UNIT I

Meaning and Scope of Accounting: Evolution and Users of Accounting, Basic Accounting terminologies,
Principles of Accounting, Accounting Concepts & Conventions, Accounting Equation, Deprecation
Accounting. GAAP(introduction).
Definition of Accounting
Accounting can be defined as a process of reporting, recording, interpreting and summarising economic data.
The introduction of accounting helps the decision-makers of a company to make effective choices, by providing
information on the financial status of the business.
The American Institute of Certified Public Accountants (AICPA) had defined accounting as the “art of
recording, classifying, and summarising in a significant manner and in terms of money, transactions and events
which are, in part at least, of financial character, and interpreting the results thereof”.
Today, accounting is used by everyone and a good understanding of it is beneficial to all. Accountancy act as a
language of finance. To understand accounting efficiently, it is important to understand the aspects of
accounting.
 Economic Events- It is a consequence of a company has to undergo when the number of monetary
transactions is involved. Such as purchasing new machinery, transportation, machine installation on-site,
etc.
 Identification, Measurement, Recording, and Communication- The accounting system should be
outlined in such a way that the right data is identified, measured, recorded and communicated to the
right individual and at the right time.
 Organization-In refers to the size of activities and level of a business operation.
 Interested Users of Information- It is about communicating important financial information to the
customers, according to which they will make the correct decision.
Fundamentals of Accounting
 Assets- The economic value of an item which is possessed by the enterprise is referred to as Assets. To
put it in other words, assets are those items that can be transformed into cash or that generates income
for the enterprise shortly. It is useful in paying any expenses of the business entity or debt.
 Liabilities- The economic value of an obligation or debt that is payable by the enterprise to other
establishment or individual is referred to as liability. To put it in other words, liabilities are the
obligations that are rising out of previous transactions, which is payable by the enterprise, through the
assets possessed by the enterprise.
 Owner’s Equity- Owner’s equity is one of the 3 vital segments of a sole proprietorship’s balance sheet
and one of the main aspects of the accounting equation: Assets = Liabilities + Owner’s Equity. It depicts
the owner’s investment in the trade minus the owner’s withdrawal from the trade + the net income since
the business concern commenced.
Objectives of Accounting
The main objectives of accounting are:
To maintain a systematic record of business transactions
 Accounting is used to maintain a systematic record of all the financial transactions in a book of
accounts.
 For this, all the transactions are recorded in chronological order in Journal and then posted to principle
book i.e. Ledger.
To ascertain profit and loss
 Every businessman is keen to know the net results of business operations periodically.
 To check whether the business has earned profits or incurred losses, we prepare a “Profit & Loss
Account”.
To determine the financial position
 Another important objective is to determine the financial position of the business to check the value of
assets and liabilities.
 For this purpose, we prepare a “Balance Sheet”.
To provide information to various users
  Providing information to the various interested parties or stakeholders is one of the most important
objectives of accounting.
 It helps them in making good financial decisions.
Characteristics of Accounting:
The following attributes or characteristics can be drawn from the definition of Accounting:
(1) Identifying financial transactions and events
 Accounting records only those transactions and events which are of financial nature.
 So, first of all, such transactions and events are identified.
(2) Measuring the transactions
 Accounting measures the transactions and events in terms of money which are considered as a common
unit.
(3) Recording of transactions
 Accounting involves recording the financial transactions inappropriate book of accounts such as Journal
or Subsidiary Books.
(4) Classifying the transactions
 Transactions recorded in the books of original entry – Journal or Subsidiary books are classified and
grouped according to nature and posted in separate accounts known as ‘Ledger Accounts’.
(5) Summarising the transactions
 It involves presenting the classified data in a manner and in the form of statements, which are
understandable by the users.
 It includes Trial balance, Trading Account, Profit and Loss Account and Balance Sheet.
(6) Analysing and interpreting financial data
 Results of the business are analyzed and interpreted so that users of financial statements can make a
meaningful and sound judgment.
(7) Communicating the financial data or reports to the users
 Communicating the financial data to the users on time is the final step of Accounting so that they can
make appropriate decisions.
What are the Different Branches of Accounting?
The following are the main branches of accounting:
(a) Financial accounting:
Financial Accounting is that branch of accounting which involves identifying, measuring, recording,
classifying, summarising the business transactions, i.e. it involves the steps from Identifying, Recording of
transactions to Summarisation, and communicating the financial data.
(b) Cost accounting:
Cost Accounting is that branch of accounting which is concerned with the process of ascertaining and
controlling the cost of products or services.
(c) Management accounting
Management accounting refers to that branch of accounting which is concerned with presenting the accounting
information in such a way that helps the management in planning and controlling the operations of a business
and in decision making.
Steps of the Accounting Process:
Accounting process is the process of collecting, recording, classifying, summarising and communicating
financial information to the users for judgement and decision-making. The following steps are involved in
accounting process:
(1) Identification: It is the process of identifying and analysing business transactions.
(2)Recording: For recording, we use ‘Journal’ or Subsidiary Books.
(3) Classification of transactions: Classification means segregation of transactions on the basis of nature and
posting them in a format known as Ledger Account.
(4) Summarisation: It includes preparation of Trial Balance and Financial Statements.
(5) Analysis & Interpretation: It includes an assessment of the financial reports and making some meaningful
conclusions.
(6) Communicating information to the users: It includes sharing the financial reports and interprets results to the
users of financial statements.
Advantages of Accounting?
The following are the main advantages of accounting:
1. Provide information about financial performance
 Accounting provides factual information about financial performance during a given period of time
 Like, profit earned or loss incurred over a period and financial position at a particular point of time.
2. Provide assistance to management
 Accounting helps management in business planning, decision making and in exercising control.
 For this, it provides financial information in the form of reports.
3. Facilitates comparative study
 By keeping systematic records and preparation of reports at regular intervals, accounting helps in
making a comparison.
4. Helps in settlement of tax liability
 Systematic accounting records help in settlement of various tax liabilities. Such as – Income Tax, GST,
etc.
5. Helpful in raising loan
 Banks and Financial Institutions grant a loan to the firm on the basis of appraisal of the financial
statement of the firm.
6. Helpful in decision making
 Accounting provides useful information to the management for taking decisions.
What Are the Limitations of Accounting?
Following are the limitations of accounting:
 Accounting is not precise: Accounting is not completely free from personal bias or judgment.
 Accounting is done on historic values of assets: Accounting records assets at their historical cost less
depreciation. It does not reflect their current market value.
 Ignore the effect of price level changes: Accounting statements are prepared at historical cost. So
changes in the value of money are ignored.
 Ignore the qualitative information: Accounting records only monetary transactions. It ignores the
qualitative aspects.
 Affected by window dressing: Window dressing means manipulation in accounting to present a more
favourable position of the business than the actual position.
Explain the Users of Accounting Information:
Users may be categorised into internal users and external users.
(A) Internal Users
 Owners: Owners contribute capital in the business and thus they are exposed to maximum risk. So, they
are always interested in the safety of their capital.
 Management: Accounting information is used by management for taking various decisions.
 Employees: Employees are interested in the financial statements to assess the ability of the business to
pay higher wages and bonuses.
(B) External Users
 Banks and financial institutions: Banks and Financial Institutions provide loans to business. So, they
are interested in financial information to ensure the safety and recovery of the loan.
 Investors: Investors are interested to know the earning capacity of business and safety of the
investment.
 Creditors: Creditors provide the goods on credit. So they need accounting information to ascertain the
financial soundness of the firm.
 Government: The government needs accounting information to assess the tax liability of the business
entity.
 Researchers: Researchers use accounting information in their research work.
 Consumers: They require accounting information for establishing good accounting control, which will
reduce the cost of production.
Qualitative Characteristics of Accounting Information
Qualitative characteristics are the attributes of accounting information, which enhance its understandability and
usefulness:
 Reliability: Reliability implies that the information must be free from material error and personal bias.
 Relevance: Accounting information must be relevant to the decision-making requirements of the users.
 Understandability: Information should be disclosed in financial statements in such a manner that these
are easily understandable.
 Comparability: Both intra-firm and inter-firm comparison must be possible over different time periods.
Explain the System of Accounting
System of accounting
 There are following two systems of recording transactions in the books of accounts:
 Double Entry System
 Single Entry System
Double-entry system
 The double entry system is based on the Dual Aspect Principle.
 Every transaction has two aspects, ‘a Debit’ and ‘a credit’ of an equal amount.
 This system of accounting recognises and records both aspects of the transaction.
Single entry system
 Under this system, both aspects are not recorded for all the transactions.
 Either only one aspect is recorded or both the aspects are not recorded for all the transactions.
What Are the Advantages of the Double-entry System of Accounting?
Following are the main advantages of the double-entry system of accounting:
Scientific system
 As compared to the other systems, this system of recording transactions is more scientific and useful to
achieve the objective of accounting.
A complete record of the transaction
 Since both the aspects of transactions are considered there is a complete recording of each and every
transaction.
 Using these records we are able to compute profit or loss easily.
Checks arithmetical accuracy of accounts
 Under this system, by preparing a Trial Balance we are able to check the arithmetical accuracy of the
records.
Determination of profit/loss and depiction of financial position
 Under this system by preparing ‘Profit & Loss A/c’ we get to know about the profit earned or loss
incurred.
 By preparing the ‘Balance Sheet’ the financial position of the business can be ascertained, i.e. position
of assets and liabilities is depicted.
Helpful in decision making
 Administration and management are able to take decisions on the basis of factual information under the
double-entry system of accounting.
Basic Accounting Terms
Basic Accounting Terms
These basic accounting terms are critical for any student who wants to develop a deeper understanding of the
subject and pursue further studies in this stream. These terms and their definitions are as follows:
 Business Transaction – A business transaction is a financial event between two or more parties. It
involves an exchange of goods, services or money and gets recorded in the books of accounts for the
organisations involved.
 Capital – Capital is a critical component of any business to run its daily operations and help its future
growth. The capital for a business comes either from its owners or from outsiders (shares, debentures or
bonds).
 Drawings – Drawings refer to the withdrawals made by the owners of a business for personal use. It
gets deducted from the Owner’s Capital in the Liabilities side of a Balance Sheet.
  Liabilities (Non-Current and Current) – Current Liabilities are the amount due to the creditors of a
business that has to be paid back within twelve months. Non-Current Liabilities are the long-term
obligations of a company that are not due for payment before a year.
 Assets (Non-Current and Current) – Current Assets are the assets that a firm can liquidate within
twelve months. Non-Current Assets are the long-term investments of a business that they cannot
liquidate within a year.
 Fixed assets (Tangible and Intangible) – Tangible Fixed Assets are the long-term investments of a
business that have a physical existence. Intangible Fixed Assets are the long-term investments made by a
company that doesn’t have a physical existence.
 Expenditure (Capital and Revenue) – A business incurs Capital Expenditure to acquire assets for
long-term income generation. It also incurs Revenue Expenditure to run the day-to-day operations of a
business.
 Expense – Expenses in accounting refer to the cost incurred or money the business owners spend to
generate revenue. A business must keep its expenses under control to generate profits both in the short
and long run.
 Income – Income is the revenue that a business earns from the sale of its goods or services. It is
essential for the survival and growth of any enterprise, and the failure to generate revenue can lead to a
shutdown of the business.
 Profit – Profit is the positive difference between the income generated from selling goods or services
and the Expenses incurred to perform that business activity. Profit is the excess of revenues over the
expenses.
 Gain – A Gain is an increase in the total value of an asset of a business. It takes place when the current
price of the asset exceeds its original purchase price. It can occur at any time during the useful life of an
asset.
 Loss – Loss is the excess of the Expenses incurred from selling goods or services over the income
generated to perform that business activity. Sustained losses over time can lead to the shutdown of a
business organisation.
 Purchase – Purchase is the activity of buying an item to either use it in the production of goods and
services or resell it to another entity.
 Sales – Sales is an economic activity where a business exchanges goods or services with another entity
for money. It is the primary source of revenue for any organisation.
 Goods – Goods are the items that a company manufactures to sell to another entity in exchange for
money. When an organisation buys goods, it is known as purchases, and when it sells goods, it is known
as sales.
 Stock – A stock is a financial instrument that represents the part ownership of a company. Organisations
use this instrument to raise capital for their business.
 Debtor – A debtor is an individual or entity that owes money to a business. Companies treat it as an
asset because they will get money from them in the near or distant future.
 Creditor – A creditor is an individual or entity to whom a business owes money. Companies treat it as a
liability because they will have to pay them in the near or distant future.
 Voucher – A Voucher is an internal document that a company uses as supporting evidence for
accounting entries. Businesses treat it as a redeemable transaction bond as it has a monetary value and is
helpful in specific cases.
 Discount (Trade Discount and Cash Discount) – A Trade Discount is a discount that a seller can offer
to the buyer by reducing the price of an item. It helps to increase sales of a product, and it doesn’t get
recorded in the accounting books. A Cash Discount is a discount that a seller can offer to the buyer at
the time of payment by reducing the invoice price of an item. It helps to ensure timely payment for a
product, and it gets recorded in the accounting books.
What Does Accounting Concepts and Principles Mean?
Accounting principles and concepts are the backbone of effective financial management and transparent
financial reporting. These essential guidelines help businesses maintain accuracy in recording and
analyzing financial data, ensuring consistency and reliability across the board. Key concepts like the
business entity concept, revenue recognition principle, and accrual concept are integral in shaping the
way financial information is handled.In this article, we will break down the meaning of accounting
concepts, explain popular accounting principles, and touch on commonly used accounting conventions.
Whether you're a beginner exploring accounting for students or a professional looking to refresh your
knowledge, this guide offers valuable insights into the core principles and concepts that define the
accounting world.
What are the Objectives of the Accounting Concept?
 The primary aim of accounting is to maintain uniformity and regularity in the preparation of accounting
statements.
 Accounting concepts act as an underlying principle that helps accountants in the preparation and
maintenance of business records.
 It aims to understand the business rules and regulations that are required to be followed by all types of
business entities, and hence simplifying the detailed and comparable financial information.
Different Accounting Concepts with Examples
Following are the different accounting concepts that are widely used all around the world and hence are termed
as universally accepted accounting rules. The different accounting concepts are:
Business Entity Concept
This concept assumes that the organization and business owners are two independent entities. Hence, the
business translation and personal transaction of its owner are different. For example, when the business owner
invests his money in the business, it is recorded as a liability of the business to the owner. Similarly, when the
owner takes away from the business cash/goods for his/her personal use, it is not treated as a business expense.
Thus, the accounting transactions are recorded in the books of accounts from the organization's point of view
and not the person owning the business.
Example:
Suppose Mr. Birla started a business. He invested Rs 1, 00, 000. He purchased goods for Rs 50,000,
furniture for Rs. 40,000, and plant and machinery for Rs. 10,000 and Rs 2000 remained in hand. These
are the assets of the business and not of the business owner. According to the business entity concept,
Rs.1,00,000 will be assumed by a business as capital i.e. a liability of the business towards the owner of
the business.

Now suppose, he takes away Rs. 5000 cash or goods for the same worth for his domestic purposes. This
withdrawal of cash/goods by the owner from the business is his private expense and not the business expense. It
is termed as Drawings.
Therefore, the business entity concept states that the business and the business owner are two separate/distinct
persons. Accordingly, any expenses incurred by the owner for himself or his family from business will be
considered as expenses and it will be represented as drawings.
Accrual Concept
The term accrual means something is due, especially an amount of money that is yet to be paid or received at
the end of the accounting period. It implies that revenue is realized at the time of sale through cash or not
whereas expenses are recognized when they become payable whether cash is paid or not. Therefore, both the
transactions are recorded in the accounting period in which they relate.
In the accounting system, the accrual concept tells that the business revenue is realized at the time goods and
services are sold irrespective of the fact when cash is received for the same. For example, On March 5, 2021,
the firm sold goods for Rs 55000, and the payment was not received until April 5, 2021, the amount was due
and payable to the firm on the date goods and services were sold i.e. March 5, 2021. It must be included in the
revenue for the year ending March 31, 2021.
Similarly, expenses are recognized at the time services are provided, irrespective of the fact that cash paid for
these services are made. For example, if the firm received goods costing Rs.20000 on March 9, 2021, but the
payment is made on April 7, 2021, the accrual concept requires that expenses must be recorded for the year
ending March 31, 2021, although no payment has been made until this date though the service has been
received and the person to whom the payment should have been made is represented as a creditor of business
firm.
In brief, the accrual concept states that revenue is recognized when realized and expenses are recognized when
they become due and payable irrespective of the cash receipt or cash payment.
Accounting Cost Concept
The accounting cost concept states all the business assets should be written down in the book of accounts at the
price assets are purchased, including the cost of acquisition, and installation. The assets are not recorded at their
market price. It implies that the fixed assets like plant and machinery, building, furniture, etc are recorded at
their purchase price. For example, a machine was purchased by ABC Limited for Rs.10,00,000, for
manufacturing bottles. An amount of Rs.2,000 was spent on transporting the machine to the factory site. Also,
Rs.2000 was additionally spent on its installation. Hence, the total amount at which the machine will be
recorded in the books of accounts would be the total of all these items i.e. Rs.10, 040, 00. This cost is also
termed as historical cost.
Dual Aspect
The dual aspect is the basic principle of accounting. It provides the basis for recording business transactions in
the books of accounts. This concept assumes that every transaction recorded in the books of accountants is
based on dual concepts. This implies that the transaction that is recorded affects two accounts on their
respective opposite sides. Hence, the transaction should be recorded at dual places. It implies that both aspects
of the transaction should be recorded in the books of account. For example, goods purchased in exchange for
cash have two aspects such as paying cash and receiving goods. Therefore, both the aspects should be registered
in the books of accounts. The duality of the transaction is commonly expressed in the terms of the following
equation given below:

Assets = Liabilities + Capital

The dual concept implies that every transaction has a similar effect on assets and liabilities in such a way that
the value of total assets is always equal to the value of total liabilities.

Going Concepts
The Going concept in accounting states that a business activities will be carried by any firm for an unlimited
duration This simply means that every business has continuity of life. Hence, it will not be dissolved shortly.
This is an important assumption of accounting as it provides a base for representing the asset value in the
balance sheet.
For example, the plant and machinery was purchased by a company of Rs. 10 lakhs and its life span is 10 years.
According to the Going concept, every year some amount of assets purchased by the business will be
represented as an expense and the balance amount will be shown as an asset in the books of accounts. Thus, if
an amount is incurred on an item that will be used in business for several years ahead, it will not be proper to
charge the amount from the revenues of that particular year in which the item was purchased Only a part of the
purchase value is shown as an expense in the year of purchase and the remaining balance is shown as an asset in
the balance sheet.
Money Measurement Concept
The money measurement concept assumes that the business transactions are made in terms of money i.e. in the
currency of a country. In India, such transactions are made in terms of the rupee. Hence, as per the money
measurement concept, transactions that can be expressed in terms of money should be recorded in books of
accounts. For example, the sale of goods worth Rs. 10000, purchase of raw material Rs. 5000, rent paid Rs.2000
are expressed in terms of money, hence these transactions can be recorded in the books of accounts.
Accounting Period Concepts
Accounting period concepts state that all the transactions recorded in the books of account should be based on
the assumption that profit on these transactions is to be ascertained for a specific period. Hence this concept
says that the balance sheet and profit and loss account of a business should be prepared at regular intervals. This
is important for different purposes like calculation of profit and loss, tax calculation, ascertaining financial
position, etc. Also, this concept assumes that business indefinite life is divided into two parts. These parts are
termed accounting periods. It can be one month, three months, six months, etc. Usually, one year is considered
as one accounting period which may be a calendar year or financial year.
The year that begins on January 1 and ends on January 31 is termed as calendar year whereas the year that
begins on April 1 and ends on March 31 is termed as financial year.
Realization Concept
The term realization concept states that revenue earned from any business transaction should be included in the
accounting records only when it is realized. The term realization implies the creation of a legal right to receive
money. Hence, it should be noted that selling goods is considered as realization whereas receiving order is not
considered as realization.

In other words, the revenue concept states that revenue is realized when cash is received or the right to receive
cash on the sale of goods or services or both have been created.

Matching Concepts
The Matching concept states that revenue and expenses incurred to earn the revenue must belong to the same
accounting period. Hence, once revenue is realized, the next step is to assign the relevant accounting period. For
example, if you pay a commission to a salesperson for the sale that you record in March. The commission
should also be recorded in the same month.
The matching concept implies that all the revenue earned during an accounting year whether received or not
during that year or all the expenses incurred whether paid or not during that year should be considered while
determining the profit and loss of the business for that year. This enables the investors or shareholders to know
the exact profit and loss of the business.
What are Accounting Conventions?
Accounting conventions are certain restrictions for the business transactions that are complicated and are
unclear. Although accounting conventions are not generally or legally binding, these generally accepted
principles maintain consistency in financial statements. While standardized financial reporting processes, the
accounting conventions consider comparison, full disclosure of transaction, relevance, and application in
financial statements.
Four important types of accounting conventions are:
 Conservatism: It tells the accountants to err on the side of caution when providing the estimates for the
assets and liabilities, which means that when there are two values of a transaction available, then the
always lower one should be referred to.
 Consistency: A company is forced to apply the similar accounting principles across the different
accounting cycles. Once this chooses a method it is urged to stick with it in the future also, unless it
finds a good reason to perform it in another way. In the absence of these accounting conventions, the
ability of investors to compare and assess how the company performs becomes more challenging.
 Full Disclosure: Information that is considered potentially significant and relevant is to be completely
disclosed, regardless of whether it is detrimental to the company.
 Materiality: Similar to full disclosure, this convention also bound organizations to put down their cards
on the table, meaning they need to totally disclose all the material facts about the company. The aim
behind this materiality convention is that any information that could influence the person’s decision by
considering the financial statement must be included.
14 Principles of Accounting
The 14 Principles of Accounting are the key guidelines that ensure accurate and consistent financial reporting.
They are used to establish the accounting system and ensure that transactions are recorded and reported in a
standard way. These principles also provide a clear framework for accountants to follow.
Here’s a list of the 14 Principles of Accounting:
1. Regularity Principle: This principle states that accountants must adhere to established rules and regulations
when recording financial transactions. This ensures consistency in accounting practices across different periods.
Example: Following GAAP (Generally Accepted Accounting Principles) for preparing financial statements.

2. Consistency Principle: Once an accounting method is chosen, it should be used consistently in future
accounting periods unless a valid reason for changing it exists. This ensures comparability across financial
statements.
Example: Using the same method of depreciation every year unless a change is warranted.
3. Sincerity Principle: Accountants must provide a true and accurate depiction of a company’s financial
situation, showing honesty in the reporting of financial transactions.
Example: Avoiding falsification or misrepresentation of financial data.
4. Permanence of Methods Principle: This principle suggests that companies should use consistent accounting
methods over time, as changes could confuse stakeholders. It promotes stability and comparability in financial
reports.
Example: Continuing to use a single method of calculating depreciation for all fixed assets.
5. Non-Compensation Principle: All financial transactions should be reported without compensating any
losses with gains or vice versa. This principle ensures transparency in reporting.
Example: Revenue and expenses should be reported separately without netting off.
6. Prudence Principle: The prudence principle recommends that accountants should not overstate income or
assets or understate liabilities. When in doubt, conservative estimates should be used to avoid misleading
financial statements.
Example: Recording an allowance for doubtful debts to account for potential non-receivables.
7. Continuity Principle
This principle assumes that a company will continue its operations indefinitely unless there is evidence
suggesting otherwise. This assumption allows the business to record its assets at cost, rather than liquidation
value.
Example: Recording assets at historical cost under the assumption that the company will continue operations.
8. Periodicity Principle
This principle states that financial reports should be prepared for specific periods, such as monthly, quarterly, or
annually, for a consistent basis of comparison.
Example: Preparing income statements on a monthly basis to track performance.
9. Full Disclosure Principle: All material and relevant information about a company’s financial performance
and position must be disclosed in financial statements, including in the footnotes, to provide full transparency to
users.
Example: Disclosing pending lawsuits or regulatory investigations in the footnotes to the financial statements.
10. Materiality Principle: This principle allows companies to disregard minor details that do not significantly
affect the financial statements, thereby simplifying the accounting process.
Example: A company may not record minor office supplies as assets but instead expense them immediately.
11. Matching Principle: This principle requires that expenses should be recorded in the same period as the
revenues they helped generate, ensuring that the net income or profit is accurately reflected.
Example: If a company incurs expenses for advertising in January to promote a product, those expenses should
be matched with the revenue generated from sales in January.

12. Revenue Recognition Principle: Revenue should be recognized when it is earned, regardless of when
payment is received. This principle ensures that income is recorded when a transaction occurs.
Example: A company recognizes revenue when a service is rendered, even if the payment is received later.
13. Economic Entity Principle: The economic entity principle states that a business is a separate entity from its
owners, and the business transactions should be recorded separately from personal transactions.
Example: If an owner withdraws money from the business for personal use, it should not be recorded as a
business expense.
14. Cost Principle: This principle asserts that assets should be recorded at their original cost, not their current
market value. This ensures reliability and consistency in financial reporting.
Example: A company purchases a piece of land for ₹10,00,000. It should be recorded at that cost, even if the
market value of the land increases or decreases over time.
Conclusion:
Accounting concepts, principles, and conventions such as the Revenue Recognition Principle and the Matching
Principle play a vital role in ensuring accurate financial reporting. These foundational elements provide
businesses with a framework to record and report financial transactions consistently and transparently. By
adhering to these principles, companies not only maintain compliance with accounting standards but also
provide stakeholders with reliable financial information for decision-making. Understanding and applying these
concepts is crucial for anyone involved in financial management or accounting, as they form the backbone of
accurate and trustworthy financial reporting.
Accounting Equation:
The accounting equation is the basic element of the balance sheet and the primary principle of accounting. It
helps the company to prepare a balance sheet and see if the entire enterprise’s asset is equal to its liabilities and
stockholder equity. It is the base of the double-entry accounting system.
Double-entry accounting is a system that ensures that accounting and transaction equation should be equal as it
affects both sides. Any change in the asset account, there should be a change in related liability and
stockholder’s equity account. While performing journal entries accounting equation should be kept in mind.
How to calculate the Accounting Equation?
The accounting equation on the basis of a balance sheet can be calculated as.
 The business total assets should be located on the balance sheet for a particular period
 The liabilities of a company should be listed separately in the balance sheet and calculated
 The total liability and total stockholder’s equity should be added
 The total liabilities and equity will equal the company’s asset
The Formula for the Accounting Equation
Assets = Liabilities + Shareholder’s Equity
Example of Accounting Equation:
1. For the budgetary year, leading retailer ABC firm incorporated the following points on its balance sheet:
Total assets: ₹190 crore
 Total liabilities: ₹130 crore
Total shareholders’ equity: ₹60 crore
If we evaluate the accounting equation (Liabilities + Equity), we arrive at ( ₹130Cr + ₹50Cr) = ₹190 crore,
which equals to the calculation of the assets submitted by the company.
2. An organisation ABC wish to buy a ₹500 manufacturing machine using cash. This deal will result in debt of
(-₹500) for equipment and (+₹500) as a credit to cash. Therefore, the accounting equation will be.
Meaning of Depreciation
Depreciation can be defined as a continuing, permanent and gradual decrease in the book value of fixed assets.
This type of shrinkage is based on the cost of assets utilised in a firm and not on its market value.

Features of Depreciation
Following are the 3 principal features of depreciation:
 Depreciation is a decrease in the book value of fixed assets.
  Depreciation involves loss of value of assets due to the passage of time and obsolescence.
 Depreciation is an ongoing process until the end of the life of assets.
Causes of Depreciation
1. Wear and Tear due to Use or Passage of Time: Wear and tear is nothing but deterioration and the
following decrease in the value of an asset, resulting from its use in business operations for earning
revenue.
2. Expiration of Legal Rights: Some categories of assets lose their value after the agreement directing
their use in business comes to an end after the expiry of the predetermined period.
3. Obsolescence: Obsolescence is another factor driving to the depreciation of fixed assets. In common
language, obsolescence means being “out-of-date”. Obsolescence refers to an actual asset becoming
outdated on account of the availability of a better type of asset.
4. Abnormal Factors: Drop in the use of the asset may be caused by abnormal factors. Namely, accidents
due to the earthquake, fire, floods, etc., Accidental loss is permanent but not continuing.
Depreciation Formula:
1. Annual amount of depreciation under Straight Line Method
Annual Depreciation =
������������−���������������������������
�����������

2. Rate of depreciation on original cost

Rate of depreciation =
��������������������������������������100
Advantages and Disadvantages of Straight Line Method:
Advantages Disadvantages
1. It is a very simple method of 1. Under this method book value of the asset will be
calculating depreciation. charged more for maintenance and repair in the
2. Under this method, Asset can be final years as compared to initial years.
depreciated up to the net scrap value 2. It is difficult to ascertain a suitable rate of
or zero value. depreciation.
3. Under this method, the same amount 3. It is not suitable for assets having long life and high
is charged as depreciation in Profit value.
& Loss Account.
Methods of Calculating Depreciation
Straight Line Method (SLM)
Under the depreciation Straight Line Method, a fixed depreciation amount is charged annually, during the
lifetime of an asset. The amount of annual depreciation is computed on Original Cost and it remains fixed from
year to year. This method is also known as the ‘Original Cost method’ or ‘Fixed Instalment method’.
Written Down Value Method (WDV)
Under the Written Down Value method, depreciation is charged on the book value (cost –depreciation) of the
asset every year. Under the WDV method, book value keeps on reducing so, annual depreciation also keeps on
decreasing. This method is also known as ‘Diminishing Balance Method’ or ‘Reducing Instalment Method’.
Straight Line Method vs Written Down Value Method
Straight Line Method Written Down Value Method
Basis of Charging Depreciation
Depreciation is calculated on the original cost of Depreciation is calculated on the book value of
fixed assets. fixed assets.
Amount of Annual Depreciation
The amount of annual depreciation is fixed for all
years of useful life. The amount of depreciation declines year after year.
 Recognition by Income Tax
The Straight Line Method is not recognised by the The Written Down Value method is recognised by
Income Tax Department. the Income Tax Department.
Cost of Depreciation and Repairs
The combined cost on account of depreciation and The combined cost on account of depreciation and
repairs is lower in the initial years and higher in repairs remains, more or less, equal throughout the
the later years. life of the asset.
What is GAAP?
Generally Accepted Accounting Principles or GAAP is a defined set of rules and procedures that needs to be
followed in order to create financial statements, which are consistent with the industry standards.
GAAP helps in ensuring that financial reporting is transparent and uniform across industries. As financial
information is based on historical data, therefore in order to facilitate comparison between data from various
sources, GAAP must be followed.
GAAP is developed by the Financial Accounting Standards Board (FASB)
The following GAAP principles can be discussed:
1. Principle of Consistency: This principle ensures that the organizations use consistent standards while
recording the transactions.
2. Principle of Regularity: This principle states that all the accountants abide by the rules and regulations as
per GAAP.
3. Principle of Sincerity: This principle states that an accountant should provide an accurate depiction of
the financial situation of a business.
4. Principle of Permanence of Method: This principle states that consistent practices and procedures should
be followed for financial reporting purposes.
5. Principle of Prudence: This principle states that financial data should be reasonable, factual and should
not be based on any speculation.
6. Principle of Continuity: This principle states that the valuation of assets is based on the assumption that
the business will be continuing its operations in the future.
7. Principle of Materiality: This principle lays emphasis on the full disclosure of the true financial position
of the business.
8. Principle of Periodicity: This principle states that business entities should abide by the commonly
accepted accounting periods for financial reporting such as yearly, half-yearly, etc.
9. Principle of Non-compensation: This principle states that no business entities should expect
compensation in return for providing accurate information in financial reporting.
10. Principle of Good Faith: This principle states that all the parties involved in financial reporting should be
honest in reporting the transactions.

UNIT II
Mechanics of Accounting: Accounting Standards and IFRS: International Accounting Principles and
Standards; Matching of Indian Accounting Standards with International Accounting Standards, Double
entry system of Accounting, journalizing of transactions; Ledger posting and Trial Balance.

Accounting Standards: In order to ensure transparency consistency, comparability, adequacy and reliability of
financial reporting, it is essential to standardize the accounting principles and policies, Accounting Standards
provide framework and standard accounting polices so that the financial statements of different enterprises
become comparable. Accounting Standards are selected set of accounting policies or broad guidelines regarding
the principles and methods to be chosen out of several alternatives. The Accounting Standards Board (ASB) of
the Institute of Chartered Accountants of India (ICAI) formulas Accounting Standards to be established by the
Council of the ICAI. Objective of Accounting Standards: Objective of Accounting Standards is to standarize the
diverse accounting policies and practices with a view to eliminate to the extent possible the non-comparability
of financial statements and the reliability to the financial statements. The institute of Chartered Accountants of
India, recognizing the need to harmonize the diverse accounting policies and practices, constituted at
Accounting Standard Board (ASB) on 21st April, 1977. IFRS: IFRS is a set of international accounting
standards stating how particular types of transactions and other events should be reported in financial
statements. IFRS are generally principles-based standards and seek to avoid a rule-book mentality. Application
of IFRS requires exercise of judgment by the preparer and the auditor in applying principles of accounting on
the basis of the economic substance of transactions. IFRS are issued by the International Accounting Standards
Board (IASB).
The term IFRS comprises IFRS issued by IASB; IAS issued by IASC; and Interpretations issued by the
Standing Interpretations Committee (SIC) and the International Financial Reporting Interpretations Committee
(IFRIC) of the IASB. “FOR THE EFFECTIVE STUDY OF ACCOUNTING STANDARDS AND IFRS
THERE IS A STRONG NEED TO STUDY THE LINKAGE BETWEEN THESE TWO TERMS THAT
MEANS CONVERGENCE.” MEANING of convergence:The convergence of accounting standards refers to
the goal of establishing a single set of accounting standards that will be used internationally, and in particular
the effort to reduce the differences between the US generally accepted accounting principles (USGAAP) and
the International financial reporting standards (IFRS) Convergence of Indian accounting standards with
International financial reporting standards (IFRS): Meaning of convergence with IFRS: Convergence means to
achieve harmony with IFRSs; in precise terms convergence can be considered “to design and maintain national
accounting standards in a way that financial statements prepared in accordance with national accounting
standards draw unreserved statement of compliance with IFRSs”, i.e., when the national accounting standards
will comply with all the requirements of IFRS. But convergence doesn’t mean that IFRS should be adopted
word by word, e.g., replacing the term ‘true & fair’ for ‘present fairly’, in IAS 1, ‘Presentation of Financial
Statements’. Such changes do not lead to non-convergence with IFRS. The reason behind convergence is: As,
Availability of essential financial information about a company to its shareholders and other stakeholders in
accordance with internationally accepted financial norms is considered as an integral and important part of good
corporate governance. To ensure this and to implement the G-20 commitment to achieve a single set of high
quality global accounting standards, the Government has taken decision to achieve convergence of Indian
accounting standards with International financial reporting standards (IFRS) in a phased manner in accordance
with the roadmap suggested by the Government. Convergence in Indian Scenario: With regard to India, the
Ministry of Corporate Affairs (MCA) has committed to converge the Indian Accounting Standards with the
IFRS effective 1st April 2011. The convergence process is picking up momentum with the credit going to the
Ministry of Corporate Affairs. The Ministry has extended its unstinted support and guidance to the various
regulatory and legal bodies that are spearheading a smooth transition process. Laudably, the highest authorities
of the Indian Government have concluded that convergence of Indian Accounting Standards with IFRS is very
vital for the country to take a lead role in the global foray. Entities covered under convergence; Keeping in view
the complex nature of IFRSs and the extent of differences between the existing ASs and the corresponding
IFRSs and the reasons therefore, the ICAI is of the view that IFRSs should be adopted for the public interest
entities from the accounting periods beginning on or after 1st April, 2011. Public interest entities: With a view
to determine which entities should be considered as public interest entities for the purpose of application of
IFRSs, the criteria for Level I enterprises as laid down by the Institute of Chartered Accountants of India and
the definition of ‘small and mediumsized company’ as per Clause 2(f) of the Companies (Accounting
Standards) Rules, 2006, as notified by the Ministry of Company Affairs (now Ministry of Corporate Affairs) in
the Official Gazette dated December 7, 2006, were considered. The ICAI is of the view that in view of the
complexity of recognition and measurement principles and the extent of disclosures required in various IFRSs,
and the fact that about four years have elapsed since the ICAI laid down the criteria for Level I enterprises, as
far as the size is concerned, it needs a revision. Accordingly, the ICAI is of the view that a public interest entity
should be an entity: (i) Whose equity or debt securities are listed or are in the process of listing on any stock
exchange, whether in India or outside India; or (ii) Which is a bank (including a cooperative bank), financial
institution, a mutual fund, or an insurance entity; or (iii) Whose turnover (excluding other income) exceeds
rupees one hundred crore in the immediately preceding accounting year; or (iv) Which has public deposits
and/or borrowings from banks and financial institutions in excess of rupees twenty five crore at any time during
the immediately preceding accounting year; or (v) which is a holding or a subsidiary of an entity which is
covered in (i) to (iv) above. Role of ICAI in convergence: India, though being an important emerging economy
in the world, is yet to adopt the IFRS. Internationally, in so far as cross-border investments are concerned, a
non-IFRS compliant country is perceived as an additional risk factor. After a series of discussion with various
legal and regulatory authorities, the Ministry of Corporate Affairs has committed itself for convergence of
Indian entities with IFRS from April 2011. ICAI was given the responsibility of formulating the convergence
process and ensure smooth convergence. For this purpose, the Accounting Standard Board (ASB) of ICAI
constituted a Task Force in the year 2006 to explore the approach for convergence with IFRS and lay down the
road map for convergence with IFRS. Since then, ICAI has been relentlessly making extensive analysis of
various phases the convergence process would go through. It has identified the legal and regulatory
requirements arising out of convergence with IFRS. ICAI has also recommended changes in the respective
Acts, guidelines and other regulatory provision related to RBI, SEBI, NACAS and IRDA and has submitted its
recommendations to the respective authorities. This would eventually pave the way to a smooth transition
process. In addition, the ICAI Accounting Board has pointed out several national issues requiring debates and
conclusions that would enable the convergence process to meet the deadline. Role Of SEBI: SEBI has been pro-
actively involved in the process of convergence of Indian Accounting Standards with IFRS. As a step towards
encouraging convergence with IFRS, listed entities having subsidiaries have been allowed an option to submit
consolidated accounts as per IFRS. SEBI has set up a group under the chairmanship of Shri Y.H. Malegam with
representation from RBI, ICAI, accounting and auditing firms, and industry to discuss and submit comments on
the exposure drafts issued by the IASB in an objective and streamlined manner. Since formation in February
2010, the group has had four meetings and has provided comments to IASB on the following exposure drafts: a.
Management Commentary (proposed new IFRS) b. Financial Instruments: Amortised Cost and Impairment
(IFRS9) c. Conceptual Framework for Financial Reporting d. Fair Value Option for Financial Liabilities
(proposed new IFRS replacing IAS 39) Role of Industry Associations: Industry associations such as Federation
of Indian Chambers of Commerce and Industry (FICCI), Associated Chambers of Commerce (Assocham) and
Confederation of Indian Industries (CII) can also play an important role in preparing their constituents for the
adoption of the IFRSs in the following ways: (i) Holding round-tables on the Exposure Drafts of the IFRSs so
that the views of the Association can be sent to the IASB/ICAI. (ii) Conducting seminars/workshops on IFRSs
for the industry participants to provide them appropriate training. (iii) Provide industry-specific forums to their
constituents to discuss the industryspecific issues in implementation of IFRSs. Advantages of convergence:
Improves investor confidence across the world with transparency and comparability Improves inter-unit/ inter-
firm/inter-industry comparison Group consolidation made easy with same standard by all companies in group
wherever located Acceptability of financial statements across all stock exchanges, which facilitates entry of any
Indian company to any stock exchange across the globe. A business can present its financial statements on the
same basis as its foreign competitors. Challenges envisaged in convergence: Change to regulatory environment:
For the success of convergence in India, certain regulatory amendment is required. For example, The
Companies Act (Schedule VI) prescribes the format for presentation of financial statements for Indian
companies, whereas the presentation requirements are significantly different under IFRS. So, the companies act
needs to be amended in line with IFRS. Lack of Preparedness Corporate India and accounting professionals
need to be trained for effective migration to IFRS. Additionally auditors would need to train their staff to audit
under IFRS environment Significant cost Significant one-time costs of converting to IFRS (including costs of
adapting IT systems, training personnel and educating investors) Impact on financial performance: Due to the
significant differences between Indian GAAP and IFRS, adoption of IFRS is likely to have a significant impact
on the financial position and financial performance of most Indian companies Communication of Impact of
IFRS to investors: Companies also need to communicate the impact of IFRS convergence to their investors to
ensure they understand the shift from Indian GAAP to IFRS. Implementation Phase in India: The applicability
of International Financial Reporting Standards for convergence of Indian entities would be in several phases as
the issues involved in one-shot adoption are complex. Hence, in the first phase, ICAI has submitted a suggested
list of companies that come under different parameters for adoptionn of IFRS standards. These entities include
companies listed with BSE / NSE Sensex, insurance companies, mutual funds, entities with a capital base of
over 50 million dollars outside India, companies that are publicly accountable with an aggregate borrowing of
over Rs. 1,000 crores and such others. Accounting Standards after convergence: A set of accounting standards
notified by the Ministry of Corporate Affairs which are converged with International Financial Reporting
Standards (IFRS) which are now termed as IND AS’s. Now India will have two sets of accounting standards
viz. existing accounting standards under Companies (Accounting Standard) Rules, 2006 and IFRS converged
Indian Accounting Standards(Ind AS). The Ind AS are named and numbered in the same way as the
corresponding IFRS. Thirty five Indian Accounting Standards converged with International Financial Reporting
Standards (henceforth called IND AS) are being notified by the Ministry and placed on the website. Students
can check that out at MCA website i.e. www.mca.gov.in Role of ICAI as an educator/trainer: With a view to
prepare its existing and prospective members for the impending adoption of the IFRSs from 1st April, 2011, the
ICAI should formulate strategies with regard to the following: (i) To revise the syllabi of the pre-qualification
Chartered Accountancy Course to include IFRSs as a part of its curriculum; (ii) The Continuing Professional
Education (CPE) Committee and the Committee for Members in Industry should hold intensive workshops on
IFRSs to train the members in practice as well as in industry. In order to encourage members to participate in
the IFRS-specific workshops, the ICAI may consider laying down minimum CPE hours requirements in this
regard. (iii) Preparation of educational material to guide its members on various intricacies involved in the
implementation of IFRS. The educational material may focus on those areas which are new compared to the
existing Accounting Standards.
MEANING OF DOUBLE ENTRY SYSTEM OF BOOK-KEEPING
The double entry system of bookkeeping can be defined as the system of recording transactions having two
fundamental aspects - one involving the receiving of a benefit and the other giving the benefit - in the same set
of books. In this theory, as the two fold aspects of each transaction are recorded, therefore it is called ‘double
entry system’. As per dual aspect concept of accounting every transaction involves two aspects, an aspect of
receiving and an other aspect of giving. One who receives is a debtor and one who gives is a creditor. Under the
double entry system, both the aspects of giving and receiving are recorded in terms of accounts. The account
which receives the benefit is debited and the account which gives the benefit is credited. It is the ultimate result
of this system that every debit must have corresponding credit and vice versa thus, on any particular day the
total of the debit entries and the credit entries on the various accounts must be equal. For example, we bought
machinery of ` 30,000 for business. It has brought two changes, machinery increases by ` 30,000 and cash
decreases by an equal amount. While recording this transaction in the books of accounts, both the changes must
be recorded. In accounting language, these two changes are termed as “a debit change” & “a credit change”.
Here machinery account will be debited and cash account will be credited. Thus, we see that for every
transaction there will be two entries, one debit entry and another credit entry. For each debit there will be a
corresponding credit entry of an equal amount. Conversely, for every credit entry there will be a corresponding
debit entry of an equal amount. So, the system under which both the changes in a transaction are recorded
together, one change is debited, while the other change is credited with an equal amount, is known as double
entry system of book- keeping. Double entry system is based on the principle that “Every debit has a credit and
every credit has a debit.”
ADVANTAGES & LIMITATIONS OF DOUBLE ENTRY SYSTEM
The main advantages of double entry system of book keeping are as follows:
1. The nominal aspects of transactions being recorded make it possible to prepare Trading and Profit and Loss
Account from which the Gross Profit and Net Profit earned by the business during a particular period can be
easily ascertained.
2. As all personal accounts of debtors and creditors as well as real accounts are kept, it is possible to prepare
Balance Sheet.
3. The transactions being recorded in the most scientific and systematic way give the most reliable information
of business.
4. It prevents frauds because doing alterations in any account becomes difficult.
5. It enables the trader to compare the different items, such as sales, purchases, opening stock and closing stock
of one period with similar items of preceding period and the trader may thus, know whether his business is
progressing or not.
6. Trial balance can be prepared on any day to prove the arithmetical accuracy of accounting records.
The main limitations of double entry system of book keeping are as follows:
1. This system requires the maintenance of a number of books of accounts which is not practical in small
concerns.
2. This system is costly because a number of records are to be maintained.
3. There is no guarantee of absolute accuracy of the books of accounts inspite of agreement of the trial balance.
MEANING AND CLASSIFICATION OF ACCOUNTS
An accounting system records, retains and reproduces financial information relating to financial transaction
flows and financial position. Financial transaction flows encompass primarily inflows on account of incomes
and outflows on account of expenses. Elements of financial position, including property, money received, or
money spent, are assigned to one of the primary groups i.e. assets, liabilities, and equity. Within these primary
groups each distinctive asset, liability, income and expense is represented by its respective “account”. An
account is simply a record of financial inflows and outflows in relation to the respective asset, liability, capital,
income and expense. It is a record of all business transaction relating to a particular person or item. In
accounting we keep a separate record of each individual, asset, liabilities, expense or income. The place where
such a record is maintained is termed as an ‘Account’. Such as the Account of Madan, the Account of Brij, the
Account of Building, the Account of Rent, the Account of Discount and likewise. All transactions entered into
with Madan will be recorded in the Account of Madan and similarly, all transactions relating to Brij will be
recorded in the Account of Brij. Thus, an account is a systematic record of transactions pretaining to a particular
item or person, which can be measured in terms of money during a particular period of time. Account is a head
under which particular type of transactions are consolidated, classified and recorded. Example: A sales account
is opened for recording the sales of goods or services. Similarly expenses during the financial period are
recorded using the respective expense accounts.
The account may be classified in two ways:
i. Traditional classification
ii. ii. Modern classification.
Classification of Accounts Based on Nature or Traditional Classification On the basis of their nature accounts
are of the following three types :
i) Personal Accounts : Accounts in the name of individuals or group of individuals are called personal
accounts e.g. Ramesh, Mahesh, M/s M.K. Computers etc.
ii) Nominal Accounts : Accounts of expenses or losses incomes or gains are called nominal accounts
e.g. wages paid, commission received etc.
iii) Real Accounts : Accounts of assets are called real accounts e.g. building, furniture etc. Modern
Classifications On the basis of this classification accounts are divided into five catagories as given below :
Capital, ii. Assets, iii. Liabilities, iv. Expenses and v. Income

• The further classification of accounts is based on the periodicity of their inflows or outflows in the context
of the accounting year.
• Income is immediate inflow during the accounting year.
• Expense is the immediate outflow during the accounting year.
• An asset is a long-term inflow with implications extending beyond the financial period.
• Liability is long term outflow with implications extending beyond the financial period.
Using Debit and Credit
In Double Entry accounting both the aspects of the transaction are recorded. Every transaction has two
aspects according to this system, both the aspects are recorded. If the business acquires something, it must
have been acquired by giving something else. While recording each transaction, the total amount debited
must be equal to the total amount credited. The terms ‘Debit’ and ‘Credit’ indicate whether the transaction
is to be recorded on the left hand side or right hand side of the account. In its simplest form, an account
looks like the English Language Letter ‘T’. Because of its shape, this simple form of account is called T-
account. You must have observed that the T format has a left side and a right side for recording increases
and decreases in the item. This helps in ascertaining the ultimate position of each item at the end of an
accounting period. For example, if it is an account of a supplier, all goods/materials supplied shall appear
on the right (Credit) side of the Supplier’s account and all payments made on the left (debit) side. In a‘T’
account, the left side is called debit (usually abbreviated as Dr.) and the right side is known as credit (as
usually abbreviated Cr.).

Rules of Accounting All accounts are divided into five categories for the purpose of recording of the
business transactions:
(i) Assets, (ii) Liability, (iii) Capital, (iv) Expenses/Losses, and (v) Revenues/Gains. Two Fundamental
Rules are followed to record the changes in these accounts:
1. For recording changes in Assets/Expenses/Losses “Increase in Asset is debited, and decrease in Asset is
credited.” “Increase in Expenses/Losses is debited, and decrease in Expenses/ Losses is credited.”
2. For recording changes in Liabilities, Capital and Revenue/Gains “Increase in Liabilities is credited and
decrease in Liabilities is debited.” “Increase in Capital is credited and decrease in Capital is debited.”
“Increase in Revenue/Gains is credited and decrease in Revenue/Gain is debited”. The rules applicable to
the five kinds of accounts are summarised in the following chart:

I. Analysis of Rule Applied to Assets Accounts Rohit Purchased Furniture for ` 80,000. Analysis of
Transaction : In this transaction, the two affected accounts are Cash account and Furniture account. Cash
account is an assets account and has decreased. As per rule if asset decreases the affected account is
credited, so cash account should be credited. Furniture is also an asset and it has increased. As per rule if
asset increases the affected account is debited thus, furniture account is to be debited.
II. Analysis of Rule Applied to Liabilities Accounts Purchased Machinery for ` 60,000 on credit from M.B.
Machinery Mart.
Analysis of Transaction : In this transaction, the two affected accounts are machinery and M.B. Machinery
Mart. Machinery is an asset, an asset has increased therefore, machinery account is debited. M.B.
Machinery Mart is the creditor on account of supply of machinery and constitutes the liability for the
buying firm which has increased. Rule is that on increase of liability the concerned liability account is
credited and vice-versa, therefore M.B. Machinery Mart A/c is credited.

III. Analysis of Rule Applied to Capital Accounts Cash of ` 50,000 introduced in business as Capital by
Suman Sharma.
Analysis of Transaction : In this transaction, the two affected accounts are Cash account and Suman
Sharma [Capital account].
Cash is an asset which increase when invested in business as per rule if an asset increases it is debited
therefore cash account will be debited. Suman Sharma invested capital which increase the capital account,
and as per rule if capital increases it is credited therefore capital account will be credited.

IV. Analysis of Rule Applied to Expenses/Losses Accounts Paid `6000 to the employees as Salary.
Analysis of Transaction :In this transaction, the two affected accounts are Salary account and Cash account.
Salary account is an expense and has increased. As per rule if expenses increase it will be debited. Cash is
an asset and has decreased, as per rule if assets decrease, it will be credited.

V. Analysis of Rule Applied to Revenue/Profit Accounts Received interest for the month `4000. Analysis of
Transaction : In this transaction, the two affected accounts are Interest and Cash. Interest is an item of
Income and Cash an item of asset, as per rule if revenue increases it will be credited and if asset increases it
will be debited.
 SOURCE DOCUMENTS
Accounting process begins with the origin of a business transaction and is followed by analysis of such
transaction. First, there should be a document showing that an accounting event took place. Such a
document is usually called a source document. Source documents serve as a basis for an accounting entry.
Source documents are documents on the basis of which the accountants record accounting transactions.
Source documents are also called as business documents. Some examples of source documents are invoices,
material requisition forms, bank statements, cash memos, receipts etc. Each transaction in a business is
supported by the documentary evidence, which are considered source documents. Examples of source
documents are an invoice shows sale of goods on credit, a Cash Memo shows cash sales and the receipt
issued by the payee shows the transaction against cash payment etc. Thus, documents which facilitate
evidence of the transactions are known as the source documents. These are the primary evidence in support
of the concerned business transactions, and are also termed as vouchers. Vouchers may be divided into two
categories (a) Supporting vouchers and (b) Accounting vouchers. Supporting Vouchers The vouchers which
support the business transactions are called supporting vouchers. Examples of supporting vouchers are:
Rent receipt, Cash memo invoice etc Accounting Vouchers These are the source documents on the basis of
which transactions are recorded in the books of accounts. Accounting vouchers are the written documents
containing the analysis of business transactions for accounting and recording purposes prepared by the
accountants on the basis of supporting vouchers and signed by another authorised person.
Features of an Accounting Voucher are as follows:
1. It is a written document.
2. It is the base for entries in the books of accounts.
3. It is prepared on the basis of evidence of the transaction.
4. It contains analysed information of a transaction so that the concerned accounts could be debited and
credited.
5. It is prepared by an accountant and countersigned by the authorised signatory.
TYPES OF ACCOUNTING VOUCHERS
Accounting vouchers may be classified as cash vouchers and non-cash vouchers. There are two types of
cash vouchers)
Debit vouchers and
credit vouchers.
The non-cash vouchers are also called as transfer vouchers.
Debit Voucher
Debit Vouchers are prepared for recording of transactions involving cash payments only. Cash payments in the
business are made on account of Payment to creditors, Purchases of goods, Purchases of assets, Repayment of
loans, Depositing cash into Bank, Drawings & advances and expenses etc.
A Debit Voucher gives the following information:
1. Name and Address of the Organisation.
2. Date of Preparing the Voucher.
3. Accounting Voucher Number.
4. Title of the Account Debited.
5. Net Transaction Amount.
6. Narration, i.e., a brief decription of the transaction.
7. Signature of the Person Preparing it.
8. Signature of the Authorised Signatory.
9. Supporting Voucher Number.
10. A Document in lieu of the Supporting Voucher.
Credit Vouchers
These vouchers are prepared for recording of transactions involving only cash receipts. Cash receipts in the
business take place on account of Cash sales of goods, Cash receipts from debtors, Cash sales of assets, Cash
withdrawn from bank for office use, Revenue income like interest, rent etc. received in cash, Loan taken and
Receipts of advances etc. In all cash receipts, one aspect is cash and the other is either person or party from
whom cash is received or item of revenue on account of which cash is received or the property on the sale of
which cash is received.
The Credit Voucher gives the following information:
1. Name and Address of the Organisation.
2. Date of Preparing the Voucher.
3. Accounting Voucher Number.
4. Title of the Account Credited.
5. Net Amount of the Transaction.
6. Narration, i.e., a brief description of the transaction.
7. Signature of the Person Preparing it.
8. Signature of the Authorised Signatory.
9. Supporting Voucher Number.
Transfer Voucher or Non Cash Voucher
Non cash vouchers refer to vouchers prepared for transactions not involving cash. They are also called transfer
vouchers. The transfer vouchers are prepared to record non-cash transactions of the business involving Credit
sales, Credit purchases, Depreciation on assets, Return of goods purchased on credit, Bad debts, Return of
goods sold on credit etc. These vouchers are prepared both in debit and credit forms simultaneously
A Non-Cash Voucher gives the following information:
1. Name and Address of the Organisation.
2. Date of Preparing Voucher.
3. Accounting Voucher Number.
4. (a) Title of the Account Debited. (b) Title of the Account Credited.
5. Net Transaction Amount.
6. Narration, i.e., a brief description of the transaction.
7. Signature of the Person Preparing it.
8. Signature of the Authorised Signatory.
9. Supporting Voucher Number.
Ledger Account
Ledger
A ledger in accounting refers to a book that contains different accounts where records of transactions pertaining
to a specific account is stored. It is also known as the book of final entry or principal book of accounts. It is a
book where all transactions either debited or credited are stored.
A ledger account is a combination of all the ledgers and contains information related to all the accounting
activities of an organisation. It is regarded as the most important book in accounting as it helps in creating a trial
balance that acts as a precursor to the preparation of financial statements.
The information stored in a ledger account contains both starting and ending balances which are adjusted during
the course of the accounting period with respective debits and credits.
A ledger contains different components which include the various transaction elements such as date, amount,
particulars and l.f (ledger folio). Individual transactions are contained within a ledger account and are identified
by a transaction number or any other type of notation.
Ledger Format
The ledger consists of two columns prepared in a T format. The two sides of debit and credit contain date,
particulars, folio number and amount columns. The ledger format is as follows.
Ledger Account Example
Following are some examples of ledger accounts
1. Accounts receivable
2. Cash
3. Depreciation
4. Accounts payable
5. Salaries and wages
6. Revenue
7. Debt
8. Inventory
9. Stockholders’ equity
10. Office expenses
Ledger Posting
The process of transferring entries from a journal to the respective ledger accounts is known as ledger posting.
For this process, first, the entries are recorded in journals and then transferred to their respective ledger
accounts.
What is a Trial Balance?
A Trial Balance is a statement that keeps a record of the final ledger balance of all accounts in a business. It has
two columns – debit and credit. Trial Balance is prepared at the end of a year and is used to prepare financial
statements like Profit and Loss Account or Balance Sheet. The main objective of a Trial Balance is to ensure the
mathematical accuracy of the business transactions recorded in a company’s ledgers.
Preparing a Trial Balance:
There are three methods by which you can prepare a Trial Balance. They are as follows:
 Total Method – Total Method records each ledger account’s debit and credit columns to the Trial
Balance. Both the columns should be equal as this method follows the double-entry bookkeeping
method.
 Balance Method – This method uses each ledger account’s final debit/credit balance in the Trial
Balance. Once the balance figures of all accounts are listed, the Trial Balance (both on the debit and
credit side) helps check the accuracy of all transactions. The Balance Method of preparing Trial Balance
is more popular compared to its alternatives.
 Total cum Balance Method – This method is a combination of both the Total Method and Balance
Method. The Trial Balance has four columns – two for the credit and debit totals of a ledger account and
two for that account’s credit/debit balances.
Objectives of Trial Balance:
The main objectives of a Trial Balance are as follows:
 It helps in ascertaining arithmetic errors that occur while preparing accounts. Accountants can make
mistakes while recording financial transactions under the double-entry bookkeeping system. When the
debit and credit sides of a Trial Balance do not match, it means one of two things. One, there was an
error in either recording the account balance. Or two, there is an accounting mistake made while
recording the transaction in the ledgers.
 It helps in preparing the financial statements of a company at the end of a financial year. The final
balance of expenses and revenue accounts is taken from the Trial Balance and used in the Profit and
Loss Account. Similarly, the accounts related to Assets, Liabilities and Capital gets recorded in the
Balance Sheet.
  A Trial Balance helps in summarising the financial transactions done while running a business. It is a
consolidated summary of the financial transactions that have taken place within a financial year. It can
help the management in making business decisions as well.
Limitations of a Trial Balance
The main limitations of a Trial Balance are as follows:
 It may hide errors of omission. Some transactions are not journalised at all. Even a correctly balanced
Trial Balance cannot reveal this mistake.
 If a journal entry with an incorrect amount gets recorded in both accounts, the Trial Balance will not
detect that error.
 A journal entry may have the right amount, but the accountant may have entered it under the wrong
accounting heads. The Trial Balance cannot identify such mistakes.
 If a journal entry is missing in the ledger, it will not reflect in the Trial Balance
UNIT III
Presentation of Financial Statement: Preparation of final accounts (Profit & Loss Account and
Balance Sheet) according to companies act 2013 (vertical format), Excel Application to make Balance
sheet, Case studies and Workshops, Preparation of Cash Flow Statement and its analysis.
Final Accounts Meaning
Final accounts are those accounts that are prepared by a joint stock company at the end of a fiscal year. The
purpose of creating final accounts is to provide a clear picture of the financial position of the organisation to its
management, owners, or any other users of such accounting information.
Final account preparation involves preparing a set of accounts and statements at the end of an accounting year.
The final account consists of the following accounts:
1. Trading and Profit and Loss Account
2. Balance Sheet
3. Profit and Loss Appropriation account
Objectives of Final Account preparation
Final accounts are prepared with the following objectives:
1. To determine profit or loss incurred by a company in a given financial period
2. To determine the financial position of the company
3. To act as a source of information to convey the users of accounting information (owners, creditors,
investors and other stakeholders) about the solvency of the company.
The format of a final account is represented as follows:
Q. Following is the Trial Balance of Rajesh Ltd., Gurgaon as on 31.12.2009.

Adjustments:
1. Transfer Rs. 10000 to Reserve Fund.
2. Provide depreciation on building at 5%.
3. Stock on 31.12.2009 was valued at Rs. 12000.
4. Dividend at 15% on share capital is to the provided.
5. Depreciation on Plant and Machinery at 10%.
Prepare Trading, Profit and Loss Account, Profit and Loss Appropriation Account and Balance Sheet in the
prescribed form.
Solution:
The solution will be as follows:
Whether you have a small business or a huge multinational corporation, you need to understand how your
company grows. You should therefore keep track of your company's finances by reviewing various financial
statements.
The Income Statement, for example, shows how the organization makes and spends money. Alternatively, the
Cash Flow Statement lets you see how much cash you have available, enabling you to budget your expenses
correctly.
Lastly, there is the balance sheet, which is also one of the basic financial statements. Here's a quick guide to
help you make your own in Microsoft Excel.
What Is a Balance Sheet, and Why Do You Need One?
Balance Sheet will let you see the breakdown of your company's assets, liabilities, and equity. In one glance,
you'll see how much of the company came from retained earnings, owner's equity, and loans.
With this information on hand, you can compute its return on investment and its various financial ratios. You
can then compare these values against similar companies in the same industry. This will give you a sense of
how the business is performing versus its peers in the industry.
1. Select the Time to Cover
As with other financial statements, you have to pick a period to cover. Typically, this starts on January 1st and
ends on December 31st.
However, you could also choose a different period for computation, called the fiscal year, which begins on Oct
1 and ends on September 30. Do note that whatever period you use here must be consistent across your other
statements.
2. Prepare Your Accounts
To avoid the hassle of having to dig through your records when you're making your balance sheet, you should
prepare it beforehand. Make sure to have your cash flow statement, bank statements, loan account statements,
and credit card balances available to you.
Before you begin, you need to know the value of the assets and inventory on hand. Don't forget to include the
amount you put down to start your business, as well as investments made by other people and entities.
Create the Excel File

Once you know the period you're covering and have the values you need, it's time to create the Excel file. Open
up a new file on Microsoft Excel. Put in [Company Name] Balance Sheet at cell A1 for easy identification.
Leave some space for formatting, then on the first column of the third row, write Assets. This is the section
where you'll put in the values for everything your company has. Then on the third column of the same row,
write the fiscal year you're covering.
After Assets, you have to create the corresponding Liabilities and Owner's Equity section. Liabilities refer to
the amount the company owes to third parties, including banks, suppliers, landlords, and the government.
Owner's Equity, on the other hand, refers to the amount the owners raised for the business, plus any earning it
retains in its accounts. These values in these two sections should equal the amount noted under assets—hence
the term Balance Sheet.
However, before creating the Liabilities and Owner's Equity section, you should first place the subcategories for
Assets. This way, you'll have less trouble with formatting.
Insert Your Categories

Assets
Each business and industry will have its own unique Asset subcategories. However, these are the typical
sections most companies have: Current Assets, Fixed or Long-Term Assets, and Other Assets. These are
then further broken down into small categories.
Current Assets are assets you can quickly liquidate. These are typically cash, accounts receivable, inventory,
and short-term investments. On the other hand, Fixed or Long-Term Assets are harder to convert into currency.
These could be Real Properties, Office Equipment, Long-term investments, and more.
Other Assets are usually minor items that can't be easily defined under current or long-term assets. These could
include Prepaid Expenses (like subscriptions), Deferred Tax Assets (like refunds), and Employee Advances.
While these categories apply to most businesses, your company might have a unique asset category, so you
should review your operations before considering this as final.
Liabilities & Owner's Equity

Similar to Assets, Liabilities & Owner's Equity has three major subcategories: Current Liabilities, Long-term
Liabilities, and Owner's Equity. As the term suggests, current liabilities are obligations that the company must
meet either in one year or in one operating cycle (where one operating cycle refers to the time it takes for
inventory to be converted into sales).
Current Liabilities could include accounts payable to suppliers and lessors, short-term loans from banks and
creditors, income taxes, payable salaries, prepaid goods and services, and the current portion of long-term debt.
Under Long-term Liabilities, you will find Long-term debt, Deferred income tax, and Pension fund benefits,
if required by law.
Lastly, Owner's Equity consists of Owner's equity, which is the amount you put in the business. If you're
running a corporation, both this section and its subsection are called Shareholders' Equity instead.
You will also find Retained earnings under the equity section, which is the amount the business earned in the
period less dividends paid out.
Adding Your Values

Under Assets, add the values for each subcategory to know how much you have for each section. You then need
to add each subtotal to get the total asset value of your company.
Likewise, you should also add the values for each Liability and Owner's Equity subcategory to find how much
of your company's assets are from creditors, the owners, and earnings.
Take note that the total values for the Assets section and the Liabilities and Owner's Equity section should
match. Otherwise, there might have been an error in your accounting.
6. Some Useful Formulas
You can use the values you find in the balance sheet to look at its financial ratios. These formulas assess your
business's performance and can be used for comparison with other similar companies in the same industry.
Debt Ratio

This is the percentage of the company's debt measured against its assets. The formula for this is Total
Liabilities / Total Assets. If you get a value greater than 100%, that means its debt is greater than all its assets.
High-ratios are also at a higher risk of default—but this value varies between industries.
Like real estate and utilities, capital-intensive businesses typically get higher average debt ratio values than
service industry-based companies.
Current Ratio

This value shows the capacity of a company to pay its short-term loans with its liquid assets. This is computed
by dividing current assets by current liabilities. If the value you get here is below zero, there is a danger a
company might default on its short-term loans because of a lack of liquidity.
Working Capital

When you subtract a company's current liabilities from its current assets, you get working capital. This
amount shows how much cash and cash equivalent a company has after paying off its current obligations.
If there is a significant positive difference between the two, the company can easily grow and scale its business.
But if it's near zero, or even negative, then it might have trouble paying its loans and liabilities, or worse, could
go bankrupt.
Asset-to-Equity Ratio

The Asset-to-Equity (A/E) Ratio is calculated by dividing total owner's equity by total assets. This formula
shows how much the company is funded by the owners versus the amount financed through loans.
A company with a high A/E ratio may indicate that most of its financing came from the owners, meaning it
doesn't have many obligations to pay. On the contrary, a low A/E ratio means that most of its assets came in
loans or credits.
If the company has consistent cash flow, a low A/E ratio will have a low impact on its daily operations.
However, it leaves it vulnerable to price, interest, and drastic changes, giving them less leeway to react.
Where to Find Balance Sheet Templates

Although you may know now how to create a balance sheet, it's sometimes better to find a template to follow.
You can do that in Excel by clicking on File. Go to the New tab, then in the Search Bar, type Balance Sheet.
After a quick search, Excel will give you at least three templates you can use.

What is a Cash Flow Statement?

It is a financial statement that summarizes an organisation’s total inflow and outflow of cash and cash
equivalents. A Cash Flow Statement helps reveal the solvency and liquidity of an enterprise. It assesses the
capability of a business to generate sufficient cash to clear its debts and operating expenses. The Cash Flow
Statement gets prepared at the end of a financial year.

Elements of the Cash Flow Statement

The three main elements of a Cash Flow Statement are as follows:

 Cash Flow from Operating Activities – Operating activities are related to bringing the products and
services of a company to the marketplace. The Cash Flow from these activities helps to understand the
organisation’s net income from selling their produce. The items under operating activities include
revenues, interest returns, salary and wage payments, rent payments, etc. You can use either the Direct
or Indirect method to calculate the Cash Flow from Operating Activities.
 Cash Flow from Investing Activities – This method calculates the overall Cash Flow from activities
selling or purchasing assets and investments along with receipt of interest, rent or dividend.
 Cash Flow from Financing Activities – Cash Flow from Financing Activities looks at proceeds from
shares, debentures or other borrowings while deducting interest and dividend payments, repayment of
debt and settlement for stocks repurchased.

Methods for preparing Cash Flow Statement

A Cash Flow Statement gets prepared using one of the two methods – Direct and Indirect. Both of them help
calculate the Cash Flow from Operating Activities. The direct method uses the total cash spent and received for
calculating the net cash flow from operating activities. On the other hand, the indirect method starts with the
Net income, adds non-cash expenses, deducts non-cash incomes, and includes the net cash adjustments between
current assets and liabilities to get the net cash flow. There are several differences between the two methods,
which are as follows:

Direct Method Indirect Method

Definition
The Direct Method considers cash The indirect method takes the net income,
transactions, i.e. total cash expenditure non-cash expenses, non-cash incomes and
and cash receipts, to calculate the net net cash adjustments between current assets
cash flow from operating activities. and liabilities to ascertain the net cash flow.
Non Cash Transactions
The direct method considers only cash The indirect method considers both cash as
transactions while calculating cash flow well as non-cash transactions while
from operating expenses. calculating cash flow from operating
expenses.
Accuracy
The direct method is very accurate as it The indirect method is not that accurate as it
makes zero adjustments while calculating has to make adjustments for current assets
the cash flow. and liabilities to the Cash Flow.
Time
The direct method is more time- The indirect method is less time-consuming
consuming as it requires you to list down since there is no need to list down cash
all cash receipts and disbursements. transactions.
Ease of Understanding
The Direct Method is easier to The Indirect Method is difficult to
comprehend as it separates the understand compared to the direct method.
transactions into negative (outflows) and
Positive (inflows).
Transparency
This method is more transparent as it The indirect method is less transparent
gives the direct sources of cash payments compared to the Direct Method.
and receipts.

UNIT IV
Analysis of financial statement: Ratio Analysis- Solvency ratios, Profitability ratios, activity ratios, liquidity
ratios, Market capitalization ratios; leverage Ratio, Detailed Analysis using excel application.
Ratio Analysis
Ratio analysis is referred to as the study or analysis of the line items present in the financial statements of the
company. It can be used to check various factors of a business such as profitability, liquidity, solvency and
efficiency of the company or the business.
Ratio analysis is mainly performed by external analysts as financial statements are the primary source of
information for external analysts.
The analysts very much rely on the current and past financial statements in order to obtain important data for
analysing financial performance of the company. The data or information thus obtained during the analysis is
helpful in determining whether the financial position of a company is improving or deteriorating.
Use of Ratio Analysis
Ratio analysis is useful in the following ways:
1. Comparing Financial Performance: One of the most important things about ratio analysis is that it helps in
comparing the financial performance of two companies.
2. Trend Line: Companies tend to use the activity ratio in order to find any kind of trend in the performance.
Companies use data from financial statements that is collected from financial statements over many accounting
periods. The trend that is obtained can be used for predicting the future financial performance.
3. Operational Efficiency: Financial ratio analysis can also be used to determine the efficiency of managing the
asset and liabilities. It helps in understanding and determining whether the resources of the business is over
utilized or under utilized.
Solvency Ratio?
Solvency ratios are a key component of the financial analysis which helps in determining whether a company
has sufficient cash flow to manage the debt obligations that are due. Solvency ratios are also known as leverage
ratios. It is believed that if a company has a low solvency ratio, it is more at the risk of not being able to fulfil its
debt obligation and is likely to default in debt repayment.
Solvency ratios are used by prospective business lenders to determine the solvency state of a business.
Companies that have a higher solvency ratio are deemed more likely to meet the debt obligations while
companies with a lower solvency ratio are more likely to pose a risk for the banks and creditors. Solvency ratios
vary with the type of industry, but as a good measure a solvency ratio of 0.5 is always considered as a good
number to have.
Solvency ratios should not be confused with liquidity ratios. They are totally different. Liquidity ratios
determine the capability of a business to manage its short-term liabilities while the solvency ratios are used to
measure a company’s ability to pay long-term debts.
Types of Solvency Ratios
Solvency ratio is calculated from the components of the balance sheet and income statement elements. Solvency
ratios help in determining whether the organisation is able to repay its long term debt. It is very important for
the investors to know about this ratio as it helps in knowing about the solvency of a company or an
organisation.
Let us see in detail about the various types of solvency ratios.
1. Debt to equity ratio
Debt to equity is one of the most used debt solvency ratios. It is also represented as D/E ratio. Debt to equity
ratio is calculated by dividing a company’s total liabilities with the shareholder’s equity. These values are
obtained from the balance sheet of the company’s financial statements.
It is an important metric which is used to evaluate a company’s financial leverage. This ratio helps understand if
the shareholder’s equity has the ability to cover all the debts in case business is experiencing a rough time.
It is represented as
Debt to equity ratio = Long term debt / shareholder’s funds
Or
Debt to equity ratio = total liabilities / shareholders’ equity
A high debt-to-equity ratio is associated with a higher risk for the business as it indicates that the company is
using debt for fuelling its growth. It also indicates lower solvency of the business.
2. Debt Ratio
Debt ratio is a financial ratio that is used in measuring a company’s financial leverage. It is calculated by taking
the total liabilities and dividing it by total capital. If the debt ratio is higher, it represents the company is riskier.
The long-term debts include bank loans, bonds payable, notes payable etc.
Debt ratio is represented as
Debt Ratio = Long Term Debt / Capital or Debt Ratio = Long Term Debt / Net Assets
Low debt to capital ratio is indicative of a business that is stable while a higher ratio casts doubt about a firm’s
long-term stability. Trading on equity is possible with a higher ratio of debt to capital which helps generate
more income for the shareholders of the company.
3. Proprietary Ratio or Equity Ratio
Proprietary ratios is also known as equity ratio. It establishes a relationship between the proprietors funds and
the net assets or capital.
It is expressed as
Equity Ratio = Shareholder’s funds / Capital or Shareholder’s funds / Total Assets
4. Interest Coverage Ratio
The interest coverage ratio is used to determine whether the company is able to pay interest on the outstanding
debt obligations. It is calculated by dividing company’s EBIT (Earnings before interest and taxes) with the
interest payment due on debts for the accounting period.
It is represented as
Interest coverage ratio = EBIT / interest on long term debt
Where EBIT = Earnings before interest and taxes or Net Profit before interest and tax.
A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt
burden on the business.
Profitability ratios are a type of accounting ratio that helps in determining the financial performance of business
at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its
operations.
Let us now discuss the types of profitability ratios.
Types of Profitability Ratios
The following types of profitability ratios are discussed for the students of Class 12 Accountancy as per the new
syllabus prescribed by CBSE:
1. Gross Profit Ratio
2. Operating Ratio
3. Operating Profit Ratio
4. Net Profit Ratio
5. Return on Investment (ROI)
6. Return on Net Worth
7. Earnings per share
8. Book Value per share
9. Dividend Payout Ratio
10. Price Earning Ratio
Gross Profit Ratio
Gross Profit Ratio is a profitability ratio that measures the relationship between the gross profit and net sales
revenue. When it is expressed as a percentage, it is also known as the Gross Profit Margin.
Formula for Gross Profit ratio is
Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100
A fluctuating gross profit ratio is indicative of inferior product or management practices.
Operating Ratio
Operating ratio is calculated to determine the cost of operation in relation to the revenue earned from the
operations.
The formula for operating ratio is as follows
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/
Net Revenue from Operations ×100
Operating Profit Ratio
Operating profit ratio is a type of profitability ratio that is used for determining the operating profit and net
revenue generated from the operations. It is expressed as a percentage.
The formula for calculating operating profit ratio is:
Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100
Or Operating Profit Ratio = 100 – Operating ratio
Net Profit Ratio
Net profit ratio is an important profitability ratio that shows the relationship between net sales and net profit
after tax. When expressed as percentage, it is known as net profit margin.
Formula for net profit ratio is
Net Profit Ratio = Net Profit after tax ÷ Net sales
Or
Net Profit Ratio = Net profit/Revenue from Operations × 100
It helps investors in determining whether the company’s management is able to generate profit from the sales
and how well the operating costs and costs related to overhead are contained.
Return on Capital Employed (ROCE) or Return on Investment (ROI)
Return on capital employed (ROCE) or Return on Investment is a profitability ratio that measures how well a
company is able to generate profits from its capital. It is an important ratio that is mostly used by investors
while screening for companies to invest.
The formula for calculating Return on Capital Employed is :
ROCE or ROI = EBIT ÷ Capital Employed × 100
Where EBIT = Earnings before interest and taxes or Profit before interest and taxes
Capital Employed = Total Assets – Current Liabilities
Return on Net Worth
This is also known as Return on Shareholders funds and is used for determining whether the investment done
by the shareholders are able to generate profitable returns or not.
It should always be higher than the return on investment which otherwise would indicate that the company
funds are not utilised properly.
The formula for Return on Net Worth is calculated as :
Return on Shareholders’ Fund = Profit after Tax / Shareholders’ Funds × 100
Or Return on Net Worth = Profit after Tax / Shareholders’ Funds × 100
Earnings Per Share (EPS)
Earnings per share or EPS is a profitability ratio that measures the extent to which a company earns profit. It is
calculated by dividing the net profit earned by outstanding shares.
The formula for calculating EPS is:
Earnings per share = Net Profit ÷ Total no. of shares outstanding
Having higher EPS translates into more profitability for the company.
Book Value Per Share
Book value per share is referred to as the equity that is available to the the common shareholders divided by the
number of outstanding shares
Equity can be calculated by:
Equity funds = Shareholders funds – Preference share capital
The formula for calculating book value per share is:
Book Value per Share = (Shareholders’ Equity – Preferred Equity) / Total Outstanding Common Shares.
Dividend Payout Ratio
Dividend payout ratio calculates the amount paid to shareholders as dividends in relation to the amount of net
income generated by the business.
It can be calculated as follows:
Dividend Payout Ratio (DPR) : Dividends per share / Earnings per share
Price Earning Ratio
This is also known as P/E Ratio. It establishes a relationship between the stock (share) price of a company and
the earnings per share. It is very helpful for investors as they will be more interested in knowing the profitability
of the shares of the company and how much profitable it will be in future.
P/E ratio is calculated as follows:
P/E Ratio = Market value per share ÷ Earnings per share
It shows if the company’s stock is overvalued or undervalued.

UNIT V
Financial Statement Analysis and Recent Types of Accounting: Common Size Statement; Comparative
Balance Sheet and Trend Analysis of manufacturing, Service & banking organizations, Case Study and
Workshops in analysing Balance sheet. Human Resource Accounting, Forensic Accounting, Accounting for
corporate social responsibility.

Financial statements are prepared for organisations or businesses to know about the state of the business at that
time or period. For an organisation or a business owner, the importance of financial statements is defined by its
interpretation and analysis.
Importance of financial statements is different for different individuals in an organisation. For a manager, it
would be the efficiency of the operations, and for a stockholder, it will be related to the earnings and profits of
the company.
What is Common Size Statement?
Common size statement is a form of analysis and interpretation of the financial statement. It is also known as
vertical analysis. This method analyses financial statements by taking into consideration each of the line items
as a percentage of the base amount for that particular accounting period.
Common size statements are not any kind of financial ratios but are a rather easy way to express financial
statements, which makes it easier to analyse those statements.
Common size statements are always expressed in the form of percentages. Therefore, such statements are also
called 100 per cent statements or component percentage statements as all the individual items are taken as a
percentage of 100.
Types of Common Size Statements
There are two types of common size statements:
1. Common size income statement
2. Common size balance sheet
1. Common Size Income Statement
This is one type of common size statement where the sales is taken as the base for all calculations. Therefore,
the calculation of each line item will take into account the sales as a base, and each item will be expressed as a
percentage of the sales.
Use of Common Size Income Statement
It helps the business owner in understanding the following points
1. Whether profits are showing an increase or decrease in relation to the sales obtained.
2. Percentage change in cost of goods that were sold during the accounting period.
3. Variation that might have occurred in expense.
4. If the increase in retained earnings is in proportion to the increase in profit of the business.
5. Helps to compare income statements of two or more periods.
6. Recognises the changes happening in the financial statements of the organisation, which will help
investors in making decisions about investing in the business.
2. Common Size Balance Sheet:
A common size balance sheet is a statement in which balance sheet items are being calculated as the ratio of
each asset in relation to the total assets. For the liabilities, each liability is being calculated as a ratio of the total
liabilities.
Common size balance sheets can be used for comparing companies that differ in size. The comparison of such
figures for the different periods is not found to be that useful because the total figures seem to be affected by a
number of factors.
Standard values for various assets cannot be established by this method as the trends of the figures cannot be
studied and may not give proper results.
Common Size Income Statement Format
The common size income statement format is as follows:

Preparing Common Size Balance Sheet

(1) Take the total of assets or liabilities as 100.
(2) Each individual asset is expressed as a percentage of the total assets, i.e., 100 and different liabilities are also
calculated as per total liabilities. For example, suppose total assets are around Rs. 4 lakhs, and inventory value
is Rs. 1 lakh. In that case, it will be counted as 25% of the total assets.
Limitations of Common Size Statement
Following are the limitations discussed
1. It is not helpful in the decision-making process as it does not have any approved benchmark.
2. For a business that is impacted by fluctuations due to seasonality, it can be misleading.
What are Comparative Statements?
Comparative statements or comparative financial statements are statements of financial position of a business at
different periods. These statements help in determining the profitability of the business by comparing financial
data from two or more accounting periods.
The data from two or more periods are updated side by side, which is why it is also known as Horizontal
Analysis. The advantage of such an analysis is that it helps investors to identify the trends of business, check a
company’s progress and also compare it with that of its competitors.
The financial data will be considered to be comparative only when the same set of accounting principles are
being used for preparing the statements.
Types of Comparative Statements
There are two types of comparative statements which are as follows
1. Comparative income statement
2. Comparative balance sheet
Comparative Income Statement
Income statements provide the details about the results of the operations of the business, and comparative
income statements provide the progress made by the business over a period of a few years. This statement also
helps in ascertaining the changes that occur in each line item of the income statement over different periods.
The comparative income statement not only shows the operational efficiency of the business but also helps in
comparing the results with the competitors, over different time periods. This is possible by comparing the
operational data spanning multiple periods of accounting.
The following points should be studied when analysing a comparative income statement
1. Compare the increase or decrease in sales with a relative increase in the cost of goods sold
2. Studying the operational profits of the business
3. Overall profitability of the business can be analysed by an increase or decrease in the net profit
Steps in preparing a comparative income statement
The below steps are followed
1. Specify absolute figures of all the items related to the accounting period under consideration.
2. Determine the absolute change that has occurred in the items of the income statement. It can be achieved by
finding the difference between previous year values with the current year values.
3. Calculate the percentage change in the items present in the current statement with respect to previous year
statements.
The format of a comparative income statement is as follows:
Comparative Balance Sheet
Comparative balance sheet analyses the assets and liabilities of business for the current year and also compares
the increase or decrease in them in relative as well as absolute parameters.
A comparative balance sheet not only provides the state of assets and liabilities in different time periods, but it
also provides the changes that have taken place in individual assets and liabilities over different accounting
periods.
The following points should be studied when analysing a comparative balance sheet
1. The present financial and liquidity position (study working capital)
2. The financial position of the business in the long term
3. The profitability of the business
Steps in preparing a comparative balance sheet
The below steps can be followed
1. Determine the absolute value of assets and liabilities related to the accounting periods.
2. Determine absolute changes in the items of the balance sheet relative to the accounting periods in question.
3. Calculate the percentage change in assets and liabilities by comparing current year values with values of
previous accounting periods.
The format of a comparative balance sheet is as follows:
What is Forensic Accounting?
An Introduction to Forensic Accounting
Contrary to popular belief, 'forensic' has nothing to do with death. 'Forensic' means being able to meet the
exacting standards of a court of law (thus forensic science, forensic psychiatry, forensic climatology etc.). Some
forensic accountants' primary skills include an understanding of the legal process; how to conduct
investigations; conducting financial analyses and other accounting procedures at a level acceptable to the legal
system.
Until recently, detecting fraud or white collar crime was thought to be part of the accounting function. Fraud
was something the internal or external auditors were supposed to guard against by their periodic audits.
However, we now know the auditors can only check for the compliance of a company's books to generally
accepted accounting principles and company policy. Thus, a new category of accounting was needed to
substantiate the fraud for companies who identified fraudulent transactions. This area of accounting is known as
forensic accounting
Forensic accountants utilise accounting, auditing and investigative skills when conducting an investigation.
Equally critical is their ability to respond immediately and to communicate financial information clearly and
concisely in a courtroom setting. Forensic accountants are trained to look beyond the numbers and deal with the
business reality of the situation.
Forensic accountants are multi-disciplinary and have a wide range of experience in the forensic and
investigative field. They are frequently called upon to serve as expert witnesses and litigation consultants.
As forensic accountants you may be working in areas such as:
 Investigations, both criminal and civil
 Preparation and review of evidence
 Preparation of expert reports
 Affidavits and proof of evidence
 Giving oral evidence in court
 Expert determination, arbitration, mediation or alternative
 Dispute resolution
Insolvency support investigation and fraud prevention and awareness strategies
Qualified forensic accountants can provide attorneys with a variety of approaches to successfully resolve claims
and disputes. From early-stage advisor to expert witness, forensic accountants give knowledgeable advice
throughout the commercial or regulatory litigation process in an effort to ascertain and develop key financial
data.
They can provide expert witness testimony supported by effective analysis, trial support by analysing materials
and developing approaches to support the direct and/or cross examination process and comprehensive support
for settlement scenarios.
So, what does it take to become a forensic accountant? Apart from a need for the same basic accounting skills
that it takes to become a good auditor, to be a forensic accountant you need to have the ability to:
 Pay attention to the smallest detail
 Analyse data thoroughly
 Think creatively
 Possess common business sense
 Be proficient with a computer and; have excellent communication skills
 A "sixth sense" that can be used to reconstruct details of past accounting transactions is also beneficial
 A photographic memory helps when trying to visualise and reconstruct these past events.
A forensic accountant also needs the ability to maintain his composure when detailing these events on the
witness stand and should be insensitive to personal attacks on his professional credibility.
One thing forensic accountants learn when conducting fraud investigations is that you can never assume, what
appears to be one thing on the first glance often turns out to be quite different when examined closely.
An increasingly complex business environment and the growing tendency for people to take legal action has led
to the demand for accountants who understand the legal process, and who can conduct investigations, financial
analysis and other accounting or audit procedures at a level acceptable to the courts.
Forensic accountants gather information to form an opinion, which is generally expressed in a report or given as
expert evidence in court. Due to the diversity of commercial matters which are brought before the courts, a
Forensic Accountant's work is often far more challenging and interesting than the traditional compliance or
statutory reporting work undertaken by many accountants in professional practice.
The key areas of work for Forensic Accountants are:
 Quantification of Damages and Loss of Profits
 Assessing the effect on profitability, cashflow, income or value, that a party claims to have incurred, or
may incur, because of either a breach in a contract, personal injury, product liability, breaches of the
Trade Practices Act or Fair Trading, etc.
The Forensic Accountant may also need to consider the impact of other circumstances on the claimed loss, and
the degree to which the loss was mitigated or could have been mitigated in order to determine the actual loss
incurred.
Valuations
Determining the value of shares, businesses, partnerships, intangibles, etc in dispute, lost or destroyed. The
Forensic Accountant must review information as both a financial analyst and as an investigating accountant,
making appropriate adjustments, where necessary, and applying a generally accepted, or arguable, methodology
to determine the value.
Professional Negligence
Reviewing transactions and the actions, or inaction, of various professionals to determine whether the parties
were negligent and, if so, to what extent.
When a review involves an accounting professional, a keen knowledge of the applicable accounting standards
and the prevailing law is required. Therefore, the Forensic Accountant must have the ability to identify the
impact and timing of changes in law and procedures.
Fraud - investigating frauds and establishing procedures to prevent or detect fraud. Forensic Accountants are
frequently called upon to investigate frauds, identify the appropriate documentary evidence, quantify the loss
and to assist in the prosecution of those involved.
Family Law Matters - assessing the existence, value and ownership of the financial resources available to
parties in matrimonial dispute. This type of work requires excellent communication skills when dealing with
related party small family businesses where the personal emotions of the parties involved as frequently the
financial information being considered frequently contains a mixture of business and personal transactions with
tax driven results.
Forensic Accountants need to have an interest in and the aptitude to develop accounting, auditing, financial and
investigative skills to recognise, document and analyse information frequently from hostile or opposing parties-
that is required to form and support an opinion.
The Forensic Accountant must have the confidence and ability to respond immediately to questions raised in
court. Further, and potentially even more important than knowing the answers, the Forensic Accountant must be
able to communicate often extremely technical and complex financial information in a manner that will
understood by the court.