PRINCIPLES OF ACCONTING (LBBA-1)

Teacher: Sir M Zia ullah

Shafquat Ali

Quaid-i-Azam School of Management Sciences (QASMS)

ACCOUNTING

An art of recording, classifying, summarizing, interpreting and communicating the financial information
of an entity for a period.

“Financial Accounting is a systematic way of recording, classifying, summarizing, analyzing and

interpreting the day to day business transactions of financial nature”.
 Financial accounting provides quantitative (numerical) financial information in the forms of
financial statement to take perspective financial decisions within and outside the firm.

BUSINESS
Any legal activity to earn profit. Business is legal, profit oriented, and is regular in nature.
FORMS OF BUSINESS
1) Sole Trader ship or Single proprietorship:
 Unincorporated business owned by one person.
 Decisions are made by owner solely
 No legal formalities are required
 Accounting may or may not be performed
 Business entity principle is applied
 Short lived and unlimited liabilities

2) Partnership:
 Business is owned by two or more people as partners
 Decisions are made by owners
 No special legal requirements are required
 Partners enters into an agreement (contract) to operate the business as partners
 Business is treated as a separate entity
 Financial accounting may be or may not be performed
 Unlimited liabilities

3) Joint Stock Companies (Corporations)

 Business incorporated under the laws of state or federal government
 Corporation is a separate single entity, separate and distinct from its owners (shareholders)
 Decision are operated by professional managers (BOD)
 Separate legal entity principle enables corporation to conduct its business affairs as a legal
person with all the rights, duties, and responsibilities of a person through agents.
 Limited Liabilities

IMPORTANT CONCEPTS

 TRANSCATION: Any monetary event in the life of a business.

 PURCHASES: When salable goods are bought by the business, it is said that purchases have been
made. Example: a book seller buys books for resale.

 SALES: When salable goods are sold, it is said that sales have been made.
 PURCHASES RETURNS/OUTWARDS
 SALES RETURNS/INWARDS

 DEBTORS/ACCOUNTS RECEIVABLE: The person to whom goods are sold on credit. E.g. Naveed
sold goods on credit to Sohail. (here Sohail is debtor to Naveed)

 CREDITORS/ACCOUNTS PAYABLE: The person from whom goods are bought on credit. (Naveed
is creditor to Sohail)

 DISCOUNT: Reduction or Concession in the price of a good.

 Trade Discount (bulk purchased discount): A reduction/concession in the list price of

goods. (It is not recorded in the books of accounts). E.g. up to 70% sales on cougar.
 Cash Discount (early payment discount): The discount that is offered by a creditor to
its debtor, if he makes a payment before specified time.
o Allowed Discount: (Seller) discount granted by a seller to the buyer.
o Received Discount: (Buyer) customer is granted a discount by the supplier.

ELEMENTS OF FINANCIAL ACCONTING

[A L C E R]

Real/Permanent Accounts,

1) Assets They are never closed

2) Liabilities Brought forwarded
3) Capital\ Owners Equity
Balance Sheet

Nominal Accounts [effects

4) Expenses on other elements]
5) Revenues
Temporary, Closed

Income Statement

Financial Statement
ASSETS
Assets are economic resources/properties/claims that are owned by a business and are
expected to benefit future operations.
i. Tangible assets: [depreciable] assets which have a physical existence and be felt and
touched.
I.e. Cash, plant and machinery, vehicles, building, stock, equipment etc.
ii. Intangible assets: [amortized] assets don’t have physical existence and cannot be
touched or felt.
Example: goodwill (cost or reputation of business), patent, copyright, trademark, company’s
brand name etc.

Classification of Assets
a) Current Assets
b) Non-Current Assets [ 1 Fixed Assets 2 Long term Investment]
Current Assets: (Consumable, expire able) those economic resources in the form of cash and
others, exclusively acquired and available to be converted into cash within shorter period of
time.
Current Assets [Features]
i. Liquidity ii. Services/benefits for shorter period of time
1. Liquidity: it refers to ease with which an asset, or security can be converted into ready
cash without affecting its market price.
Liquidity: assets are converted into cash and then cash is used for paying short liabilities.
Examples: Cash: most liquid asset while tangible items are less liquid.
 Notes receivables: Promissory note/written promise acceptable by the firms in
acknowledgement of debt for a shorter period of time.
 Accounts receivable: verbal promise (Debtor)
 Merchandising inventories (Stocks): Material/goods/products exclusively
acquired/purchased for the purpose of sell.

2. Services/benefits for shorter period of time

 Prepaid Expenses: advance payments made by company for goods and services to
be received in the future. They cannot be converted into cash, they are the
payments already made. Example: prepaid rent, prepaid insurances and contractors.
 Supplies: items purchased and used for business. Once supplies are used, they are
converted to an expanse. Example: office supplies, stationary (pen, books, files,
notes, staplers, printers etc.)
 1) FIXED ASSETS/NON CURRENT/PLANT ASSETS
Fixed assets are those tangible economic resources, available (acquired) in the business, to
use them for a long period of time, (exceeding one year) and are usually depreciated in the
end of the accounting period of firm.
Example: land (Non-depreciable, unlimited life) building, office equipment, office furniture,
plant and machinery etc.
Features:
I. Tangibility
II. Long life services
III. Depreciation (cost of usage/oldness/services received) or reduction of recorded cost of
a fixed asset in a systematic manner until the value of the asset becomes zero or
negligible.

LIABILITIES
Liabilities are financial obligation/debt/the claim of creditor’s payable in future.

Total Claims - Owner’s Claim = Liabilities

Classification of Liabilities
I. Current/Short term Liabilities: liabilities payable in short period of time (Maximum one
year)
 Accounts Payable: an amount owed (to be paid) to a creditor.
 Notes Payable: amount owed because of promissory notes given to creditors.
 Bank overdraft: Bank loan for short period of time.
II. Long Term Liabilities: liabilities payable in long period of time (more than one year)
 Bonds Payable
 Debentures Payable
 Mortgage Payable: long term debt for which the creditor has a secured prior claim
against some one or more of the debtor’s assets.

CAPITAL/OWNER’S EQUITY
The claims of owner/owners on the properties of business is known as owner’s equity.
Owner’s equity is essentially the owner’s rights to the assets of the business. It’s what left over
for the owner after you have subtracted all the liabilities from the assets.
The amount of money needed to start and run the business.
Owner’s Equity include:

 Money or resources invested by owners to the business

 Plus profit of the business since its inception
 Minus money taken out of the business by the owner
 Minus money owed to others

Total Claims – Creditors’ Claims = Owner’s Equity

Assets - Liabilites = Owner’s Equity

Transactions increasing the owners’ Equity:

1. Subsequent Investment/Capital: Assets from owner’s personnel resources in business.

When assets in the business increases, liabilities are not affected/increasing,

owner’s equity will be increasing and vice versa.

 Assets ∞ Owner’s Equity @Liabilities not increasing

2. Retained Earnings (Joint Stock Companies): amount of net income left over for the
business after it has paid out dividends and its shareholders.
Transactions decreasing the owner’s equity
1. Drawings/Dividends:
o Drawings are any asset taken out by the owner from the business for his/their
personal use. (Sole Trader ship and Partnership)
o Dividends are distribution of profit among the shareholders (Owners) in
proportionality of their investment. (Joint Stock Companies)
In companies profit distribution decisions are made by BOD.
2. Losses: Loss is a decrease in net income that is outside the normal operations of the
business or business loss occurs when business has more expanses than earnings during
an accounting period.

REVENUES
 Amounts generated, received or to be received, against the services rendered/performed or
against the sale of merchandising inventories.
(The price of goods sold or services provided)
Revenues are recorded when income is earned not necessarily when the cash is collected
from the sale. This is consistent with the accrual basis of accounting.
Revenues are not an income/profit but it is means to income/profit.
Possible Examples:
o Title of revenues recorded: depends upon nature of services like Teaching, medical
consulting, architectural designing revenues etc.
o Sales: (Merchandising Business) revenues generated from sell of common products
like medicines, electronics, groceries etc.
Classification of Revenues
1. Operating Revenues: Revenues that are generated through operating activities of
business. E.g. sells of electronics if having an electronics business.
2. Non-Operating Revenues: Revenues that are generated against non-operating activities
of business like revenue from rent if not having a renting business.
Non-operating revenues generate additional revenues in addition to the operating
business activities.

EXPENSES
(The cost of goods and services used in the process of generating revenues)
Accounts incurred, paid or to be paid, against the services/benefits received during the
accounting period and are recoverable/adjustable from the current’s period revenue is known
as an expense. E.g. salaries, bills, rents, advertising of business, repair/maintenance expanses
etc.
Depreciation Expanses
Classification of Expanses
1. Operating Expenses: expenses incurred against operating activities of business. I.e.
salaries, bills, rents etc.
2. Non-operating Expenses: expenses incurred against non-operating activities of
business. I.e. Interest, Income taxes etc.

PROFIT/INCOME
Revenue - Expenses = Profit
Revenues ˃ Expenses = Profit
 Expenses ˃ Revenues = Loss
Revenues = Expenses = Breakdown

ACCOUNTING/BALANCE SHEET EQUATION

An expression in dollar amounts of the equivalency of the assets and equities of an enterprise,
usually sated:

Assets = Equities

Assets = Liabilities + Owner’s Equity

Liabilities: Outsiders claim

Owners’ Equity: Owners Claim

 Every transaction in business brings about at least two changes in the business.
 Revenues increases owner’s capital, while expenses or losses, drawing and dividends
decreases owner’s capital.
ACCOUNTING PRINCPLES
Accounting information that is communicated externally to investors, creditors, and other
users must be prepared in accordance with all standards that are understood by both the
preparers and users of the information.
1) Generally Accepted Accounting Principles (GAAP)
 Used in the USA
 Principles established by SEC and Financial Accounting Standard Board (FASB)
USA.
2) International Financial Reporting Standards (IFRS)
 More realistic and flexible approach
 Used in almost 166 counties including Pakistan all around the Globe
 Principles established by International Accounting Standard Board (IASB)
 IFRS is used in modified version in Pakistan according to the instructions of
Institute of Chartered Accountants Pakistan (ICAP) and Security Exchange
Commission of Pakistan (SECP)
ACCOUNTING PRINCIPLES
1. ACCOUNTING PERIOD:
The life of business is divided into various periods and for each period financial statements
are prepared in order to check the progress and performance.
2. STABLE DOLLAR/ CURRENCY/ MONATRY/ UNIT ASSUMPTION:
 Accounting record remains same
 No impact of inflation and deflation on currency.
 Stable currency
 Purpose: to check the progress of business.
3. HISTORICAL /COST PRINCIPLE
The assets are recorded in the accounting record at the value which was payed to
acquire those assets.
4. REVENUE RECOGNITION/ REALIZATION/ ACCRUALS
The revenue in the accounting records should be recorded when goods are sold or
services have been provided, ignoring the payment of cash.

 Accrual = mercantile system of accounting

 Cash = small business
5. Matching Principle:
The expenses of one accounting period should be matched against revenues of the
same accounting period in order to determine profit/loss of that accounting period.
6. CONISTENCY PRINCIPLE
Once an accounting policy/method/technique is adopted it must be used consistently in
future.
7. PRUDENCE/CONSERVATISM
Assets and profits must not be overstated, and liabilities and expenses must not
understated.
 We record expected future losses, but we don’t record expected future profits.
8. FULL DISCLOUSRE:
Everything must be disclosed fully by the business and nothing must be kept hidden.
9. MONEY MEASUREMENT CONCEPT
Everything recorded in the accounting record must be measured/expressed in terms of money.
10. MATERIALITY PRINCIPLE:
Some immaterial nature items may be treated differently as compared to material items.
Material item: heavily impact on financial statement
Immaterial item: lightly impact on financial statement
11. BUSINESS/SEPARATE ENTITY PRINCIPLES:
The owner and the business are considered separate and distinct from each other, so
there is no record of personal transactions of the owner in the business record.
12. GOING CONCERN PRINCIPLE:
The business is supposed to continue forever or for foreseeable future.
 The business will never stop its activities/operations.

ACCOUNTING CYCLE
Accounting cycle is a step-by-step process of recording, classification and summarization
of economic transactions of a business. The accounting cycle is generally comprises a
year or other accounting period.

Closing Recording
Entries General-Entries

Balance Classifying
Sheet General-Ledger

Summarizing
Income
Trial-Balance
Statements

Adjusting
Adjusted Trial-
Entries
Balance

1 Recording General Journal: the information is generally recorded.

2 classifying General Ledger: transactions are then posted in general ledger. It provides a
breakdown of all accounting activities by account.
Example: salaries: 100,000 Cash: 50,000 Fan: 5,000 Payable 2,000
3 Summarizing Unadjusted Trial Balance: After general Ledger an unadjusted trial balance is
prepared to ensure that total debits equal the total credits in the financial records.
Example: Fan 500
4 Adjusting Entries (Summarizing): after trial balance adjusting entries are made to adjust
(update) the revenues and expenses for the period in which they occurred. Exp: -200

5 Adjusted Trial Balance (Summarizing): it is listing of all account balances after posting all
necessary adjusting entries. Exp: FAN: 5,000-200= 4,800

6 Income Statements (Accounting): A financial statement showing revenues earned by a

business, the expenses (Operating Cost) incurred in earning of revenues, and the resulting net
income or net loss. It is temporary information. [Closed]

7 Balance Sheet (Accounting): A financial report showing the assets, liabilities, and owner
equity of an enterprise on a specific date. Also called a position statement. It is permanent
financial statement. [Not closed]

Remember: first we make Income statement and balance sheet afterwards.

8 Closing Entries: Closing entries are made at the end of the accounting period to zero out all
temporary (Income statement) accounts and transfer their balances to permanent (Balance
Sheet) accounts to retained earnings.

GENERAL JOURNAL (Book of Original Entries)

General journal is a book of original entries, where day to day business transactions of financial
nature are recorded/entered systematically in a chronological order (in sequence). (A/c to
stated procedures/international standards, universally accepted).
o Five Columns
o Five elements (A.L.C.E.R) will be recorded in General Journal.

General Ledger (Book of Final Entries)

Classifying takes place in a book known as General Ledger:
Definition: General Ledger is a book of final entries, comprising the bunch of accounts, account
being a unit of ledger, where the financial information is gathered/accumulated under their
respective heads/titles, in order to determine their (accounts) balances, so that financial
statements can be prepared accurately and timely.
  Posting/Ledgering: to take or to forward information from General Journal to their
respective accounts (Ledger).
NORMAL BALANCES OF ACCOUNTS IN GENERAL LEDGER
1. Assets account must be of debit balance
2. All liabilities accounts must be of credit balance
3. Accounts increasing Owner’s Equity must be of credit balance and decreasing the owner
equity of debit balance.
4. Each revenue account must be of credit balance (except contra accounts that decreases
revenue i.e. Sales Returns).
5. All Expense accounts must be of debit balance.

T ACCOUNTS
BOOKKEEPING: General Journal and General Ledger

 It is recording part of accounting

 It is prerequisite of financial accounting
 Bookkeeping ends accounting starts

TRIAL BALANCE
 It is summarized part of accounting
 It is prepared through General Ledger
Definition: Trial Balance is a summarized statement of Ledger accounts, necessarily prepared by
the firms at the end of the respective accounting period.
The ultimate purpose of trial balance is preparing financial statements.
Specific Definition: Trial Balance is two columns schedule, (debit and credit), listing the titles of
accounts and theirs balances in the order, in which they (accounts) appear in the ledger.

 Trial balance is a list of all accounts balances in the ledger.

 It serves the work of bridge between books and financial statements.
PURPOSE OF PREPAIRING A TRIAL BALANCE
1) To check the accuracy of the accounting records.
2) To prepare the financial statements accurately and timely.

 Correction should be made through correction entry in physical book Recording.

  100% accuracy is not provided by trial balance, there may be some mistakes that
can be identified by Auditor. (Physical examination)
 Error of Omission (whole transaction is not recorded).
 Error of reverse entry

RULES FOR DEBIT AND CREDIT

1. Assets
Increase in asset debit
Decrease in assets credit
2. Expenses
Increase in expenses debit
Decrease in expenses credit
3. Liabilities
Increase in liabilities credit
Decrease in liabilities debit
4. Revenues
Increase in revenues credit
Decrease in revenues debit
5. Owner’s equity
Increase in Owner’s equity credit
Decrease in Owner’s equity debit
 Drawings: increase (debit), Decrease (credit)
 Retained Earnings: Increase (credit), Decrease (debit)
ADJUSTING ENTRIES
Some business activities affect the revenue and expenses of multiple accounting periods.
Therefore adjusting entries are needed at the end of accounting period.
A business could make adjusting entries on a daily basis. But as a practical matter, these entries
are made only at the end of each accounting period. For most companies adjusting entries are
made on a monthly basis.
TYPES OF ADJUSTING ENTRIES

1. Converting assets to expenses:

 A cash expenditure (or cost) that benefit more than one accounting period usually is
recorded by debiting an asset account. (For example: Supplies, prepaid rent, prepaid
or unexpired Insurance so on) and by crediting cash.
 For this adjusting entry is recorded by debiting the appropriate expense account (for
example supplies expenses or Insurance Expense)

2. Converting liabilities to revenue:

 A business may collect cash in advance for services to be rendered for future
accounting periods.
 Transactions of this nature are usually recorded by debiting the cash and crediting
the liability account (typically called unearned revenues).
 Liability account created represents the deferral (or the postponement) of a revenue.
 In the period that services are actually rendered (or that goods are sold), an adjusting
entry is made to allocate a portion of the liability from the balance sheet to the
income statement to recognize the revenue earned during the period.
 The adjusting entry is recorded by debiting the liability (Unearned Revenue) and by
crediting Revenue Earned (or a similar account) for the value of the services.
3. Accruing unpaid expenses:
 An expense may be incurred in the current accounting period even though no cash
payment will occur until a future period.
 These accrued expenses are recorded by an adjusting entry made at the end of each
accounting period.
 The adjusting entry is recorded by debiting the appropriate expense account (for
example, Interest Expense or Salary Expense) and by crediting the related liability (for
example, Interest Payable or Salaries Payable)
4. Accruing uncollected Revenue:
 Revenue may be earned (or accrued) during the current period, even though the
collection of cash will not occur until a future period.
 Unrecorded earned revenue, for which no cash has been received, requires an
adjusting entry at the end of the accounting period.
 The adjusting entry is recorded by debiting the appropriate asset (for example,
Accounts Receivable or Interest Receivable) and by crediting the appropriate revenue
account (for example, Service Revenue Earned or Interest Earned).
ADJUSTING ENTRIES AND TIMING DIFFERENCES
1. Adjusting entries to convert assets to expenses result from cash being paid prior to an
expense being incurred.
2. Adjusting entries to convert liabilities to revenue result from cash being received prior
to revenue being earned.
3. Adjusting entries to accrue unpaid expenses result from expenses being incurred before
cash is paid.
4. Adjusting entries to accrue uncollected revenue result from revenue being earned
before cash is received

Accrue: recorded not

necessarily paid or
received.
DEPRECIABLE ASSETS
Depreciable assets are physical objects that retain their size and shape but that eventually wear
out or become obsolete. They are not physically consumed, as are assets such as supplies, but
nonetheless their economic usefulness diminishes over time.
DEPRICIATION
Decrease in the value of an asset due to its use over a period of time.
In accounting, the term depreciation means the systematic allocation of the cost of a
depreciable asset to expense over the asset’s useful life.
The rationale for depreciation lies in the matching principle. Our goal is to offset a reasonable
portion of the asset’s cost against revenue in each period of the asset’s useful life.

 Depreciation is recorded for only fixed assets

 It is a non-cash expense
 Land has no depreciation
  Depreciation Is Only an Estimate
 Depreciation is recorded by debiting the depreciation expense and crediting the
accumulated depreciation (contra) account.
Depreciation causes:
 Wear and tear
 Obsolesce
 Economic factors such as inflation
 Oldness
 Technology advancement
Fixed Balance method or Straight Line method of Depreciation

Cost−Residual Value
Depreciation Expense =
Estimate Life
Cost – Accumulated Depreciation = Book Value

EFFECT OF ADJUSTIG ENTRIES