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Accounting Equation

The three components of a balance sheet can be stated in the form of following basic accounting equation Assets = Liabilities + Capital (owners equity) eg: Rs.50,000=Rs. 10,000+Rs.40,000 This equation tells at a glance that the resources of this enterprise total Rs. 50,000 and these assets are financed by two sources Rs. 10,000 by the creditors(liabilities), also known as outsiders claims, and Rs.40,000 by the owner (capital), also known as owner equity.

Business Transactions
It is an economic event that relates to a business entity. It can be a purchase of goods, collection of money, payment to creditors for goods and expenses. An event to be a transaction must possess the quality of economic substance, relate to business and affect the economic results. In other words, an event must be capable of being measured in monetary terms and related to business enterprise in terms of economic consequence.

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. For example, Departmental Store owns a fleet of trucks, which is used by it for delivering food stuff; the trucks, thus, provides economic benefits to the enterprise. This item will be shown of the asset side of the balance sheet of Departmental Store. Assets can be broadly classified into two types: Fixed Assets and Current Assets.
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Fixed Assets are assets held on a long term basis, such as land, buildings, machinery, plant, furniture and fixtures. These assets are used for doing business and not for re-sale in normal course of operation. Current Assets are assets held on a short term basis such as debtors (account receivable), bills receivable (notes receivable), stock (inventory), temporary investment in securities, cash and bank balances. Normally the short term refers to an accounting year.

Liabilities
These are the obligations or debts that the enterprise must pay in money or services at sometime in the future. Therefore, represent creditors, claims against assets of the firms. Both small and big businesses find it necessary to borrow money at some time or the other, and to purchase goods on credit.

For example, super bazaar, purchases goods for Rs. 10,000 on credit for a month from Fast Foods Products Company on 25 December 2001. If the balance sheet of Departmental stores is prepared as at 31 December 2001, Fast Food Products Company will be shown as creditors (accounts payable) on the liabilities side of the balance sheet. If the departmental store also takes a loan for a period of three years from ABC Bank Ltd., this will be shown as a liability in the balance sheet of the Departmental Stores.
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Long term liabilities are those that are usually payable after a period of one year, for example, a term loan from financial institution or debentures (bonds) issued by the company. Short term liabilities are obligations that are payable within a period of one year, for example, creditors (accounts payable), bills payable (notes payable), cash credit overdraft from a bank for a short period.

Capital
Investment by the owners for the use in the firm is known as capital. From the accounting equation given earlier, it can easily be found that the capital is Rs.40,000. Owners equity is the ownership claim on total assets. It is equal to total assets minus total external liabilities: E=A-L this is also called residual interest. Owner's equity is equal to capital.

Sales
Sales are total revenues from goods sold and/or services sold or provided to customers. Sales may be cash sales or credit sales.

Revenues
These are the amounts the business earns by selling it products or providing services to customers. These are called 'sales revenues'. Other items and sources of revenues 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 revenues. Generally, expenses are measured by the cost of assets consumed or services used during an accounting period. The usual items of expenses are: depreciation, rent, wages, salary, interest, costs of heat, light and water, telephone, etc.

Expenditure
Expenditure is the amount of resources consumed. Usually, it is of long term in nature. Therefore, its benefit is to be derived in future. For example: capital expenditure.

Loss
Loss is the gross decreases in the assets or gross increases in the liabilities. It is the excess of expenses over revenues. It represents reduction in owners' equity due to inability of the firm to recover the assets used in the business. For example, a firm spends Rs. 70,000 and generates revenue of Rs. 60,000, there is a loss of Rs. 10,000 which represents non-recovery of assets consumed in doing business.

Income
Income is the increase in the net worth of the organization either from business activity or other activities. Income is a comprehensive term, which includes profit also. In accounting income is the positive change in the wealth of the firm over a period of time.

Profit
Profit is the excess of revenues over expenses during an accounting year. It increases the owners equity.

Gains
Gain is the change in the equity (net worth) arising from change in the form and place of goods and holding of assets over a period of time whether realized or unrealized. It may either be of capital nature or revenue nature or both.

Drawings
It is the amount of cash or other assets withdrawn by the owner for his personal use.

Purchases
Purchases are total amounts 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 purchases or credit purchases.

Stock
Stock (inventory) is a measure of something on hand-goods, spares and other items-in a business. It is called stock on hand.

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 (ending inventory). In a manufacturing company, closing stock comprises raw materials, semi-finished goods and finished goods on hand on the closing date. Similarly, opening stock (beginning inventory) is the amount of stock at the beginning of the accounting year.

Debtors/Accounts Receivable
Debtors (accounts receivable) are persons and/or other entities who owe to an enterprise an amount for receiving goods and services on the credit. The total amount due from such persons and/or entities on the closing date is shown in the balance sheet as the sundry debtors (account receivables) on the asset side.

Creditors/Accounts Payable
Creditors (accounts payable) are persons and/or other entities who have to be paid by an enterprise an amount for providing the enterprise goods and/ or services on credit. The total amount standing due to such persons and/or entities on the closing date is shown on the balance sheet as sundry creditors (accounts payable) on the liability side. Accounting - process of identifying, measuring, and reporting financial information of an entity Accounting Equation - assets = liabilities + equity Accounts Payable - money owed to creditors, vendors, etc. Accounts Receivable - money owed to a business, i.e. credit sales Accrual Accounting - a method in which income is recorded when it is earned and expenses are recorded when they are incurred, all independent of cash flow Accruals - a list of expenses that have been incurred and expensed, but not paid or a list of sales that have been completed, but not yet billed Amortization gradual reduction of amounts in an account over time, either assets or liabilities Asset - property with a cash value that is owned by a business or individual Audit Trail a record of every transaction, when it was done, by whom and where, used by auditors when validating the financial statement Auditors third party accountants who review an entitys financial statements for accuracy and provide a statement to that effect

Balance Sheet - summary of a company's financial status, including assets, liabilities, and equity Bookkeeping - recording financial information Budgeting the process of assigning forecasted income and expenses to accounts, which amounts will be compared to actual income and expense for analysis of variances Capital Stock found in the equity portion of the balance sheet describing the number of shares sold to shareholders at a predetermined value per share, also called common stock or preferred stock Capital Surplus found in the equity portion of the balance sheet accounting for the amount shareholders paid that is greater or lesser than the capital stock amount Capitalized Expense expenses that are accumulated, not expensed as incurred, to be amortized over a period of time; i.e. the development cost of a new product Chart of Accounts - a listing of a company's accounts and their corresponding numbers Cash-Basis Accounting - a method in which income and expenses are recorded when they are paid. Cash Flow - a summary of cash received and disbursed showing the beginning and ending amounts Closing the Books/Year End Closing the process of reversing the income and expense for a fiscal or calendar year and netting the amount into retained earnings Cost Accounting - a type of accounting that focuses on recording, defining, and reporting costs associated with specific operating functions Credit - an account entry with a negative value for assets, and positive value for liabilities and equity. Debit - an account entry with a positive value for assets, and negative value for liabilities and equity. Departmental Accounting separating operating divisions into their own sub entities on the income statement, showing individual income, expenses, and net profit by entity Depreciation - recognizing the decrease in the value of an asset due to age and use Dividends amounts paid to shareholders out of current or retained earnings Double-Entry Bookkeeping - system of accounting in which every transaction has a corresponding positive and negative entry (debits and credits)

Equity - money owed to the owner or owners of a company, also known as "owner's equity" Financial Accounting - accounting focused on reporting an entity's activities to an external party; ie: shareholders Financial Statement - a record containing the balance sheet and the income statement Fixed Asset - long-term tangible property; building, land, computers, etc. General Ledger - a record of all financial transactions within an entity Goodwill an intangible asset reflecting the value of an entity in excess of its tangible assets Income Statement - a summary of income and expenses Inventory merchandise purchased for resale at a profit Inventory Valuation the method to set the book value of unsold inventory: i.e. LIFO, last in, first out; FIFO, first in, first out; average, an average cost over a given period, last cost, the cost based on the last purchase; standard, a deemed amount related to but not tied to a specific purchase, serialized, based on a uniquely identifiable serial number or character of each inventory item Invoice the original billing from the seller to the buyer, outlining what was purchased and the terms of sale, payment, etc. Job Costing - system of tracking costs associated with a job or project (labor, equipment, etc) and comparing with forecasted costs Journal - a record where transactions are recorded, also known as an "account" Liability - money owed to creditors, vendors, etc Liquid Asset - cash or other property that can be easily converted to cash Loan - money borrowed from a lender and usually repaid with interest Master Account an account on the general ledger that subtotals the subsidiary accounts assigned to it; i.e. Cash might be the master account for a list of depository accounts at banks Net Income - money remaining after all expenses and taxes have been paid Non Cash Expense - recognizing the decrease in the value of an asset; i.e. depreciation and amortization

Non-operating Income - income generated from non-recurring transactions; ie: sale of an old building Note - a written agreement to repay borrowed money; sometimes used in place of "loan" Operating Income - income generated from regular business operations Other Income - income generated from other than regular business operations, i.e. interest, rents, etc. Payroll - a list of employees and their wages Posting the process of entering then permanently saving or archiving accounting data Profit - see "net income" Profit/Loss Statement - see "income statement" Reconciliation the process of matching one set of data to another; i.e. the bank statement to the check register, the accounts payable journal to the general ledger, etc. Retained Earnings the amount of net profit retained and not paid out to shareholders over the life of the business Revenue - total income before expenses. Shareholder Equity - the capital and retained earnings in an entity attributed to the shareholders Single-Entry Bookkeeping - system of accounting in which transactions are entered into one account Statement of Account - a summary of amounts owed to a vendor, lender, etc. Subsidiary Accounts the subaccounts that are totaled on the financial statement under master accounts; i.e. Cash-ABC Bank might be one of several subsidiary accounts that are subtotaled under Cash Supplies assets purchased to be consumed by the entity Treasury Stock shares purchased by the entity from shareholders, reducing shareholder equity Write-down/Write-off an accounting entry that reduces the value of an asset due to an impairment of that asset; i.e. the account receivable from the bankrupt customer

Role of Accounting

Accounting is not an end in itself; it is a means to an end. It performs the service activity by providing quantitative financial information that helps the users in making better business decisions. Accounting also describes and analyses the mass of data of an enterprise through measurement, classification, and summarization, and reduces that data into reports and statements, which show the financial condition and results of operations of that enterprise. Accounting as an information system collects processes and communicates information about an enterprise to a wide variety of interested parties.

Objectives of Accounting
The basic objective of accounting is to provide information to the interested users to enable them to make business decisions. The necessary information, particularly in the case of external users, is provided in the basic financial statements: Profit and loss statement and Balance sheet. Besides the above sources of information, the internal users, officers and staff of the enterprise, can obtain additional information from the records of business. Thus the primary objectives of accounting can be stated as : 1. 2. 3. 4. Maintenance of Records of Business transactions. Calculation of Profit or Loss Depiction of Financial Position. Provide Information to the Users

Maintenance of Records of Business


First record, then pay; if there is an error, trace it from the records. Human memory is short. Even the most brilliant executive or manager cannot accurately remember what he might have observed regarding the daily operations. He need not strain his memory unnecessarily, if proper and complete records of all business transactions are kept regularly. More-over, records can be used by different officials for different decision-making purposes.

Calculation of Profit or Loss


Earning profit is the main purpose for which a business is carried on. This information is available from the profit and loss statement. Profit is calculated by deducting expenses from the associated revenues. Profit is a measure of the performance of the enterprise.

Depiction of Financial Position


A balance sheet depicts the financial position of an enterprise. It is a statement of assets and liabilities. It shows the resources (assets) owned by an enterprise and depicts the claims

(liabilities) against the resources. The balance of assets minus the external liabilities shows the capital (owners equity).

Provide Information to the Users


Generation of information is not an end in itself. It is a means to facilitate the dissemination of information among different user groups. Therefore, communication of information is the essential function of accounting. Accounting information is communicated in the form of reports, statements, graphs and charts to the internal and external users who need it in different decision situations. Internal users: The officers and staff of an enterprise need useful and timely information for making different types of business decisions. A major objective of accounting is to provide management with relevant and reliable information. For example, some of the questions a manager might ask are: How much profit did the company make during the last accounting period? Is the return to share holders adequate? How can it be improved? Does the company have enough cash on hands to pay debts when they fall due? What are the projected cash needs in the next quarter? Which are the most profitable products? What is the cost of manufacturing each product? Which costs exceed the budget? How much money should be borrowed to expand the business? External users : The outside users have limited authority, ability or resources to obtain information. Unlike internal users, they have to rely on financial statements (Balance sheet, Profit and Loss statement) as their principal source of information about an enterprise's economic activity. Primarily the external users are interested in the following: The amount and the time when they are likely to receive cash in the future from dividend, interest etc. Reliable information about economic resources (assets) and obligations (liabilities) of a business enterprise in order to evaluate its strengths and weaknesses, and its financial position in general. Information about the performance and the earning power of the business enterprise. Any other information relevant to the users needs.

Limitations of Accounting
Accounting records relate to the past transactions, which provide fairly good account of the economic activity of the business enterprise. However, from decision-making viewpoint we need information, which relates not only to past but also about present and future. Financial accounting makes provision for financial information but it does not provide non-financial information such as behavioral and socio-economic. If the objective of accounting reports is to

influence the behavior through decision-making then it must provide the data concerning the behavior and outcome of human activity to facilitate performance evaluation. Therefore, the accounting information does not fully meet different types of information-requirements of varied decision making situations. Accounting provides stewardship information and not decisional information. Bad Debts Reserve Account: An account used to record an estimate of bad debts for the year (usually as a percentage of sales). This cannot be deducted as an expense against tax liabilit