Financial Accounting Chapter 03 – Basics of Accounting

Basics of Accounting

03.01. Events and Transactions:

Transaction: Transaction is exchange of an asset and discharge of liabilities with

consideration of monetary value.

Events: While event is anything in general purpose which occur at specific time and
particular place.

We can also say that all transactions are events and but all events are not
transactions. This is because in order events to be called transaction an event must
involve exchange of values.

03.02. Source Documents:

 Source documents are the evidences of business transactions which provide

information about the nature of the transaction, the date, the amount and the
parties involved in it. Transactions are recorded in the books of accounts
when they actually take place and are duly supported by source documents.

 According to the verifiable objective principle of Accounting, each transaction

recorded in the books of accounts should have adequate proof to support it.

 These supporting documents are the written and authentic proof of the
correctness of the recorded transactions. These documents are required for
audit and tax assessment. They also serve as the legal evidence in case of a
dispute. The following are the most common source documents
(i) Cash Memo / Cash Bill (ii) Invoice or Bill
(iii) Receipt (iv) Debit Note
(v) Credit Note (vi) Pay-in-slip
(vii) Cheque (viii) Voucher

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03.03. Double Entry System :

Features of Double Entry System

(i) Every transaction has two fold aspects, i.e., one party giving the benefit
and the other receiving the benefit.

(ii) Every transaction is divided into two aspects, Debit and Credit. One
account is to be debited and the other account is to be credited.

(iii) Every debit must have its corresponding and equal credit.

Advantages of Double Entry System

(1) It keeps a complete record of business transactions. Both personal accounts

and impersonal accounts are kept. The entire information regarding the
values of assets and profits earned during year can be easily obtained.

(2) It provides a check on the arithmetical accuracy of accounts, since every debit
has corresponding credit to it and vice-versa.

(3) The detailed profit and loss account can be prepared to show profits earned
or loss suffered during any given period.

(4) The system makes possible the comparison of purchases as well as sales,
expenditure, income etc., of current year with those of the previous years,
thus enabling a businessman to control his business activities. The balance
sheet can be prepared at any specified point of time or any date showing the
actual amount of assets, liabilities and capital.

(5) It significantly reduces the chances of a fraud and if a fraud is committed it can
be easily detected.

(6) The accurate details with regard to any account can be easily obtained.

Limitations of Double Entry System

(i) The system does not disclose all the errors committed in the books
accounts.
(ii) The trial balance prepared under this system does not disclose certain
types of errors.
(iii) It is costly as it involves maintenance of numbers of books of accounts.

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03.04. Accounting Equation

The source document is the origin of a transaction and it initiates the accounting
process, whose starting point is the accounting equation.

Accounting equation is based on dual aspect concept (Debit and Credit). It

emphasizes on the fact that every transaction has a two sided effect i.e., on the
assets and claims on assets. Always the total claims (those of outsiders and of the
proprietors) will be equal to the total assets of the business concern.

The claims are also known as equities, are of two types:

i.) Owners equity (Capital); ii.) Outsiders’ equity (Liabilities).

Assets = Equities
Assets = Capital + Liabilities (A = C+L)
Capital = Assets – Liabilities (C = A–L)
Liabilities = Assets – Capital (L = A–C)

03.04.01. Effect of Transactions on Accounting Equation :

Transaction 1: Murugan started business with Rs.50,000 as capital.

The business unit has received assets totalling Rs.50,000 in the form of cash and the
claims against the firm are also Rs.50,000 in the form of capital. The transaction can
be expressed in the form of an accounting equation as follows:

Assets = Capital + Liabilities

Cash = Capital + Liabilities
Rs. 50,000 = Rs. 50,000 + 0

Transaction 2: Murugan purchased furniture for cash Rs.5,000.

The cash is reduced by Rs,5,000 but a new asset (furniture) of the same amount has
been acquired. This transaction decreases one asset (cash) and at the same time
increases the other asset (furniture) with the same amount, leaving the total of the
assets of the business unchanged. The accounting equation now is as follows:

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Transaction 3: He purchased goods for cash Rs.30,000.

As a result, cash balance is reduced by the goods purchased, leaving the total of the
assets unchanged.

Transaction 4: He purchased goods on credit for Rs.20,000.

The above transaction will increase the value of stock on the assets side and will
create a liability in the form of creditors.

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Transaction 5: Goods costing Rs.25,000 sold on credit for Rs.35,000.

The above transaction will give rise to a new asset in the form of Debtors to the
extent of Rs.35,000. But the stock of goods will be reduced by Rs.25,000 i.e., the cost
of goods sold. The net increase of Rs.10,000 is the amount of revenue which will be
added to the capital.

Transaction 6: Rent paid Rs.3,000.

It reduces cash and the rent is an expense, it results in a loss which decreases the
capital.

From the above transactions, it may be concluded that every transaction has a
double effect and in each case - Assets = Capital + Liabilities, i.e., ‘Accounting
equation is true in all cases’. The last equation appearing in the books of
Mr.Murugan may also be presented in the form of a statement called Balance Sheet.
It will appear as below:

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03.05. Rules for Debiting and Crediting

In actual practice, the individual transactions of similar nature are recorded, added
and subtracted at one place. Such place is customarily the meaning of debit and
credit, it is essential to understand the meaning and form of an account.

An account is a record of all business transactions relating to a particular person or

asset or liability or expense or income. In accounting, we keep a separate record of
each individual, asset, liability, expense or income. The place where such a record is
maintained is termed as an ‘Account’.

All accounts are divided into two sides. The left hand side of an account is called
Debit side and the right hand side of an account is called Credit side. In the
abbreviated form Debit is written as Dr. And Credit is written as Cr. For example, the
transactions relating to cash are recorded in an account, entitled ‘Cash Account’ and
its format will be as given below:

In order to decide when to write on the debit side of an account and when to write
on the credit side of an account, there are two approaches. They are:

1. Accounting Equation Approach,

2. Traditional Approach.

03.05.01. Accounting Equation Approach:

The accounting equation is a statement of equality between the debits and the
credits. The rules of debit and credit depend on the nature of an account. For this
purpose, all the accounts are classified into the following five categories in the
accounting equation approach:-
(1) Assets Accounts
(2) Capital Account
(3) Liabilities Accounts
(4) Revenues or Incomes Accounts
(5) Expenses or Losses Accounts
If there is an increase or decrease in one account, there will be equal decrease or
increase in another account. Accordingly, the following rules of debit and credit in
respect of the various categories of accounts can be obtained.

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03.05.02. Traditional Approach :

In the traditional approach, transactions can be divided into three categories.

(i) Transactions relating to individuals and firms

(ii) Transactions relating to properties, goods or cash
(iii) Transactions relating to expenses or losses and incomes or gains.
Therefore, accounts can also be classified into Personal, Real and Nominal. The
classification may be illustrated as follows

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(1) Personal Account: As the name suggests these are accounts related to persons.

(a) These persons could be natural persons like Suresh’s A/c, Anil’s a/c, Rani’s A/c
etc.

(b) The persons could also be artificial persons like companies, bodies corporate
or association of persons or partnerships etc. Accordingly, we could have
Videocon Industries A/c, Infosys Technologies A/c, Charitable Trust A/c, Ali
and Sons trading A/c, ABC Bank A/c, etc.

(c) There could be representative personal accounts as well. Although the

individual identity of persons related to these is known, the convention is to
reflect them as collective accounts. e.g. when salary is payable to employees,
we know how much is payable to each of them, but collectively the account is
called as ‘Salary Payable A/c’. Similar examples are rent payable, Insurance
prepaid, commission pre-received etc. The students should be careful to have
clarity on this type and the chances of error are more here.
When a person starts a business, he is known as proprietor. This proprietor is
represented by capital account for all that he invests in business and by drawings
accounts for all that which he withdraws from business. So, capital accounts and
drawings account are also personal accounts.

(2) Real Accounts: These are accounts related to assets or properties or possessions.
Depending on their physical existence or otherwise, they are further classified as
follows:-

(a) Tangible Real Account – Assets that have physical existence and can be seen, and
touched. e.g. Machinery A/c, Stock A/c, Cash A/c, Vehicle A/c, and the like.

(b) Intangible Real Account – These represent possession of properties that have no
physical existence but can be measured in terms of money and have value attached
to them. e.g. Goodwill A/c, Trade mark A/c, Patents & Copy Rights A/c, Intellectual
Property Rights A/c and the like.

(3) Nominal Account: These accounts are related to expenses or losses and incomes
or gains e.g. Salary and Wages A/c, Rent of Rates A/c, Travelling Expenses A/c,
Commission received A/c, Loss by fire A/c etc.

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03.06. Basic Accounting Terms:

Transaction: A transaction is a business event that has a monetary impact on an

entity's financial statements, and is recorded as an entry in its accounting records.

Goods: 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.

Services: These are intangible in nature which is rendered with or without the object
of earning profits.

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

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

Accounts Payable: Money which a company owes to vendors for products and
services purchased on credit. This item appears on the company's balance sheet as a
current liability, since the expectation is that the liability will be fulfilled in less than a
year.

Accounts Receivable: Money which is owed to a company by a customer for

products and services provided on credit. This is often treated as a current asset on a
balance sheet.

Asset: Asset is a resource owned by the business with the purpose of using it for
generating future profits. Assets can be classified into Tangible & Intangible; assets
can also be classified as Current Assets & Non-current Assets.

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. Depending
upon the period of holding, these obligations could be further classified into Long
Term or non-current liabilities and Short Term or current liabilities.

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Tangible Assets: These 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.

Intangible Assets: The capital assets which have no physical existence and whose
value is limited by the rights and anticipated benefits that possession confers upon
the owner are known as lntangible Assets. They cannot be seen or felt although they
help to generate revenue in future, e.g. Goodwill, Patents, Trade-marks, Copyrights,
Brand Equity, Designs, Intellectual Property, etc.

Current Assets – An asset shall be classified as Current when it satisfies any of the
following :

(a) It is expected to be realised in, or is intended for sale or consumption in the

Company’s normal Operating Cycle,
(b) It is held primarily for the purpose of being traded ,
(c) It is due to be realised within 12 months after the Reporting Date, or
(d) It is Cash or Cash Equivalent unless it is restricted from being exchanged or
used to settle a Liability for at least 12 months after the Reporting Date.

Non-Current Assets: All other Assets shall be classified as Non-Current Assets. e.g.
Machinery held for long term etc.

Current Liabilities – A liability shall be classified as Current when it satisfies any of

the following :

(a) It is expected to be settled in the Company’s normal Operating Cycle,

(b) It is held primarily for the purpose of being traded,
(c) It is due to be settled within 12 months after the Reporting Date, or
(d) The Company does not have an unconditional right to defer settlement of the
liability for at least 12 months after the reporting date (Terms of a Liability
that could, at the option of the counterparty, result in its settlement by the
issue of Equity Instruments do not affect its classification)

Non-Current Liabilities: All other Liabilities shall be classified as Non-Current

Liabilities. E.g. Loan taken for 5 years, Debentures issued etc.

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Internal Liability: These represent proprietor’s equity, i.e. all those amount which
are entitled to the proprietor, e.g., Capital, Reserves, Undistributed Profits, etc.

Contingent Asset: An asset in which the possibility of an economic benefit depends

solely upon future events that can't be controlled by the company. Due to the
uncertainty of the future events, these assets are not placed on the balance sheet.
However, they can be found in the company's financial statement notes.

Contingent Liability: It represents a potential obligation that could be created

depending on the outcome of an event. E.g. if supplier of the business files a legal
suit, it will not be treated as a liability because no obligation is created immediately.
If the verdict of the case is given in favour of the supplier then only the obligation is
created. Till that it is treated as a contingent liability. Please note that contingent
liability is not recorded in books of account, but disclosed by way of a note to the
financial statements.

Working capital: It is the amount of cash and liquid assets a company owns. In the
normal course of operations, a business must have cash to pay expenses and
liabilities that are due. This may include payroll, monthly rent and utility expenses,
and other operating costs. Working capital is the money that is available to cover
these expenses and is readily accessible.
There is another concept of working capital. Working capital is the excess of current
assets over current liabilities. This concept of working capital is known as Net
Working Capital which is a more realistic concept.
Working Capital (Net) = Current Assets – Currents Liabilities.

Current Investments: Current investments are investments that are by their nature
readily realizable and are intended to be held for not more than one year from the
date on which such investment is made. e. g. 11 months Commercial Paper.

Non-current Investments: Non-current Investments are investments which are held

beyond the current period as to sale or disposal. e. g. Fixed Deposit for 5 years.

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. Creditors are
generally classified as Current Liabilities.

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Debtor : The sum total or aggregate of the amounts which the customer owe to the
business for purchasing goods on credit or services rendered or in respect of other
contractual obligations, is known as Sundry Debtors or Trade Debtors, or Trade
Payable, or Book-Debts or Debtors. In other words, Debtors are those persons from
whom a business has to recover money on account of goods sold or service rendered
on credit. These debtors may again be classified as under:
(i) Good debts: The debts which are sure to be realized are called good debts.
(ii) Doubtful Debts: The debts which may or may not be realized are called
doubtful debts.
(iii) Bad debts: The debts which cannot be realized at all are called bad debts.

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. From business point of view, capital of owners is a liability
which is to be settled only in the event of closure or transfer of the business. Hence,
it is not classified as a normal liability. For corporate bodies, capital is normally
represented as share capital.

Drawings: It represents an amount of cash, goods or any other assets which the
owner withdraws from business for his or her personal use. Drawings will result in
reduction in the owners’ capital. The concept of drawing is not applicable to the
corporate bodies like limited companies.

Net worth: It represents excess of total assets over total liabilities of the business.
Technically, this amount is available to be distributed to owners in the event of
closure of the business after payment of all liabilities. That is why it is also termed as
Owner’s equity. A profit making business will result in increase in the owner’s equity
whereas losses will reduce it.

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. At times expenditure may be incurred for enhancing the production
capacity of the machine. This also will be a capital expenditure. Capital expenditure
forms part of the Balance Sheet.

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Trade Discount: It is the discount usually allowed by the wholesaler to the retailer
computed on the list price or invoice price. For example, the list price of a TV set
could be Rs. 15000. The wholesaler may allow 20% discount thereof to the retailer.
This means the retailer will get it for Rs.12000 and is expected to sale it to final
customer at the list price. Thus the trade discount enables the retailer to make profit
by selling at the list price. Trade discount is not recorded in the books of accounts.
The transactions are recorded at net values only. In above example, the transaction
will be recorded at Rs.12000 only.

Cash Discount: This is allowed to encourage prompt payment by the debtor. This has
to be recorded in the books of accounts. This is calculated after deducting the trade
discount. e.g. if list price is Rs.15000 on which a trade discount of 20% and cash
discount of 2% apply, then first trade discount of Rs.3000 (20% of Rs.15000) will be
deducted and the cash discount of 2% will be calculated on Rs.12000 (Rs.15000 –
Rs.3000). Hence the cash discount will be Rs.240 (2% of Rs.12000) and net payment
will be Rs.11,760 (Rs.12,000 – Rs.240)

Revenue is the amount earned from a company's main activities such as selling
merchandise or providing services.
A gain results from a peripheral activity, such as selling the old delivery truck. A gain
is the amount received that is in excess of the asset's carrying amount (book value).
For example, if the company receives $3,000 for the truck, and its carry amount was
$600, the company will report a gain of $2,400.
Income is sometimes used instead of the word revenue: some people refer to the
rent they receive as rent income. Generally, accountants use the word income to
mean "net of revenues and expenses." For example, a retailer's income from
operations is sales minus the cost of goods sold minus operating expenses.

An expense is a cost used up in earning revenues in a company's main operations.

Some examples of expenses include advertising expense, commission expense, rent
expense, cost of goods sold, salaries expense, and so on. Expenses also include costs
used up during the accounting period such as interest expense, insurance expense,
and depreciation expense.
A loss is associated with a "peripheral" or "incidental" transaction. Examples of losses
include the loss on the sale of an asset used in the business, loss from a lawsuit
settlement, and loss from retirement of bonds. However, there are some losses that
are closer to operations, such as the loss on write-down of inventory from cost to
market.

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