinery).
2. Provides benefits over multiple accounting periods.
3. Recorded in the Balance Sheet as an asset.
4. Non-recurring in nature.
Examples:
Purchase of land or machinery.
Construction of buildings.
Cost of installing equipment.
Renovation or improvement of existing assets.
Accounting Treatment: Capital expenditure is added to the cost of the asset and is not charged as an expense in the Profit and Loss Account.
2. Revenue Expenditure
Definition:
Revenue expenditure refers to the spending incurred for day-to-day operations and maintenance of the business. It provides short-term benefits, typically within the current accounting period.
Characteristics:
1. Does not create or enhance fixed assets.
2. Benefits are consumed within the current accounting period.
3. Recorded in the Profit and Loss Account as an expense.
4.Recurring in nature.
Examples:
Salaries and wages.
Rent and utilities.
Repairs and maintenance.
Purchase of raw materials.
Advertising expenses.
Accounting Treatment: Revenue expenditure is charged directly to the Profit and Loss Account as an expense for the period.
Differences Between Capital and Revenue Expenditure
| Basis | Capital Expenditure | Revenue Expenditure |
|---|---|---|
| Nature | Long-term benefits | Short-term benefits |
| Purpose | Spent on acquiring, upgrading, or improving fixed assets. | Spent on daily operations and maintenance of the business. |
| Accounting Treatment | Recorded as an asset in the Balance Sheet. | Recorded as an expense in the Profit and Loss Account. |
| Benefit Period | Provides benefits over multiple accounting periods. | Benefits are limited to the current accounting period. |
| Recurring/Non-Recurring | Non-recurring in nature. | Recurring in nature. |
| Examples | Purchase of machinery, land, or building; renovation of assets. | Rent, wages, repairs, maintenance, utilities, and raw materials. |
| Impact on Financial Statements | Increases the value of assets and may depreciate over time. | Directly reduces profit for the period. |
| Purpose of Expenditure | Adds to the earning capacity of the business. | Maintains or sustains the current earning capacity. |