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Introduction to Accounting

By Prof. Harvinder S. Chawla

Accounting was born before writing or numbers existed, some 10,000 years ago in Mesopotamia later know as Persia (Iran and Iraq). This area contains the Tigris river valley, fertile area with a large population and active trading being done between towns and cities up and down the river valley. And what happens next will directly lead to the invention of both writing and number systems.

Before shipping their goods, a merchant would take one token for each item in the shipment, and encase the tokens in a ball of clay, called a "BOLLAE" (pronounced "bowl-eye") - meaning ball. This ball would be dried in the sun, given to the boatman, and then broken by the buyer on the other end of the transaction. The buyer would match the tokens with the items, to verify that everything sent was accounted for. This is the function of protection of assets, and is a major function of all modern accounting systems. It was important 10,000 years ago and is just as important now.

Written accounting records are some of the oldest writings that have been excavated across the world. These early records were simple single-entry listings of wages paid, temple assets, taxes and tributes to the king or Pharaoh.

Picture in the Tomb of Chnemhotep, pharaoh of Egypt dated 1950 BC. Minute care is not only taken in the case of large amounts, but even the smallest quantities of corn or dates are conscientiously entered." In ancient Egypt, the accountants literally counted food, beer, clothing and everything else. Ancient Egyptians were paid in kind as the concept of money was not invented till then.

Marble tablet: Account of Disbursements of the Athenian State c. 418-415 BC By the time Christopher Columbus was trying to sail west, a new form of accounting was in use by merchants in Venice . Luca Pacioli set down in writing for the first time a description of the double-entry system of accounting, which we still use today in the same form. Although he didn't actually invent the system he is called "The Father Of Accounting" for his contributions and for documenting the system in his fifth book on mathematics Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion).

Important Concepts & Necessity of Accounting


By Prof. Harvinder S. Chawla

Why should managers and other decisionmakers know accounting? If Finance is the language of business, then Accounting is its grammar. Accounting is an information system Accounting provides information for making decisions Accounting and economic decisions

Are the companys share good for medium to long term investment horizon? Investor

Can the borrower repay its obligation on time & what should be the collateral? Lender

How is our company performing As compared to our competitors? Can we improve? Manager

Assess whether the employer can meet the future obligations i.e. Bonus, Salary.etc? Employee & Trade Unions

Can the company pay on time for purchases? Can the borrower pay interest on time? Suppliers & Trade Financiers

The supplier will be able to provide spare parts? Can supplier meets warranty obligations? Customers

Is the company evading income tax, excise duty and other government levies? Government & Regulatory Authorities

Is the company exploiting its customers, labour, natural resources, suppliers, etc? The Public

Accounting entity Business is distinct from owner Going concern Business is a continuing enterprise Periodicity Business activities divided into periods Money measurement Money is a stable measurement unit Accrual Concept Record business transaction when they occur not when the cash is received

Importance of GAAP
What is GAAP?

Institutions that influence GAAP


Government Accounting profession Securities regulators Other regulators International organizations

FORMS OF BUSINESS ORGANIZATION

SOLE PROPRIETORSHIP

PARTNERSHIP

TYPICAL SIZE

Single Owner

Few Individuals (Min 2 - Max20)

DECISION MAKING

Completely Flexible

Largely Flexible but Partners may disagree

GOVT. REGULATION

None

Virtually None

SUITABILITY

Small Business

Small to Medium

FORMS OF BUSINESS ORGANIZATION

LIMITED COMPANY (Private)

LIMITED CO. PUBLIC (Not listed)

LIMITED CO. PUBLIC (Listed)

TYPICAL SIZE

Few Individuals (Min 2 Max50)

Min 7 to Unlimited Shareholders Very Rigid (Shareholders approval needed at every stage)

Min 7 to Unlimited Shareholders Very Rigid (Shareholders approval needed at every stage) Companied Act & SEBI Act (applies to full extent Filing of Documents, Disclosure, etc.)

DECISION MAKING

Largely Flexible but Directors may disagree

GOVT. REGULATION

Companies Act (applies but to very less extent)

SUITABILITY

Small to Medium (often due to legal restriction Permit, Licence, Loan, etc.)

Companied Act (applies to full extent Filing of Documents, Disclosure, etc.)

Medium to Larger

Large to Very Large Business (especially ones which need huge Capital Investment)

Overview of Income Statement & Balance Sheet


By Prof. Harvinder S. Chawla

15

Measurement: Past & Current Performance

Forecasting: Future Financial Position


Decision Making: Relevant information to users Comparison & Evaluation: Targets vs. Actual

Control: Identify Weakness & offer Feedback


Government Regulation & Taxation

Profit and loss account Statement of financial performance Revenues; Expenses (Profitability) Balance sheet Statement of financial position Assets; Liabilities; Equity (Solvency) Cash flow statement Statement of cash receipts and cash payments Activities: Operating;Investing;Financing (Changes in Financial Position)

Sources of Funds = Uses of Funds

Equities = Asset

Assets=Liabilities + Equity
Capital+ RevenuesExpensesDrawingsDividends
Can be rewritten as (Assets + Expenses + Drawings + Dividends = Liabilities + Capital + Revenues

Probable future economic benefits (Cash or something that can generate cash for business) Assets = what a business owns Examples Cash, Cash at Bank, Bills Receivables, Prepaid Expenses, Debtors or Account Receivable, Stock (of Raw Material, Work in Progress, Finished Goods, etc.) Land, Buildings, Plant & Machinery, Patents, Copyrights, Loose Tools, Goodwill, etc.

Probable future sacrifices of economic benefits Liabilities = what a business owes (Contractual, statutory, or constructive) Examples
Bank Overdraft, Outstanding Expenses, Bills Payable, Creditors on accounts, Loan short term as well as long term, Debentures, etc.

Equity represent the claims of those who supplied or invested the money to start the business. Difference between Asset Liabilities. Equity is the residual interest in the asset of the business after deducting all its liabilities. Example
Money supplied by the Proprietor for business or seed money (less withdrawals) Reserve & surplus of profit (accumulated profit)

Increase in one Asset Increase in one Liability Increase in one item of Proprietor's Equity Increase in Proprietor's Equity Increase in Liability Decrease in Asset Increase in Asset Increase in Asset Decrease in Asset

Decrease in another Asset Decrease in another Liability Decrease in one item of Proprietor's Equity Decrease in Liability Decrease in Proprietor's Equity Decrease in Proprietor's Equity Increase in Proprietor's Equity Increase in Liability Decrease in Liability

The account is the basic building block of any accounting system. An accounting system classifies transactions into meaningful categories to prepare financial statements & reports. Accounts facilitates easy & quick retrieval of companys financial data. An account is used to record increase & decrease in these item (assets, liabilities, capital, revenue, drawings, dividends & expenses) resulting from business transactions. No matter whether a company uses either a manual or electronic accounting system, it is essential to have a proper system of classification of transaction into various accounts.

The T account
Debit = Left Credit = Right

Debits = Credits
We need to record each transaction in two accounts so that the accounting equation is always in balance. Double Entry System records every transaction with equal debits & credits. As a result, the total of all Debits must equal total of all Credits

The terms Debit (Dr.) & Credit (Cr.) are used to describe the left hand side & right hand side of an account. To debit means to make an entry in the left hand side of an account & to credit means to make an entry on the right hand side.
(Any type of Account)

Debit Always the left side

Credit Always the right side

The term debit & credit has no other meaning in accounting. All accounts show entries recording increase & decrease. In some accounts increase are recorded on the left side & decrease on right side whereas in other accounts the reverse is true. It means debits & credits by themselves do not indicate increase & decrease unless reference is made to a specific account to determine the debits & credits represent increases & decreases.

Asset Accounts Debit Side Credit Side Shows Increases Shows Decreases Normal Balance - Debit Expenses Account Debit Side Credit Side Shows Increases Shows Decreases Normal Balance - Debit Drawings Account Debit Side Credit Side Shows Increases Shows Decreases Normal Balance - Debit

Assets, Required Expenses, Effect Drawings, Dividends

Liabilities, Equity, Revenues

Debit Credit

Credit Debit

Owners' Equity Account Debit Side Credit Side Revenue Account Shows Decreases Shows Increases Debit Side Credit Side Normal Balance - Credit Shows Decreases Shows Increase Normal Balance - Credit

Liabilities Account Debit Side Credit Side Shows Decreases Shows Increases Normal Balance - Credit

The accounts maintained by the business organization can be classified into three types. Personal Account: It deals with accounts of individuals like Creditors, Debtors, Bank etc. It give you an idea about the balance due to these individuals or due from them on a particular date. Real Account: It relates to assets of the firm but not debts. Eg: Machinery, Land, Buildings, Fixed Deposits Goodwill etc. This account shows the worth of an asset on a particular date. Nominal Account: It consists of different types of expenses or losses and income or profit. The account shows the amount of income earned or expenses incurred for a particular period.

PERSONAL ACCOUNT Debit the receiver, Credit the giver. REAL ACCOUNT Debit what comes in, Credit what goes out. NOMINAL ACCOUNT Debit all expenses & losses, Credit all incomes & gains.
Assets, Required Expenses, Effect Drawings, Dividends Liabilities, Equity, Revenues

Debit Credit

Credit Debit

Sr. No Title of Account Equation Approach Traditional Approach


1 2 3 4 5 6 7 8 9 10 BUILDING STOCK SALES BANK DEPOSIT RENT CASH DEBTORS LOAN DRAWINGS FURNITURE ASSET ASSET REVENUE ASSET

REAL
REAL NOMINAL PERSONAL

EXPENSES
ASSET ASSET LIABILITY DRAWINGS ASSET

NOMINAL
REAL PERSONAL PERSONAL

PERSONAL
REAL

The Journal is a chronological record of transaction entered into by the business. It is called the Book of Original entry or primary book because we record all the business transaction first in this book.
The process of recording transaction in Journal is called Journalizing.

JOURNAL Date (1) Description (2) Post. Ref (3) NARRATION (6) Debit (Dr.) (4) Credit (Cr.) (5)

The procedure for recording transactions in the journal is as follows: Enter the year, month & date of the transaction on the Date Column Write the account titles under the Description Column Enter the account to debit on the first line. Enter the account to credit under the debited account & indent it to set the account apart from the debited account. If there are several accounts enter them one after another.

Enter the amount of the debit in the Debit Column alongside the account to debit & the amount of the credit in the Credit Column alongside the account to credit. Write a brief explanation of the transaction The Post. Ref. (Posting Reference) is left blank at the time of making the journal entry.

After recording transaction in the Journals, all entries are classified & grouped into set of accounts. Transferring information from Journal to Ledger is called Posting. A ledger account has two sides debit side & credit side. Each of this sides has four columns: Date, Particulars, Journal Folio, Amount.
ACCOUNT NAME Particulars
To Vijays A\c

Dr. Date
1/6/10

Cr. Particulars
By Machinery A\c

J.F.

Amount
1,000

Date
10/6/10

J.F.

Amount
500

Separate account is opened in ledger book for each account & entries from ledger posted to respective account accordingly. It is a practice to use words TO & BY while posting debit & credit entries respectively. To ascertain the balance, total both the sides and find out the difference. Cr. > Dr. The account has a credit balance. Dr. > Cr. The account has a debit balance.

Dr.

CASH ACCOUNT

Cr.

Date
1/6/10

Particulars
To Vijays A\c

J.F.

Amount
1,000 1,000

Date
10/6/10 31/6/10

Particulars
By Machinery A\c By Balance

J.F.

Amount
500 500 1,000

1/7/10

To Balance b\d

500