Chapter- 01

Introduction to Accounting

What Is Accounting?
Accounting is the process of recording financial transactions pertaining to a business. The
accounting process includes summarizing, analyzing, and reporting these transactions to
oversight agencies, regulators, and tax collection entities. The financial statements used in
accounting are a concise summary of financial transactions over an accounting period,
summarizing a company's operations, financial position, and cash flows.

Objectives of Accounting
(i) Providing Information to the Users for Rational Decision-making
The primary objective of accounting is to provide useful information for decision-making to
stakeholders such as owners, management, creditors, investors, etc. Various outcomes of
business activities such as costs, prices, sales volume, value under ownership, return of
investment, etc. are measured in the accounting process.
(ii) Systematic Recording of Transactions
To ensure reliability and precision for the accounting measurements, it is necessary to keep a
systematic record of all financial transactions of a business enterprise which is ensured by
bookkeeping. These financial records are classified, summarized and reposted in the form of
accounting measurements to the users of accounting information i.e., stakeholder.
(iii) Ascertainment of Results of above Transactions
‘Profit/loss’ is a core accounting measurement. It is measured by preparing profit and loss
account for a particular period. Various other accounting measurements such as different
types of revenue expenses and revenue incomes are considered for preparing this profit and
loss account. Difference between these revenue incomes and revenue expenses is known as
result of business transactions identified as profit/loss. As this measure is used very
frequently by stockholders for rational decision making, it has become the objective of
accounting.
(iv) Ascertain the Financial Position of Business
‘Financial position’ is another core accounting measurement. Financial position is identified
by preparing a statement of ownership i.e., Assets and Owings i.e., liabilities of the business
as on a certain date. This statement is popularly known as balance sheet. Various other
accounting measurements such as different types of assets and different types of liabilities as
existed at a particular date are considered for preparing the balance sheet. This statement may
be used by various stakeholders for financing and investment decision.
(v) To Know the Solvency Position
Balance sheet and profit and loss account prepared as above give useful information to
stockholders regarding concerns potential to meet its obligations in the short run as well as in
the long run.

The main functions of accounting are as follows:

(a) Measurement: Accounting measures past performance of the business entity and depicts
its current financial position
(b) Forecasting: Accounting helps in forecasting future performance and financial position
of the enterprise using past data.
(c) Decision-making: Accounting provides relevant information to the users of accounts to
aid rational decisionmaking.
(d) Comparison & Evaluation: Accounting assesses performance achieved in relation to
targets and discloses information regarding accounting policies and contingent liabilities
which play an important role in predicting, comparing and evaluating the financial results.
(e) Control: Accounting also identifies weaknesses of the operational system and provides
feedbacks regarding effectiveness of measures adopted to check such weaknesses.
(f) Government Regulation and Taxation: Accounting provides necessary information to
the government to exercise control on die entity as well as in collection of tax revenues.

What Is a Transaction?
A transaction is a completed agreement between a buyer and a seller to exchange goods,
services, or financial assets in return for money. The term is also commonly used in corporate
accounting. In business bookkeeping, this plain definition can get tricky. A transaction may
be recorded by a company earlier or later depending on whether it uses accrual accounting or
cash accounting.

 A transaction involves a monetary exchange for a good or service.

 Transactions can be a little more tricky when it comes to corporate accounting.
 Accrual accounting recognizes a transaction immediately after it is finalized,
regardless of when payment is received or made.
 Cash accounting is used mostly by smaller businesses and records a transaction only
when money is received or paid out.
 Third-party transactions can often complicate the process.
Features of Transaction:
Transaction is an event. All events are not accounting transactions. An event must have the
following features to become a transaction:
1. There must be two parties:
No transaction is possible without two parties. Just as it takes two hands to clap, so it takes
two parties for a transaction to take place. There cannot be a giver unless there is a receiver.
Suppose, X borrows $10,000 from a bank. This is a transaction, since there are two parties
here - X and bank.
2. The event must be measurable in terms of money:
An event will not be regarded as a transaction, unless it is capable of being measured in terms
of money.
3. The event must result in transfer of property or service:
Suppose, we buy a motor-car from S for $40000. This results in transfer of property from S to
us, so it is a transaction. Again suppose, we pay salary to our employee $2000. This results in
transfer of service - the employee renders service and we receive it. So it is a transaction.
4. The event must change the financial position of the business:
Transaction takes place only when there is a change in the financial position of the business.
The change in financial position may be of two kinds:
A. Quantitative change:
This changes the total value of assets and liabilities of a business concern. Suppose,
machinery of $50,000 is destroyed. This reduces the total value of the assets of the business.
As a result, the financial position changes and hence it is a transaction.
B. Qualitative change:
This causes increase or decrease in the different elements of assets or liabilities, but the value
of total assets and total liabilities remains unchanged. Suppose, we buy machinery worth
$50,000. This results in exchange of properties - cash $50,000 goes out of our possession and
at the same time machinery of an equal value comes into our possession. This does not
change the total value of our assets, but this causes a qualitative change in our financial
position, hence it is a transaction.

What is Book-Keeping?
As defined by Carter, ‘Book-keeping is a science and art of correctly recording in books-of
accounts all those business transactions that result in transfer of money or money’s worth’.
Book-keeping is an activity concerned with recording and classifying financial data related to
business operation in order of its occurrence.
Steps/Phases of Accounting Cycle:

(i) Recording of Transaction: As soon as a transaction happens it is at first recorded

in subsidiary book.
(ii) Journal: The transactions are recorded in Journal chronologically.
(iii) Ledger: All journals are posted into ledger chronologically and in a classified
manner.
(iv) Trial Balance: After taking all the ledger account closing balances, a Trial
Balance is prepared at the end of the period for the preparations of financial
statements.
(v) Adjustment Entries: All the adjustments entries are to be recorded properly and
adjusted accordingly before preparing financial statements
(vi) Adjusted Trial Balance: An adjusted Trail Balance may also be prepared.
(vii) Closing Entries: All the nominal accounts are to be closed by the transferring to
Trading Account and Profit and Loss Account.
(viii) Financial Statements: Financial statement can now be easily prepared which
will exhibit the true financial position and operating results.

BASIS OF ACCOUNTING
(I) Accrual Basis of Accounting: Accrual Basis of Accounting is a method of recording
transactions by which revenue, costs, assets and liabilities are reflected in the accounts for the
period in which they accrue. This basis includes consideration relating to deferrals,
allocations, depreciation and amortization. This basis is also referred to as mercantile basis of
accounting.
(II) Cash Basis of Accounting: Cash Basis of Accounting is a method of recording
transactions by which revenues, costs, assets and liabilities are reflected in the accounts for
the period in which actual receipts or actual payments are made.
BASIC ASSUMPTIONS OF ACCOUNTING
(a) Business Entity Concept: This concept explains that the business is distinct from the proprietor.
Thus, the transactions of business only are to be recorded in the books of business.
(b) Going Concern Concept: This concept assumes that the business has a perpetual succession or
continued existence.
(c) Money Measurement Concept: According to this concept only those transactions which are
expressed in money terms are to be recorded in accounting books.
(d) The Accounting Period Concept: Businesses are living, continuous organisms. The splitting of
the continuous stream of business events into time periods is thus somewhat arbitrary. There is no
significant change just because one accounting period ends and a new one begins. This results into the
most difficult problem of accounting of how to measure the net income for an accounting period. One
has to be careful in recognizing revenue and expenses for a particular accounting period. Subsequent
section on accounting procedures will explain how one goes about it in practice.
(e) The Accrual Concept: The accrual concept is based on recognition of both cash and credit
transactions. In case of a cash transaction, owner’s equity is instantly affected as cash either is
received or paid. In a credit transaction, however, a mere obligation towards or by the business is
created. When credit transactions exist (which is generally the case), revenues are not the same as
cash receipts and expenses are not same as cash paid during the period.

BASIC PRINCIPLES OF ACCOUNTING

(a) Realization Concept: This concept speaks about recording of only those transactions which are
actually realized. For example Sale or Profit on sales will be taken into account only when money is
realized i.e. either cash is received or legal ownership is transferred.
(b) Matching Concept: It is referred to as matching of expenses against incomes. It means that all
incomes and expenses relating to the financial period to which the accounts relate should be taken in
to account without regard to the date of receipts or payment.
(c) Full Disclosure Concept: As per this concept, all significant information must be disclosed.
Accounting data should properly be clarified, summarized, aggregated and explained for the purpose
of presenting the financial statements which are useful for the users of accounting information.
Practically, this principle emphasizes on the materiality, objectivity and consistency of accounting
data which should disclose the true and fair view of the state of affairs of a firm.
(d) Duality Concept: According to this concept every transaction has two aspects i.e. the benefit
receiving aspect and benefit giving aspect. These two aspects are to be recorded in the books of
accounts.
(e) Historical Cost Concept: Business transactions are always recorded at the actual cost at which
they are actually undertaken. The basic advantage is that it avoids an arbitrary value being attached to
the transactions. Whenever an asset is bought, it is recorded at its actual cost and the same is used as
the basis for all subsequent accounting purposes such as charging depreciation on the use of asset.

BASIC ACCOUNTING TERMS

(i) Transaction: It means an event or a business activity which involves exchange of
money or money’s worth between parties. The event can be measured in terms of
money and changes the financial position of a person.

(ii) Goods/Services: These are tangible article or commodity in which a business

deals. These articles or commodities are either bought and sold or produced and
sold. At times, what may be classified as ‘goods’ to one business firm may not be
‘goods’ to the other firm.

(iii) Profit: The excess of Revenue Income over expense is called profit. It could be
calculated for each transaction or for business as a whole.

(iv) Loss: The excess of expense over income is called loss. It could be calculated for
each transaction or for business as a whole.

(v) Asset: Asset is a resource owned by the business with the purpose of using it for
generating future profits. Assets can be Tangible and Intangible. Tangible Assets
are the Capital assets which have some physical existence. They can, therefore, be
seen, touched and felt, e.g. Plant and Machinery, Furniture and Fittings, Land and
Buildings, Books, Computers, Vehicles, etc.

(vi) Liability: It is an obligation of financial nature to be settled at a future date. It

represents amount of money that the business owes to the other parties.

(vii) Working Capital: In order to maintain flows of revenue from operation, every
firm needs certain amount of current assets. For example, cash is required either to
pay for expenses or to meet obligation for service received or goods purchased.

(viii) Capital: It is amount invested in the business by its owners. It may be in the form
of cash, goods, or any other asset which the proprietor or partners of business
invest in the business activity.
(ix) Drawings: It represents an amount of cash, goods or any other assets which the
owner withdraws from business for his or her personal use.

(x) Debtor: Debtors are those persons from whom a business has to recover money
on account of goods sold or service rendered on credit.

(xi) Creditor: A creditor is a person to whom the business owes money or money’s
worth. e.g. money payable to supplier of goods or provider of service.

(xii) Capital Expenditure: This represents expenditure incurred for the purpose of
acquiring a fixed asset which is intended to be used over long term for earning
profits there from. e. g. amount paid to buy a computer for office use is a capital
expenditure.

(xiii) Revenue expenditure: This represents expenditure incurred to earn revenue of

the current period. The benefits of revenue expenses get exhausted in the year of
the incurrence. e.g. repairs, insurance, salary & wages to employees, travel etc.

(xiv) Balance Sheet: It is the statement of financial position of the business entity on a
particular date. It lists all assets, liabilities and capital. It is important to note that
this statement exhibits the state of affairs of the business as on a particular date.