Chapter 1

The Nature of Accounting

Accounting is the process of recording, summarizing, analyzing, and
interpreting financial (money related) activities to permit individuals and
organizations to make informed judgments and decisions.

The American Institute of Certified Public Accountant has defined Financial

Accounting as:
“the art of recording, classifying and summarizing in a significant manner and
in terms of money, transactions and events which in part at least of a financial
character and interpreting the results thereof.”

Objectives and Scope of Accounting

To keep systematic records:

To ascertain profitability:

To ascertain the financial position of the business:

To assist in decision-making:

To fulfill compliance of Law:

What is Business : a person's regular occupation, profession, or trade is

called business. A business, also known as an enterprise, agency or
a firm, is an entity involved in the provision
of goods and/or services to consumers.

There are different types of business organizations:

• Service business—doctors, lawyers, barber shop, etc.
• Trading business—purchases goods for resale
• Manufacturing business—produces a product to sell

Method of Business :

1. Sole proprietors

This is the simplest and the most common type of business out there. The
sole proprietor is responsible for everything the business does.

2. Partnership
Partnerships comprise two or more people and any profits, debts and
decisions related to the business are shared.

3. Company

Companies are owned by shareholders who each put an amount of money

into a central pool. This pool of capital is then added to by borrowing and
other forms of finance. Directors run the company on behalf of shareholders,
who receive a share of the profits. Each shareholder receives a portion – or
share – of the company that is equivalent to what they put in.

4. Franchise

Franchises are licensing arrangements whereby an individual or group can

buy the right to trade and produce under a well-known brand name in a given
locality. A franchise involves you using another company’s successful
business model – and name – to establish your own business.

Accounting Concepts
The most important concepts of accounting are as follows:
 Business Entity Concept
 Money Measurement Concept
 Going Concern Concept
 Cost Concept
 Dual Aspects Concept
 Accounting Period Concept
 Matching Concept
 Accrual Concept
 Objective Evidence Concept

Business Entity Concept

According to this concept, the business and the owner of the business are
two different entities. In other words, I and my business are separate.

For example, Mr A starts a new business in the name and style of M/s P R
Trading Company and introduced a capital of Rs 2,00,000 in cash. It means
the cash balance of M/s P R Trading Company will increase by a sum of Rs
2,00,000/-. At the same time, the liability of M/s P R Trading Company in the
form of capital will also increase. It means M/s P R Trading Company is liable
to pay Rs 2,00,000 to Mr A.
Money Measurement Concept
According to this concept, ―we can book all transactions in our accounting
record measured in monetary terms.‖

Going Concern Concept

Our accounting is based on the assumption that a business unit is a going
concern. We record all the financial transaction of a business in keeping this
point of view in our mind that a business unit is a going concern; not a gone
concern. Otherwise, the banker will not provide loans, the supplier will not
supply goods or services, the employees will not work properly, and the
method of recording the transaction will change altogether.
PROFIT MOTIVE : ALL BUSNIESS TRANSACTION
MUST HAVING PROFIT MOTIVE.
Cost Concept
It is a very important concept based on the Going Concern Concept. We book
the value of assets on the cost basis, not on the net realizable value or
market value of the assets based on the assumption that a business unit is a
going concern. No doubt, we reduce the value of assets providing
depreciation to assets, but we ignore the market value of the assets.
Dual Aspect Concept
There must be a double entry to complete any financial transaction, means
debit should be always equal to credit. Hence, every financial transaction has
its dual aspect:
 we get some benefit, and
 we pay some benefit.

For example, if we buy some stock, then it will have two effects:
 the value of stock will increase (get benefit for the same amount), and
 it will increase our liability in the form of creditors.

Accounting Period Concept

To determine the profit or loss of a firm, and to ascertain its financial position,
profit & loss accounts and balance sheets are prepared at regular intervals of
time, usually at the end of each year. This one-year cycle from 1-April to 31-
March is known as the accounting period.

The purpose of having an accounting period is to take corrective measures

keeping in view the past performances, to nullify the effect of seasonal
changes, to pay taxes, etc.
Based on this concept, revenue expenditure and capital expenditure are
segregated. Revenues expenditure are debited to the profit & loss account to
ascertain correct profit or loss during a particular accounting period. Capital
expenditure comes in the category of those expenses, the benefit of which
will be utilized in the next coming accounting periods as well. Accounting
period helps us ascertain correct position of the firm at regular intervals of
time, i.e., at the end of each accounting period.

Objective Evidence Concept

According to the Objective Evidence concept, every financial entry should be
supported by some objective evidence. Purchase should be supported by
purchase bills, sale with sale bills, cash payment of expenditure with cash
memos, and payment to creditors with cash receipts and bank statements.
Similarly, stock should be checked by physical verification and the value of it
should be verified with purchase bills. In the absence of these, the accounting
result will not be trustworthy, chances of manipulation in accounting records
will be high, and no one will be able to rely on such financial statements.

THE ELEMENTS OF ACCOUNTING

Capital : Capital account is personal account. Whenever the owner

introduces capital in the form of cash, goods or assets,

Drawing : Whenever the owner of the business withdraws money for his
personal use, it is called drawing.

ASSETS : Assets are items with money value that are owned by a business.

 Fixed Assets : It also known as tangible assets or property, plant, and

equipment (PP&E), is a term used in accounting for assets and property that
cannot easily be converted into cash.
 Current Assets : In accounting, a current asset is any asset which can
reasonably be expected to be sold, consumed, or exhausted through the normal
operations of a business within the current fiscal year or operating cycle
(whichever period is longer). Typical current assets include cash, cash
equivalents, short-term investments, accounts receivable, stock inventory and
the portion of prepaid liabilities which will be paid within a year.

LIABILITIES
Liabilities are debts owed by the business. Paying cash is often not possible
or convenient, so businesses purchase goods and services on credit. The
name of the account used is Accounts Payable.
What are 'Long-Term Liabilities'
Long-term liabilities, in accounting, form part of a section of
the balance sheet that lists obligations of the company that
become due more than one year into the future. Long-
term liabilities include items like debentures, loans, and
pension obligations.
Current liabilities are a company's debts or obligations that are due
within one year include short term debt, accounts payable,
accrued liabilities and other debts. Essentially, these are bills that
are due to creditors and suppliers within a short period of time.

Another type of liability is Notes Payable. This is a formal written promise to

pay a specific amount of money at a definite future date.

OWNER’S EQUITY
The difference between Assets and Liabilities is Owner’s Equity. The can also
be called capital, proprietorship, or net worth.

Bank A/c :
TYPES OF BANK ACCOUNTS IN INDIA (Deposit Accounts)

CURRENT DEPOSITS / ACCOUNTS

SAVING BANK / Saving Fund DEPOSITS / ACCOUNTS
RECURRING DEPOSITS / ACCOUNTS
FIXED DEPOSITS / ACCOUNTS OR TERM DEPOSITS
What is a Current Account
Current Accounts are basically meant for businessmen and are never used for
the purpose of investment or savings. These deposits are the most liquid
deposits and there are no limits for number of transactions or the amount of
transactions in a day. Most of the current account are opened in the names of
firm / company accounts. Cheque book facility is provided and the account
holder can deposit all types of the cheques and drafts in their name or endorsed
in their favour by third parties. No interest is paid by banks on these accounts.
On the other hand, banks charges certain service charges, on such accounts.
What is a Savings Bank Account ?
These deposits accounts are one of the most popular
deposits for individual accounts. These accounts not only
provide cheque facility but also have lot of flexibility for
deposits and withdrawal of funds from the account.
What are Recurring Deposit Accounts ?

These are popularly known as RD accounts and are

special kind of Term Deposits and are suitable for
people who do not have lump sum amount of savings,
but are ready to save a small amount every month.
Systematic investment plan

What are Fixed Deposit Accounts in India or Term

Deposits

All Banks in India (including SBI, PNB, BoB, BoI,

Canara Bank, ICICI Bank, Yes Bank etc.) offer fixed
deposits schemes with a wide range of tenures for
periods from 7 days to 10 years. These are also
popularly known as FD accounts. However, in some
other countries these are known as "Term Deposits"
or even called "Bond".

OD A/C (OVER DRAFT A/C)

LAS A/C (LOAN AGAINST SECURITY)
LIMIT A/C
PURCHASE :
The activity of acquiring goods or services to accomplish the goals of its
enterprises. The main purpose of goods bought is selling the goods.

Sales : In accounting, sales refers to the

revenues earned when a company sells its goods,
products, etc. (If a company sells one of its
noncurrent assets that was used in its business,
the amount received is not recorded in
its Sales account.)
A sale may be made on cash or on credit.

Mortgage
Cash Sale : cash / dr card / cr
card
Credit Sale : Cheque / Draft

Trade Discount
Trade discount is allowed by seller to buyer
directly on their sales invoice. Buyer in this
case are usually whole-sellers, traders or
manufacturers, who further sell this material to
their customers or use the material in their
manufacturing process

Cash discount : Cash

discount is also allowed by
seller to his buyer; still it
does not come in the
category of trade discount.
Cash discount is a sort of
scheme to inspire their
debtors to release their due
payment in time.

Bad Debts
Part of credit sale which is
unrecovered from debtors due to
some reason like insolvency,
dishonesty, etc. are called bad
debts of the company. Bad debts
are loss to the company.

There are a few types of expenses

incurred on the purchases of goods like
inward freight, octroi, cartage, unloading
charges, etc
Expenses are also incurred while selling products to customers such as
freight outward, insurance charges, etc.

Outstanding Expenses
we need to book those expenses which are due for payment and to be paid in
the next accounting year. For example, the salary due on the last day of the
accounting year to be paid in the next year.

Prepaid Expenses
Sometimes we pay expenses in advance such as insurance paid three
months before the closing of the accounting year. Since insurance is usually
paid for the whole year, in this case, the insurance for nine months is treated
as prepaid insurance. Similarly, rent for the first month of next accounting
year may be paid in advance.

Banking Transactions
(1) Cheque deposited in bank
(2) Payment made to party through cheque
(3) Cash withdrawn for office Expenses
(4) Cash deposited with Bank
(5) Bank charge debited by bank
Interest on Capital
Interest on capital, introduced by sole proprietor or partners of the firm:

Cash Book
Cash book is a record of all the transactions related to cash. Examples
include: expenses paid in cash, revenue collected in cash, payments made to
creditors, payments received from debtors, cash deposited in bank,
withdrawn of cash for office use, etc.

BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION

A transaction is any activity that changes the value of a firm’s assets,
liabilities, or owner’s equity.
Each transaction has a dual effect on the basic accounting elements. A
transaction may affect more than
two accounts in a transaction. This is called a combined entry.

A ―T” ACCOUNT is so named because it looks like a capital T. Use this form
of an account to help you
determine whether the amount is placed on the left (debit) or right (credit) side
of the account.
It is important that you think of debits and credits as only meaning left and
right!
Double-entry accounting means that there will be at least two (2) accounts
affected by each transaction.

Rules of Debit and Credit under Double Entry System of Accounts

The following rules of Rules Effect
debit and credit are
called the golden rules
of accounts:
Classification of
accounts
Personal Accounts Receiver is Debit Debit = credit
Giver is Credit
Real Accounts What Comes In Debit Debit = credit
What Goes Out Credit
Nominal Accounts Expenses are Debit Debit = credit
Incomes are Credit

Trial Balance
Trial balance is a summary of all the debit and credit balances of ledger
accounts. The total of debit side and credit side of trial balance should be
matched. Trial balance is prepared on the last day of the accounting cycle.
Trial balance provides us a comprehensive list of balances. With the help of
that, we can draw financial reports of an organization. For example, the
trading account can be analyzed to ascertain the gross profit, the profit and
loss account is analyzed to ascertain the profit or Loss of that particular
accounting year, and finally, the balance sheet of the concern is prepared to
conclude the financial position of the firm.

Financial Statements

Financial statements are prepared to ascertain the profit or loss of the

business, and to know the financial position of the company.
Trading, profit & Loss accounts ascertain the net profit for an accounting
period and balance sheet reflects the position of the business.
All the above has almost a fixed format, just put all the balances of ledger
accounts into the format given below with the help of the trial balance. With
that, we may derive desired results in the shape of financial equations

Current Assets

in bank, fixed deposit receipts (FDRs), inventory, debtors, receivable bills,

short-term investments, staff loan and advances; all these come Financial
Accounting
35

under current assets. In addition, prepaid expenses are also a part of current
assets.
Current Liabilities Like current assets, current liabilities are immediate
liabilities of the firm that are to be paid within one year from the date of
balance sheet.
Current liabilities primarily include sundry creditors, expenses payable, bills
payable, short-term loans, advance from customers, etc.

Depreciation

Depreciation reduces the value of assets on a residual basis. It also reduces

the profits of the current year.
Depreciation indicates reduction in value of any fixed assets. Reduction in
value of assets depends on the life of assets. Life of assets depends upon the
usage of assets.

Depreciation= Cost of Assets−Scrap Value of AssettsEstimated Life of Assets

Classification of Accounts
It is necessary to know the classification of accounts and their treatment in
double entry system of accounts. Broadly, the accounts are classified into
three categories:

1. Personal accounts
2. Real accounts
a. Tangible accounts
b. Intangible accounts
3. Nominal accounts

Let us go through them each of them one by one.

Personal Accounts
Personal accounts may be further classified into three categories:
Natural Personal Account
An account related to any individual like David, George, Ram, or Shyam is
called as a Natural Personal Account.
Artificial Personal Account
An account related to any artificial person like M/s ABC Ltd, M/s General
Trading, M/s Reliance Industries, etc., is called as an Artificial Personal
Account.
Representative Personal Account
Representative personal account represents a group of account. If there are a
number of accounts of similar nature, it is better to group them like salary
payable, rent payable account, insurance prepaid account, interest receivable
account, capital account and drawing account, etc.

Real Accounts
Every Business has some assets and every asset has an account. Thus,
asset account is called a real account. There are two type of assets:
 Tangible assets are touchable assets such as plant, machinery,
furniture, stock, cash, etc.

 Intangible assets are non-touchable assets such as goodwill, patent,

copyrights, etc.

Accounting treatment for both type of assets is same.

Nominal Accounts
Since this account does not represent any tangible asset, it is called nominal
or fictitious account. All kinds of expense account, loss account, gain account
or income accounts come under the category of nominal account. For
example, rent account, salary account, electricity expenses account, interest
income account, etc.

Accounting Systems

There are two systems of accounting followed:

 Single Entry System
 Double Entry System

Single Entry System

Single entry system is an incomplete system of accounting, followed by small
businessmen, where the number of transactions is very less. In this system of
accounting, only personal accounts are opened and maintained by a business
owner. Sometimes subsidiary books are maintained and sometimes not.
Since real and nominal accounts are not opened by the business owner,
preparation of profit & loss account and balance sheet is not possible to
ascertain the correct position of profit or loss or financial position of business
entity.

Double Entry System

Double entry system of accounts is a scientific system of accounts followed
all over the world without any dispute. It is an old system of accounting. It was
developed by ‘Luco Pacioli’ of Italy in 1494. Under the double entry system
of account, every entry has its dual aspects of debit and credit. It means,
assets of the business always equal to liabilities of the business.

Assets = Liabilities
Method of Depreciation
Depreciation can be calculated using any of the following methods, however
the most popular methods remain (a) Straight Line Method and (b) Written
Down Value Method.
 Straight Line Method
 Written Down Value Method
 Annuity Method
 Insurance Policy Method
 Machine Hour Rate Method
 Depletion Method
 Revaluation Method
 Depreciation Fund Method
Accrual Concept
As stated above in the matching concept, the revenue generated in the
accounting period is considered and the expenditure related to the accounting
period is also considered. Based on the accrual concept of accounting, if we
sell some items or we rendered some service, then that becomes our point of
revenue generation irrespective of whether we received cash or not. The
same concept is applicable in case of expenses. All the expenses paid in
cash or payable are considered and the advance payment of expenses, if
any, is deducted.
Most of the professionals use cash basis of accounting. It means, the cash
received in a particular accounting period and the expenses paid cash in the
same accounting period is the basis of their accounting. For them, the income
of their firm depends upon the collection of revenue in cash. Similar practice
is followed for expenditures. It is convenient for them and on the same basis,
they pay their Taxes.

Accounting Period Concept

The purpose of having an accounting period is to take corrective measures

keeping in view the past performances, to nullify the effect of seasonal
changes, to pay taxes, etc.
Based on this concept, revenue expenditure and capital expenditure are
segregated. Revenues expenditure are debited to the profit & loss account to
ascertain correct profit or loss during a particular accounting period. Capital
expenditure comes in the category of those expenses, the benefit of which
will be utilized in the next coming accounting periods as well. Accounting
period helps us ascertain correct position of the firm at regular intervals of
time, i.e., at the end of each accounting period.