Basic of Accountings Basic Accounting Theory 1.1 Introduction The wants of human beings are unlimited and the basic cause of all productive activities is to satisfy them. If we recall our daily routine from the time we get up from bed till the time we go to bed, we consume or use a lot of things. The tooth-paste and soap we use, the tea we use, the furniture we use, the dress we wear, the television we see, are some of the examples. We generally do not think how these things are made available to us. Each one of them has a long process behind it. For example, a soap is produced by Hindustan Unilever Limited. They procure the oils, fats etc. which are the basic raw materials used in the soap. These raw materials are processed into soap cake. Then, these cakes are packed in attractive printed paper. The soap are shifted from the factory and stored in company’s warehouse. The producer sells the soaps to wholesalers who buy it in large quantities and move them to their places and keep them in their warehouses. The wholesaler sells in small quantities to the retail traders from whom we purchase it. There are many agencies like banks, insurance companies, transportation firms, warehouses, advertising agencies etc. which help the manufactures and traders. Whatever they are doing, is their business. They are doing all these for earning profit. Hence, an activity carried with profit motive is business. In other words, the term business can be defined as production of goods and services and all those activities that are involved in flow of goods from production to consumption with a view to earn profit.
Meaning of Accounting <ul><li>A businessman works hard to earn profit. He performs various activities in business known as transactions e.g. purchasing of goods, selling of goods, deposit and withdrawal of money from bank, making payment to employees and workers, receiving payment from customers etc. A transaction may be defined as an economic activity between two or more persons or firms. A transaction involves transfer of money or money’s worth (goods or services) from one person to another. These transactions take place regularly in the business. It is impossible for the businessman to keep all these transactions in memory. For this, it is essential to record the transactions properly. There must be documentary evidence for every business transaction. It requires a systematic and scientific system in the business to record all the transactions of financial nature. </li></ul>
Need of Accounting <ul><li>1. Transaction take place regularly in the business. It is not possible to keep all transactions in memory. </li></ul><ul><li>2. Systematic record of day-to-day transactions is compulsory for every business organization. </li></ul><ul><li>3. It helps in knowing the periodic results of business in terms of profit or loss. </li></ul><ul><li>4. Accounting is an important decision-making tool. </li></ul><ul><li>5. Accounting is useful to the management. It helps the management to assess the performance and achievements. </li></ul><ul><li>6. Accounting records can be used as a documentary evidence in the court. </li></ul><ul><li>7. It helps in ascertaining the value of the firm. </li></ul><ul><li>8. Accounting is essential for inter-period and enter-firm comparison. </li></ul><ul><li>9. Provides information to users of financial statement such as creditors, shareholders, banks, government and the society. </li></ul><ul><li>10. Helps government for collecting proper taxation from business units which leads to economic development. </li></ul>
Meaning of Book Keeping <ul><li>Book-Keeping is combination of two works ‘Book’ + ‘Keeping’ which means maintaining the books of accounts in a proper and systematic way. First, the business transactions must be identified and they must be supported by the documents. The book-keeper identifies the accounting transactions and records them in the proper books of accounts. Thus, book-keeping may be defined as the art and science of identifying and recording accounting transactions systematically in the proper books of accounts. </li></ul>
Accounting Cycle Step 1 IDENTIFY THE TRANSACTION Identify the event as a transaction and generate the source document, i.e. invoice, voucher Step 2 ANALYE THE TRANSACTION Determine the transaction amount and which accounts are affected Step 3 JOURNAL ENTRIES The transaction is recorded in the journal as a debit and a credit Step 4 POST TO LEDGER The journal entries are transferred to the appropriate accounts i.e. Accounts in ledger. Step 5 TRIAL BALANCE A trial balance is prepared to verify that the sum of the debits are equal to the sum of the credits. Step 6 ADJUSTING ENTRIES Adjusting entries are made for accrued and deferred items.The entries are journalized and posted to the accounts in the ledger. Step 7 ADJUSTED TRIAL BALANCE A new Trial Balance is prepared after making the adjusting entries. Step 8 FINANCIAL STATEMENTS The financial statements are prepared i.e. Trading, Profit and Loss Account and Balance Sheet. Step 9 CLOSING ENTRIES Transfer the balance of the temporary accounts.(e.g. revenues and expenses)to owner’s equity.
Difference between Book Keeping & Accounting Basis of Difference Book Keeping Accounting 1. Scope <ul><li>Book-keeping involver- </li></ul><ul><li>identifying the transactions, </li></ul><ul><li>measuring the identified transactions, </li></ul><ul><li>recording the measured transactions, and </li></ul><ul><li>classifying the recorded transactions. </li></ul>Accounting in addition to Book-keeping involver-Summarizing the classified transactions, analyzing the summarized results, interpreting analyzed results and communicating the interpreted information to the interested parties. 2. Stage Book-keeping is Primary stage. Accounting is the secondary stage. It starts where book-keeping ends. 3 Basic Objective The basic objective of book-keeping is to maintain systematic records of financial transactions. The basic objective of accounting is to ascertain net results of operations and financial position and to communicate information to the interested parties. 4. Knowledge Level The book-keeper is not required to have higher level of knowledge than that of an account. The accountant is required to have higher level of knowledge than that of book-keeper. 5. Analytical skill The book-keeper may or may not possess analytical skill. An accountant is required to possess analytical skill. 6. Nature of Job The job of a book-keeper of often routine and clerical in nature The job of an accountant is analytical in nature.
Users of Accounting Information Users Need for Information 1. Short-term Creditors [for example, suppliers of raw-materials/goods, suppliers of short-term loans] Short-term creditors need information of determine whether the amount owing to them will be paid when due and whether they should extend, 2. Long-term Creditors [for example, suppliers of long-term loans] Long-term creditors need information to determine whether their principals and the interest thereof will be paid when due and whether they should extend, 3. Present Investors [for example, equity share holders] Present investors need information to judge prospects for their investment and to determine whether they should buy, hold or sell the shares. 4. Potential Investors [for example, those who want to invest] Potential investors need information of judge prospects of an enterprise and to determine whether they should buy the shares. 5. Management Management needs information to review the firm’s (a) short-term solvency, (b) long-term solvency, (c) activity(d) profitability in relation to turnover, (e) profitability in relation to investments and to decide upon the course of action to be taken in future. 6. Employees Employees and their representative groups are interested in information about the stability and profitability of the employers. ability of the enterprise to pay remuneration, retirement benefits and to provide employment opportunities. 7 Tax Authorities to assess the tax liabilities of an enterprise. 8. Customers Customers have an interest in information about the continuation of an enterprise, especially when they have established a long term involvement with, or are dependent on, the enterprise. 9. Government and their agencies Government and their agencies are interested in the allocation of resources and therefore, the activities of enterprise. They also require information in order to regulate the activities of enterprise, determine taxation policies and as the basis for the national income and similar statistics. 10. Public Financial statements may assist the public by providing information about trends and recent developments in the prosperity of the enterprise.
Branches of Accounts Branches of Accounts Financial Accounts Cost Accounts Management Accounts Social Responsibility Accounts Human Resource Accounts
Financial Accounting It is the process of identifying, measuring, recording, classifying, summarizing, analyzing, interpreting and communicating the financial transactions and events. The purpose of this branch of accounting is to keep systematic records to ascertain financial performance and financial position and to communicate the accounting information to the interested parties. Cost Accounting It is the process of accounting and controlling the cost of a product, operation or function. The purpose of this branch of accounting is to ascertain the cost, to control the cost and to communicate information for decision-making Management Accounting It is the application of accounting techniques for providing information designed to help all levels of management in planning and controlling the activities of business enterprise and in decision making. The purpose of this branch of accounting is to supply any and all information that management may need in taking decision and to evaluate the impact of its decisions and actions. Management accounting is not only confined to the area of cost accounting but also covers other areas (such as Capital Expenditure Decisions, Capital Structure Decisions, Dividend Decisions) as well. Social Responsibility Accounting It is process of identifying, measuring and communicating the social effects of business decisions to permit informed judgments and decisions by the user of informations. It is accounting for social responsibility aspects of a business. Management is held responsible for what it contributes to the social well being and progress. Accounting for environment and ecology is part of social responsibility accounting. Human Resource Accounting An important development in financial accounting which has taken place recently is Human Resource Accounting. It is a branch of accounting which reports the importance of human resource in the earning process of an organization. A knowledgeable, trained and loyal employee is a valuable asset of any organization. It is very important to note that all other resources depreciate in value with time and use, the human resources appreciate in value with greater knowledge and experience. Human resource accounting is concerned with measuring data about human resources and communicating this information to interested parties. In simple words, it is accounting for people as a resource of organization.
Accounting Concept <ul><li>Going Concern/Continuity Concept - While recording business transactions in the books of accounts, it is assumed that the business will be carried on for a long period of time unless there is any reason to stop it. This is why, the business purchases fixed assets like land and building, plant and machinery, furniture etc. If the assumption of going concern may not have been there, the assets would have been hired and not purchased. These assets are acquired for use and not for sale. </li></ul><ul><li>2. Revenue Realization - In accounting language, ‘revenue’ is the amount received or receivable from the sale of goods. The principle tells us about when we should assume that revenues have been earned. According to accounting period assumption, revenue must be concerned with the specific accounting period. Revenue realization can be determined on the following basis : </li></ul><ul><li>Sales basis :- - as per Sales of Goods Act. Revenue is supposed to have been realized when payment becomes legally due. </li></ul><ul><li>Cash basis :- On Cash basis, revenue is supposed to have been realized when actual payment is received. In case of sales on hire purchase and installment, payment is divided into have been complete for that part goods whose payment has been received. </li></ul><ul><li>(iii) Production basis :- In this case, sales of goods or realization of amount is not the criteria. According to production basis, revenue is supposed to be realized for that part of work which has been completed. For example, in construction work, revenue is determined on production basis. The contractor of a multi-stored building is not paid the full value of work during the accounting period. So he prefers to determine his revenue on the basis of work completed by him during the year. </li></ul>3. Convention of Consistency - The convention of consistency indicates that the accounting practices and methods should remain unchanged from one accounting period to another. The comparison of one accounting period with that in the past is possible only when the concept of consistency is followed.
Accounting Concepts 4. Money Measurement Concept - In accounting system, money has been adopted as the basic unit of measurement. Since money is the medium of exchange, this concept required that only those transactions which are capable of being measured in terms of money are only to be recorded in the books of accounts. In other words, any event which can be translated into monetary terms, can not be called transaction, and therefore, can not be recorded. 5 Matching Cost and Revenue - Every businessmen wants to earn profit. Reasonable profit is the object of every business enterprise. It is the duty of the accountant to calculate accurate profit.The matching concept is an essential part of accrual accounting and so these two are often used interchangeably. According to accrual concept, the revenue and expenses are recognized on accrual basis and not on cash basis. 6 Full Disclosure - According to this principle, accounting must disclose all material information. It should be prepared honestly without any favour. Figures should not be manipulated. No material information should be concealed. Material information means the information which can change the results of business. There are many parties and people interested in accounting information like shareholders, investors, employees and customers. Accounting records should disclose informations required by them. But full disclosure does not mean leakage of business secrecy. It should disclose only those informations required by various groups. 7. Principle of Dual Aspect - This principle is the base of accountancy. All business transactions are recorded on the basis of this concept. Every transaction has two aspects – one is debited and another is credited. In other words, ‘every debit must have a corresponding credit’. Double Entry System is based on this principle. 8. Principle of Historical Cost - Historical cost means the cost at the time of acquisition. According to this principle, all business transactions must be recorded in the books of accounts at their cost of acquisition. The principle is called historical because once the assets and liabilities are recorded, their balance are carried forward from year to year their original cost. 9. Accounting Period / Periodicity concept - Every businessman wants to know the result of business operations. Since the life of the business is assumed to be indefinite, it is not possible to wait for a very long period to determine the income and financial position. Therefore, it has been agreed that the accounting records should be evaluated after a period of twelve months.
Accounting Conventions 1. Convention of Materiality - According to this convention, accounting should disclose all the material information. According to American Accounting Association (AAA), “An item is regarded as material if the knowledge of it may influence the decision of investors.” In simple words, the information which is capable of changing the business results are regarded as material. 2. Convention of Conservatism (Prudence) - This is the policy of playing safe. Since the future is uncertain, some provisions must be made for future uncertainties. The concept requires an accountant to record an every in such a way that they will show some weaker state of affairs than what actually exists. It is often said that, “Recognize all losses and anticipate no gain”. Thus, provisions should be made for all possible losses and liabilities, whether the amount is known with certainty or is based on estimation. On the other hand, profits and revenues should never be anticipated, until they take place. 3. Convention of Timeliness - This is one of the latest accounting conventions. It means the transactions should be recorded in appropriate way as well as at proper time. The business transaction of a particular day should be recorded on the same day. While recording transactions, the policy of ‘first come first served’ should be adopted.
Accounting Terminologies <ul><li>Accounting Equation </li></ul><ul><li>The three components of a balance sheet can be stated in the form of following basic accounting equation </li></ul><ul><li>Assets = Liabilities + Capital (owners equity) </li></ul><ul><li>e.g.: Rs.50,000 = Rs. 10,000 + Rs. 40,000 </li></ul><ul><li>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. </li></ul>
Business Transactions <ul><li>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. </li></ul>
Assets <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul>F.A. C.A.
Liabilities <ul><li>Liabilities :- These are the obligations or debts that the enterprise must pay in money or services at sometime in the future. </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul>
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 Income 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. Loss 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. Expenditure 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. Expenses 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. Revenues Sales are total revenues from goods sold and/or services sold or provided to customers. Sales may be cash sales or credit sales. Sales 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. Owner’s 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. Capital
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. Creditors/Accounts Payable 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. Debtors/Accounts Receivable 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. Stock 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 Purchases It is the amount of cash or other assets withdrawn by the owner for his personal use Drawings 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. Gains Profit is the excess of revenues over expenses during an accounting year. It increases the owner’s equity Profit