Welcome to the session of Basics of Accounting.

Let us begin with some basic understanding on

Accounting and its application in the common world. We shall be discussing concepts like Need of
accounting for business, Revenue and expenses and Basic accounting principles, concepts and
assumption

Accounting is a system which collects and processes financial information of a business.

Accounting is called as language of business. The need of business for recording (business)
transactions in systematic manner has given rise to Book-keeping. Only transactions related to
business expressible in money terms are recorded.

The process of accounting is below.

Identifying,
Recording,
Business
Classifying,
Transactions
Summarizing, Information
(monetary value)
Analyzing, to users
Interpreting,
Communicating

Let us start with the question what is accounting?

Accounting is a system which collects and processes financial information of a business.

It is called the language of business. This information is reported to the users to enable them to
make appropriate decisions. This need of recording business transactions in a systematic manner has
given rise to Book-keeping. All transactions, related to business and expressed in monetary terms
are recorded.

The Accounting process starts with the Business transactions, then moves onto identifying,
recording, classifying, summarizing, analyzing, interpreting, communicating in monetary terms, thru
financial statements and finally it is passed on the users

Now we have an idea about what is accounting theoretically, let us understand its application.

The Accounting cycle, which is an end-to end sequence of the accounting process, begins with the
recording of transactions and ends with the preparation of final accounts.

When a company starts its activities, day-to-day transactions are recorded in the journal.
Transactions from the journal are moved to ledgers where the accounts are written

The ledger has combined effect of debit and credit pertaining to each account in the form of
balances

These balances are then transferred to a statement called Trial Balance to prove the accuracy of the
work done. The preparation of trading and profit and loss account is the next step.
P&L account gives the net result of the business transactions

Balance sheet is prepared at the end to know financial position of the business. The last year’s
figures are carried forward as the opening balances for the next year.

Double Entry System of Accounting

Each amount recorded in at least TWO accounts.

For each transaction, there are two aspects

1. ‘receiving aspect’ / ‘expenses/loss aspect’ / ‘incoming aspect’ – Debit aspect

2. ‘giving aspect’ / ‘income/gain concept’ / ‘outgoing aspect’ – Credit aspect

Accounting Equation Approach

Assets = Liabilities + Stockholders’ (Owner’s) Equity

Expense is a loss to the company and reduces capital.

Income is a profit to the company and hence increases capital.

Now it is time to explain the term - Double Entry System of Accounting.

For ages, accountants have been using an accounting procedure termed as double entry system of
accounting for recording transactions. In double entry system, each amount is recorded in at least
TWO accounts

Recording of transactions can be done by 2 approaches: One is Accounting Equation Approach The
Other one is Traditional Approach

Accounting Equation Approach is also called American approach wherein transactions are recorded
based on accounting equation

Where as Traditional Approach is called British Approach wherein transactions are recorded on the
basis of existence of two aspects in each transaction i.e. debit and credit.

We have learnt about double entry system of accounting, where we ended up with list of accounts.
We shall now look at the classification of those accounts.

As per double entry system, the transaction amount is entered on left side of one account and on
the right side of another account... Account is a summary of relevant transactions relating to a
particular head. Accounts may be classified based on kind of transactions. Transactions can be
divided into three categories

Transactions relating to individuals and firms, transactions relating to properties, goods or cash and
transactions relating to expenses or losses and incomes or gains.
Therefore accounts may be classified as :Personal accounts, Impersonal Accounts

Impersonal accounts are further classified into Real Accounts and Nominal Accounts

Business transactions are recorded on the basis of the following golden rules of accounting, For
Personal accounts, debit the receiver and credit the giver. For Real accounts, debit what comes in
and credit what goes out and For Nominal accounts, debit all expenses and losses and credit all
income and gains

Journals Ledgers

1. Process of making entries in the books. 1. It is principal book containing all the
accounts.

2. Record of transactions of each account 2. Gives snapshot of an account with all the
separately with double entry system transactions.

Now, let us discuss on Journals and Ledgers

Journaling is the process of making entries in the accounting books by following the double entry
system. The accounting books in which transaction is recorded for first time from any of above
source documents is known as books of prime entry or journal because “journal” is one such book
where business transactions are recorded in chronological order by following double entry system

Where as Ledger is the principal book containing all the accounts. This is also called “Book of Final
Entry” or “Book of secondary entry” because transactions are recorded here finally? Benefits of
Ledgers are

Ledger gives snapshot of an account, all at one place. For example all cash transactions at one place.

Trial balance can be prepared to check arithmetical accuracy of the accounts in ledger

It facilitates preparation of final accounts for ascertaining operating result and financial position of
the firm.

There are four accounting assumptions

 Accounting Entity Assumption

 Money Measurement Assumption

 Accounting Period Principle

  Going Concern Assumption

Let us now understand accounting assumptions which are the pillars to understand the accounting
results of the company.

Business is an entity separate from the owners or creditors. By this logic owner’s capital is credit to
the company. This is Accounting Entity Assumption

Only financial transactions and events get recorded in accounting. This is Money Measurement
Assumption

Users of the financial reports are interested in periodical reports because they want to know
financial position for certain period by certain date. This is Accounting period principle.

Business shall go on without winding it up in foreseeable future is the assumption while recording
transaction. This is Going Concern Assumption.

 Dual aspect principle

 Revenue Realisation (Recognition) Concept

 Historical Cost Concept

 Matching Concept

 Full Disclosure Concept

 Verifiable and Objective Evidence Concept

In accounting there are certain concepts which guide recording of business transactions.
Assumptions given above have given rise to following concepts

All business transactions are recorded in TWO aspects. When business acquires asset, it is receiving
benefit but it must pay which is giving benefit. This is called Dual aspect principle which is the basis
for Double Entry System of book-keeping.

Any revenue is recognized as income earned on a date only when it is realized. This is Revenue
Realisation (Recognition) Concept. Unrealised revenue should not be considered as it may inflate
income and hence profits

All the assets are recorded at their acquisition price and further accounting treatment is based on
this cost. This is historical cost concept.

All revenues earned are matched with expenses (cost) during a given accounting period to come to
the final financial position. This is known as the matching concept. This concept helps in determining
accurate profits for the given period.

Various interested parties expect full and complete disclosure so that they can make rational
decision. This is Full Disclosure Concept.
For each business transaction,the books of accounts should have adequate evidence to support it
and should be free from any bias. This is Verifiable and Objective Evidence Concept.

 Cost-benefit principle

 Materiality principle

 Consistency principle

 Prudence principle

As we have discussed the principles and concepts, we shall now discuss their modification using
modifying principles.

The Cost of applying principle should not be more than the benefit derived from it. If cost is more
than benefit then that accounting principle may be modified. This is cost - benefit principle.

All relevant information should be disclosed in the financial statement. Insignificant and immaterial
information should be left out. This is materiality principle.

The rules, practices, concepts and principles used in accounting by a firm should be applied year
after year consistently to ensure comparability of financial statements. This is Consistency principle.

Consider all prospective losses but leave all prospective profits. This is Prudence principle .The
essence is ‘“anticipate no profit and provide for all possible losses

 It shows the profitability and financial soundness of the business.

 Prepared at end of the year.

 For external reporting and internal needs of the management like planning, decision-making
and control.

As of now, we have looked into the basics and fundamentals of accounting. Now, let us dive into
ascertaining the financial position of a company thru final accounts.

A businessman is interested in knowing whether the business has resulted in profit or loss and what
the financial position of the business is at a given period. This can be ascertained by preparing the
final accounts. The final accounts are prepared at the end of the year from the trial balance. Hence
the trial balance is said to be the connecting link between the ledger accounts and the final
accounts.
The final Accounts generally include two statements known as balance sheet and income statement,
which is required for external reporting and also for internal needs of the management like planning,
decision-making and control.

The profit and loss account is the accounting report which summarizes the revenues and expenses
and ascertains the profit or loss for a specified accounting period.

The purpose of the balance sheet is to showcase the resources and obligations i.e., assets and
liabilities. Balance sheet is the statement prepared on a particular date and shows classified
properties and assets on the right hand side and obligations or liabilities on the left hand side.

Revenue Expenses

Cash method Record when money is received. Record when money is paid.

Accrual basis Record when they are earned. Record when they are incurred.

The difference between revenue and expenses is often referred as bottom line and labeled as Net
income or Net loss.

The difference between revenue and expenses is often referred as bottom line and labeled as Net
income or Net loss.

The company should record revenues when they are earned under “accrual basis of accounting” and
not when company receives the money which is generally done under “cash method of accounting”.

Recording revenues when they are earned is the result of one of the basic accounting principles
known as the revenue recognition principle.

Let us try and understand this concept with an illustration. Suppose you sell one thousand pizzas in
July for Rs. hundred per pizza, you have earned Rs. 1 lakh for that month. You ask consumers to pay
by August 5 as per payment terms. Even if customers did not pay by August 5, “accrual basis of
accounting” require that Rs. 100,000 be recorded as July revenue because pizzas were sold in that
month. When you match revenue with expenses, the company’s income statement shows how
profitable it was in July.

When you receive Rs. 100,000 on August 5, you will have to make an accounting entry to show the
money was received. This receipt will not be considered to be August revenues, since the sales were
already reported as revenues in July when they were earned. Rs. 1 lakh will be recorded in July as a
reduction in Accounts Receivable because in July you had made an entry to Accounts Receivable and
to Sales.

After understanding about “revenue”, let’s turn our attention to another part of income statement,
“expenses”. The income statement for July should show expenses incurred in July regardless of
when the actual payment happened. This recording of expenses with the related revenues is based
on basic accounting principle known as the matching principle.
Interest expense is a cost necessary to earn revenue

We have made things easy here. In reality, there are many complexities to the Income statement

The difference between revenue and expenses is often referred to, as the bottom line and labelled
as Net income or Net Loss

Assets are the resources that a company owns.

1. Cash in bank

2. Securities

3. Motor Vehicles/Real Estate

4. Accounts receivable

5. Prepaid expenses

Assets are the resources that a company owns. So all motor vehicles, real estate, cash in the bank,
security investment and other holdings are assets. These assets can be reported in their respective
account heads. Accounts Receivable is also one asset as it records earning or sale made but not paid.

Assets valuation

 Cost principle – To show assets at original cost even when market value has increased.

 Conservatism – The value may be decreased thru this concept.

 Depreciation – Asset shown at Book Value (Book Value = Cost minus total depreciation)

* Land is never depreciated.

 Current assets values are close to their market values, since they tend to “turn over” in short
periods of time.

A Company’s assets, are recorded at original cost and are carried forward at the original cost, even
when market value of theitem has increased. This is due to another basic accounting principle
known as the cost principle. By cost principle we mean that the assets can not be reported at more
than the cost at which they were acquired a All assets such as equipments, vehicles, and buildings
are routinely depreciated. This is as per the matching principle. For the sake of definition,
depreciation is allocation of cost of the asset to “depreciation expenses” in the income statement
over its useful life. Generally depreciation is used for assets whose life is limited.
Thus the value of asset on the balance-sheet might have appreciated in the market but it is
consistently reduced in the balance-sheet as the accountant will allocate some of its cost to
depreciation expenses in the income statement. It is also possible that some asset (e.g. furniture)
might have a lesser fair market value than the book value reported on balance sheet. Land is not
depreciated hence it appears at its original cost. Current asset or short term asset values are close to
their market values, since they tend to "turn over" in short periods of time.
Liabilities are obligations of the company to others.

1. Loan payable (loan from lenders)

2. Interest payable

3. Accounts payable

4. Deferred income

5. Outstanding expenses

The balance sheet also showcases the liabilities of the business as on date of reporting. Liabilities
are obligations of the company to others such that loans from lenders, the interest on the loan, the
amount payable to others, generally known as Accounts Payable. Occasionally companies also
receive money in advance before actually earning it and also sometimes are liable to pay expenses
which are accrued but not yet paid. These are also categorised as liabilities.

1. Difference between the asset and liability

2. It comprises

1. Common stock

2. Preferred stock

3. Retained earnings

4. Current year’s net income

1. Difference between the asset and liability

2. It comprises

1. Common stock

2. Preferred stock

3. Retained earnings

4. Current year’s net income

Another section in the balance sheet is stockholder’s equity. It is also called Owner’s equity, if
company is a sole proprietorship firm. The Stockholders' Equity is the difference between the asset
and liability. It is "book value" of the company It comprise of common stock, preferred stock,
retained earnings, and current year’s net income. Whenever a company issue shares, the common
stock increases. With the increase in profit, retained earnings increase and exactly the opposite
happens when a company incurs a loss. This implies increase in revenue increases stockholder’s
equity and expenses cause decrease in the equity.

As per accounting equation approach, debit and credit rules depend on nature of an account.
Account classified as
 Assets, Liabilities, Capital, Incomes and Expenses

In the preceding session we learnt that an account is a record of all business transactions relating to
a particular person or asset or liability or expense or income. This record is maintained in an
‘Account’ As per accounting equation, approach rules for debit and credit depend on the nature of
an account. Account may be classified as follows

1. Assets Accounts
2. Liabilities Accounts
3. Capital Account
4. Incomes (Revenues) Accounts
5. Expenses (Losses) Accounts Whenever there is an increase or decrease in one account, there will
be a corresponding decrease or increase in another account. The table will explain this in detail

Shows inflows and outflows of cash and cash equivalents of a company.

Three Sections

Shows inflows and outflows of cash and cash equivalents of a company.

Three Sections

Let us discuss another financial statement - the statement of cash flows. This statement shows how
cash has changed during the time interval for which it is made. It shows the cash generated and used
by your company's operating activities, investing activities, and financing activities. Much of the
information in this statement comes from the balance sheet and the income statement. 1.
Operating activities.
a. It converts the items reported on the income statement from the accrual basis of accounting to
cash. It shows the results of cash inflows and outflows related to the fundamental operations of the
basic line of business in which the company is engaged in.
b. Cash receipt from the sale of goods and cash outflows for purchasing inventory and paying rent
and taxes. 2. Investing activities
a. It reports the purchase and sale of long term investments and property, etc 3. Financing activities.
a. It reports the issuance and redemption of shares and the payment of the dividends.

Some important and common items, which need to be adjusted at the time of preparing final
accounts are as below.

 Outstanding expenses

 Prepaid expenses

 Accrued incomes

 Incomes received in advance

 Interest on loan
  Dividend pay out

 Forgiveness of loan

 Accounts Receivables/Payables

There are certain adjusting entries which need to be considered while preparing the final accounts
of a company.
Adjusting Entries are journal entries made at the end of the accounting period to allocate revenue
and expenses to the period in which they actually are applicable. Hence, many items need some
adjustment while preparing the financial statements. Adjusting entries almost always involve a
Balance sheet account and an Income statement account. Some important and common items,
which need to be adjusted at the time of preparing final accounts, are as below.
Outstanding expenses are expenses accrued but not yet paid Prepaid expenses are expenses paid
but not yet accrued. Accrued incomes are incomes pertaining to this period, but not yet received.
Incomes received in advance are income for future period received now. Accrued Interest on loan is
the loan interest not paid which has been accrued during the financial period. Dividend pay out is
the excess of distributions over the loan to beneficiary. Accounts Receivables/Payables

 The accounts are not closed at the end of the accounting year, their balances are
automatically carried forward to the next accounting year.

 In case of revenue and expense accounts, the balances are cleared to income/expense
summary account. The net amount is then moved to retained earnings, which is the part of
total capital contributed of a company.

EOY Closure

Once the accounts are finalized, they are not closed at the end of the accounting year; their balances
are automatically carried forward to the next accounting year. In case of revenue and expense
accounts, the balances are cleared to income or expense summary account. The net amount is then
moved to retained earnings, which is the part of total capital contributed.

International Accounting Standards Committee (IASC)

1. Setup in 1973

2. To formulate the accounting standards.

3. It minimizes differences in accounting

IASC became IASB (B for Board) in 2003.

1. Proposed new IFRSs

2. Some IASs amended/replaced with new IFRSs.

In India, the Institute of Chartered Accountants of India (ICAI) constitute Accounting

Standard Board (ASB) to formulate and issue accounting standards.
To promote world-wide uniformity in published accounts, the International Accounting Standards
Committee (IASC) was set up in 1973 to formulate and publish standards which are popularly known
as International Accounting Standards to be observed in presentation of financial statements for
world-wide uniformity. This committee minimizes differences in accounting practices across
countries. IASC became IASB (B for Board) in 2003. Since then, the IASB has amended some IASs and
replaced some IASs with new International Financial Reporting Standards (IFRSs) and proposed
certain new IFRSs on topics for which there was no previous IAS. In our country the Institute of
Chartered Accountants of India (ICAI) has constituted Accounting Standard Board (ASB) in 1977. The
ASB has been empowered to formulate and issue accounting standards.