1.

1 Introduction
Commercial businesses run with the objective of earning profit, and financial transactions are the
order of the day. It becomes essential for a business owner to keep a record of the business' income
and expenditure, in order to find answers to numerous questions, a few of which are:

 Is the business earning profits or is it incurring a loss?

 How much do third parties owe the business?
 How much does the business owe to third parties?
 Can the business be expanded?
 Should a specific operation be withdrawn?
 What is the total value of business assets?

These answers can be arrived at, by studying the financial information of a business operation. Thus,
accounting is an integral part of any business.

Accounting is the practice of maintaining precise records of the financial dealings of a business. It
involves identifying business transactions, recording them, and summarising the same in such a way
that important financial information can be communicated to the stakeholders of the business.
Accounting is also called as language of business.

The stakeholders of a typical business concern are:

Owners

Management

Employees

Investors (existing and potential)

Suppliers

Customers

Lending institutions

Government authorities

1.2 Accounting Terms

To help you understand accountancy better, a few commonly-used accounting terms are explained
below:

1. Transaction
A transaction is a business activity that involves the transfer of money or money's worth between
two accounts. A transaction can be of two types:

 Cash transaction: A cash transaction is one where money is immediately received or paid in
the form of cash.
 Credit transaction: A credit transaction is one where money is paid later, but the benefits
are enjoyed immediately.

2. Capital

Total amount of money or money worth invested in the business by owner is called capital.

3. Assets:

Anything possessed or owned by an individual or company, which are not for usual selling or trading
purpose and utilised over a period of time are called assets.

4. Liability:

Liability is the amount due for the goods, services or anything taken from party or anyone is called as
liability of the business.

5. Drawings

The money withdrawn or taken something of money worth from business for the personal use is
called drawings.

6. Bad debts:

The amount which is unrecoverable from the debtor due to reason like insolvency or absconding and
company will not be able to realize due amount from the debtor, hence the unrealized amount is
called bad debts.

7. Purchases:

A purchase is the amount of goods bought by a business for further use or for reselling. Goods
purchased with immediate payment of cash are called cash purchases. Goods purchased on credit
are called credit purchases.

8. Purchase returns:

Goods that have been purchased but are returned to the seller before consumption due to reasons
like poor quality and damage are called 'purchase returns.

9. Sales:
Sales refer to the amount of goods sold by a business. Sales made against immediate payment of
cash are called cash sales. Sales on credit, are called credit sales.

10.Sales returns:

Goods that have been sold but are returned by the buyer before consumption, due to reasons like
poor quality and damage, are called 'sales returns'

11. Debtor:

A debtor is a person who receives benefits from the business immediately, but is obligated to pay for
the same in future. For example, a buyer who purchases goods from the business on credit, becomes
a debtor to the business.

12.Creditor:

A person who provides benefit without receiving immediate payment for the same, and who will
claim the payment in future, is called a 'creditor. For example, when the business purchases goods
on credit from a supplier, the supplier becomes a creditor to the business.

13. Stock:

Unsold goods, raw material, etc., that lie with the business are collectively known as 'stock.

14.Revenue:

The earnings of a business through its activities and operations, is called 'revenue'.

1.3 Accounting Assumptions, Concepts

and Principles.
To ensure that the interpretation of financial information derived from accounting is uniform, the
following assumptions, concepts, and principles have been developed. They form the basis for
accountancy.

1.3.1 Assumptions
1. Accounting Entity Assumption:

As per this assumption, a business is considered as a separate unit or entity from its owner. That is,
the proprietor and his business are treated as two distinct entities. Therefore, the transactions of the
business are separate from its owner's personal transactions. All the business transactions are
recorded in the Books of Accounts from the business' perspective.

Example: A vehicle purchased by the business owner for his personal use, should not be recorded in
the business' Books of Accounts.
2. Accounting Period Assumption:

The stakeholders of a business use its financial statements and periodical reports to assess the
operational and the financial position of the business concern. Thus, it is essential for a business to
close its accounts at regular intervals. A time span of 365 days or 52 weeks or 1 year is generally
considered as the accounting period.

Note
A year that begins on 1st January and ends on 31st December is a Calendar Year. For some
businesses the calendar year is also the financial year.

For Example: In Bangladesh, the financial year starts from 1 July and ends on next 30 June. In Iran,
the financial year starts from 21st March and ends on next 20th March.

3. Going Concern Assumption:

As per this assumption, accounts have to be maintained with an expectation that the business will
exist for a long period. That is, the business will run with the assumption that it intends to continue,
and there will be no need to close operations in the near future. Example: The cost of a plant or
machinery acquired by a company, will be accounted for across financial year that is, the total cost
of acquisition will not be reflected in the accounts of the same year as its acquisition; the cost will be
broken into specific amounts which will be accounted for in subsequent years of the business. This is
done with the assumption that the business concern will continue to operate in the forthcoming
year.

4. Money Measurement Assumption: According to this assumption, only those business

transactions that can be measured in terms of money are recorded. Example: The sales made by a
business during a particular day will be recorded in its books of accounts, as it can be expressed in
terms of money. However, aspects like employee satisfaction will not be recorded in the books of
accounts, as they cannot be accounted in terms of money.

1.3.2 Concepts
1. Accrual Concept:

This concept requires that income or expenditure are recorded when they become receivable or
payable rather than when they are collected or paid i.e., transactions are recorded on the basis of
income earned or expense incurred irrespective of actual receipt or payment.

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.

2.Dual Aspect Concept:

This concept states that every financial transaction has two aspects: one where the business receives
a benefit, and the other where it provides a benefit. Therefore, every transaction should be recorded
in such a way that its effect is reflected in two places in a business' books of accounts. This concept
forms the basis for the Double Entry System of Accounting.

Example: When a business buys a machinery, it receives a benefit (the machinery), and also
provides a benefit (pays for the machinery).

3. Full Disclosure Concept:

The various stakeholders of a business derive important information from its financial statements.
Hence, this concept explains that the financial records of a business concern give a true and fair view
of the business' financial position.

4. Historical Cost Concept:

This concept states that assets need to be recorded, at the price paid for their acquisition, and not at
their current market value. Thus, a business' financial statement will not indicate the price at which
its assets could be sold for, Example: If a business has purchased a machinery for 10,00,000, and its
market value has come down to 8,00,000 at the time of preparing final accounts, the value will be
recorded as * 10,00,000.

5. Matching Concept:

As per this concept, the revenue earned and the cost incurred to earn such revenue, need to belong
to the same period, and hence they need to be 'matched. This will help ascertain the result of the
business operations. This concept serves as the basis for calculating accurate profit earned during a
period.

Example: A business pays ₹ 1,00,000 as factory rent. Other expenses incurred for business
operations like salaries and wages paid, maintenance of machinery, etc., amount to 15,00,000. The
sales, made for the month, amount to Rs 25,00,000. The profit of the business will be 9,00,000,
which is the revenue minus expenses

6. Revenue Realisation Concept:

According to this concept, revenue is considered as the income earned on the date when it is
received. 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.

Example: On 25th December 2017, ABC Company received a sales order to supply goods worth
50,00,000 to M/s. National Traders ABC Company delivered goods worth 35,00,000 on 31th
December. The remaining supply was delivered on 2nd January 2017. The revenue from this
transaction for 2017 will be Rs 35,00,000 only. The remaining amount of 15,00,000 should be
accounted for in 2017.

7. Verifiable and Objective Evidence Concept:

This concept requires that all financial transactions be supported with documentary evidence. Such
evidence should be easy to verify, and also provide unbiased proof of transaction.

Example: If a piece of land is purchased by a business, the transaction needs to be supported by the
relevant documents like the Title Deed.

1.3.3 Principles
1. Cost Benefit Principle:

This principle states that the cost incurred for applying an accounting principle should be lesser than
the profits derived from doing so.

2.Materiality Principle:

As stated earlier in this chapter, financial statements are used by the various stakeholders to do
analysis and arrive at decisions. Hence, all information that is disclosed in financial statements,
should aid the interested parties in arriving at decisions.

3. Consistency Principle:

The accounting practices adopted by a business for a year should be applied in the coming years too.
That is, the accounting practices followed for one financial year should not vary from those of the
previous financial year. Consistency in accounting practices facilitates the comparison of financial
statements across years and can help draw important conclusions about a business.

4.Prudence (Conservatism) Principle:

This principle highlights the uncertainty with which businesses operate. It requires that a business
make provisions for probable losses, but operate by anticipating profits.
Conservatism leads accountants to anticipate/disclose losses, but it does not allow a similar action
for gains.

1.4 Double Entry System of Accounting

Every business transaction has a two-fold effect, wherein two accounts are affected in opposite
directions. Thus, if a complete record were to be made of each such transaction, it is necessary to
debit one account and credit another account. Recording of this two-fold effect of every transaction
is called the Double Entry System of Accounting.

As explained in the Dual Aspect Concept, every financial transaction has two aspects: one where the
business receives a benefit, and the other where it provides benefit. Therefore, every transaction
should be recorded in such a way that its effect is reflected in two places in a business Books of
Accounts. The receiving aspect is termed the 'Debit' aspect. The giving aspect is termed the 'Credit'
aspect. Therefore, every business transaction will have an effect on two accounts; one will be
debited, whereas the other will be credited.

1.5 Types of Accounts

An’ account' is a statement of transactions relating to one of the two aspects of a business
transaction. Based on the aspect being recorded, an account can be 'debited' or 'credited.

Accounts are classified based on the three categories of business transactions:

 Transactions involving individuals or other business entities

 Transactions involving assets, goods, cash
 Transactions involving incomes, expenses, losses and gains.

In effect, there are three types of accounts maintained for transactions:

Personal Accounts:

Personal Accounts are relating to individuals, a group of individuals, firms and

institutions. They are of three types:

 Natural person's accounts: represents the accounts of real persons the business deal with.
The proprietor's account, the accounts of suppliers and customers are some examples of
natural person's accounts.
 Artificial person's accounts: represents the accounts of firms the business deals with. The
accounts of a limited companies or banks that are not real persons are the examples of
artificial person's accounts.

 Representative personal account: If a business has not paid the rent of a number of shops
for the past two months then all the landlords are creditors of the business and the amount
 due to them is recorded under a common head called Rent Outstanding Account. This is a
representative personal account,

Real Accounts:
Real accounts are relating to the property or assets and cash belonging to a business
concern.

They can be of two types:

 Tangible Real accounts: are accounts of things that can be touched, measured, sold or
purchased. Examples of tangible real accounts are furniture account, plant and machinery
account, and cash account.
 Intangible Real accounts: are accounts of things that cannot be touched in the physical
sense but can be measured in terms of money value. Goodwill, trademark, and patents,
copyrights are examples of intangible real accounts.

Nominal Accounts
Nominal accounts relating to the incomes, expenses, losses and gains of a business concern.
Without nominal accounts, it is difficult for the management to find out where the money
was spent. The net result of all the nominal accounts helps the management to find out the
profit earned or loss incurred by the business.

Example: Salary accounts, discount allowed, discount received, etc.,

1.6 Golden Rules of Accounting

The Golden Rules of Accounting are guidelines that every accountant should follow while
recording business transactions.
The Rules are:

Type of Accounts Golden Rules

Debit the receiver

Personal accounts
Credit the giver

Debit what comes in

Real accounts
Credit what goes out

Debit all expenses and losses

Nominal accounts Credit all income and gains

Table 1.1

Note
The cash basis of accounting is a method wherein revenue is recognised 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 used by businesses and is, therefore,
used only in select situations such as for very small businesses.

Rule for Personal Accounts

In a Personal account, the rule to be followed is, "Debit the receiver; Credit the giver".

The debit balance in a personal account shows that the business has to receive money or
money equivalent, and the credit balance shows that the business owes something.

For example: A sale of iPhone 7 for ₨ 80,000 is made to Mr. Praveen, a customer of PG &
Co. who does not make the payment at the time of the sale. In such a case Mr. Praveen is
liable to pay ₹ 80,000 to PG & Co. Hence, in the books of