FOREWORD iii

Chapter 1 Introduction to Accounting 1

1.1 Meaning of Accounting 2

1.2 Accounting as a Source of Information 6

1.3 Objectives of Accounting 10

1.4 Role of Accounting 13

1.5 Basic Terms in Accounting 14

Chapter 2 Theory Base of Accounting 23

2.1 Generally Accepted Accounting Principles (GAAP) 24

2.2 Basic Accounting Concepts 25

2.3 Systems of Accounting 33

2.4 Basis of Accounting 34

2.5 Accounting Standards 35

Chapter 3 Recording of Transactions - I 46

3.1 Business Transactions and Source Document 46

3.2 Accounting Equation 50

3.3 Using Debit and Credit 52

3.4 Books of Original Entry 60

3.5 The Ledger 72

3.6 Posting from Journal 75

Chapter 4 Recording of Transactions - II 99

4.1 Cash Book 100

4.2 Purchases (Journal) Book 125

4.3 Purchases Return (Journal) Book 127

4.4 Sales (Journal) Book 129

4.5 Sales Return (Journal) Book 131

4.6 Journal Proper 139

4.7 Balancing the Accounts 141

Chapter 5 Bank Reconciliation Statement 160

5.1 Need for Reconciliation 161

5.2 Preparation of Bank Reconciliation Statement 166

2019-2020

Chapter 6 Trial Balance and Rectification of Errors 180

6.1 Meaning of Trial Balance 180

6.2 Objectives of Preparing the Trial Balance 181

6.3 Preparation of Trial Balance 184

6.4 Significance of Agreement of Trial Balance 189

6.5 Searching of Errors 191

6.6 Rectification of Errors 192

Chapter 7 Depreciation, Provisions and Reserves 226

7.1 Depreciation 226

7.2 Depreciation and other Similar Terms 230

7.3 Causes of Depreciation 230

7.4 Need for Depreciation 231

7.5 Factors Affecting the Amount of Depreciation 232

7.6 Methods of Calculating Depreciation Amount 234

7.7 Straight Line Method and Written Down Method: 238

A Comparative Analysis

7.8 Methods of Recording Depreciation 240

7.9 Disposal of Asset 249

7.10 Effect of any Addition or Extension to the 259

Existing Asset

7.11 Provisions 262

7.12 Reserves 264

7.13 Secret Reserve 268

Chapter 8 Bill of Exchange 277

8.1 Meaning of Bill of Exchange 278

8.2 Promissory Note 280

8.3 Advantages of Bill of Exchange 281

8.4 Maturity of Bill 282

8.5 Discounting of Bill 282

8.6 Endorsement of Bill 282

8.7 Accounting Treatment 283

8.8 Dishonour of a Bill 290

8.9 Renewal of the Bill 296

8.10 Retiring of the Bill

Meaning of Accounting

In 1941, The American Institute of Certified Public Accountants (AICPA) had

defined accounting as the art of recording, classifying, and summarising in a
significant manner and in terms of money, transactions and events which are, in
part at least, of financial character, and interpreting the results thereof.

In 1966, the American Accounting Association (AAA) defined accounting as ‘the

process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of information’

Organisation refers to a business enterprise, whether for profit or not-forprofit

motive. Depending upon the size of activities and level of business operation, it
can be a sole-proprietory concern, partnership firm, cooperative society, company,
local authority, municipal corporation or any other association of persons.

Sole Proprietorship Concern. : A business enterprise exclusively owned,

managed and controlled by a single person with all authority, responsibility and
risks.

A partnership firm is an organization which is formed with two or more persons

to run a business with a view to earn profit. Each member of such a group is
known as partner and collectively known as partnership firm. These firms are
governed by the Indian Partnership Act, 1932.

A cooperative society is a group of individuals who have specific common

needs.It is an economic enterprise,the purpose of which is to improve the economic
status of owners or members. Most cooperative societies offer their products to
their members and others do not serve non-members

A company is a legal entity formed by a group of individuals to engage in and

operate a business—commercial or industrial—enterprise. A company may be
organized in various ways for tax and financial liability purposes depending on the
corporate law of its jurisdiction.
Interested Users of Information
Many users need financial information in order to make important decisions. These
users can be divided into two broad categories: internal users and external users.

Internal users include: Chief Executive, Financial Officer, Vice President,

Business Unit Managers, Plant Managers, Store Managers, Line Supervisors, etc.

External users include: present and potential Investors (shareholders), Creditors

(Banks and other Financial Institutions, Debentureholders and other Lenders), Tax
Authorities, Regulatory Agencies (Department of Company Affairs, Registrar of
Companies, Securities Exchange Board of India, Labour Unions, Trade
Associations, Stock Exchange and Customers, etc.

Qualitative Characteristics of Accounting Information

• Reliability
• Relevance
• Understandability
• Comparability
  Relevance

To be relevant, information must be available in time, must help in prediction and

feedback, and must influence the decisions of users by :

(a) helping them form prediction about the outcomes of past, present or future
events; and/or

(b) confirming or correcting their past evaluations.

 Understandability

Understandability means decision-makers must interpret accounting information in

the same sense as it is prepared and conveyed to them.

 Comparability

It is not sufficient that the financial information is relevant and reliable at a

particular time, in a particular circumstance or for a particular reporting entity.

Types of Accounting / Branches of Accounting

1. Financial Accounting
Financial accounting involves recording and classifying business transactions, and
preparing and presenting financial statements to be used by internal and external
users.
In the preparation of financial statements, strict compliance with generally
accepted accounting principles or GAAP is observed. Financial accounting is
primarily concerned in processing historical data.

The purpose of this branch of accounting is to keep a

record of all financial transactions so that:
(a) the profit earned or loss sustained by the business during an accounting period
can be worked out.

(b) the financial position of the business as at the end of the accounting period
can be ascertained, and
(c) the financial information required by the management and other interested
parties can be provided

2. Managerial Accounting
Managerial or management accounting focuses on providing information for use
by internal users, the management. This branch deals with the needs of the
management rather than strict compliance with generally accepted accounting
principles.
Managerial accounting involves financial analysis, budgeting and forecasting, cost
analysis, evaluation of business decisions, and similar areas.
3. Cost Accounting
Often times considered as a subset of management accounting, cost accounting
refers to the recording, presentation, and analysis of manufacturing costs. Cost
accounting is very useful in manufacturing businesses since they have the most
complicated costing process.
Cost accountants also analyze actual costs versus budgets or standards to help
determine future courses of action regarding the company's cost management.
The purpose of cost accounting is to analyse the expenditure so as to ascertain the
cost of various products manufactured by the firm and fix the prices. It also helps
in controlling the costs and providing necessary costing information to
management for decision-making.

4. Management Accounting : The purpose of management accounting is to

assist the management in taking rational policy decisions and to evaluate the
impact of its decisons and actions.

5. Auditing
External auditing refers to the examination of financial statements by an
independent party with the purpose of expressing an opinion as to fairness of
presentation and compliance with GAAP.

 Internal auditing focuses on evaluating the adequacy of a company's internal

control structure by testing segregation of duties, policies and procedures, degrees
of authorization, and other controls implemented by management.
6. Tax Accounting
Tax accounting helps clients follow rules set by tax authorities. It includes tax
planning and preparation of tax returns. It also involves determination of income
tax and other taxes, tax advisory services such as ways to minimize taxes legally,
evaluation of the consequences of tax decisions, and other tax-related matters.
7. Accounting Information Systems
Accounting information systems (AIS) involves the development, installation,
implementation, and monitoring of accounting procedures and systems used in the
accounting process. It includes the employment of business forms, accounting
personnel direction, and software management.
8. Fiduciary Accounting
Fiduciary accounting involves handling of accounts managed by a person entrusted
with the custody and management of property of or for the benefit of another
person. Examples of fiduciary accounting include trust accounting, receivership,
and estate accounting.
9. Forensic Accounting
Forensic accounting involves court and litigation cases, fraud investigation, claims
and dispute resolution, and other areas that involve legal matters. This is one of the
popular trends in accounting today.
Basic Terms in Accounting

1. Asset
Anything the company owns that has monetary value. These are listed in
order of liquidity, from cash (the most liquid) to land (least liquid).

Assets are generally classified in three ways:

1. Convertibility: Classifying assets based on how easy it is to convert them into

cash.
2. Physical Existence: Classifying assets based on their physical existence (in
other words, tangible vs. intangible assets).
3. Usage: Classifying assets based on their business operation usage/purpose.

If assets are classified based on their convertibility into cash, assets are classified
as either current assets or fixed assets. An alternative expression of this concept is
short-term vs. long-term assets.
  Current Assets

Current assets are assets that can be easily converted into cash and cash equivalents
(typically within a year). Current assets are also termed liquid assets and examples
of such are:

 Cash
 Cash equivalents
 Short-term deposits
 Stock
 Marketable securities
 Office supplies
 Current investments
 Inventories
 Trade receivables
 Cash and cash equivalents
 Short term loans and advances

 Liquid Assets:

Liquid Assets are those which are already in the form of cash or can easily be
convertible into cash and has a negligible effect on the price available in the
market.

For example marketable securities, government bonds, certificates of deposits etc.

 Wasting Assets:

Wasting Assets are the assets that have a useful life and as we use it depreciates
with the time and after some time or years, it becomes useless.

For example Natural resources such as gas, timber, coal. The value of these assets
goes down as we take out the contents. And when we take out these completely, it
will become useless.

 Fictitious Assets:
The assets which are valueless but are shown in the financial statements or the
expenses which are treated as assets are known as Fictitious Assets.

For example, preliminary expenses which incur at the time of establishment of the
company.

 Fixed or Non-Current Assets

Non-current assets are assets that cannot be easily and readily converted into cash
and cash equivalents. Non-current assets are also termed fixed assets, long-term
assets, or hard assets. Examples of non-current or fixed assets include:

 Land
 Building
 Machinery
 Equipment
 Patents
 Trademarks
 Deferred tax assets
 Long term loans
 Non current investments

If assets are classified based on their physical existence, assets are classified as
either tangible assets or intangible assets.

 Tangible Assets

Tangible assets are assets that have a physical existence (we can touch, feel, and
see them). Examples of tangible assets include:

 Land
 Building
 Machinery
 Equipment
 Cash
 Office supplies
 Stock
 Marketable securities
  Intangible Assets

Intangible assets are assets that do not have a physical existence. Examples of
intangible assets include:

 Goodwill
 Patents
 Brand
 Copyrights
 Trademarks
 Trade secrets
 Permits
 Corporate intellectual property

If assets are classified based on their usage or purpose, assets are classified as
either operating assets or non-operating assets.

Operating Assets

 Operating assets are assets that are required in the daily operation of a business.
In other words, operating assets are used to generate revenue from a company’s
core business activities. Examples of operating assets include:

 Cash
 Stock
 Building
 Machinery
 Equipment
 Patents
 Copyrights
 Goodwill

 Non-Operating Assets:

Non-operating assets are assets that are not required for daily business operations
but can still generate revenue. Examples of non-operating assets include:
  Short-term investments
 Marketable securities
 Vacant land
 Interest income from a fixed deposit

 Entity Entity means a reality that has a definite individual existence. Business
entity means a specifically identifiable business enterprise like Super Bazaar,
Hire Jewellers, ITC Limited, etc. An accounting system is always devised for a
specific business entity (also called accounting entity)
 Transaction An event involving some value between two or more entities. It
can be a purchase of goods, receipt of money, payment to a creditor, incurring
expenses, etc. It can be a cash transaction or a credit transaction.
 Liabilities Liabilities are obligations or debts that an enterprise has to pay at
some time in the future.

Classification of Liabilities

These are the three main classifications of liabilities:

 Current liabilities (short-term liabilities) are liabilities that are due and
payable within one year.
 Non-current liabilities (long-term liabilities) are liabilities that are due after a
year or more.
 Contingent liabilities are liabilities that may or may not arise, depending on
a certain event.

Types of Liabilities: Current Liabilities

Current liabilities, also known as short-term liabilities, are debts or obligations

that need to be paid within a year. Current liabilities should be closely watched by
management to make sure that the company possesses enough liquidity from
current assets to guarantee that the debts or obligations can be met.

Examples of current liabilities:

  Accounts payable
 Interest payable
 Income taxes payable
 Bills payable
 Bank account overdrafts
 Accrued expenses
 Short-term borrowings

Current liabilities are used as a key component in several short-term liquidity

measures.  Below are examples of metrics that management teams and investors
look at when performing financial analysis of a company.

Examples of key ratios that use current liabilities are:

 The current ratio: Current assets divided by current liabilities

 The quick ratio: Current assets, minus inventory, divided by current
liabilities
 The cash ratio: Cash and cash equivalents divided by current liabilities

Types of Liabilities: Non-current Liabilities

Non-current liabilities, also known as long-term liabilities, are debts or

obligations that are due in over a year’s time. Long-term liabilities are an important
part of a company’s long-term financing. Companies take on long-term debt to
acquire immediate capital to fund the purchase of capital assets or invest in new
capital projects.

Long-term liabilities are crucial in determining a company’s long-term solvency. If

companies are unable to repay their long-term liabilities as they become due, then
the company will face a solvency crisis.

List of non-current liabilities:

 Bonds payable
 Long-term borrowings
 Deferred tax liabilities
 Mortgage payable
 Capital leases
Types of Liabilities: Contingent Liabilities

Contingent liabilities are liabilities that may occur, depending on the outcome of a
future event. Therefore, contingent liabilities are potential liabilities. For example,
when a company is facing a lawsuit of $100,000, the company would incur a
liability if the lawsuit proves successful. However, if the lawsuit is not successful,
then no liability would arise. In accounting standards, a contingent liability is only
recorded if the liability is probable (defined as more than 50% likely to happen)
and the amount of the resulting liability can be reasonably estimated.

Examples of contingent liabilities:

 Lawsuits
 Product warranties

 Capital Capital Amount invested by the owner in the firm is known as capital.
It may be brought in the form of cash or assets by the owner
 Sales Sales are total revenues from goods or services sold or provided to
customers. Sales may be cash sales or credit sales.
 Revenues These are the amounts of the business earned by selling its products
or providing services to customers, called sales revenue. Other items of revenue
common to many businesses are: commission, interest, dividends, royalities,
rent received, etc. Revenue is also called income
 Expenses Costs incurred by a business in the process of earning revenue are
known as expenses. The usual items of expenses are: depreciation, rent, wages,
salaries, interest, cost of heater, light and water, telephone, etc.
 Expenditure Spending money or incurring a liability for some benefit, service
or property received is called expenditure. Purchase of goods, purchase of
machinery, purchase of furniture, etc. are examples of expenditure

 If the benefit of expenditure is exhausted within a year, it is treated as an

expense (also called revenue expenditure).
 On the other hand, the benefit of an expenditure lasts for more than a year,
it is treated as an asset (also called capital expenditure) such as purchase
of machinery, furniture, etc.

 Profit The excess of revenues of a period over its related expenses during an
accounting year is profit. Profit increases the investment of the owners.
 Gain A profit that arises from events or transactions which are incidental to
business such as sale of fixed assets, winning a court case, appreciation in the
value of an asset.
 Loss The excess of expenses of a period over its related revenues its termed as
loss. It decreases in owner’s equity. It also refers to money or money’s worth
lost (or cost incurred) without receiving any benefit in return.

 Discount Discount is the deduction in the price of the goods sold

 Offering deduction of agreed percentage of list price at the time selling
goods is one way of giving discount. Such discount is called ‘trade
discount’. It is generally offered by manufactures to wholesellers and by
wholesellers to retailers.

 After selling the goods on credit basis the debtors may be given certain
deduction in amount due in case if they pay the amount within the
stipulated period or earlier. This deduction is given at the time of payment
on the amount payable. Hence, it is called as cash discount. Cash
discount acts as an incentive that encourages prompt payment by the
debtors.

 Voucher The documentary evidence in support of a transaction is known as

voucher. For example, if we buy goods for cash, we get cash memo,if we buy
on credit, we get an invoice when we make a payment we get a receipt and so
on.
 Drawings Withdrawal of money and/or goods by the owner from the business
for personal use is known as drawings. Drawings reduces the investment of the
owners.
 Purchases Purchases are total amount of goods procured by a business on
credit and on cash, for use or sale.
 Debtors are persons and/or other entities who owe to an enterprise an amount
for buying goods and services on credit.

 The total amount standing against such persons and/or entities on the
closing date, is shown in the balance sheet as sundry debtors on the asset
side.
 Creditors Creditors are persons and/or other entities who have to be paid by an
enterprise an amount for providing the enterprise goods and services on credit.
  The total amount standing to the favour of such persons and/or entities on
the closing date, is shown in the Balance Sheet as sundry creditors on the
liabilities side.

Depreciation : Depreciation is defined as the reduction of recorded cost of a fixed

asset in a systematic manner until the value of the asset becomes zero or negligible.

An example of fixed assets are buildings, furniture, office equipment, machinery

etc.. A land is the only exception which cannot be depreciated as the value of land
appreciates with time.

An example of Depreciation – If a delivery truck is purchased a company with a

cost of Rs. 100,000 and the expected usage of the truck are 5 years, the business
might depreciate the asset under depreciation expense as Rs. 20,000 every year for
a period of 5 years.

The most common depreciation methods include:

1) Straight-line
2) Double declining balance
3) Units of production
4) Sum of years digits

Three main inputs are required to calculate depreciation:

 Useful life – this is the time period over which the organisation considers the
fixed asset to be productive. Beyond its useful life, the fixed asset is no
longer cost-effective to continue the operation of the asset.
 Salvage value – Salvage value is the estimated resale value of an asset at
the end of its useful life.. This is known as the salvage value of the asset.
Salvage value is also known as residual value

For example, ABC Company buys an asset for Rs.100,000, and estimates that its
salvage value will be Rs10,000 in five years, when it plans to dispose of the asset.
This means that ABC will depreciate Rs.90,000 of the asset cost over five years,
leaving Rs.10,000 of the cost remaining at the end of that time. ABC expects to
then sell the asset for Rs.10,000, which will eliminate the asset from ABC's
accounting records.

 The cost of the asset – this includes taxes, shipping, and preparation/setup
expenses.

1. Straight-line depreciation method

This is the simplest method of all. It involves simple allocation of an even rate of
depreciation every year over the useful life of the asset. The formula for straight
line depreciation is:

Annual Depreciation expense = (Asset cost – Residual Value) / Useful life of

the asset

 
Example – Suppose a manufacturing company purchases a machinery for Rs.
100,000 and the useful life of the machinery are 10 years and the residual value of
the machinery is Rs. 20,000
Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000

Thus the company can take Rs. 8000 as the depreciation expense every year over
the next   ten years as shown in depreciation table below.

Year Original cost – Residual value Depreciation expense

1 Rs. 80000 Rs. 8000
2 Rs. 80000 Rs. 8000
3 Rs. 80000 Rs. 8000
4 Rs. 80000 Rs. 8000
 2. Units of Production Depreciation Method

The units-of-production depreciation method depreciates assets based on the total

number of hours used or the total number of units to be produced by using the
asset, over its useful life.

The steps are:

Step 1: Calculate per unit depreciation:

Per unit Depreciation = (Asset cost – Residual value) / Useful life in

units of production

Step 2: Calculate the total depreciation of actual units produced:

Total Depreciation Expense = Per Unit Depreciation * Units Produced

Example1: ABC company purchases a printing press to print flyers for

Rs. 40,000 with a useful life of 1,80,000 units and residual value of Rs.
4000. It prints 4000 flyers.

Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2

Step 2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800

Example 2
Consider a machine that costs $25,000, with an estimated total unit production of
100 million and a $0 salvage value. During the first quarter of activity, the machine
produced 4 million units.
 3. Double Declining Balance Depreciation Method

Example
Consider a piece of property, plant, and equipment (PP&E) that costs Rs.250,000,
with an estimated useful life of 8 years and a Rs.2,500 salvage value. To calculate
the double-declining balance depreciation, set up a schedule:

The information on the schedule is explained below:

The beginning book value of the asset is filled in at the beginning of year 1 and the
salvage value is filled in at the end of year 8.
The rate of depreciation (Rate) is calculated as follows:
Expense = (100% / Useful life of asset) x 2

Expense = (100% / 8) x 2 = 25%

Note: Since this is a double-declining method, we multiply the rate of depreciation

by 2.

3. Multiply the rate of depreciation by the beginning book value to determine the
expense for that year. For example, Rs25,000 x 25% = Rs6,250 depreciation
expense.
4. Subtract the expense from the beginning book value to arrive at the ending book
value. For example, Rs25,000 – Rs6,250 = Rs18,750 ending book value at the end
of the first year.

5. The ending book value for that year is the beginning book value for the
following year. For example, the year 1 ending book value of Rs18,750 would be
the year 2 beginning book value. Repeat this until the last year of useful life.

Sum-of-the-Years-Digits Depreciation Method

The sum-of-the-years-digits method is one of the accelerated depreciation

methods. A higher expense is incurred in the early years and a lower expense in the
latter years of the asset’s useful life.

The depreciation formula for the sum-of-the-years-digits method:

Depreciation Expense = (Remaining life / Sum of the years digits) x (Cost –

Salvage value)

The information in the schedule is explained below:

The depreciation base is constant throughout the years and is calculated as follows:

Depreciation Base = Cost – Salvage value

Depreciation Base = $25,000 – $0 = $25,000

2. The remaining life is simply the remaining life of the asset. For example, at the
beginning of the year, the asset has a remaining life of 8 years. The following year,
the asset has a remaining life of 7 years, etc.

3. RL / SYD is “remaining life divided by sum of the years.” In this example, the
asset has a useful life of 8 years. Therefore, the sum of the years would be 1 + 2 +
3 + 4 + 5 + 6 + 7 + 8 = 36 years. The remaining life in the beginning of year 1 is 8.
Therefore, the RM / SYD = 8 / 36 = 0.2222.
4. The RL / SYD number is multiplied by the depreciating base to determine the
expense for that year.

5. The same is done for the following years. In the beginning of year 2, RL / SYD
would be 7 / 36 = 0.1944. 0.1944 x $25,000 = $4,861 expense for year 2.