Unit 1

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.

What is Financial Accounting?

Financial Accounting is the language of business. The purpose of any language is to communicate.

Therefore being a language, Financial Accounting is a tool to communicate and tell the affairs of the
company to the outside world and also to the owners.

This is done through accounting statements.

Therefore, the financial statements should be prepared in a manner, which is understood by all.

It should be prepared and presented in such a manner that what is intended to be conveyed should be clear
and understandable.

It can be said that Financial Accounting is the science of:

●​ Recording and
●​ Classifying business transactions and events, primarily of financial character,

And

Art of making significant summaries,

●​ Analysis and interpretations of these transactions and events and
●​ Communicating the results to persons, who may be managers, investors, employees unions,
government, tax authorities and any other stake holders.

The above definition brings out the following features/Attributes.

1.​ Financial Transactions.

It records only those transactions, which are of financial character.

If a transaction has no financial character then it will not be measured in terms of money and therefore
will not be recorded.

2.​ Recording

It is an art of recording business transactions in a systematic manner. Recording is done in the

book called “journal”.

This book may be further subdivided into various subsidiary books such as:

●​ Cashbook,
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 ●​ Purchase daybook,
●​ Sales daybook etc.

3.​ Classifying

Classifying refers to grouping of transactions or entries of one nature at one place. This is done by
opening accounts in a book called “ledger”.

“Ledger” contains all the accounts of the business.

4.​ Summarizing

Summarizing is the art of presenting the classified data, (ledger) in a manner, which is understandable,
and user-friendly to the management and other stakeholders.

This involves preparation of final accounts, which includes trading and profit and loss accounts and
balance sheet.

5.​ Analysis and interpretations.

For the purpose of analysis, the accounting record must be in such a way as to be able to bring out the
significance of all transactions and events individually and collectively.

Thus the analysis of financial statements will help the management and other stakeholders to judge the
performance of business operations and for preparing for further course of action.

In fact Financial Accounting is the original form of accounting.

Accounting can be defined as the systematic recording, reporting of financial transactions of a business and
a person who manages the accounts of any company or financial institution is called an accountant.

The main purpose of accounting is to allow a company to analyze its statistical data’s and prepare its
financial accounts.

There are certain objectives of accounting. They are the following:

I. To Maintain Systematic Records:

Accounting keeps the systematic records of all the financial transactions of a company or any financial
institution. Proper decision making and analysis of profits are impossible if records are not maintained
systematically in a company. Even tracking previous transactions or remembering the minute detail of a
transaction would be impossible without maintaining these records.

II. Estimating Profit and Loss:

It is impossible to estimate the profit and loss of a company and even a household if proper accountancy
records are not made. Moreover without the proper estimation of profit and loss it is impossible to make
any further financial decisions for a company.

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III. Balance Sheet:

It is easy to understand the financial position of a company when a proper balance sheet is maintained by
the accountant or any other individual of a company. It is difficult to set future targets without the
estimation of the financial position of a company.

IV. Facilitating Rational Decision Making:

As a result of accounting in any particular company, it is easy for a company to make rational decisions in
matters relating to the investment of capital, raising the salaries and providing incentives to the working
staff.

V. Striking a Balance:

In order to maintain the balance between the input and output of the cash flow accounting is extremely
essential to maintain the financial accounts of a company.

VI. True Financial Statement:

In order to gain a proper understanding of the financial status and position of a company auditing is
essential. As a result, the company can understand whether or not it is headed to the right direction.

VII. Prevention and Detection of Errors:

When systematic financial accounts are maintained, a proper trial and error is conducted as a result of
which no errors are committed and even the future errors are corrected.

VIII. Prevention and Detection of Fraud:

As a result of maintenance of proper accounts, it is impossible for any member of the company to conduct
any financial activity that will fill his own pocket and empty the company. As a result of proper
maintenance of accounts, the fraud ratio of a company drops down to zero.

IX. Cost and Property Audit: Proper cost and property audit is conducted by means of accounting as a
result of which proper estimation is made benefiting the company to a large extent.

X. Management, Tax and Social Audit: Apart from cost and property audit, management tax and social
auditing is also conducted by the means of accounting.

To whom it is useful (Users of Accounting Information)

Business information conveyed through financial accounting is useful to different groups of persons who
have interest in the business like:

Owners: Owners need accounting information to know the profitability and financial soundness of their
organization.

Accounting information enables them to take proper decisions.

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2.Investors: Investors need accounting information to know how safe is the company, growth potential
etc for taking a decision to invest further or to withdraw.

3.Creditors: Creditors need accounting information to know the liquidity position and credit worthiness
of the firm in which they are going to extend credit.

4. Employees: Employee’s union need accounting information to know the profitability in order to
demand more wages and bonuses and other employee related benefits.

Government: Government needs accounting information to assess the indirect and direct taxes.

Researchers are interested in interpreting the financial statements of the business concerns for a given
objective.

BOOKKEEPING VS ACCOUNTING

Bookkeeping is maintaining the record of transactions, i.e. recording the transactions.

Accounting means classifying, summarizing in a systematic manner and then interpreting the
results to serve various purposes depending on need of the stakeholders.

Thus bookkeeping is part of accounting, concerned only with original record of transactions.

While accounting is a generic term and bookkeeping is an essential part of it. Accounting begins
where bookkeeping ends. Bookkeeping provides the basis for accounting. It is complementary
to accounting process.

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Comparison Chart
Basis for
Bookkeeping Accounting
Comparison
Bookkeeping is an activity of recording Accounting is an orderly recording and
Meaning the financial transactions of the reporting of the financial affairs of an
company in a systematic manner. organization for a particular period.
What is it? It is the subset of accounting. It is regarded as the language of business.
On the basis of bookkeeping records, Decisions can be taken on the basis of
Decision Making
decisions cannot be taken. accounting records.
Preparation of
Not done in the bookkeeping process Part of Accounting Process
Financial Statements
Balance Sheet, Profit & Loss Account and
Tools Journal and Ledgers
Cash Flow Statement
Single Entry System of Bookkeeping Financial Accounting, Cost Accounting,
Methods /
and Double Entry System of Management Accounting, Human Resource
Sub-fields
Bookkeeping Accounting, Social Responsibility Accounting.
Determination of Bookkeeping does not reflect the Accounting clearly shows the financial position
Financial Position financial position of an organization. of the entity.

LIMITATIONS OF ACCOUNTING

While the financial accounting has many advantages, it has got certain limitations also. Some of
the limitations arise from the fundamental principles, concepts and assumptions.

The limitations are as follows:

Financial Accounting is not fully exact:

Although most of the transactions are recorded on actual basis such as sale or purchase or receipt of cash.
Some estimates must be made such as useful life of an asset, possible bad debts, value of closing stock
to enable the firm to arrive at profit or loss figure.

People have different views on estimates and therefore the figure of profit differs.

Sometimes it is deliberately manipulated to suit certain requirements.

Thus the profit figure cannot be treated as exact.

Financial Accounting does not indicate what the business will realize if sold:

The balance sheet should not be taken to show the amount of cash which the firm may realize by sale of all
its assets.

This is because many assets are not meant to be sold:

They are meant for use and are shown at cost less depreciation.

The actual value may be much more than what is appearing in the balance sheet.
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 Financial Accounting does not tell the whole story:

It is known that in the books of accounts only such transactions and events are recorded as can be
interpreted in terms of money.

There are, however, many other important factors, which though not recorded in the books of accounts, may
make or mar the firm such as:

●​ Relations with the employees,

●​ Caliber of management,
●​ Brand of the product,
●​ Integrity of management etc.
Unless such factors are also kept in mind it is difficult to assess the future of the firm.
Accounting statements may be drawn up wrongly:

Due to different method being employed, say for valuing closing stock, it is possible to arrive at different
figure of profit and loss and to give totally different financial picture.

Off course auditing gives measure of checks but still one must be cautious and also go through the footnotes
and also comments by the auditors carefully.

ACCOUNTING TERMINOLOGY

1.Capital: Capital means the amount (in terms of money or assets having money value), which the
proprietor/ owner/ shareholders/ partners have invested in the organization/business.

For the business, capital is a liability towards the owner. It is also known as owner’s equity and also net
worth. Owner’s equity means owner’s claim against the assets.

It is always equal to:

Capital = Assets – Liabilities.

2.Liability:Liabilities mean the amount, which the firm owes to outsiders, excepting the proprietors.

Thus claim of those who are not owners are called “Liabilities”.

Liabilities=Assets –Capital (Accounting Equation)

3.Asset: “Assets are things of value owned”.

It can be said that “assets” are anything, which will enable the firm to get cash or a benefit in future.
Building, debtors, stock of goods are some of the example of assets. these are resources owned by
company and can be expressed in money.

4. Revenue: Revenue means the amount, which, as a result of operations is added to the capital.

“Revenue” is an inflow of assets which results in an increase in the owner’s equity”

Example of revenues is receipts generated from rendering of services like Doctor, Hospital etc etc.
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5.Expense: Expense is the amount spent in order to produce and sell goods and services, which produce the
revenue.“Expenses” are the use of things or services for the purpose of generating revenues”.

Examples are: payment of salaries, wages, rent etc.

6.Income: “Revenue” is different from “Income”

When goods /services are sold, the receipt is called “revenue”.

The cost of goods sold is called “expense”.

The difference between “revenue” and “expense” is called income.

For example, the goods costing Rs. 15,000 are sold for Rs. 21,000.

The “revenue” is Rs.21, 000,

The “expense” is Rs 15,000 and

The “income” is Rs.21, 000 – Rs. 15,000 =Rs.6, 000.

Income is known as profit.

Income or Profit = Revenue – Expense.
​
7. Purchases: The term purchase is used only for purchase of goods.

Goods are those things which are purchased for resale or producing finished products which are also meant
for sale.

Goods purchased for cash is called “cash purchases”.

Goods purchased on credit are called “credit purchases”

The term “purchases” includes both “Cash purchases” as well as “Credit purchases”.

8. Sale: This term is used for sale of goods only. When goods are sold for cash, it is called “cash
sales”.When goods are sold but payment is not received immediately, it is called “credit sale”.

The term “sale” includes: “cash sales” and “credit sales”.

9.Stock: The term “stock” includes goods lying unsold on a particular date.

To ascertain the value of the closing stock, it is necessary to make a complete list of all the items in the
godown together with quantities.

The stock is valued on the basis of: “Cost” or “market price” which ever is less. The “opening stock”
means:

Goods lying unsold in the beginning of the accounting year.

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 Whereas the term “Closing stock” includes: Goods lying unsold at the end of the accounting period.so
closing stock of one accounting period will be opening stock of next accounting period.

10. Debtors: A person who owes money to the firm mostly on account of credit sale of goods or services
is called debtor.

For example, when goods are sold to a person on credit that person does not pay immediately but he pays
in future.

He is called a debtor because he owes some money to the firm.

11. Creditors: A person to whom the firm owes some money is called a creditor. It is mostly on account
of credit purchases by the firm, where the money is not paid immediately by the firm but paid at a
future date.

12. Losses: Loss really means something against which the firm receives no benefit. Expenses lead to
revenue but losses do not, such as theft etc.

13. Proprietor: A person who invests in business and bears all the risks connected with the business is
called proprietor.

14. Drawings: It is the amount of money or the value of goods, which the proprietor takes for his
domestic or personal use.

15. Transaction: Transaction means any exchange of goods or services for cash or on credit, big or
small like purchasing a machine or a pencil. Strictly, transactions are only with the outsiders.

However, there are some events like wear and tear of machinery, which also must be recorded like other
transactions.

Thus, a transaction is a business event involving transfer of money or money’s worth.

16. Entry: The record made in the books of accounts in respect of a transaction or an event is called an
entry.

18 .Gross Profit:Refers to what is left after you subtract the cost of goods sold from the sales. It is also
called gross margin. For example, if an organization buys in an item for $50 and sells it for $75 (plus sales
tax), then the gross profit will be $25.

19. Fixed Assets: This refers to all of those things that the business owns which will have a value to the
business over a long period. This is usually understood to be any time longer than one year. It includes
freehold property, plant, machinery, computers, motor vehicles, and so on.

20. Current Assets : This refers to assets with the value available entirely in the short term. This is usually
understood to be a period of less than a year. This is either because they are what the business sells or
because they are money or can quickly be turned into money. Examples of assets include inventory/stock,
money owing by customers, money in the bank, or other short-term investments.

21. Current Liabilities :This refers to those things that the business could be called upon to pay in the short
term - within the year. Examples include bank overdrafts and money owing to suppliers.

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22. Working Capital : This is the difference between current assets and current liabilities. An organization
without sufficient working capital cannot pay its debts as they fall due. In this situation it may have to stop
trading even if it is profitable.

23. Liquidity: This is the ability to meet current obligations with cash or other assets that can be quickly
converted into cash in order to pay bills as they become due. In other words the organization has enough
cash or assets that will become cash so that it is able to write checks without running out of money.

24. Bad Debt: All reasonable means to collect a debt have been tried and have failed so the amount owed is
written off as a loss and becomes categorized as an expense on an income statement. This results in net
income being reduced. Bad debts are normally generated due to payment defaults of debtor.

25. Depreciation :Assets have a certain length of time in which they operate efficiently, referred to as 'an
asset's useful life.' During this period the value of that asset depreciates due to age, wear and tear, or
obsolescence. The loss in value is recorded in accounts as a non-cash expense, which reduces earnings
whilst raising cash flow.

26. Accrual Accounting: Accrual accounting is a type of accounting in which all transactions are recorded
at the point when they occur. It is different from cash accounting, whereby transactions are recorded when
money changes hands. Because cash accounting produces a less than accurate picture of the state of an
organization's finances, accrual accounting is used worldwide by businesses, governments, and
non-governmental organizations.

27. Accounting Period: An accounting period, in bookkeeping, is the period with reference to which
accounting books of any entity are prepared. It is the period for which books are balanced and the financial
statements are prepared. Generally, the accounting period consists of 12 months.

28. Financial year: the financial year is the period between 1 April and 31 March in which you earn an
income.

29. Balance Sheet: A quantitative summary of a company's financial condition at a specific point in time,
including assets, liabilities and net worth.

The first part of a balance sheet shows all the productive assets a company owns, and the second part shows
all the financing methods (such as liabilities and shareholders' equity).

30. Income Statement - An accounting of sales, expenses, and net profit for a given period. an income
statement depicts what happened over a month, quarter, or year. It is based on a fundamental
accounting equation (Income = Revenue - Expenses) and shows the rate at which the owners’ equity
is changing for better or worse.

31. A contingent liability is a potential liability. This means that the contingent liability might become an
actual liability and a loss, or it might not. It depends on something in the future.
32. Operating Cycle

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10
Business Structure in India

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ACCOUNTING CONCEPTS (PRINCIPLES) AND CONVENTIONS.

A renowned accountant once observed that: ‘accounting was born without notice and reared in neglect’.

Accounting was first practiced and then theorized. Certain ground rules were initially set for financial
accounting; these rules arose out of conventions. Therefore, these are called accounting concepts or
conventions and are very much useful in understanding accounting.

These are:

1.The entity concept: Under this concept a business is an artificial entity distinct from its proprietor. A
business entity is an economic unit, which owns its assets and has its obligations (Liabilities).

The owner(s) may have personal bank accounts, real estate and other assets, but these will not be
considered as assets of the business.

A business entity may be in the form of:

●​ A sole proprietorship concern,

●​ A partnership entity, or

●​ A corporate entity.

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In the case of a proprietorship business, the sole proprietor is considered fully responsible for the welfare
of the entity and, in the eyes of the law the proprietor and business are not considered to have
separate existence.

For accounting purposes, however they are separate entities and an accountant will record transactions
between the owner and the firm:

For instance, when capital is provided by the owner, the record will show that the firm has received so
much money and is owing it to proprietor.

In case the proprietor withdraws the money from business for his personal use, it will be charged to him.
An account is kept for the owners like other persons.

A partnership form of business has more than one owner who have “agreed to share profits of a business
carried on by all or any one of them acting for all.”

A corporate entity is a separate legal entity, entirely divorced from its owners (called equity
shareholders).

A sole proprietorship business normally comes to an end with the expiry of owner,

A partnership firm may cease to operate or, at least, there will be reconstruction of the agreement on the
expiry of an owner (called partner).

But a corporate entity is not disturbed at all on the expiry of any equity shareholder.

2.Money Measurement concept

This implies that only those transactions and events are recorded in accounting, which can be
expressed in monetary terms.

In other words, an event, howsoever important may be to the business, will not be recorded unless
its monetary effect can be measured with a fair degree of accuracy.

For example the death of Dhiru Bhai Ambani cannot be recorded in the books of accounts, as the
monetary effect cannot be measured with a fair degree of accuracy.

Although it had great effect on the fortunes of various Reliance group companies.

This has been one of the serious limitations of accounting since, probably; one of the most
important assets of an undertaking is the quality and caliber of its management, which cannot
be recorded.

The basic measurement in accounting is money and it is assumed that the monetary unit i.e. rupee
is stable unit in value.

Although this assumption is not valid as money value changes over a period of time, the
purchasing power of money changes quite often due to inflation and changes in global
markets.

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 3.The Going concern concept: The going concern means that the firm will last for a long time. This
implies that the business will exist for an infinite time and transactions are recorded from this point
of view.

This necessitates distinction between expenditure that will render benefit for a long period and that whose
benefit will be exhausted quickly, say within a year.

Of course if it is certain that the business will exist only for a limited time, the accounting record will keep
the expected life in view.

The financial statement of a business is prepared on the assumption that it is a continuing enterprise.

On the basis of this assumption fixed assets are recorded at their original cost and are depreciated in a
systematic manner without reference to their market value.

An example of this would be purchase of machinery, which would last, say for next 10 years.

The cost of machinery would be spread on a suitable basis over the next 10 years for ascertaining the profit
and loss of each year.The full cost of machine would not be treated as an expense in the year of its
purchase.

In the absence of this concept no outside parties would enter into long term contracts with the company for
supplying funds and goods.

A firm is said to be a going concern when there is neither the intention nor the necessity to wind up its
operations.

4. The cost concept: Assets such as land, buildings, plant and machinery etc. and obligations such as loans,
public deposits should be recorded at historical cost (i.e., cost at the time of acquisition)

For example: Land purchased by a business entity five years back at a cost of Rs. 20 lacs should be shown,
as per cost concept, at the same amount even today when the current price of land have increased five
fold.

The greatest limitation of this concept is that it distorts the true worth of an asset by sticking to its original
cost.

5.The periodicity concept: The activities of a going concern are continuous flows.

In order to judge the performance of a business entity, one cannot wait for eternity to see the business
coming to a halt.

Therefore the best way to judge a business is to have a periodic performance appraisal.

Such a period to measure business performance is called an accounting period.

The results of operations of an entity are measured periodically i.e., in each accounting period.

As per Companies Act, 1956 different business entities may follow different accounting periods depending
on convenience.

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An entity may follow calendar year as an accounting period another may follow the financial year.

But the Income Tax Act, 1961 has now made it compulsory for all companies to follow financial year as an
accounting period for reporting to Income tax authorities.

6.The Accrual Concept:It suggests that income and expenses should be recognized as and when they are
earned and incurred, irrespective of fact whether the money is received or paid in connection thereof.

The Companies Act, 1956 has prescribed that this concept has to be followed for practically all-accounting
purposes.

The alternative to accrual concept is cash basis of accounting as per which the entry will be made only
when the cash is received.

As per Act, wherever it is not possible to follow the accrual concept, the cash basis may be followed and the
fact must be reported as a footnote to the balance sheet.

Example of accrual concept is:

(i)​ Rent paid for fifteen months in advance on 1st January 2005.

The business follows calendar year as accounting year.

In this case rent for first twelve months should be recognized as an expense for the year 2005.

(ii)​ Credit sales for the year 2005 were Rs.20 lacs.

Cash collected from customers during the year was Rs 15 lacs.

Therefore the sales for 2005 should be considered as Rs 20 lacs and not Rs 15 lacs.

7. Matching Concept: The inherent concept involved in accrual accounting is called matching concept.

The revenue earned in an accounting year is offset (matched) with all the expenses incurred during the same
period to generate that revenue. The matching concept is very much vital to measure the financial
results of a business.

In accrual basis of accounting, revenue is recognized when the sale is complete or services are rendered
rather than when the cash is received.

Similarly the expenses are recognized not when cash is paid but when assets or services have been used to
generate revenue.

For example:

(i) When an item of revenue is entered in the profit and loss account, all the expenses incurred (whether
paid for in cash or not) should be taken in the expense side.

If an amount is spent but against which the revenue will be earned in the next period.

The amount should be carried down to the next period and

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(the amount is shown in the balance sheet as an asset) and the same will be treated as an expense in the next
period.

To illustrate the point we take the following example:

(a)​ At the end of the year, some of the goods purchased remain unsold.

Then the cost of the goods concerned should be carried to the next year and set off against the sales of the
next year.

The valuation of the stock and deducting it from the total costs (or being put in the credit side of the
trading account) makes sales and costs comparable.

(b)​ Machinery purchased will last say for ten years .

Then only one tenth of the cost will be treated as expense for the year and remaining amount should be
shown in the balance sheet as an asset.

8.Concept of Prudence

It states that ‘anticipate no profits but provide for all possible losses’.

Prudence means the caution in the exercise of the judgments needed in making the estimates required
under conditions of uncertainty, such that:

Assets and income are not, overstated and liabilities or expenses are not understated.

The principle is that: Expected losses should be accounted for but not the anticipated gains.

9.The Realization Concept

The realization concept tells that to recognize revenue, it has to be realized. Realization principle does
not demand that the revenue has to be received in cash.

The revenue from sales should be recognized when the seller of goods has transferred to the buyer the
title of the goods for a price and no uncertainty exists regarding the consideration that will be derived
from the sale of goods.

Accounting Conventions
Convention of Consistency

To compare the results of different years, it is necessary that accounting rules, principles, conventions and
accounting concepts for similar transactions are followed consistently and continuously. Reliability of
financial statements may be lost, if frequent changes are observed in accounting treatment. For example, if a
firm chooses cost or market price whichever is lower method for stock valuation and written down value
method for depreciation to fixed assets, it should be followed consistently and continuously.

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Consistency also states that if a change becomes necessary, the change and its effects on profit or loss and
on the financial position of the company should be clearly mentioned.

Convention of Disclosure

The Companies Act, 1956, prescribed a format in which financial statements must be prepared. Every
company that fall under this category has to follow this practice. Various provisions are made by the
Companies Act to prepare these financial statements. The purpose of these provisions is to disclose all
essential information so that the view of financial statements should be true and fair. However, the term
‘disclosure’ does not mean all information. It means disclosure of information that is significance to the
users of these financial statements, such as investors, owner, and creditors.

Convention of Materiality

If the disclosure or non-disclosure of information might influence the decision of the users of financial
statements, then that information should be disclosed.

For better understanding, please refer to General Instruction for preparation of Statement of Profit and Loss
in revised scheduled VI to the Companies Act, 1956:

●​ A company shall disclose by way of notes additional information regarding any item of income or
expenditure which exceeds 1% of the revenue from operations or Rs 1,00,000 whichever is higher.
●​ A Company shall disclose in Notes to Accounts, share in the company held by each shareholder
holding more than 5% share specifying the number of share held.

Conservation or Prudence

It is a policy of playing safe. For future events, profits are not anticipated, but provisions for losses are
provided as a policy of conservatism. Under this policy, provisions are made for doubtful debts as well as
contingent liability; but we do not consider any anticipatory gain.

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18
DOUBLE ENTRY ACCOUNTING

Accounting starts with recording and ends in presenting financial information in a manner which
facilitates

“informed judgments and decisions by users”

The recording of transactions and events follow a definite rule.

Each transaction and /or events has two aspects or sides- debit and credit.

Every debit has an equal and opposite credit. This is the crux of double entry concept.

Each transaction should be recorded in such a way that it affects two sides- debit and credit- equally.

The Accounting Trail – Steps of Book keeping

The sequence of activities in an accounting process can be shown as below: steps to be follow in
preparation of financial statement

Transaction/event

Preparation of vouchers

Recording in the primary books

Posting in the secondary books

Preparation of Trial balance

Preparation and presentation of financial statements i.e. profit &loss account

,Balance sheet and cash flow statement.

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 The Accounting Equation

The balance sheet has three elements:

Assets,
Liabilities and
Equity

Equity is the residual interest of owners in assets over liabilities.

The relationship is expressed with the help of an equation, known as Fundamental Accounting Equation:

Assets (A) =Liabilities (L) + Equity (E).

The above equation has a unique feature in the sense that all business transactions will affect the equation in
such a way that either the equality will be maintained or a new equality achieved.

This is possible by the operation of double entry concept.

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Example 2

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Every business transaction can be explained in terms of its effect on accounting equation. We take an
example:

Consider X Ltd. having the following position of assets and liabilities as on 31st March 2005.

Assets​ ​ ​ ​ ​ (Rs. in lacs)

​
​ ​ ​ Land and building​ ​ ​ 120
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​ ​ ​ Plant and Machinery​ ​ 235

​ ​ ​ Furniture and Fittings​​ ​ 35

​ ​ ​ Inventory​ ​ ​ ​ ​ 90

​ ​ ​ Debtors​ ​ ​ ​ ​ ​ 40
​ ​ ​ Cash & Bank Balance​​ ​ 25
​ ​ --------
​ 545
--------
​ ​ Liabilities
​ ​ ​ Equity​​ ​ ​ ​ ​ 345
​ ​ ​ Long- term Loan​ ​ ​ ​ 140
​ ​ ​ Short-term Loan​ ​ ​ ​ 25
​ ​ ​ Creditors​ ​ ​ ​ ​ 35
​ ​ ​ ​ ​ ​ ​ ​ -------
545
-------

The following are some of the transactions entered into by X Ltd. during the year.

(a) Purchased piece of land for Rs 5 lacs in cash.

(b) Collected Rs. 35 lacs from debtors.
(c) Repaid an instalment of long term loan Rs 15 lacs
(d) Paid Rs. 20 lacs to creditors.

Show the effect of the above transactions upon the accounting equation.
Solution

The accounting equation (A=L+E) as on 31st March 2005 is as follows:

A=L+E
545 = 200+345

The above equation is affected by every transaction as follows:

(a)​ Purchased a piece of land for Rs 5 lacs in cash.

Original position:

A (Rs.545 lacs) = L (Rs. 200 lacs) + E (Rs.345 lacs)

Revised position after the above transactions

A [Rs 545 lacs+ Rs 5 lacs (land) – 5 lacs (cash)] = L (Rs.200 lacs) +E (Rs.345 lacs)

i.e.:

A (Rs. 545 lacs) = L (Rs. 200 lacs) + E (Rs. 345 lacs)

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(b)​ Collected Rs 35 lacs from debtors.

A [Rs 545 lacs + Rs 35 lacs (cash) – Rs.35 lacs (Debtors)] =L (Rs. 200 lacs)+ E (Rs.345 lacs)

i.e.:
A (Rs.545 lacs) = L (Rs. 200 lacs) + E (Rs 345 lacs)

(c)​ Repaid an instalment of long-term loan of Rs 15 lacs.

A [Rs 545 lacs- Rs 15 lacs (cash)] = L [Rs.200 lacs- Rs.15 lacs (long term loan)] + E (Rs. 345 lacs)
i.e.:

A (Rs.530 lacs)= L (Rs 185 lacs) +E (Rs.345 lacs)

(d)​ Paid Rs. 20 lacs to creditors:

A [Rs.530 lacs- Rs. 20 lacs (cash)] =L (Rs. 185 lacs –Rs. 20 lacs (creditors)] + E (Rs.345 lacs)
i.e.:

A (Rs.510 lacs) = L (Rs 165 lacs) +E (Rs.345 lacs)

Example 2:

ABC Ltd. is an incorporated company and carry on the business of selling soft drinks. ABC Ltd’s
transactions for the month of January were as follows:

Jan 1: ​ Issued equity shares of Rs 20,00,000 (cash

received in full)

Jan 5: Purchased land for Rs.5, 75,000

Jan 8: ​ Purchased building for Rs. 4,40,000, paying

Rs.1, 40,000 in cash and balance payable in
three monthly instalments.

Jan 15:​ Purchased Machinery worth Rs. 2,20,000

Jan 20: Purchased syrup (raw material) for making soft

drinks worth Rs.5,75,000 paying Rs 1,75,000
in cash and accepting a bill drawn by the
supplier for the balance.

Jan 25:​ Purchased further Machinery worth Rs 50,000

Jan 31:​ Sold cold drinks worth Rs 50,000 (consuming

Rs 30,000 of syrup)

Show the effects of the above transactions upon accounting equation.

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Jan Cash Inventory Land Building Machinery Creditors Bills Equity
Payable
1 +20,00,000 +20,00,0
5 -5,75,000 +5,75,000 00

14,25,000 5,75,000
Balance 20,00,00
0
8 -1,40,000 +4,40,000 +3,00,000

12,85,000 5,75,000 4,40,000 3,00,000 20,00,00

Balance 0
15 -2,20,000 +2,20,000

10,65,000 5,75,000 4,40,000 2,20,000 3,00,000 20,00,00

Balance 0
20 -1,75,000 +5,75,000 +4,00,000

8,90,000 5,75,000 5,75,000 4,40,000 2,20,000 3,00,000 4,00,000 20,00,00

Balance 0
25 -50,000 +50,000

8,40,000 5,75,000 5,75,000 4,40,000

Balance 2,70,000 3,00,000 4,00,000 20,00,00
0
31 +50,000 -30,000 +20,000

Balance 8,90,000 5,45,000 5,75,000 4,40,000 2,70,000 3,00,000 4,00,000 20,20,00

0

Overview of Depreciation | Depreciation Accounting

What is Depreciation?

Depreciation is the systematic reduction in the recorded cost of a fixed asset. Examples of fixed assets that
can be depreciated are buildings, furniture, leasehold improvements, and office equipment. The only
exception is land, which is not depreciated (since land is not depleted over time, with the exception of
natural resources). The reason for using depreciation is to match a portion of the cost of a fixed asset to the
revenue that it generates; this is mandated under the matching principle, where you record revenues with
their associated expenses in the same reporting period in order to give a complete picture of the results of a
revenue-generating transaction. The net effect of depreciation is a gradual decline in the reported carrying
amount of fixed assets on the balance sheet.

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It is very difficult to directly link a fixed asset with a revenue-generating activity, so we do not try - instead,
we incur a steady amount of depreciation over the useful life of each fixed asset, so that the remaining cost
of the asset on the company's records at the end of its useful life is only its salvage value.

There are three factors to consider when you calculate depreciation, which are:

●​ Cost of Asset: An asset's cost is considered to be all of the costs of getting an asset in place and
ready for use. Therefore, the labor cost of installing a new machine is considered to be part of the
asset's cost. So cost of assets for depreciation will be

Purchase price+ loading / unloading exp.+commission paid on purchase+ installation cost+

transportation cost + taxes and duties etc.

The total cost of the asset, including installation costs, will be depreciated over the useful life of the
asset.

●​ Useful life. This is the time period over which the company expects that the asset will be
productive. Past its useful life, it is no longer cost-effective to continue operating the asset, so it is
expected that the company will dispose of it. Depreciation is recognized over the useful life of an
asset.
●​ Salvage value. When a company eventually disposes of an asset, it may be able to sell it for some
reduced amount, which is the salvage value. Depreciation is calculated based on the asset cost, less
any estimated salvage value. If salvage value is expected to be quite small, then it is generally
ignored for the purpose of calculating depreciation.
●​ Depreciation method. You can calculate depreciation expense using an accelerated depreciation
method, or evenly over the useful life of the asset. The advantage of using an accelerated method is
that you can recognize more depreciation early in the life of a fixed asset, which defers some income
tax expense recognition into a later period. The advantage of using a steady depreciation rate is the
ease of calculation. Examples of accelerated depreciation methods are the declining balance and
sum-of-the-years digits methods. The primary method for steady depreciation is the straight-line
method. The units of production method is also available if you want to depreciate an asset based on
its actual usage level, as is commonly done with airplane engines that have specific life spans tied to
their usage levels.

If, midway through the useful life of an asset, you expect its useful life or the salvage value to change, you
should incorporate the alteration into the calculation of depreciation over the remaining life of the asset; do
not retrospectively change any depreciation that has already been recorded.

Other Depreciation Issues

Depreciation has nothing to do with the market value of a fixed asset, which may vary considerably from
the net cost of the asset at any given time.

Depreciation is a major issue in the calculation of a company's cash flows, because it is included in the
calculation of net income, but does not involve any cash flow. Thus, a cash flow analysis calls for the
inclusion of net income, with an add-back for any depreciation recognized as expense during the period.

Why Depreciation is Important

Depreciation has multiple benefits:

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●​ The process helps companies accurately state incurred expense from using the asset and compare
that to the revenue that asset brings in. Lack of depreciation can lead to over or under stating total
asset expenses, which can lead to misleading financial information.
●​ It also helps businesses reports the correct net book value of a given asset. Most businesses report
the original purchase cost of the asset. But since assets experience wear and tear from daily use, the
actual value declines over time. Companies can find an asset’s net book value by subtracting the
asset’s overall depreciation expense from the cost when the asset was purchased.
●​ Depreciation allows for companies to recover the cost of an asset when it was purchased. The
process allows for companies to cover the total cost of an asset over it’s lifespan instead of
immediately recovering the purchase cost. This allows companies to replace future assets using the
appropriate amount of revenue.
●​ There are tax rules that make depreciation tax deductible. A greater depreciation expense lowers
taxable income and increases tax savings.

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Example of SLM

Example of wdv

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 ASIS FOR
SLM WDV
COMPARISON

Meaning A method of depreciation A method of depreciation

in which the cost of the in which a fixed rate of
asset is spread uniformly depreciation is charged
over the life years by on the book value of the
writing off a fixed amount asset, over its useful life.
every year.

Calculation of On the original cost On the written down

depreciation value of the asset.

Annual depreciation Remains fixed during the Reduces every year

charge useful life.

Value of asset Completely written off Not completely written

off

Amount of Initially lower Initially higher

depreciation

Impact of repairs Increasing trend Remains constant

and depreciation on
P&L A/c

Appropriate for Assets with negligible Assets whose repairs

repairs and maintenance increase, as they get older
like leases, copyright. like machinery, vehicles
etc.

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