Mefa Unit V

UNIT - V
INTRODUCTION TO FINANCIAL ACCOUNTING
CONCEPTS
Synopsis:
1. Introduction
2. Book-keeping and Accounting
3. Function of an Accountant
4. Users of Accounting
5. Advantages of Accounting
6. Limitations of Accounting
7. Basic Accounting concepts
1. INTRODUCITON
As you are aware, every trader generally starts business for purpose of earning profit.
While establishing business, he brings own capital, borrows money from relatives,
friends, outsiders or financial institutions. Then he purchases machinery, plant ,
furniture, raw materials and other assets. He starts buying and selling of goods,
paying for salaries, rent and other expenses, depositing and withdrawing cash from
bank. Like this he undertakes innumerable transactions in business. Observe the
following transactions of small trader for one week during the month of July, 1998.
1998 Rs.
July 24 Purchase of goods from Sree Ram 12,000
July 25 Goods sold for cash 5,000
July 25 Sold gods to Syam on credit 8,000
July 26 Advertising expenses 5,200
July 27 Stationary expenses 600
July 27 Withdrawal for personal use 2,500
July 28 Rent paid through cheque 1,000
July 31 Salaries paid 9,000
July 31 Received cash from Syam 5,000
The number of transactions in an organization depends upon the size of the

organization. In small organizations, the transactions generally will be in thousand
and in big organizations they may be in lakhs. As such it is humanly impossible to
MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 1

remember all these transactions. Further, it may not by possible to find out the final
result of the business without recording and analyzing these transactions.
Accounting came into practice as an aid to human memory by maintaining a

systematic record of business transactions.
1.1 History of Accounting:

Accounting is as old as civilization itself. From the ancient relics of Babylon, it
can be will proved that accounting did exist as long as 2600 B.C. However, in modern
form accounting based on the principles of Double Entry System came into existence
in 17th Century. Fra Luka Paciolo, a Fransiscan monk and mathematician published a
book De computic et scripturies in 1494 at Venice in Italyl. This book was translated
into English in 1543. In this book he covered a brief section on ‘book-keeping’.
1.2 Origin of Accounting in India:

Accounting was practiced in India thousand years ago and there is a clear
evidence for this. In his famous book Arthashastra Kautilya dealt with not only politics
and economics but also the art of proper keeping of accounts. However, the
accounting on modern lines was introduced in India after 1850 with the formation
joint stock companies in India.
Accounting in India is now a fast developing discipline. The two premier
Accounting Institutes in India viz., chartered Accountants of India and the Institute of
Cost and Works Accountants of India are making continuous and substantial
contributions. The international Accounts Standards Committee (IASC) was
established as on 29th June. In India the ‘Accounting Standards Board (ASB) is
formulating ‘Accounting Standards’ on the lines of standards framed by International
Accounting Standards Committee.
2. BOOK-KEEPING AND ACCOUNTING
According to G.A. Lee the accounting system has two stages.

1. The making of routine records in the prescribed from and according to set rules
of all events with affect the financial state of the organization; and

2. The summarization from time to time of the information contained in the
records, its presentation in a significant form to interested parties and its
interpretation as an aid to decision making by these parties.
First stage is called Book-Keeping and the second one is Accounting.
Book – Keeping: Book – Keeping involves the chronological recording of financial

transactions in a set of books in a systematic manner.
Accounting: Accounting is concerned with the maintenance of accounts giving
stress to the design of the system of records, the preparation of reports based on the
recorded date and the interpretation of the reports.
Distinction between Book – Keeping and Accountancy

Thus, the terms, book-keeping and accounting are very closely related, through
there is a subtle difference as mentioned below.
1. Object : The object of book-keeping is to prepare original books of Accounts. It
is restricted to journal, subsidiary book and ledge accounts only. On the other hand,
the main object of accounting is to record analyse and interpret the business
transactions.
2. Level of Work: Book-keeping is restricted to level of work. Clerical work is
mainly involved in it. Accountancy on the other hand, is concerned with all level of
management.
3. Principles of Accountancy: In Book-keeping Accounting concepts and
conventions will be followed by all without any difference. On the other hand, various
firms follow various methods of reporting and interpretation in accounting.
3. Final Result: In Book-Keeping it is not possible to know the final result of
business every year,
2.1 Meaning of Accounting

Thus, book-keeping is an art of recording the business transactions in the books
of original entry and the ledges. Accountancy begins where Book-keeping ends.
Accountancy means the compiliation of accounts in such a way that one is in a
position to know the state of affairs of the business. The work of an accountant is to
analyse, interpret and review the accounts and draw conclusion with a view to guide
the management in chalking out the future policy of the business.

2.2 Definition of Accounting:
Smith and Ashburne: “Accounting is a means of measuring and reporting the

results of economic activities.”
R.N. Anthony: “Accounting system is a means of collecting summarizing,
analyzing and reporting in monetary terms, the information about the business.
American Institute of Certified Public Accountants (AICPA): “The art of
recording, classifying and summarizing in a significant manner and in terms of money
transactions and events, which are in part at least, of a financial character and
interpreting the results thereof.”
Thus, accounting is an art of identifying, recording, summarizing and
interpreting business transactions of financial nature. Hence accounting is the
Language of Business.
2.3 Branches of Accounting:

The important branches of accounting are:
1. Financial Accounting: The purpose of Accounting is to ascertain the
financial results i.e. profit or loass in the operations during a specific period. It
is also aimed at knowing the financial position, i.e. assets, liabilities and
equity position at the end of the period. It also provides other relevant
information to the management as a basic for decision-making for planning
and controlling the operations of the business.
2. Cost Accounting: The purpose of this branch of accounting is to ascertain
the cost of a product / operation / project and the costs incurred for carrying
out various activities. It also assist the management in controlling the costs.
The necessary data and information are gatherr4ed form financial and other
sources.
3. Management Accounting : Its aim to assist the management in taking
correct policy decision and to evaluate the impact of its decisions and actions.
The data required for this purpose are drawn accounting and cost-accounting.
4. Inflation Accounting : It is concerned with the adjustment in the values of
assest and of profit in light of changes in the price level. In a way it is
concerned with the overcoming of limitations that arise in financial statements
on account of the cost assumption (i.e recording of the assets at their
historical or original cost) and the assumption of stable monetary unit.

5. Human Resource Accounting : It is a branch of accounting which seeks to
report and emphasize the importance of human resources in a company’s
earning process and total assets. It is concerned with the process of
identifying and measuring data about human resources and communicating
this information to interested parties. In simple words, it is accounting for
people as organizational resources.
3. FUNCTIONS OF AN ACCOUNTANT
The job of an accountant involves the following types of accounting works :
1. Designing Work : It includes the designing of the accounting system, basis
for identification and classification of financial transactions and events, forms,
methods, procedures, etc.
2. Recording Work : The financial transactions are identified, classified and
recorded in appropriate books of accounts according to principles. This is “Book
Keeping”. The recording of transactions tends to be mechanical and repetitive.
3. Summarizing Work : The recorded transactions are summarized into
significant form according to generally accepted accounting principles. The work
includes the preparation of profit and loss account, balance sheet. This phase is
called ‘preparation of final accounts’
4. Analysis and Interpretation Work: The financial statements are analysed
by using ratio analysis, break-even analysis, funds flow and cash flow analysis.
5. Reporting Work: The summarized statements along with analysis and
interpretation are communicated to the interested parties or whoever has the
right to receive them. For Ex. Share holders. In addition, the accou8nting
departments has to prepare and send regular reports so as to assist the
management in decision making. This is ‘Reporting’.
6. Preparation of Budget : The management must be able to reasonably
estimate the future requirements and opportunities. As an aid to this process,
the accountant has to prepare budgets, like cash budget, capital budget,
purchase budget, sales budget etc. this is ‘Budgeting’.
7. Taxation Work : The accountant has to prepare various statements and
returns pertaining to income-tax, sales-tax, excise or customs duties etc., and
file the returns with the authorities concerned.

8. Auditing : It involves a critical review and verification of the books of
accounts statements and reports with a view to verifying their accuracy. This is
‘Auditing’
This is what the accountant or the accounting department does. A person

may be placed in any part of Accounting Department or MIS (Management
Information System) Department or in small organization, the same person may
have to attend to all this work.
4. USERS OF ACCOUNTING INFORMATION
Different categories of users need different kinds of information for making

decisions. The users of accounting can be divided in two board groups (1). Internal users
and (2). External users.
4.1 Internal Users:

Managers : These are the persons who manage the business, i.e. management at
he top, middle and lower levels. Their requirements of information are different because
they make different types of decisions.
Accounting reports are important to managers for evaluating the results of their
decisions. In additions to external financial statements, managers need detailed internal
reports either branch division or department or product-wise. Accounting reports for
managers are prepared much more frequently than external reports.
Accounting information also helps the managers in appraising the performance of
subordinates. As such Accounting is termed as “ the eyes and ears of management.”
4.2 External Users :

1. Investors : Those who are interested in buying the shares of company are naturally
interested in the financial statements to know how safe the investment already made is
and how safe the proposed investments will be.
2. Creditors : Lenders are interested to know whether their load, principal and
interest, will be paid when due. Suppliers and other creditors are also interested to know
the ability of the firm to pay their dues in time.
3. Workers : In our country, workers are entitled to payment of bonus which

depends on the size of profit earned. Hence, they would like to be satisfied that he bonus
being paid to them is correct. This knowledge also helps them in conducting negotiations
for wages.

4. Customers : They are also concerned with the stability and profitability of the
enterprise. They may be interested in knowing the financial strength of the company to
rent it for further decisions relating to purchase of goods.
5. Government: Governments all over the world are using financial statements for
compiling statistics concerning business which, in turn, helps in compiling national
accounts. The financial statements are useful for tax authorities for calculating taxes.
6. Public : The public at large interested in the functioning of the enterprises because it
may make a substantial contribution to the local economy in many ways including the
number of people employed and their patronage to local suppliers.
7. Researchers: The financial statements, being a mirror of business conditions, is of

great interest to scholars undertaking research in accounting theory as well as business
affairs and practices.
5. ADVANTAGES FROM ACCOUNTING
The role of accounting has changed from that of a mere record keeping during the
1 decade of 20th century of the present stage, which it is accepted as information system
st
and decision making activity. The following are the advantages of accounting.
1. Provides for systematic records: Since all the financial transactions are recorded
in the books, one need not rely on memory. Any information required is readily
available from these records.
2. Facilitates the preparation of financial statements: Profit and loss accountant
and balance sheet can be easily prepared with the help of the information in the
records. This enables the trader to know the net result of business operations (i.e.
profit / loss) during the accounting period and the financial position of the business
at the end of the accounting period.
3. Provides control over assets: Book-keeping provides information regarding cash
in had, cash at bank, stock of goods, accounts receivables from various parties and
the amounts invested in various other assets. As the trader knows the values of the
assets he will have control over them.
4. Provides the required information: Interested parties such as owners, lenders,
creditors etc., get necessary information at frequent intervals.
5. Comparative study: One can compare the present performance of the organization
with that of its past. This enables the managers to draw useful conclusion and make
proper decisions.

6. Less Scope for fraud or theft: It is difficult to conceal fraud or theft etc., because
of the balancing of the books of accounts periodically. As the work is divided among
many persons, there will be check and counter check.
7. Tax matters: Properly maintained book-keeping records will help in the settlement
of all tax matters with the tax authorities.
8. Ascertaining Value of Business: The accounting records will help in ascertaining
the correct value of the business. This helps in the event of sale or purchase of a
business.
9. Documentary evidence: Accounting records can also be used as an evidence in the
court to substantiate the claim of the business. These records are based on
documentary proof. Every entry is supported by authentic vouchers. As such, Courts
accept these records as evidence.
10. Helpful to management: Accounting is useful to the management in various
ways. It enables the management to asses the achievement of its performance. The
weakness of the business can be identified and corrective measures can be applied to
remove them with the helps accounting.
6. LIMITATIONS OF ACCOUNTING
The following are the limitations of accounting.

1. Does not record all events: Only the transactions of a financial character will be
recorded under book-keeping. So it does not reveal a complete picture about the
quality of human resources, locational advantage, business contacts etc.
2. Does not reflect current values: The data available under book-keeping is
historical in nature. So they do not reflect current values. For instance, we record
the value of stock at cost price or market price, which ever is less. In case of,
building, machinery etc., we adopt historical cost as the basis. Infact, the current
values of buildings, plant and machinery may be much more than what is recorded
in the balance sheet.
3. Estimates based on Personal Judgment: The estimate used for determining the
values of various items may not be correct. For example, debtor are estimated in
terms of collectibility, inventories are based on marketability, and fixed assets are
based on useful working life. These estimates are based on personal judgment and
hence sometimes may not be correct.
4. Inadequate information on costs and Profits: Book-keeping only provides
information about the overall profitability of the business. No information is given
about the cost and profitability of different activities of products or divisions.

FINAL ACCOUNTS
INTRODUCTION: The main object of any Business is to make profit. Every trader
generally starts business for the purpose of earning profit. While establishing Business, he
brings his own capital, borrows money from relatives, friends, outsiders or financial
institutions, then purchases machinery, plant, furniture, raw materials and other assets.
He starts buying and selling of goods, paying for salaries, rent and other expenses,
depositing and withdrawing cash from Bank. Like this he undertakes innumerable
transactions in Business.
The number of Business transactions in an organization depends up
on the size of the organization. In small organizations the transactions generally will be in
thousands and in big organizations they may be in lacks. As such it is humanly impossible
to remember all these transactions. Further it may not be possible to find out the final
result of the Business with out recording and analyzing these transactions.
Accounting came in practice as an aid to human memory by
maintaining a systematic record of Business transactions.
BOOK KEEPING AND ACCOUNTING:

According to G.A.Lee the Accounting system has two stages. First
stage is Book keeping and the second stage is accounting.
[A]. BOOK KEEPING:

Book keeping involves the chronological recording of financial transactions in
a set of books in a systematic manner
“Book keeping is the system of recording Business transactions for the

purpose of providing reliable information to the owners and managers about
the state and prospect of the Business concepts”.
Thus Book keeping is an art of recording business transactions in the books

of original entry and the ledges.
[B]. ACCOUNTING: Accounting begins where the Bookkeeping ends

1. SMITH AND ASHBUNNE: Accounting means “measuring and reporting the results of
economic activities”.
2. R.N ANTHONY: Accounting is a system of “collecting, summarizing, Analyzing and
reporting in monster terms, the information about the Business”.
3. ICPA: Recording, classifying and summarizing is a significant manner and in terms of
money transactions and events, which are in part at least, of a financial character and
interpreting the results there.

Thus accounting is an art of recording, classifying, summarizing and interpreting business
transactions of financial nature. Hence accounting is the “Language of Business”.
ADVANTAGE OF ACCOUNTING
The following are the advantages of Accounting…………
1. PROVIDES FOR SYSTEMATIC RECORDS: Since all the financial transactions are
recorded in the books, one need not rely on memory. Any information required is
readily available from these records.
2. FACILITATES THE PRPARATION OF FINANCIAL STATEMENTS: Profit and Loss

account and balance sheet can be easily prepared with the help of the information
in the records. This enables the trader to know the net result of Business
operations (i.e. profit/loss) during the accounting period and the financial position
of the business at the end of the accounting period.
3. PROVIDES CONTROL OVER ASSETS: Book keeping provides information

regarding cash in hand, cash at hand, stack of goods, accounts receivable from
various parties and the amounts invested in various other assets. As the trader
knows the values of the assets he will have control over them.
4. PROVIES THE REQUIRED INFORMATION: Interested parties such as owners,

lenders, creditors etc, get necessary information at frequent intervals.
5. COMPARITIVE STUDY: One can compare present performance of the organization

with that of its past. This enables the managers to draw useful conclusions and
make proper decisions.
6. LESS SCOPE FOR FRAUD OR THEFT: It is difficult to conceal fraud or theft etc.
because of the balancing of the books of accounts periodically. As the work is
divided among many persons, there will be check and counter check.
7. TAX MALTERS: Properly maintained Book keeping records will help in the
settlement of all tax matters with the tax authorities.
8. ASCERTAINING VALUE OF BUSINESS: The accounting records will help in

ascertaining the correct value of the Business. This helps in the event of sale or
purchase of a business.
9. DOCUMENTARY EVIDENCE: Accounting records can also be used as evidence in

the court of substantial the claim of the Business. Thus records are based on

documentary proof. Authentic vouchers support every entry. As such, courts accept
these records as evidence.
10.HELPFUL TO MANAGEMENT: Accounting is useful to the management in various

ways. It enables the management to assess the achievement of its performance. The
weaknesses of the business can be identified and corrective measures can be applied
to remove them with the help of accounting.
LIMITATIONS OF ACCOUNTING
The following are the limitations of accounting…………..
1.DOES NOT RECORD ALL EVENTS: Only the transactions of a financial character
will be recorded under book keeping. So it does not reveal a complete picture about
the quality of human resources, locational advantages, business contacts etc.
2.DOES NOT REFLECT CURRENT VLAUES: The data available under book keeping is
historical in nature. So they do not reflect current values. For instance we record the
values of stock at cost price or market price, which ever is less. In case of building,
machinery etc., we adapt historical case as the basis. Infact, the current values of
Buildings, plant and machinery may be much more than what is recorded in the
balance sheet.
3. ESTIMATES BASED ON PERSONAL JUDGEMENT: The estimates used for

determining the values of various items may not be correct. For example, debtors are
estimated in terms of collectibles, inventories are based on marketability and fixed
assets are based on useful working life. These estimates are based on personal
judgment and hence sometimes may not be correct.
4. INADEQUATE INFORMATION ON COSTS AND PROFITS: Book keeping only

provides information about over all profitability of the business. No information is
given about the cost and profitability of different activities of products or divisions.
BASIC ACCOUNTING CONCEPTS
Accounting is a system evolved to achieve a set of objectives. In order to achieve the

goals, we need a set of rules or guidelines. These guidelines are termed here as “BASIC
ACCOUNTING ONCEPTS”. The term concept means an idea or thought. Basic accounting
concepts are the fundamental ideas or basic assumptions underlying the theory and profit
of FINANCIAL ACCOUNTING. These concepts help in bringing about uniformity in the
practice of accounting. In accountancy following concepts are quite popular.

1. BUSINESS ENTITY CONEPT: In this concept “Business is treated as separate from
the proprietor”. All the
Transactions recorded in the book of Business and not in the books of proprietor. The
proprietor is also treated as a creditor for the Business.
2. GOING CONCERN CONCEPT: This concept relates with the long life of Business. The
assumption is that business will continue to exist for unlimited period unless it is dissolved
due to some reasons or the other.
3. MONEY MEASUREMENT CONCEPT: In this concept “Only those transactions are

recorded in accounting which can be expressed in terms of money, those transactions
which can not be expressed in terms of money are not recorded in the books of
accounting”.
4. COST CONCEPT: Accounting to this concept, can asset is recorded at its cost in the
books of account. i.e., the price, which is paid at the time of acquiring it. In balance sheet,
these assets appear not at cost price every year, but depreciation is deducted and they
appear at the amount, which is cost, less classification.
5. ACCOUNTING PERIOD CONCEPT: every Businessman wants to know the result of his
investment and efforts after a certain period. Usually one-year period is regarded as an
ideal for this purpose. This period is called Accounting Period. It depends on the nature of
the business and object of the proprietor of business.
6. DUAL ASCEPT CONCEPT: According to this concept “Every business transactions has
two aspects”, one is the receiving benefit aspect another one is giving benefit aspect. The
receiving benefit aspect is termed as
“DEBIT”, where as the giving benefit aspect is termed as “CREDIT”. Therefore, for every
debit, there will be corresponding credit.
7. MATCHING COST CONCEPT: According to this concept “The expenses incurred during
an accounting period, e.g., if revenue is recognized on all goods sold during a period, cost
of those good sole should also
Be charged to that period.
8. REALISATION CONCEPT: According to this concept revenue is recognized when a

sale is made. Sale is
Considered to be made at the point when the property in goods posses to the buyer and
he becomes legally liable to pay.
ACCOUNTING CONVENTIONS

Accounting is based on some customs or usages. Naturally accountants here to adopt that
usage or custom.
They are termed as convert conventions in accounting. The following are some of the
important accounting conventions.
1.FULL DISCLOSURE: According to this convention accounting reports should disclose

fully and fairly the information. They purport to represent. They should be prepared
honestly and sufficiently disclose information which is if material interest to proprietors,
present and potential creditors and investors. The companies ACT, 1956 makes it
compulsory to provide all the information in the prescribed form.
2.MATERIALITY: Under this convention the trader records important factor about the
commercial activities. In the form of financial statements if any unimportant information is
to be given for the sake of clarity it will be given as footnotes.
3.CONSISTENCY: It means that accounting method adopted should not be changed from
year to year. It means that there should be consistent in the methods or principles
followed. Or else the results of a year
Cannot be conveniently compared with that of another.
4. CONSERVATISM: This convention warns the trader not to take unrealized income in to
account. That is why the practice of valuing stock at cost or market price, which ever is
lower is in vague. This is the policy of “playing safe”; it takes in to consideration all
prospective losses but leaves all prospective profits.
KEY WORDS IN BOOK-KEEPING
1. TRANSACTIONS: Any sale or purchase of goods of services is called the

transaction.
Transactions are two types.
[a]. cash transaction: cash transaction is one where cash
receipt or payment is involved in the exchange.
[b]. Credit transaction: Credit transaction will not have cash,
either received or paid, for something given or received
respectively.
2.GOODS: Fill those things which a firm purchases for resale are called goods.
3.PURCHASES: Purchases means purchase of goods, unless it is stated otherwise

it also represents the
Goods purchased.

4.SALES: Sales means sale of goods, unless it is stated otherwise it also
represents these goods sold.
5.EXPENSES: Payments for the purchase of goods as services are known as

expenses.
6.REVENUE: Revenue is the amount realized or receivable from the sale of goods
or services.
7.ASSETS: The valuable things owned by the business are known as assets. These
are the properties
Owned by the business.
8.LIABILITIES: Liabilities are the obligations or debts payable by the enterprise in

future in the term
Of money or goods.
9. DEBTORS: Debtors means a person who owes money to the trader.
10.CREDITORS: A creditor is a person to whom something is owned by the business.
11.DRAWINGS: cash or goods withdrawn by the proprietor from the Business for
his personal or Household is termed to as “drawing”.
12.RESERVE: An amount set aside out of profits or other surplus and designed to
meet contingencies.
13.ACCOUNT: A summarized statements of transactions relating to a particular

person, thing,
Expense or income.
14.DISCOUNT: There are two types of discounts..

a. cash discount: An allowable made to encourage frame payment or
before the expiration of the period allowed for credit.
b. Trade discount: A deduction from the gross or catalogue price
allowed to traders who buys them for resale.
CLASSIFICATION OF BUSINESS TRANSACTIONS
All business transactions are classified into three categories:

1. Those relating to persons
2. Those relating to property (Assets)
3. Those relating to income & expenses

Thus, three classes of accounts are maintained for recording all business
transactions. They are:
1.Personal accounts
2.Real accounts
3.Nominal accounts
1.Personal Accounts :Accounts which are transactions with persons are called “Personal
Accounts” .
A separate account is kept on the name of each person for recording the benefits received
from ,or given to the person in the course of dealings with him.
E.g.: Krishna’s A/C, Gopal’s A/C, SBI A/C, Nagarjuna Finanace Ltd.A/C, ObulReddy &
Sons A/C , HMT Ltd. A/C, Capital A/C, Drawings A/C etc.
2.Real Accounts: The accounts relating to properties or assets are known as “Real
Accounts” .Every business needs assets such as machinery , furniture etc, for running its
activities .A separate account is maintained for each asset owned by the business .
E.g.: cash A/C, furniture A/C, building A/C, machinery A/C etc.
3.NominalAccounts: Accounts relating to expenses, losses, incomes and gains are

known as “Nominal Accounts”. A separate account is maintained for each item of
expenses, losses, income or gain.
E.g.: Salaries A/C, stationery A/C, wages A/C, postage A/C, commission A/C, interest
A/C, purchases A/C, rent A/C, discount A/C, commission received A/C, interest received
A/C, rent received A/C, discount received A/C.
Before recording a transaction, it is necessary to find out which of the accounts is to be

debited and which is to be credited. The following three different rules have been laid
down for the three classes of accounts….
ACCOUNTING RULES
1.Personal Accounts: The account of the person receiving benefit (receiver) is to be

debited and the account of the person giving the benefit (given) is to be credited.
Rule: “Debit----The Receiver

Credit---The Giver”
2.Real Accounts: When an asset is coming into the business, account of that asset is to
be debited .When an asset is going out of the business, the account of that asset is to be
credited.
Rule: “Debit----What comes in

Credit---What goes out”
3. Nominal Accounts: When an expense is incurred or loss encountered, the account
representing the expense or loss is to be debited . When any income is earned or gain
made, the account representing the income of gain is to be credited.
Rule: “Debit----All expenses and losses

Credit---All incomes and gains”
JOURNAL
The first step in accounting therefore is the record of all the transactions in the books of
original entry viz., Journal and then posting into ledges.
JOURNAL: The word Journal is derived from the Latin word ‘journ’ which means a day.
Therefore, journal means a ‘day Book’ in day-to-day business transactions are recorded in
chronological order.
Journal is treated as the book of original entry or first entry or prime entry. All the
business transactions are recorded in this book before they are posted in the ledges. The
journal is a complete and chronological(in order of dates) record of business transactions.
It is recorded in a systematic manner. The process of recording a transaction in the
journal is called “JOURNALISING”. The entries made in the book are called “Journal
Entries”.
The proforma of Journal is given below.
Date Particulars L.F. Debit Credit

no RS. RS.
1998 Jan 1 Purchases account to cash 10,000/- 10,000/-

account(being goods
purchased for cash)

LEDGER
All the transactions in a journal are recorded in a chronological order. After a certain
period, if we want to know whether a particular account is showing a debit or credit
balance it becomes very difficult. So, the ledger is designed to accommodate the various
accounts maintained the trader. It contains the final or permanent record of all the
transactions in duly classified form. “A ledger is a book which contains various accounts.”
The process of transferring entries from journal to ledger is called “POSTING”.
Posting is the process of entering in the ledger the entries given in the journal. Posting
into ledger is done periodically, may be weekly or fortnightly as per the convenience of the
business. The following are the guidelines for posting transactions in the ledger.
1. After the completion of Journal entries only posting is to be made in the ledger.
2. For each item in the Journal a separate account is to be opened. Further, for each
new item a new account is to be opened.
3. Depending upon the number of transactions space for each account is to be
determined in the ledger.
4. For each account there must be a name. This should be written in the top of the
table. At the end of the name, the word “Account” is to be added.
5. The debit side of the Journal entry is to be posted on the debit side of the
account, by starting with “TO”.
6. The credit side of the Journal entry is to be posted on the debit side of the
account, by starting with “BY”.
Proforma for ledger: LEDGER BOOK
Particulars account
Date Particulars Lfno Amount Date Particulars Lfno amount
sales account

cash account
TRAIL BALANCE
The first step in the preparation of final accounts is the preparation of trail balance. In the
double entry system of book keeping, there will be credit for every debit and there will not
be any debit without credit. When this principle is followed in writing journal entries, the
total amount of all debits is equal to the total amount all credits.
A trail balance is a statement of debit and credit balances. It is prepared on a particular

date with the object of checking the accuracy of the books of accounts. It indicates that all
the transactions for a particular period have been duly entered in the book, properly
posted and balanced. The trail balance doesn’t include stock in hand at the end of the
period. All adjustments required to be done at the end of the period including closing
stock are generally given under the trail balance.
DEFINITIONS:
SPICER AND POGLAR : A trail balance is a list of all the balances standing on the ledger
accounts and cash book of a concern at any given date.
J.R.BATLIBOI:
A trail balance is a statement of debit and credit balances extracted from the ledger with a
view to test the arithmetical accuracy of the books.
Thus a trail balance is a list of balances of the ledger accounts’ and cash book of a
business concern at any given date.
PROFORMA FOR TRAIL BALANCE:

Trail balance for MR…………………………………… as on …………
NO NAME OF ACCOUNT DEBIT CREDIT
(PARTICULARS) AMOUNT(RS.) AMOUNT(RS.)

Trail Balance
Specimen of trial balance
1 Capital Credit Loan

2 Opening stock Debit Asset
3 Purchases Debit Expense
4 Sales Credit Gain
5 Returns inwards Debit Loss
6 Returns outwards Debit Gain
7 Wages Debit Expense
8 Freight Debit Expense
9 Transport expenses Debit Expense
10 Royalities on production Debit Expense
11 Gas, fuel Debit Expense
12 Discount received Credit Revenue
13 Discount allowed Debit Loss
14 Bas debts Debit Loss
15 Dab debts reserve Credit Gain
16 Commission received Credit Revenue
17 Repairs Debit Expense
18 Rent Debit Expense
19 Salaries Debit Expense
20 Loan Taken Credit Loan
21 Interest received Credit Revenue
22 Interest paid Debit Expense
23 Insurance Debit Expense
24 Carriage outwards Debit Expense
25 Advertisements Debit Expense
26 Petty expenses Debit Expense
27 Trade expenses Debit Expense
28 Petty receipts Credit Revenue
29 Income tax Debit Drawings
30 Office expenses Debit Expense
31 Customs duty Debit Expense
32 Sales tax Debit Expense
33 Provision for discount on debtors Debit Liability
34 Provision for discount on creditors Debit Asset
35 Debtors Debit Asset
36 Creditors Credit Liability

37 Goodwill Debit Asset
38 Plant, machinery Debit Asset
39 Land, buildings Debit Asset
40 Furniture, fittings Debit Asset
41 Investments Debit Asset
42 Cash in hand Debit Asset
43 Cash at bank Debit Asset
44 Reserve fund Credit Liability
45 Loan advances Debit Asset
46 Horse, carts Debit Asset
47 Excise duty Debit Expense
48 General reserve Credit Liability
49 Provision for depreciation Credit Liability
50 Bills receivable Debit Asset
51 Bills payable Credit Liability
52 Depreciation Debit Loss
53 Bank overdraft Credit Liability
54 Outstanding salaries Credit Liability
55 Prepaid insurance Debit Asset
56 Bad debt reserve Credit Revenue
57 Patents & Trademarks Debit Asset
58 Motor vehicle Debit Asset
59 Outstanding rent Credit Revenue

FINAL ACCOUNTS
In every business, the business man 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
time. In brief, he wants to know (i)The profitability of the business and (ii) The soundness
of the business.
The trader can ascertain this by preparing the final accounts. The final accounts are
prepared from the trial balance. Hence the trial balance is said to be the link between the
ledger accounts and the final accounts. The final accounts of a firm can be divided into two
stages. The first stage is preparing the trading and profit and loss account and the second
stage is preparing the balance sheet.
TRADING ACCOUNT
The first step in the preparation of final account is the preparation of trading
account. The main purpose of preparing the trading account is to ascertain gross profit or
gross loss as a result of buying and selling the goods.
Trading account of MR……………………. for the year ended ……………………
Particulars Amount Particulars Amount
To opening stock Xxxx By sales xxxx

To purchases xxxx Less: returns xxx Xxxx
Less: returns xx Xxxx By closing stock Xxxx
To carriage inwards Xxxx

To wages Xxxx
To freight Xxxx
To customs duty, octroi Xxxx
To gas, fuel, coal,

Water Xxxx
To factory expenses
To other man. Expenses Xxxx
To productive expenses Xxxx
To gross profit c/d
Xxxx
Xxxx
Xxxx
Xxxx

Finally, a ledger may be defined as a summary statement of all the transactions relating to
a person , asset, expense or income which have taken place during a given period of time.
The up-to-date state of any account can be easily known by referring to the ledger.
PROFIT AND LOSS ACCOUNT
The business man is always interested in knowing his net income or net profit.Net profit
represents the excess of gross profit plus the other revenue incomes over administrative,
sales, Financial and other expenses. The debit side of profit and loss account shows the
expenses and the credit side the incomes. If the total of the credit side is more, it will be
the net profit. And if the debit side is more, it will be net loss.
PROFIT AND LOSS A/C OF MR…………………….FOR THE YEAR ENDED…………

PARTICULARS AMOUNT PARTICULARS AMOUNT
TO office salaries Xxxxxx By gross profit b/d Xxxxx
TO rent,rates,taxes Xxxxx Interest received Xxxxx
TO Printing and stationery Xxxxx Discount received Xxxx
TO Legal charges Commission received Xxxxx
Audit fee Xxxx Income from
TO Insurance Xxxx investments
TO General expenses Xxxx Dividend on shares Xxxx
TO Advertisements Xxxxx Miscellaneous Xxxx
TO Bad debts Xxxx investments
TO Carriage outwards Xxxx Rent received xxxx
TO Repairs Xxxx
TO Depreciation Xxxxx
TO interest paid Xxxxx
TO Interest on capital Xxxxx
TO Interest on loans Xxxx
TO Discount allowed Xxxxx
TO Commission Xxxxx
TO Net profit------- Xxxxx
(transferred to capital a/c)
xxxxxx Xxxxxx
BALANCE SHEET
The second point of final accounts is the preparation of balance sheet. It is prepared often
in the trading and profit, loss accounts have been compiled and closed. A balance sheet
may be considered as a statement of the financial position of the concern at a given date.

DEFINITION: A balance sheet is an item wise list of assets, liabilities and proprietorship
of a business at a certain state.
J.R.botliboi: A balance sheet is a statement with a view to measure exact financial

position of a business at a particular date.
Thus, Balance sheet is defined as a statement which sets out the assets and liabilities of a
business firm and which serves to as certain the financial position of the same on any
particular date. On the left-hand side of this statement, the liabilities and the capital are
shown. On the right-hand side all the assets are shown. Therefore, the two sides of the
balance sheet should be equal. Otherwise, there is an error somewhere.
BALANCE SHEET OF ………………………… AS ON …………………………………….

Liabilities and capital Amount Assets Amount
Creditors Xxxx Cash in hand Xxxx

Bills payable Xxxx Cash at bank Xxxx
Bank overdraft Xxxx Bills receivable Xxxx
Loans Xxxx Debtors Xxxx
Mortgage Xxxx Closing stock Xxxx
Reserve fund Xxxx Investments Xxxx
Capital xxxxxx Furniture and fittings Xxxx
Add: Plats&machinery
Net Profit xxxx Land & buildings Xxxx
------- Patents, tm Xxxx
xxxxxxx ,copyrights Xxxx
-------- Goodwill
Prepaid expenses Xxxx
Less: Outstanding incomes Xxxx
Drawings xxxx Xxxx Xxxx
--------- XXXX XXXX
Advantages: The following are the advantages of final balance .

1. It helps in checking the arithmetical accuracy of books of accounts.
2. It helps in the preparation of financial statements.
3. It helps in detecting errors.
4. It serves as an instrument for carrying out the job of rectification of entries.
5. It is possible to find out the balances of various accounts at one place.

FINAL ACCOUNTS -- ADJUSTMENTS
We know that business is a going concern. It has to be carried on indefinitely. At the end
of every accounting year. The trader prepares the trading and profit and loss account and
balance sheet. While preparing these financial statements, sometimes the trader may
come across certain problems .The expenses of the current year may be still payable or
the expenses of the next year have been prepaid during the current year. In the same
way, the income of the current year still receivable and the income of the next year have
been received during the current year. Without these adjustments, the profit figures
arrived at or the financial position of the concern may not be correct. As such these
adjustments are to be made while preparing the final accounts.
The adjustments to be made to final accounts will be given under the Trial Balance. While
making the adjustment in the final accounts, the student should remember that “every
adjustment is to be made in the final accounts twice i.e. once in trading, profit and loss
account and later in balance sheet generally”. The following are some of the important
adjustments to be made at the time of preparing of final accounts:-
1. CLOSING STOCK :-
(i)If closing stock is given in Trail Balance: It should be shown only in the balance
sheet “Assets Side”.
(ii)If closing stock is given as adjustment :
1. First, it should be posted at the credit side of “Trading Account”.

2. Next, shown at the asset side of the “Balance Sheet”.
2.OUTSTANDING EXPENSES :-
(i)If outstanding expenses given in Trail Balance: It should be only on the liability
side of Balance Sheet.
(ii)If outstanding expenses given as adjustment :

1. First, it should be added to the concerned expense at the
debit side of profit and loss account or Trading Account.
2. Next, it should be added at the liabilities side of the
Balance Sheet.
3.PREAPID EXPENSES :-
(i)If prepaid expenses given in Trial Balance: It should be shown only in assets side
of the Balance Sheet.

(ii)If prepaid expense given as adjustment :
1. First, it should be deducted from the concerned expenses at the debit side of profit
and loss account or Trading Account.
2. Next, it should be shown at the assets side of the Balance Sheet.
4.INCOME EARNED BUT NOT RECEIVED [OR] OUTSTANDING INCOME [OR]

ACCURED INCOME :-
(i)If incomes given in Trial Balance: It should be shown only on the assets side of the
Balance Sheet.
(ii)If incomes outstanding given as adjustment:
1. First, it should be added to the concerned income at the credit side of profit and
loss account.
2. Next, it should be shown at the assets side of the Balance sheet.
5. INCOME RECEIVED IN ADVANCE: UNEARNED INCOME:-

(i)If unearned incomes given in Trail Balance : It should be shown only on the
liabilities side of the Balance Sheet.
(ii)If unearned income given as adjustment :

1. First, it should be deducted from the concerned income in the credit side of the
profit and loss account.
2. Secondly, it should be shown in the liabilities side of the
Balance Sheet.
6.DEPRECIATION:-
(i)If Depreciation given in Trail Balance: It should be shown only on the debit side of
the profit and loss account.
(ii)If Depreciation given as adjustment

1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deduced from the concerned asset in the Balance sheet
assets side.
7.INTEREST ON LOAN [OR] CAPITAL :-

(i)If interest on loan (or) capital given in Trail balance :It should be shown only on
debit side of the profit and loss account.

(ii)If interest on loan (or)capital given as adjustment :
1. First, it should be shown on debit side of the profit and loss account.
2. Secondly, it should added to the loan or capital in
the liabilities side of the Balance Sheet.
8.BAD DEBTS:-
(i)If bad debts given in Trail balance :It should be shown on the debit side of the
profit and loss account.
(ii)If bad debts given as adjustment:

1. First, it should be shown on the debit side of the profit and loss account.
2. Secondly, it should be deducted from debtors in the assets side of the Balance
Sheet.
9.INTEREST ON DRAWINGS :-
(i)If interest on drawings given in Trail balance: It should be shown on the credit
side of the profit and loss account.
(ii)If interest on drawings given as adjustments :

1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be deducted from capital on liabilities
side of the Balance Sheet.
10.INTEREST ON INVESTMENTS :-
(i)If interest on the investments given in Trail balance :It should be shown on the
credit side of the profit and loss account.
(ii)If interest on investments given as adjustments :
1. First, it should be shown on the credit side of the profit and loss account.
2. Secondly, it should be added to the investments on assets side of the Balance
Sheet.
Note: Problems to be solved on final accounts
SUBSIDIARY BOOKS
In a small business concern, the numbers of transactions are limited. These transactions
are first recorded in the journal as and when they take place. Subsequently, these

transactions are posted in the appropriate accounts of the ledger. Therefore, the journal is
known as “Book Of Original Entry” or “Book of Prime Entry” while the ledger is known as
main book of accounts.
On the other hand, the transactions in big concern are numerous and sometimes even run
into thousands and lakhs. It is inconvenient and time wasting process if all the
transactions are going to be managed with a journal.
Therefore, a convenient device is made. Smaller account books known as subsidiary books
or subsidiary journals are disturbed to various sections of the business house. As and
when transactions take place, they are recorded in these subsidiary books simultaneously
without delay. The original journal (which is known as Journal Proper) is used only
occasionally to record those transactions which cannot be recorded in any of the
subsidiary books.
TYPES OF SUBSIDIARY BOOKS:-- Subsidiary books are divided into eight types. They are,
1. Purchases Book
2. Sales Book
3. Purchase Returns Book
4. Sales Returns Book
5. Cash Book
6. Bills Receivable Book
7. Bills Payable Book
8. Journal Proper
1. PURCHASES BOOK :- This book records all credit purchases only. Purchase of goods
for cash and purchase of assets for cash. Credit will not be recorded in this book.
Purchases book is otherwise called Purchases Day Book, Purchases Journal or Purchases
Register.
2. SALES BOOK :-This book is used to record credit sales only. Goods are sold for cash
and sale of assets for cash or credit will not be recorded in this book. This book is
otherwise called Sales Day Book, Sales Journal or Sales Register.
3.PURCHASE RETURNS BOOK :- This book is used to record the particulars of goods
returned to the suppliers .This book is otherwise called Returns Outward Book.
4.SALES RETURNS BOOK :- This book is used to record the particulars of goods
returned by the customers. This book is otherwise called Returns Inward Book.
5.CASH BOOK :- All cash transactions , receipts and payments are recorded in this book.
Cash includes cheques, money orders etc.

6.BILLS REECEIVABLE BOOK :- This book is used to record all the bills and promissory
notes are received from the customers.
7.BILLS PAYABLE BOOK :- This book is used to record all the bills or promissory notes
accepted to the suppliers.
8.JOURNAL PROPER :- This is used to record all the transactions that cannot be
recorded in any of the above mentioned subsidiary books.
FORMAT FOR PURCHASE BOOK
Date Name of supplier Invoice Lf no Details Amount(Rs.)

No
FORMAT FOR SALES BOOK
Date Name of customer Invoice Lf no Details Amount(Rs.)

No
FORMAT FOR PURCHASE RETURNS BOOK
Date Name of supplier Debit Lf no Details Amount(Rs.)

note
No
FORMAT FOR SALES RETURNS BOOK

Date Name of supplier Credit Lf no Details Amount(Rs.)
note
No

FINANCIAL ANALYSIS THROUGH RATIOS
Ratio Analysis
Absolute figures are valuable but they standing alone convey no meaning unless
compared with another. Accounting ratio show inter-relationships which exist among
various accounting data. When relationships among various accounting data supplied by
financial statements are worked out, they are known as accounting ratios.
Accounting ratios can be expressed in various ways such as:

1. a pure ratio says ratio of current assets to current liabilities is 2:1 or
2. a rate say current assets are two times of current liabilities or
3. a percentage say current assets are 200% of current liabilities.
Each method of expression has a distinct advantage over the other the analyst will
selected that mode which will best suit his convenience and purpose.
Uses or Advantages or Importance of Ratio Analysis
Ratio Analysis stands for the process of determining and presenting the relationship of
items and groups of items in the financial statements. It is an important technique of
financial analysis. It is a way by which financial stability and health of a concern can be
judged. The following are the main uses of Ratio analysis:
(a) Useful in financial position analysis: Accounting reveals the financial position of
the concern. This helps banks, insurance companies and other financial institution
in lending and making investment decisions.
(ii) Useful in simplifying accounting figures: Accounting ratios simplify,
summaries and systematic the accounting figures in order to make them more
understandable and in lucid form.
(iii) Useful in assessing the operational efficiency: Accounting ratios helps to

have an idea of the working of a concern. The efficiency of the firm becomes evident
when analysis is based on accounting ratio. This helps the management to assess
financial requirements and the capabilities of various business units.
(iv) Useful in forecasting purposes: If accounting ratios are calculated for number
of years, then a trend is established. This trend helps in setting up future plans and
forecasting.
(v) Useful in locating the weak spots of the business: Accounting ratios are of
great assistance in locating the weak spots in the business even through the overall
performance may be efficient.

(vi) Useful in comparison of performance: Managers are usually interested to
know which department performance is good and for that he compare one department
with the another department of the same firm. Ratios also help him to make any
change in the organisation structure.
Limitations of Ratio Analysis: These limitations should be kept in mind while

making use of ratio analyses for interpreting the financial statements. The following
are the main limitations of ratio analysis.
1. False results if based on incorrect accounting data: Accounting ratios can be

correct only if the data (on which they are based) is correct. Sometimes, the
information given in the financial statements is affected by window dressing, i. e.
showing position better than what actually is.
2. No idea of probable happenings in future: Ratios are an attempt to make an
analysis of the past financial statements; so they are historical documents. Now-a-
days keeping in view the complexities of the business, it is important to have an
idea of the probable happenings in future.
3. Variation in accounting methods: The two firms’ results are comparable with
the help of accounting ratios only if they follow the some accounting methods or
bases. Comparison will become difficult if the two concerns follow the different
methods of providing depreciation or valuing stock.
4. Price level change: Change in price levels make comparison for various years
difficult.
5. Only one method of analysis: Ratio analysis is only a beginning and gives just a
fraction of information needed for decision-making so, to have a comprehensive
analysis of financial statements, ratios should be used along with other methods of
analysis.
6. No common standards: It is very difficult to by down a common standard for
comparison because circumstances differ from concern to concern and the nature of
each industry is different.
7. Different meanings assigned to the some term: Different firms, in order to
calculate ratio may assign different meanings. This may affect the calculation of
ratio in different firms and such ratio when used for comparison may lead to wrong
conclusions.
8. Ignores qualitative factors: Accounting ratios are tools of quantitative analysis
only. But sometimes qualitative factors may surmount the quantitative aspects. The
calculations derived from the ratio analysis under such circumstances may get
distorted.
9. No use if ratios are worked out for insignificant and unrelated figure:
Accounting ratios should be calculated on the basis of cause and effect relationship.
One should be clear as to what cause is and what effect is before calculating a ratio
between two figures.

RATIO ANALYSIS
Ratio is an expression of one number is relation to another. It is one of the methods of

analyzing financial statement. Ratio analysis facilities the presentation of the information
of the financial statements in simplified and summarized from. Ratio is a measuring of two
numerical positions. It expresses the relation between two numeric figures. It can be
found by dividing one figure by another ratios are expressed in three ways.
1. Jines method
2. Ratio Method
3. Percentage Method
CLASSIFICATION OF RATIOS
All the ratios broadly classified into four types due to the interest of different parties for
different purposes. They are:
I. Profitability ratios
II. Activity ratios or Turn over ratios
III. Liquidity or Financial ratios
IV. Leverage ratios
1. Profitability ratios: These ratios are calculated to understand the profit positions
of the business. These ratios measure the profit earning capacity of an enterprise.
These ratios can be related its save or capital to a certain margin on sales or
profitability of capital employ. These ratios are of interest to management. Who are
responsible for success and growth of enterprise? Owners as well as financiers are
interested in profitability ratios as these reflect ability of enterprises to generate
return on capital employ important profitability ratios are:
Profitability ratios in relation to sales: Profitability ratios are almost importance of

concern. These ratios are calculated is focus the end results of the business
activities which are the sole eritesiour of overall efficiency of organisation.
gross profit
1. Gross profit ratio: x 100
Nest sales
Note: Higher the ratio the better it is
Net profit after interest & Tax

2. Net profit ratio: X 100
Net sales
3. Operating ratio (Operating expenses ratio)

Cost of goods sold  operating exenses
X 100
Net sales
Net: Lower the ratio the better it is
Operating profit
4. Operating profit ratio: X 100 = 100 operating ratio
Net sales
Note: Higher the ratio the better it is cost of goods sold= opening stock + purchase +
wages + other direct expenses- closing stock (or) sales – gross profit.
Operating expenses:
= administration expenses + setting, distribution expenses operating profit= gross

profit – operating expense.
concern expense
Expenses ratio = X 100
Net sales
Note: Lower the ratio the better it is
Profitability ratios in relation to investments:
Net profit after tax & latest depreciati on

1. Return on investments: X 100
share holders funds
Share holders funds = equity share capital + preference share capital + receives &
surpluses +undistributed profits.
Net Profit after tax & interest - preference divident

2. Return on equity capital: X 100
equity share capital
Net profit after tax - preferecne divident

3. Earnings per share=
No. of equity shares
operating profit
4. Return on capital employed = x 100
capital employed
N. P. after tax and interest
5. Return on total assets =
Total Assets
Here, capital employed = equity share capital + preference share capital + reserves &
surpluses + undistributed profits + debentures+ public deposit + securities + long
term loan + other long term liability – factious assets (preliminary
expressed & profit & loss account debt balance)
II. Turn over ratios or activity ratios:

These ratios measure how efficiency the enterprise employees the resources of assets at
its command. They indicate the performance of the business. The performance if an
enterprise is judged with its save. It means ratios are also laced efficiency ratios.
These ratios are used to know the turn over position of various things in the
___________. The turnover ratios are measured to help the management in taking the
decisions regarding the levels maintained in the assets, and raw materials and in the
funds. These ratio s are measured in ratio method.
cost of goods sold

1. Stock turnover ratio =
average stock
Here,
opening stock  closing stock
Average stock=
2
Note: Higher the ratio, the better it is
sales
2. Working capital turnover ratio =
working capital
Note: Higher the ratio the better it is working capital = current assets – essential
liabilities.
sales
3. Fixed assets turnover ratio =
fixed assets
Note: Higher the ratio the better it is.
sales
3 (i) Total assets turnover ratio is :
total assets
Sales
4. Capital turnover ratio=
Capital employed
credits sales or sales

5. Debtors turnover ratio=
average debtors
5(i)= Debtors collection period= 365 (or) 12
Turnove ratio
Here,
opening debitors  closing bebtors
Average debtors =
2

Debtors = debtors + bills receivable
credit purchasers or purchases

6. Creditors turnover ratio =
average credetors
365 (or) 12
6 (i) creditors collection period=
Creditor t urnover ratio
Here,
opening  closing credetors
Average creditor=
2
Creditors = creditors + bills payable.
Note: lower the ratio the better it is.
III. Financial ratios or liquidity ratios:
Liquidity refers to ability of organisation to meet its current obligation. These ratios are
used to measure the financial status of an organisation. These ratios help to the
management to make the decisions about the maintained level of current assets & current
libraries of the business. The main purpose to calculate these ratios is to know the short
terms solvency of the concern. These ratios are useful to various parties having interest in
the enterprise over a short period – such parties include banks. Lenders, suppliers,
employees and other.
The liquidity ratios assess the capacity of the company to repay its short term liabilities.
These ratios are calculated in ratio method.
current assets
Current ratio =
current liabilitie s
Note: The ideal ratio is 2:1
i. e., current assets should be twice. The current liabilities.
quick assets
Quick ratio or liquid ratio or acid test ratio:
Quick assets = cash in hand + cash at bank + short term investments + debtors + bills
receivables short term investments are also known as marketable securities.
Here the ideal ratio is 1:1 is, quick assets should be equal to the current liabilities.
absolute liquid assets

Absolute liquid ratio=
Here,

Absolute liquid assets=cash in hand + cash at bank + short term investments +
marketable securities.
Here, the ideal ratio is 0,0:1 or 1:2 it, absolute liquid assets must be half of current
liabilities.
IV. Leverage ratio of solvency ratios: Solvency refers to the ability of a business to
honour long item obligations like interest and installments associated with long term
debts. Solvency ratios indicate long term stability of an enterprise. These ratios are used
to understand the yield rate if the organisation.
Lenders like financial institutions, debenture, holders, banks are interested in ascertaining
solvency of the enterprise. The important solvency ratios are:
outsiders funds Debt

1. Debt – equity ratio= =
share holders funds Equity
Here,
Outsiders funds = Debentures, public deposits, securities, long term bank loans + other
long term liabilities.
Share holders funds = equity share capital + preference share capital + reserves &
surpluses + undistributed projects.
The ideal ratio is 2:1
share holder funds

2. Preprimary ratio or equity ratio=
The ideal ratio is 1:3 or 0.33:1
total assets
3. Capital – greasing ratio:
(equity share capital  reserves & surplusses  undistributed projects)

=
Here,
(Outsiders funds  preference share capital )
higher gearing ratio is not good for a new company or the company in which future
earnings are uncertain.
outsiders funds
11. Debt to total fund ratio=
capital employed
Capital employed= outsiders funds + share holders funds = debt + equity.
The ideal ratio is 0.6.7 :1 or 2:3

QUIZ
1. A company’s ‘return on investment’ indicates its ____. ( )

(a) Solvency (b) Stock turnover
(c) Profitability (d) Debtors collection
2. Which would a business be most likely to use its ‘solvency’ ( )

(a) Gross profit ratio (b) Debtors collection period
(c) Debt – Equity ratio (d) Current ratio
3. Higher ‘Assets turnover ratio’ explains ____. ( )

(a) More profitability (b) Higher sales turnover
(c) Better utilization of assets (d) large liability base
4. Which of the following measures company’s liquidity position ( )

(a) Stock Turnover ratio (b) Debtor’s collection period
(c) Current ratio (d) Net profit ratio
5. The difference between current assets and current liabilities is called___. ( )

(a) Cost of goods sold (b) Outsiders funds
(c) Working capital (d) Shareholders funds
6. Debtor’s is a current asset, where as creditor’s is ________. ( )

(a) Fixed Asset (b) Fixed Liability
(c) Current Liability (d) Long-term Liability
7. What is the Desirable current Ratio ______? ( )

(a) 1:2 (b) 3:2 (c) 2:1 (d) 1:1
8. Long-term stability of an enterprise indicates by ____ ratios. ( )

(a) Liquidity (b) Profitability
(c) Solvency (d) Turnover
9. The Liquidity ratios assess the capacity of the company to repay

Its_____________ Liability. ( )
(a) Long-term (b) Profitability
(c) Solvency (d) Turnover
10. In which Book-keeping system, business transactions are recorded as

two separate accounts at the same time? ( )
(a) Single entry (b) Triple entry
(c) Double entry (d) None
11. In which Concept “Business is treated separate from the Proprietor? ( )

(a) Cost concept (b) Dual aspect concept
(c) Business entity concept (d) Matching concept
12. When a deduction allowed from the gross or catalogue price to traders;
then it is called as ____. ( )
(a) Cash discount (b) Credit discount
(c) Trade discount (d) None

13. “Out standing wages” is treated as _________. ( )
(a) Asset (b) Expense
(c) Liability (d) Income
14. How many types of accounts are maintained to record all types of
business transactions? ( )
(a) Five (b) four
(c) Three (d) Two
15. Which connects the link between Journal and Trial Balance? ( )
(a) Trading Account (b) Profit & Loss account
(c) Ledger (d) Balance sheet
16. Which assets can be converted into cash in short period? ( )

(a) Fixed Assets (b) Intangible Assets
(c) Current Assets (d) Fictious Assets
17. “Bank over draft” is a ________. ( )

(a) Asset (b) Expense
(c) Liability (d) Income
18. Profit and Loss account is prepared to find out the business ____. ( )
(a) Gross result (b) Financial position
(c) Net result (d) Liquidity position
19. The statement of “Debit and credit balances of Ledger accounts”

is called as _________. ( )
(a) Journal (b) Ledger
(c) Trial balance (d) Balance sheet
20. _____ is a person who owes money to the firm. ( )

(a) Creditor (b) Owner
(c) Debtor (d) Share holder
21. The statement reveals the financial positions of a business at any given
date is called __________. ( )
(a) Trading account (b) Profit and loss account
(c) Balance sheet (d) Trial balance
22. ______ is called as ‘Book of Original Entry’. ( )

(a) Ledger (b) Trial Balance
(c) Journal (d) Trading account
23. Debit what comes in; Credit what goes out is ____ account principle? ( )
(a) Nominal (b) Personal
(c) Real (d) None
24. The process of entering transactions in to Ledge accounts known as __. ( )

(a) Journal entry (b) First entry
(c) Posting (d) None

25. Debit Expenses and Losses; Credit Incomes and Gains is ___ account
Principle ( )
(a) Personal (b) Real
(c) Nominal (d) None
26. “Prepaid Insurance Premium” is treated as _________. ( )

(a) Gain (b) Income
(c) Asset (d) Liability
27. Acid Test Ratio is also called as ________. ( )

(a) Current Ratio (b) Absolute Liquid Ratio
(c) Quick Ratio (d) Debt-Equity Ratio
28. The relationship between two numerical values is called as ____. ( )

(a) Account (b) Ledger
(c) Ratio (d) Discount
29. “Gross Profit” can be found out by preparing _______. ( )

(a) Profit and Loss account (b) Balance sheet
(c) Trading account (d) Trial balance
30. “Net Profit” can be found out by preparing _______. ( )

(a) Trading account (b) Trial balance
(c) Profit and Loss account (d) Balance sheet
Note: Answer is “C” for all the above questions.

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UNIT - V

INTRODUCTION TO FINANCIAL ACCOUNTING

The number of transactions in an organization depends upon the size of the

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 1

Accounting came into practice as an aid to human memory by maintaining a

1.1 History of Accounting:

1.2 Origin of Accounting in India:

2. BOOK-KEEPING AND ACCOUNTING

According to G.A. Lee the accounting system has two stages.

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 2

Book – Keeping: Book – Keeping involves the chronological recording of financial

Distinction between Book – Keeping and Accountancy

2.1 Meaning of Accounting

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 3

Smith and Ashburne: “Accounting is a means of measuring and reporting the

2.3 Branches of Accounting:

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 4

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 5

This is what the accountant or the accounting department does. A person

4. USERS OF ACCOUNTING INFORMATION

Different categories of users need different kinds of information for making

4.1 Internal Users:

4.2 External Users :

3. Workers : In our country, workers are entitled to payment of bonus which

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 6

7. Researchers: The financial statements, being a mirror of business conditions, is of

5. ADVANTAGES FROM ACCOUNTING

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 7

The following are the limitations of accounting.

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 8

BOOK KEEPING AND ACCOUNTING:

[A]. BOOK KEEPING:

“Book keeping is the system of recording Business transactions for the

Thus Book keeping is an art of recording business transactions in the books

[B]. ACCOUNTING: Accounting begins where the Bookkeeping ends

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 9

The following are the advantages of Accounting…………

2. FACILITATES THE PRPARATION OF FINANCIAL STATEMENTS: Profit and Loss

3. PROVIDES CONTROL OVER ASSETS: Book keeping provides information

4. PROVIES THE REQUIRED INFORMATION: Interested parties such as owners,

5. COMPARITIVE STUDY: One can compare present performance of the organization

8. ASCERTAINING VALUE OF BUSINESS: The accounting records will help in

9. DOCUMENTARY EVIDENCE: Accounting records can also be used as evidence in

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 10

10.HELPFUL TO MANAGEMENT: Accounting is useful to the management in various

The following are the limitations of accounting…………..

3. ESTIMATES BASED ON PERSONAL JUDGEMENT: The estimates used for

4. INADEQUATE INFORMATION ON COSTS AND PROFITS: Book keeping only

BASIC ACCOUNTING CONCEPTS

Accounting is a system evolved to achieve a set of objectives. In order to achieve the

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 11

3. MONEY MEASUREMENT CONCEPT: In this concept “Only those transactions are

8. REALISATION CONCEPT: According to this concept revenue is recognized when a

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 12

1.FULL DISCLOSURE: According to this convention accounting reports should disclose

KEY WORDS IN BOOK-KEEPING

1. TRANSACTIONS: Any sale or purchase of goods of services is called the

3.PURCHASES: Purchases means purchase of goods, unless it is stated otherwise

MANAGERIAL ECONOMICS AND FINANCIAL ANALYSIS 13