Chapter 1

Accounting: The Language

of Business
What is accounting?
The language of business

Measures financial aspects of a business

Communicates this information to decision
makers
1- 2
The Need for Accounting
Managers, investors, and other internal groups
want the answers to two important questions:
How well did
the organization
perform?
Where does
the organization
stand?
The Need for Accounting
Accountants answer these questions
with three major financial statements:
Income
statement
Balance
sheet
Statement of
cash flows
Introduction
Accounting - a process of identifying, recording,
summarizing, and reporting economic
information to decision makers in the form of
financial statements
Financial accounting - focuses on the specific
needs of decision makers external to the
organization, such as stockholders, suppliers,
banks, and government agencies
The Nature of Accounting
The accounting system is a series of steps
performed to analyze, record, quantify,
accumulate, summarize, classify, report, and
interpret economic events and their effects on an
organization and to prepare the financial
statements.
The Nature of Accounting
Accounting systems are designed to meet the
needs of the decisions makers who use the
financial information.
Every business has some sort of accounting
system.
These accounting systems may be very complex or
very simple, but the real value of any accounting
system lies in the information that the system
provides.
Accounting as an Aid to
Decision Making
Accounting information is useful to anyone
who makes decisions that have economic
results.
Managers want to know if a new product will be
profitable.
Owners want to know which employees are productive.
Investors want to know if a company is a good
investment.
Creditors want to know if they should extend credit,
how much to extend, and for how long.
Government regulators want to know if financial
statements conform to requirements.
Accounting as an Aid to
Decision Making
Fundamental relationships in the decision-
making process:
Event
Accountants
analysis &
recording
Financial
Statements
Users
Financial and Management Accounting
The major distinction between financial and
management accounting is the users of the
information.
Financial accounting serves external users.
Management accounting serves internal users,
such as top executives, management,
and administrators within
organizations.
Financial and Management Accounting
The primary questions about an organizations
success that decision makers want to know are:
What is the financial picture of the organization
on a given day?
How well did the organization do during a given
period?
Financial and Management Accounting
Accountants answer these primary questions
with three major financial statements.
Balance Sheet - financial picture on a given day
Income Statement - performance over a given
period
Statement of Cash Flows - performance over a
given period
Financial and Management Accounting
Annual report - a document prepared by
management and distributed to current and
potential investors to inform them about the
companys past performance and future
prospects.
The annual report is one of the most common
sources of financial information used by investors
and managers.
Financial and Management Accounting
The annual report usually includes:
a letter from corporate management
a discussion and analysis of recent economic events
by management
footnotes that explain many elements of the financial
statements in more detail
the report of the independent auditors
a statement of managements responsibility for
preparation of the financial statements
other corporate information
The Balance Sheet
What are the different sections of the
Balance Sheet?
Balance Sheet
The balance sheet (also called statement of
financial position or statement of financial
condition) is a snapshot of the financial
status of an organization at a point in time.
Balance Sheet
Assets are economic resources that
are expected to benefit future
activities of the organization.
Liabilities are the entitys economic
obligations to others.
Owners equity is the excess
of the assets over the liabilities.
Balance Sheet
Shareholders equity
Paid-in
capital
Retained
earnings
The owners equity of a corporation
is called shareholders equity.
The Balance Sheet
Sections of the balance sheet:
Assets - resources of the firm that are expected to
increase or cause future cash flows (everything the
firm owns)
Liabilities - obligations of the firm to outsiders or
claims against its assets by outsiders (debts of the
firm)
Owners Equity - the residual interest in, or
remaining claims against, the firms assets after
deducting liabilities (rights of the owners)
The Balance Sheet
The balance sheet equation:
Assets = Liabilities + Owners Equity
or
Owners Equity = Assets - Liabilities
Four Basic Financial Statements
Balance Sheet
Assets = Liabilities + Equity

Income Statement (also called Statement of Operations,
Earnings Statement, Profit/Loss (or P&L) Statement
Revenues - Expenses = Net income (or Net Earnings)
Statement of Changes in Stockholders Equity
Beginning of period total equity + Stock issued + Net
income - Dividends = End of period total equity
Statement of Cash Flows
Cash inflow - Cash outflow = Net cash flow
1- 21
Users of Accounting Information
Different categories of users need different
kinds of information for making decisions.
These users can be divided into :
Internal Users; and
External Users.
Internal Users
These are the persons who manage the
business, i.e. management at the top,
middle, and lower levels. Their requirements
of information are different because they
make different types of decisions.
Internal Users continue
The top level is more concerned with
planning; the middle level is concerned
equally with planning and control; and the
lower level is concerned more with
controlling operations. Information is
supplied on different aspects, e.g. cash
resources, sales estimates, results of
operations, financial position, etc.
External Users
All persons other than internal users come
in the group of external users. External
users can be divided into two groups:
those having direct interest; and
those having indirect interest
in a business organization.
External Users continue
The main sources of information for external
users are annual reports of business
organizations, which state the financial
position and performance and give the
auditors report, directors report and other
information.
External Users continue
Investors and creditors are the external
users having direct interest. Tax authorities,
regulatory agencies, customers, labour
unions, trade associations, stock exchanges,
investors, etc are indirectly interested in the
companys financial strength, its ability to
meet short-term and long-term obligations,
its future earning power, etc for making
various decisions.
ASSETS
These are economic resources of an
enterprise that can be usefully expressed in
monetary terms. Assets are things of value
used by the business in its operations.
Fixed Assets
Current Assets
ASSETS continue
Fixed Assets are assets held on a long-
term basis.
e.g. Land, Building, Machinery, Plant,
Furniture and Fixtures, etc.
ASSETS continue
Current Assets are assets held on a
short-term basis.
e.g. Debtors, Bills receivable,
Stock(Inventory), Cash and Bank
balances, etc.
LIABILITIES
These are obligations or debts that the
enterprise must pay in money or services at
some time in the future.
Long-term liabilities
Short-term liabilities
LIABILITIES continue..
Long-term liabilities are those that are
usually payable after a period of one year.
e.g. A term loan from a financial institution,
debentures (bonds) issued by a company.
LIABILITIES continue..
Short-term liabilities are obligations that
are payable within a period of one year.
e.g. Creditors, bills payable, overdraft from
a bank for a short period.
CAPITAL
Investment by the owner for use in the firm
is known as capital. Owners equity is the
ownership claim on total assets. It is equal
to total assets minus total liabilities.
REVENUES
These are the amounts the business earns
by selling its products or providing services
to customers. Other titles and sources of
revenue common to many businesses are:
sales, fees, commission, interest, dividends,
royalties, rent received, etc.
EXPENSES
These are costs incurred by a business in
the process of earning revenue. Generally,
expenses are measured by the cost of
assets consumed or services used during an
accounting period. The usual titles of
expenses are: depreciation, rent, wages,
salaries, interest, costs of heat, light and
water, telephone, etc.
PURCHASES
Purchases are total amount of goods
procured by a business on credit and for
cash, for use or sale. In a trading concern,
purchases are made of merchandise for
resale with or without processing.
In a manufacturing concern, raw materials
are purchased, processed further into
finished goods and then sold. Purchases
may be cash purchase or credit purchase.
SALES
Sales are total revenues from goods or
services sold or provided to customers.
Sales may be cash sales or credit sales.
STOCK
Stock (Inventory) is a measure of
something on hand goods, spares and
other items in a business.
It is called stock on hand.
STOCK: continue
In a trading concern, the stock on hand is
the amount of goods which have not been
sold on the date on which the balance sheet
is prepared. This is also called closing
stock.
STOCK continue
In a manufacturing concern, closing stock
comprises raw materials, semi-finished
goods and finished goods on hand on the
closing date.
Similarly, opening stock is the amount of
stock at the beginning of the accounting
year.
DEBTORS
Debtors are persons and/or other entities who
owe to an enterprise an amount for receiving
goods and services on credit.
The total amount standing against such persons
and/or entities on the closing date, is shown in the
Balance Sheet as Sundry Debtors on the asset
side.
CREDITORS
Creditors are persons and/or other entities who
have to be paid by an enterprise an amount for
providing the enterprise goods and services on
credit.
The total amount standing to the favour of such
persons and/or entities on the closing date, is
shown in the Balance Sheet as Sundry Creditors
on the liability side.
ACCOUNTING PRINCIPLES
Accounting principles can be subdivided into
two categories:
Accounting Concepts; and
Accounting Conventions.
ACCOUNTING PRINCIPLES
Accounting principles can be subdivided into
two categories:
Accounting Concepts; and
Accounting Conventions.
ACCOUNTING PRINCIPLES
Accounting Concepts
Accounting Conventions
The term concept is used to connote
accounting postulates, that is necessary
assumptions and conditions upon which
accounting is based. The term convention
is used to signify customs and traditions as
a guide to the presentation of accounting
statements.
ACCOUNTING PRINCIPLES
Accounting Concepts
Business Entity Concept
Money Measurement Concept
Cost Concept
Going Concern Concept
Dual Aspect Concept
Realization Concept
Accounting Period Concept
ACCOUNTING PRINCIPLES
Accounting Conventions
Convention of Consistency
Convention of Disclosure
Convention of Conservation
ACCOUNTING PRINCIPLES
Accounting Concepts
The term concept is used to connote
accounting postulates, that is necessary
assumptions and conditions upon which
accounting is based.
Business Entity Concept
Business is treated as a separate entity or
unit apart from its owner and others. All the
transactions of the business are recorded in
the books of business from the point of view
of the business as an entity and even the
owner is treated as a creditor to the extent
of his/her capital.
Money Measurement Concept
In accounting, we record only those
transactions which are expressed in terms
of money. In other words, a fact which can
not be expressed in monetary terms, is not
recorded in the books of accounts.
Cost Concept
Transactions are entered in the books of
accounts at the amount actually involved.
Suppose a company purchases a car for
Rs.1,50,000/- the real value of which is
Rs.2,00,000/-, the purchase will be recorded
as Rs.1,50,000/- and not any more. This is
one of the most important concept and it
prevents arbitrary values being put on
transactions.
Going Concern Concept
It is persuaded that the business will exists
for a long time and transactions are
recorded from this point of view.
Dual Aspect Concept
Each transaction has two aspects, that is,
the receiving benefit by one party and the
giving benefit by the other. This principle is
the core of accountancy.
Dual Aspect Concept continue
For example, the proprietor of a business
starts his business with Cash Rs.1,00,000/-,
Machinery of Rs.50,000/- and Building of
Rs.30,000/-, then this fact is recorded at
two places. That is Assets account (Cash,
Machinery & Building) and Capital accounts.
The capital of the business is equal to the
assets of the business.
Dual Aspect Concept continue
Thus, the dual aspect can be expressed as
under

Capital + Liabilities = Assets
or
Capital = Assets Liabilities
Realization Concept
Accounting is a historical record of
transactions. It records what has happened.
It does not anticipate events. This is of
great important in preventing business firms
from inflating their profits by recording sales
and income that are likely to accrue.
Accounting Period Concept
Strictly speaking, the net income can be
measured by comparing the assets of the
business existing at the time of its
liquidation. But as the life of the business is
assumed to be infinite, the measurement of
income according to the above concept is
not possible. So a twelve month period is
normally adopted for this purpose. This time
interval is called accounting period.
ACCOUNTING PRINCIPLES
Accounting Conventions
The term convention is used to signify
customs and traditions as a guide to the
presentation of accounting statements.
Convention of Consistency
In order to enable the management to draw
important conclusions regarding the working
of the company over a few years, it is
essential that accounting practices and
methods remain unchanged from one
accounting period to another. The
comparison of one accounting period with
that of another is possible only when the
convention of consistency is followed.
Convention of Disclosure
This principle implies that accounts must be
honestly prepared and all material
information must be disclosed therein. The
contents of Balance Sheet and Profit and
Loss Account are prescribed by law. These
are designed to make disclosure of all
material facts compulsory.
Convention of Conservation
Financial statements are always drawn up
on rather a conservative basis. That is,
showing a position better than what it is,
not permitted. It is also not proper to show
a position worse than what it is. In other
words, secret reserves are not permitted.
FUNCTIONS OF ACCOUNTING
Keeping systematic records
Protecting properties of the business
Communicating the results
Meeting legal requirements

Keeping systematic records
The first function of accounting is to keep a
systematic record of financial transactions,
to post them to the ledger accounts and
ultimately prepare final statements.
Protecting properties of the business
The second important function is to protect
the property of the business. The system
accounting is designed in such a way that it
protects its assets from an unjustified and
unwarranted use.
Meeting legal requirements
The fourth and the last function of
accounting is to meet the legal
requirements under the Companies Act,
Income Tax Act, Sales Tax Act and so on.
THE ACCOUNTING CYCLE
Recording transactions in subsidiary books.
Classifying data by posting from subsidiary
books to the accounts.
Closing the books and preparation of final
accounts.
CLASSIFICATION OF ACCOUNTS
Accounts in the names of persons are known as
Personal Accounts
Accounts in the names of assets are known as
Real Accounts
Accounts in respect of expenses and incomes
are known as Nominal Accounts
CLASSIFICATION OF ACCOUNTS
ACCOUNTS
PERSONAL
ACCOUNTS
IMPERSONAL
ACCOUNTS
REAL
ACCOUNTS
NOMINAL
ACCOUNTS
PERSONAL ACCOUNTS
Accounts in the name of persons are known as
personal accounts.
Eg: Babu A/C,
Babu & Co. A/C,
Outstanding Salaries A/C, etc.

REAL ACCOUNTS
These are accounts of assets or properties. Assets
may be tangible or intangible. Real accounts are
impersonal which are tangible or intangible in
nature.
Eg:- Cash a/c, Building a/c, etc are Real
Accounts related to things which we can
feel, see and touch.
Goodwill a/c, Patent a/c, etc Real Accounts
which are of intangible in nature.
NOMINAL ACCOUNTS
These accounts are impersonal, but invisible and
intangible. Nominal accounts are related to those
things which we can feel, but can not see and
touch. All expenses and losses and all incomes
and gains fall in this category.
Eg:- Salaries A/C, Rent A/C, Wages A/C, Interest
Received A/C, Commission Received A/C,
Discount A/C, etc.
DEBIT AND CREDIT
Each accounts have two sides the left side and
the right side. In accounting, the left side of an
account is called the Debit Side and the right
side of an account is called the Credit Side. The
entries made on the left side of an account is
called a Debit Entry and the entries made on the
right side of an account is called a Credit Entry.
RULES FOR DEBIT AND CREDIT
Personal
Account
Debit the Receiver
Credit the Giver
Real Accounts
Debit what comes in
Credit what goes
out
Nominal
Accounts
Debit all Expenses
and Losses
Credit all Incomes
and Gains
Steps for finding the debit and credit aspects of a
particular transaction
Find out the two accounts involved in the
transaction.
Check whether it belongs to Personal, Real or
Nominal account.
Apply the debit and credit rules for the two
accounts.
Exercise
Purchased a Building for Rs.20,000/-.
Paid Cash Rs.1,000/- to Satheesh.
Paid Salary Rs.1000/-.
Received Commission Rs.250/-.
Sold goods for Cash Rs.3500/-.
Subsidiary Books
General Journal
Special Journals
Purchase Book
Sales Book
Purchase Return Book
Sales Return Book
Bills Receivable Book
Bills Payable Book
Cash Book
Petty Cash Book
Journal
Journal is the prime or original book of entry in
which all transactions are recorded in the form of
entries. Journalising is an act of recording or
entering transactions in a Journal in the order of
date.




Date Particulars LF Debit
Amount
Credit
Amount
Journal Entry
Jan 1, 1981 Prakash Started a business Rs.
15,000/-
Date Particulars LF Debit
Amount
Credit
Amount
1981
Jan 1
Cash a/c
Dr.
To Prakashs Capital
a/c
(Being cash invetsed to
business)
15,000
15,000