UNIT - I

Meaning of Accounting: It is a systematic process of identifying, recording, measuring, classifying,

verifying, summarizing, interpreting and communicating financial information. It reveals profit or loss
for a given period, and the value and nature of a firm's assets, liabilities and owners' equity.
Definition:
The American Institute of Certified Public Accountant (AICPA) defined Accounting as follows :
"Accounting is the art of recording, classifying and summarising in significant manner and in terms of
money, transactions and events which are in part, at least of a financial character and interpreting the
result there of."
The American Accounting Association (AAA) defined accounting as follows :
"Accounting is the process of identifying, measuring and communicating economic information to
permit informed judgements and decisions by users of the information".

Functions of Accounting
1) Recording : This is the basic function of accounting. It is concerned that all transactions of
financial character are recorded in an orderly manner, recording is done in the book of "Journal".
2) Classifying : Classification is concerned with the systematic analysis of the recorded data with a
view to group entries of one nature at one place. The work of classification is done in the book
"Ledger".
3) Summarising : This involves presently the classified data in a manner which is understandable.
This includes preparation of the following statements :
a) Trial Balance
b) Income Statement
c) Balance Sheet
4) Analysing and Interpreting : The financial data is analysed and interpreted in a manner that the
end users can make judgement about the financial condition and profitability of the business
operations.
5) Communicating : The accounting information has to be communicated in a proper form and
manner to the various users.

Objectives of Accounting
1) To Know Profit or Loss : The basic objective of accounting is to ascertain the profit or loss. For
this purpose a statement called Trading and Profit and Loss account is prepared. Profit is the

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 biggest motivator from the point of view to businessman so, he naturally wants to know how
much the profit or loss is.
2) To Know Financial Position : The second main objective of accounting is to know the financial
position of the concern; for this purpose a balance sheet is prepared which includes all the assets
and liabilities of the concern.
3) To Facilitate Management for Control : Accounting provides several kinds of information to
the management on the basis of which management takes several decisions. It helps management
in planning, decision making and controlling.
4) Provides Accounting Information to Users : This is another important objective of accounting
because the persons related to the business also require some information like Income statement
(Profit and Loss Account and Balance Sheet) to take their decisions regarding the concern.
5) Maintenance of Businss Records : Accounting keeps the systematic record of the financial
transaction, classified under the appropriate account and summarised into financial statement.

Features/ Attributes of Accounting

1) Accounting is both an Art and a Science \
2) It involves recording, classifying and summarising accounting, records the transaction into the
books, classifies the entries of one nature at one place and it summarise the results by making
reports and statements which are useful for management and other users of accounting
information.
3) It records only those transactions and events which are of financial character \
4) It is the art of interpreting the result of operation
5) It involves communication

Key Differences between Bookkeeping and Accounting

1. Bookkeeping is keeping proper records of the financial transactions of an entity. Accounting is

recording, measuring, grouping, summarizing, evaluating and reporting of transactions of the entity
which are in monetary terms.
2. The task of Bookkeeping is performed by a bookkeeper whereas the accountant performs the
task of Accounting.
3. Financial Statement forms a part of the accounting process but not the bookkeeping process.
4. Accounting records are taken as a base for taking managerial decision unlike bookkeeping
records, in which decision making is difficult.
5. Bookkeeping is the first step to Accounting.

Accounting Cycle

1. Identify the transaction from source documents, like purchase orders, loan agreements, invoices, etc.

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(2) Record the transaction as a journal entry (see the Double-Entry Bookkeeping Section above).

(3) Classification i.e. Post the entry in the individual accounts in ledgers.

(4) Summarisation: At the end of the reporting period (usually the end of the month), create a
preliminary trial balance of all the accounts by (a) netting all the debits and credits in each account to
calculate their balances and (b) totaling all the left-side (i.e., debit) balances and right-side (i.e., credit)
balances. The two columns should be equal.

(5) Combine the sums in the various accounts and present them in financial statements created for
both internal and external use.

(6) Close the books for the current month by recording the necessary reversing entries to start fresh in
the new period (usually the next month).

Users of Accounting Information - Internal & External

Internal users (Primary 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 and financial statements.

External users (Secondary Users) of accounting information include the following:

 Creditors: for determining the credit worthiness of the organization. Terms of credit are set by
creditors 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
company.

 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 suppliers which is necessary for them to
maintain 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.

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

Advantages of Accounting
1) Replace Memory : Today the business is so large that no businessmen can remember everything
because of the limitation of human memory power. It is, therefore, necessary to record
transaction properly.
2) Helps in Comparision : We can compare the performance with previous year's performance or
with others easily on the basis of proper accounts.
3) Evidence in Court : The records of accounts are treated by the court as evidence.
4) Facilitates Sale of Business : If the businessman wants to sale the business the accounts help in
the determination of the sale value.
5) Helps in Management : Accounts help the management for planning, decision making and
controlling.
6) Provides Financial Information : It provides the information regarding profit, loss, assets and
liabilities.
Limitations of Accounting
1) Accounting is not fully Exact : Accounts are based on some estimations, those estimations can
be correct or incorrect, for e.g. if we purchase a machine of Rs.1,00,000 and estimated life is 10
years so the yearly depreciation comes to Rs.10,000 now suppose, the machine is damaged in the
8th year so depreciation should be charged 12,500 so our estimation was incorrect and the
accounts maintained are also not fully correct.
2) Accounting does not Indicate the Realisable Values : In accounting, fixed assets are shown at
cost. This value may change over time so there may be a great difference between original cost
and realisable value of assets.
3) Accounting Ignores the Qualitative Elements : In accounting only Quautitative elements are
recorded and qualitative element are ignored for e.g. sinceraty or dedication of employees are not
recorded in the books of accounts.
4) Accounting Ignores the Effect of Price Level : Accounting statements are prepared at
historical cost. Money as a measurement unit changes in value. Unless price level changes are
considered in measurement of income, the accounting information will not show true financial
result.
5) Accounting may Lead to Window Dressing: Window dressing means misrepresentation of
facts. Manipulations of accounts is a way to conceal vital facts and present the financial
statement better than what it actually is.

Basis of Accounting

 Accrual Basis of accounting : The accrual method records income items when they
are earned and records deductions when expenses are incurred.For a business invoicing for
an item sold, or work done, the corresponding amount will appear in the books even though
no payment has yet been received – and debts owed by the business show as they are
incurred, even though they may not be paid until much later.

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  Cash basis of accounting . Under this basis of accounting, a business recognizes revenue
when cash is received, and expenses when bills are paid. This is the easiest approach to
recording transactions, and is widely used by smaller businesses.

 A variation on these two approaches is the modified cash basis of accounting . This concept
is most similar to the cash basis, except that longer-term assets are also recorded with
accruals, so that fixed assets and loans will appear on the balance sheet. This concept better
represents the financial condition of a business than does the cash basis of accounting.

Branches of Accounting
1) Financial Accounting : Financial accounting is primarily concerned with record keeping
directed towards the preparation of Profit and Loss account and Balance Sheet.
2) Cost Accounting : Cost accounting is the process of accounting for cost. It is a procedure for
determining the unit cost of product or services rendered.
3) Management Accounting : Management accounting is primarily concerned with the supply of
information which is useful to management in decision making for the efficient running of the
business and maximising profit. This is the newly developed branch. This accounting is done by
the management for the management itself.

Accounting Principles
According to the American Institute of Public Accountants “ Accounting principles are the
general laws or rules adopted or professed as a guide to action. It is a basis of conduct or
practice.”

Characteristics of Accounting principles:

1. These rules are based on the custom, usages and traditions.

2. These principles are dynamic and not fixed or rigid.

3. They are designed to make accounting data provide objectivity, application, usefulness and
simplicity to its users.

 Business Entity Concept-Business is treated as a separate entity or unit apart from its owner and
others. All the transactions of the business are recorded in the books of business from the point
of view of the business as an entity and even the owner is treated as a creditor to the extent of
his/her capital.
 Money Measurement Concept-In accounting, we record only those transactions which are
expressed in terms of money. In other words, a fact which can not be expressed in monetary
terms, is not recorded in the books of accounts.
 Accounting Period Concept-In accounting, life of the business is perpetual but still it has to
report the results of activity undertaken in one year. So final accounts are prepared for the
accounting period which is 12 months period and normally it is the Financial Year ( 1 st April to
31st March).
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  Cost Concept-Transactions are entered in the books of accounts at the amount actually involved.
Suppose a company purchases a car for Rs.1,50,000/- the real value of which is Rs.2,00,000/-,
the purchase will be recorded as Rs.1,50,000/- and not any more. This is one of the most
important concept and it prevents arbitrary values being put on transactions.
 Going Concern Concept-It is persuaded that the business will exists for a long time and
transactions are recorded from this point of view. The entity is assumed to remain in operation
sufficiently long to carry out its objects and plans.
 Dual Aspect Concept-Each transaction has two aspects, that is, the receiving benefit by one
party and the giving benefit by the other. This principle is the core of accountancy. For example,
the proprietor of a business starts his business with Cash Rs.1,00,000/-, Machinery of
Rs.50,000/- and Building of Rs.30,000/-, then this fact is recorded at two places. That is Assets
account (Cash, Machinery & Building) and Capital accounts. The capital of the business is equal
to the assets of the business. Thus, the dual aspect can be expressed as under- 
Capital + Liabilities = Assets
or
Capital = Assets – Liabilities

 Realization Concept-This concept emphasizes that profits should be considered only when
realized . Accounting should take into consideration profits only when the same have been
realized.
 Matching Concept-Matching concept requires that expenses should be matched to the revenues
of the appropriate accounting period. So we must determine the revenue earned during a
particular accounting period and the expenses incurred to earn those revenues.
 Accrual Concept-Accrual is concerned with expected future cash receipts and payments :
Accounting attempts to recognize non-cash events and circumstances as they occur. Examples
are – purchase and sales of goods on credit ,wages and salaries outstanding.
 Stable Monetary Unit Concept-This concept presumes that the purchasing power of monetary
unit ,say, rupee, remains the same throughout , thus ignoring the effect of rising or falling
purchasing power of monetary unit due to deflation or inflation.
 Convention of Consistency-In order to enable the management to draw important conclusions
regarding the working of the company over a few years, it is essential that accounting practices
and methods remain unchanged from one accounting period to another. The comparison of one
accounting period with that of another is possible only when the convention of consistency is
followed.
 Convention of Disclosure-This principle implies that accounts must be honestly prepared and
all material information must be disclosed therein. The contents of Balance Sheet and Profit and
Loss Account are prescribed by law. These are designed to make disclosure of all material facts
compulsory.
 Convention of Conservation-The convention of conservatism, also known as the doctrine of
prudence in accounting is a policy of anticipating possible future losses but not future gains. This
policy tends to understate rather than overstate net assets and net income, and therefore lead
companies to "play safe".
 Convention of Relevance-Relevance is the concept that the information generated by
an accounting system should impact the decision-making of someone perusing the

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 information. ... This improves the speed with which various internal and external parties receive
the financial statements, which improves the relevance of the information they receive.
 Convention of Objectivity-The objectivity principle is the concept that the financial statements
of an organization be based on solid evidence. The intent behind this principle is to keep the
management and the accounting department of an entity from producing financial statements
that are slanted by the opinions and biases of the company.

Accounting Terms/ Terminology

 Accounting Equation - The Accounting Equation is Assets = Liabilities + Equity. With accurate
financial records, the equation balances.
 Accounting - Accounting keeps track of the financial records of a business. In addition to
recording financial transactions, it involves reporting, analyzing and summarizing information.
 Accounts Payable - Accounts Payable are liabilities of a business and represent money owed to
others.
 Accounts Receivable - Assets of a business and represent money owed to a business by others.
 Accrual Accounting - Records financial transactions when they occur rather than when cash
changes hands. For example, when goods are received without payment, an Accounts Payable is
recorded.
 Accruals - Accruals acknowledge revenue when it is earned and expenses when they are
incurred even though a cash transaction may not be involved.
 Amortization - Reduces debts through equal payments that include interest.
 Asset - Items of value that are owned.
 Audit Trail - Allow financial transactions to be traced to their source.
 Auditors - Examine financial accounts and records to evaluate their accuracy and the financial
condition of the entity.
 Balance Sheet - Provides a snapshot of a business' assets, liabilities, and equity on a given date.
 Bookkeeping - Recording of financial transactions in an accounting system.
 Budgeting - Budgeting involves maintaining a financial plan to control cash flow.
 Capital Stock - Total amount of common and preferred stock issued by a company.
 Capital Surplus - The amount in excess of par value for shares of common stock.
 Capitalized Expense - Accumulated expenses that are expensed over time.
 Cash Flow - The difference in money flowing in and out. A negative flow indicates more money
going out than coming in. A positive flow shows more money coming in than going out.
 Cash-Basis Accounting - Records when cash is received through revenues and disbursed for
expenses.
 Chart of Accounts - An organization's list of accounts used to record financial transactions.
 Closing the Books/Year End Closing - Closing the Books occurs at the end of the annual
period and allows for a start with a clean book at the beginning of the next year.
 Cost Accounting - Used internally to determine the cost of operations and to establish a budget
to increase profitability.
 Credit - Entered in the right column of accounts. Liability, equity and revenue increase on the
credit side.
 Debit - Entered in the left column of accounts. Assets and expenses increase on the debit side.
 Departmental Accounting - Shows individual departments' income, expenses and net profit.
 Depreciation - The decrease in an asset's value over time.
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  Dividends - Profits returned to the shareholders of a corporation.
 Double-Entry Bookkeeping - Requires entries of debits and credits for each financial
transaction.
 Equity - Represents the value of company ownership.
 Financial Accounting - The accounting branch that prepares financial reporting primarily for
external users.
 Financial Statement - Financial Statements detail the financial activities of a business.
 Fixed Asset - Used for a long period of time, e.g. - equipment or buildings.
 General Ledger - Where debit and credit transactions are recorded.
 Goodwill - Intangible asset a business enjoys like its reputation or brand popularity.
 Income Statement - A Financial Statement documents the difference in revenue and expenses
resulting in income.
 Inventory Valuation - A valuation method modified for use in real estate and business
appraisals.
 Inventory - Inventory consists of raw materials, work in progress, and finished goods.
 Invoice - An Invoice shows the amount of money owed for goods or services received.
 In The Black - Makes reference to a profit on the books; opposite of “in the red.” Black Friday
sales are known for the profit retailers are adding to their books.
 In The Red - Makes reference to a loss on the books; opposite of “in the black.” In the days of
handwritten accounting, ledger entries written in black meant there was a profit, but those in red
meant there was a loss.
 Job Costing - Job Costing tracks costs of a particular job against its revenues.
 Journal - The first place financial transactions are entered. They are entered chronologically.
 Liability - Liabilities are the obligations of an entity, usually financial in nature.
 Liquid Asset - Consist of cash and other assets that can be easily converted to cash.
 Loan - A monetary advance from a lender to a borrower.
 Master Account - A Master Account has subsidiary accounts. Accounts Receivable could be a
master account for various individual receivable accounts.
 Net Income - Net Income equals revenue minus expenses, taxes, depreciation and interest.
 Non-Cash Expense - Does not require cash outlay, e.g. - depreciation.
 Non-operating Income - Income not generated from the business. An example might be the sale
of unused equipment.
 Note - A Note is a document promising to repay a debt.
 Operating Income - Determined by subtracting operating expenses from operating revenue.
Interest and income tax expenses are not included.
 Other Income - Non-recurring income, e.g. - interest.
 Payroll - An account listing employees and any wages and salaries due them.
 Posting - Refers to the recording of ledger entries.
 Profit - Profit is revenue minus expenses. Reductions for taxes, interest, and depreciation are
included.
 Profit/Loss Statement - A financial report issued by a company on a regular basis that discloses
earnings, expenses and net profit for a given time period.
 Reconciliation - The act of proving an account balances; debits and credits equal. An example of
reconciling an account is to verify that the bank statement matches the checkbook balance,
making allowances for outstanding checks and deposits.
 Retained Earnings - Money left after all the bills have been paid and all the shareholder
dividends have been distributed; often reinvested in the business.

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  Revenue - The actual amount of money a company brings in during a particular time period;
gross income.
 Shareholder Equity - A company’s total assets less its total liabilities; owner’s equity; net
worth. Shareholder equity comes from the start-up capital of the business plus retained earnings
amassed over time.
 Single-Entry Bookkeeping - An accounting process that uses on one entry, instead of debit and
credit entries. Small businesses using cash accounting system benefit from the ease of this
system, which is much like keeping a checkbook.
 Statement of Account - A written document that shows all charges and payments; accounts
receivable statement; accounts payable statement. Generally, a monthly accounts receivable
statement is sent to a charge customer; and reconciled by an accounts payable clerk for payment.
 Subsidiary Accounts - Accounts that are under a control account; they must equal the main
account balance. Examples of subsidiary accounts may be “Office Supplies,” or “Cleaning
Supplies,” under the control account called “Supplies.”
 Supplies - Consumable materials used in business and replenished as needed. Supplies are not
inventory for sale; rather they are used to carry out business activities.
 Treasury Stock - Shares a company retains or buys back once offered to the public for purchase.
 Write-down/Write-off - An accounting transaction that reduces the value of an asset.

Abbreviations used in bookkeeping -

a/c – account
B/S – Balance Sheet
c/d – carried down
b/d – brought down
b/f – brought forward
Dr – Debit record
Cr – Credit record
P&L – Profit & Loss
TB – Trial Balance

ACCOUNTING EQUATION
An Accounting Equation is based on the dual aspect concept. In the dual aspect concept, we discussed
that every business transaction has a two-sided effect, that is, on the assets and also claims on assets.
The total claims (those of outsiders and of the proprietors) will always equal the total assets of the firm.
We can express the same as :
Assets = Liabilities + Capital
Or
Liabilities = Assets – Capital
Or
Capital = Assets – Liabilities
The above relationship is usually known as the accounting equation or the balance sheet equation. The
Accounting Equation is the basis for Double Entry System of accounting.

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 An Accounting Equation always holds true with every change that occurs due to a transaction taking
place. It is because of this reason that it is based on the dual aspect concept of accounting which holds
that for every debit or credit there is equal credit or debit.

Accounting Equation- Practical Problems

1. What will be the effect of the following on the Accounting Equation?
i. Harish started business with cash Rs.18,000
ii. Purchased goods for cash 5,000 and on credit Rs.2,000
iii. Sold goods for cash Rs.4,000 (costing Rs.2,400)
iv. Rent paid Rs.1,000 and rent outstanding Rs.200
Ans. Rs. 20,600

2. Prepare an Accounting Equation and Balance Sheet on the following basis:

i. Ajeet started business with cash Rs.20,000.
ii. He purchased furniture for Rs.2,000.
iii. He paid rent of Rs.200.
iv. He purchased goods on credit Rs.3,000.
v. He sold goods (cost price Rs.2,000) for Rs.5,000 on cash.
Ans. Rs. 25,800 B/S

3. Prove that the Accounting Equation is satisfied in all the following transactions of Suresh. Also
prepare a Balance sheet.
i. Commenced business with cash Rs.60,000.
ii. Paid rent in advance Rs.500.
iii. Purchased goods for cash Rs.30,000 and credit Rs.20,000.
iv. Sold goods for cash Rs.30,000 costing Rs.20,000.
v. Paid salary 500 and salary outstanding being Rs.100
vi. Bought motorcycle for personal use Rs.5,000.
Ans. Rs. 85,500

4. Raghunath had the following transaction in an accounting year:

i. Commenced business with cash Rs.50,000.
ii. Paid into bank Rs.10,000.
iii. Purchased goods for cash Rs.20,000 and credit Rs.30,000.
iv. Sold goods for cash Rs.40,000 costing Rs.30,000.
v. Rent paid Rs.500.
vi. Rent outstanding Rs.100.
vii. Bought furniture Rs.5,000 on credit.
viii. Bought refrigerator for personal use Rs.5,000.
ix. Purchased motorcycle for cash Rs.20,000.
Create an Accounting Equation to show the effect of the above transactions on his assets, liabilities and
capital and also show his final Balance sheet.
Ans. Rs. 89,500

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