FUNDAMENTALS

OF
ACCOUNTING

Accounting
Ref Book By
Meigs, Williams, Haka,
Bettner
INTRODUCTION
TO
ACCOUNTING
Need and Importance of Accounting
•We live in a word where people need things from the day
they are born to the day that they die.
•Some of these NEEDS are physical needs, like food,
shelter, clothing etc. Some of these are emotional WANTS,
like, entertainment.
•In satisfying such needs and wants businessmen perform
useful services to their fellow humans. In return they
expect to earn a reasonable reward for their efforts in the
form of profit.
Every individual will have to plan his expenditure according to his
income.
Obviously the question arises
–why is this planning necessary?
The need for such planning arises as our needs ( and wants) for
goods and services are unlimited, while the means i.e., the income
with which to buy such goods and services are limited and goods
or services are not available free of cost.

A proper and fair planning of expenditure of expenditure helps us

to ensure proper use of our income. Of course, it is true that the
quantity of goods or money cannot be increased by making a
proper planning. But certainly we can ensure most economic use
of goods or money at our disposal.
BOOK-KEEPING
Most of us do maintain some kind of written record of our income
and expenditure. The idea behind maintaining this record is to
know the correct position regarding income and expenditure. The
need for keeping a record of income and expenditure in a clear and
systematic manner has given rise to the subject of “Book
Keeping.”

•The proper recording of the financial transactions in the book of

accounts is known as Book Keeping.

•Difference between book keeping and accounting:

▫Book keeping is the first stage, while Accounting is the final stage, that is
why it is said that accounting starts where book keeping ends.
The function of book keeping ends with the recording of
transactions in the book of accounts. But the function of
accounting is to classify the recorded transactions, summarize
them, interpret them and communicate information to the
management and other important persons.

An organization or business concern need to keep proper

accounts. At the end of the year (or at a certain time) the true
result of the economic activities of a concern must be made
available otherwise it will not be possible to run the organization
or concern.
In case of a business concern
▫The profit or loss at the end of a year must be ascertained, because the
amount of profit must be adequate in relation to that of investment made in
the business.
Accounting versus Accountancy

The two words “accounting” and “accountancy” are

often used to mean the same thing. But it is not correct.
Accountancy is the main subject whereas accounting is
one of its branches. The word “accountancy” is far
extensive i.e., the scope of accountancy is far wide and
extensive compared to accounting. It covers the entire
body of theory and practice e.g., book keeping,
accounting, costing, auditing, taxation etc.
Areas of Accounting

• Financial Accounting
The main purpose of f/accounting to ascertain the true
results(Profit or Loss) of the business operations during
a period of time and to state the financial position of the
business on a Particular point of time.
F/Accounting also produces special purpose reports for
use by the great variety of people who are interested in
the organization but who are not actively engaged in its
day to day operation.
 • Cost Accounting
The main object of cost accounting is to determine the
cost of goods manufactured or produced by the
business. It also helps the management of the business
in controlling the costs by indicating avoidable losses
and wastes.
 • Managerial Accounting
The object of M/accounting is to communicate the
relevant information periodically to the management of
the business to enable it to take suitable decisions.

Financial accounting is the oldest and other branches

have developed from it.
 IDENTIFICATION
OF USERS

NEEDS OF
USERS

ECONOMIC OR ACCOUNTING DECISION

REPORTING
BUSINESS ACTIVITIES SYSTEM MAKING

USERS: Owners, Investors, Creditors, Managers,

Agencies, Employees, Government,
• Business
Any profit oriented activity is called business.
• How Do We Measure Performance?
We should have certain facts about the activities. These facts
about business activities pass through an system, known as
Accounting System, which performs two functions:

• To develop an Accounting information in such a way that:-

 Information is recorded.
 Information is classified.
 Information is summarized.
• To communicate this information to users (decision makers)
Accounting is a basis for business decisions.

• What type of reports are generated?

Two types of reports are generated:
 Financial Statements
 Special Reports
• Financial Statements
A set of following four statements. These are
open documents.
– Balance Sheet
– Statement of Owner’s Equity
– Income Statement
– Statement of Cash Flow
• Special Reports
Special Reports are specific reports, other than
Financial Statements, like General Purpose
 reports, Income Tax Returns etc. These reports may be on daily, weekly, or
quarterly basis etc.
• Why We Study the Financial Statement?
We study these reports to find out
– Solvency (ability to pay debts)
– Profitability
– Future Prospects (ability to grow)
• What is an Accounting System?
An accounting system consists of personnel, procedures, devices, and record
etc for the sake of developing accounting information and
communicating it to users (decision makers).
• What are the basic qualities these Reports should contain?
– Reliability (true, actual, reliable etc)
• Qualified and competent personnel
• Internal Control System
• External Audit
 Generally Accepted Accounting
Principles (GAAPs)
Accounting Information, that is communicated externally to users (investors,
creditors etc) must be prepared in accordance with the standards that are
understood by both the preparers and users of that information. We call these
standards as GAAPs. These include broad principles of measurement and
presentation, as well as, detailed rules that are used by professional accountants in
preparing accounting information and reports.
PRINCIPLES

• Economic entity assumption.

▫ Financial records must be separately maintained for each
economic entity.
▫ Economic entities include businesses, governments, school
districts, churches, and other social organizations.

 Although accounting information from many different entities may be

combined for financial reporting purposes, every economic event must
be associated with and recorded by a specific entity. In addition,
business records must not include the personal assets or liabilities of
the owners.
• Monetary unit assumption.
An economic entity's accounting records include only quantifiable
transactions.
▫ Certain economic events that affect a company, such as hiring a
new chief executive officer or introducing a new product, cannot
be easily quantified in monetary units and, therefore, do not
appear in the company's accounting records.

• Full disclosure principle.

Financial statements normally provide information about a
company's past performance. However, pending lawsuits,
incomplete transactions, or other conditions may have imminent
and significant effects on the company's financial status. The full
disclosure principle requires that financial statements include
disclosure of such information. Footnotes supplement financial
statements to convey this information and to describe the policies
the company uses to record and report business transactions.
• Time period assumption. Most businesses exist for long periods
of time, so artificial time periods must be used to report the results
of business activity. Depending on the type of report, the time
period may be a day, a month, a year, or another arbitrary period.
Using artificial time periods leads to questions about when certain
transactions should be recorded.

▫ For example, how should an accountant report the cost of equipment expected to
last five years? Reporting the entire expense during the year of purchase might
make the company seem unprofitable that year and unreasonably profitable in
subsequent years. Once the time period has been established, accountants use
GAAP to record and report that accounting period's transactions.

• Accrual basis accounting. In most cases, GAAP requires the use

of accrual basis accounting rather than cash basis accounting.
▫ Accrual basis accounting, you record income when the sale occurs, not
necessarily when you receive payment. You record an expense when you receive
goods or services, even though you may not pay for them until later.
▫ Under cash basis accounting, revenues are recognized only when the company
receives cash or its equivalent, and expenses are recognized only when the
company pays with cash or its equivalent.
• Revenue recognition principle.
Revenue is earned and recognized upon product delivery or service
completion, without regard to the timing of cash flow.
Suppose a store orders five hundred compact discs from a wholesaler in
March, receives them in April, and pays for them in May. The wholesaler
recognizes the sales revenue in April when delivery occurs, not in March
when the deal is struck or in May when the cash is received. Similarly, if an
attorney receives a $100 retainer from a client, the attorney doesn't
recognize the money as revenue until he or she actually performs $100 in
services for the client.

• Matching principle. The costs of doing business are recorded in the same
period as the revenue they help to generate.
Examples of such costs include the cost of goods sold, salaries and
commissions earned, insurance premiums, supplies used, and estimates for
potential warranty work on the merchandise sold.
Consider the wholesaler who delivered five hundred CDs to a store in April.
These CDs change from an asset (inventory) to an expense (cost of goods
sold) when the revenue is recognized so that the profit from the sale can be
determined.
• Cost principle. Assets are recorded at cost, which equals the value
exchanged at the time of their acquisition. In the United States, even
if assets such as land or buildings appreciate in value over time, they
are not re-valued for financial reporting purposes.

• Going concern principle.

Financial statements are prepared under the assumption that the
company will remain in business indefinitely. Therefore, assets do
not need to be sold at fire‐sale values, and debt does not need to be
paid off before maturity. This principle results in the classification
of assets and liabilities as short‐term (current) and
long‐term. Long‐term assets are expected to be held for more
than one year. Long‐term liabilities are not due for more than
one year.
• Relevance, reliability, and consistency.
• To be useful, financial information must be relevant, reliable, and
prepared in a consistent manner.
• Relevant information helps a decision maker understand a
company's past performance, present condition, and future outlook
so that informed decisions can be made in a timely manner. Of
course, the information needs of individual users may differ,
requiring that the information be presented in different formats.
Internal users often need more detailed information than external
users, who may need to know only the company's value or its ability
to repay loans.
• Reliable information is verifiable and objective.
• Consistent information is prepared using the same methods
each accounting period, which allows meaningful comparisons to be
made between different accounting periods and between the
financial statements of different companies that use the same
methods.
 Accounting is for Comparability

To compare the performance

(profitability) of one organization and the
others, by following certain uniform rules
and regulations, which are globally
accepted.
Financial Statements:
 Balance Sheet (Statement of Financial Position):
The Balance Sheet is a position Statement that shows where the
company stands in financial terms at a specific date.
 Income Statement:
The Income Statement is an activity statement that shows detailed and results
of the company’s profit related activities for a period of time ( for example ,
a month, a quarter, or a year).
Statement of Cash Flows:
The Statement of Cash Flows is an activity statement that shows the details of
the company’s activities involving cash during a period of time.
Statement of Owner’s Equity:
The Statement of Owner’s Equity is an activity statement that shows the details
of the owner’s claim to the assets of the business during a period of time.
Balance Sheet
Every business prepares a balance sheet at the end of the year,
and many companies prepare one at the end of each month. It
consists of listing of the assets, the liabilities, and the owner’s
equity of a business.
Balance Sheet has two parts –Title & Body.
Title consists of three sub-sections:
(a) Name of Business entity
(b) Name of Financial Statement
(c) Date on which Balance Sheet is prepared

Body of the Balance Sheet consists of three sections:

(a) Assets:
Assets are the economic (or business) resources owned by the company.
Cash is listed first among the assets, followed by Notes Receivables,
Accounts Receivables, Supplies, & other assets.
Cash is a liquid asset. Less liquid assets, such as Land, Building
& Equipment etc are written afterwards.
Receivables are any cash which we have to receive from others.
Notes mean Promissory Notes (written promise)& if nothing
exists in writing & we do credit on understanding, such
Receivables mean Accounts Receivables.
Supplies mean the items which have been purchased & these will
be used subsequently in the process of business.
Payables are any cash which we have to pay to others. Notes
mean Promissory Notes (written promise)& if nothing exists in
writing & we do credit on some understanding, such Payables
mean Accounts Payables.
 (b) Liabilities:
Debt or obligation of an entity that resulted from past transactions. This
represents the claim of creditors on the assets( other than the owner).

(c) Owner’s Equity:

This represents the claim of owner on the assets

Accounting Equation

Assets = Liabilities + Owner’s Equity

The amount of total Assets is always equal to the total amount of Liabilities
and Owner’s Equity. This is why it is called Balance Sheet.
 Overnight Auto Services
Balance Sheet
Dec.31,2007
Assets Liabilities & Owner’s equity
$ Liabilities
Cash 10,000 $
Notes Receivables 20,000 Notes Payable 25,000
Accounts Receivables 30,000 Accounts Payable 70,000
Suppliers 15,000 Salaries Payable 5,000
Land 85,000 Total Liabilities 100,000
Building 100,000
Office Equipment 40,000 Owner’s Equity
Rehman’s Capital 200,000

Total(Assets) 300,000
Total 300,000
(Liabilities & Owner’s
Equity)
Income Statement
The Income Statement is a separate representation of the
company’s revenues & expense for a period of time. Generally the
time period is one year & is known as accounting year. It actually
explains how the company’s financial position changed during the
period (Profitability)
Revenue is the price of goods & services which we sell.
Expense is the cost of goods & services we use to generate revenue.
Revenue = $ 2200
Expense = $ 1400
Net Income = $ 800
 ABC Company
Income Statement
For the month ended November 30, 2008

$ $
Revenue
Repair Service Revenue 2200
Operating Expense
Wages Expense 1200
Utilities Expense 200 1400
Net Income 800
Statement of Cash Flows
This shows how cash position changed during the period.

Revenue/ Operating
Operating Expenses Activities

Assets Investing
Activities

Capital / Loan Financing

Activities
• Operating Activities (Revenue / Expense) should be positive
(generation of funds within the organization).

• Investing Activities ( Assets)

means any cash which we pay for buying assets or cash
receivables because of selling assets. This should be negative
showing expansion in the business ( Business is expanding).
 ABC Company
Statement of Cash Flows
For the month ended Nov.30, 2007
Cash flow from operating activities $ $
Cash received from sales revenue 2,200
Cash paid for expenses ( 1,400)
Net cash provided by operating expenses 800
Cash flow from investing activities
Purchase of lands (58,200)
Purchase of tools and machinery ( 6,600)
Purchase of tools(receipt) 600
Net cash used by investing activities (64,200)
Cash flow from financing activities
Investment by McBryan 80,000
Net cash provided by financing activities 80,000
Double Entry System
Every business transaction causes at least two changes
in the financial position of a business concern at the
same time—hence both the changes are recorded in the
book of accounts.

For example we buy machinery for Rs. 100,000,

obviously it is a business transaction.
It has brought two changes—machinery increases by
Rs. 100,000 and cash decreases by an equivalent
amount.
Both the changes must be recorded.
In account language these two changes are termed
as “a debit change” and “a credit change.”
Thus we see that for every transaction there will be
two entries—one debit entry and another credit
entry.
For each debit there will be a corresponding credit
entry of an equal amount.
Conversely for every credit, there will be a
corresponding debit entry of an equal amount. Such
system is known as Double Entry System.
Transaction is always in Past Tense.
• The following events are transactions to business or
not?
1. I started a business with Rs. 500,000.00
2. I bought furniture for Rs. 100,000.00 for business.
3. I submitted a tender for goods worth Rs. 10(M).
4. I appointed a cashier on a salary of Rs. 20,000 per
month.
5. I paid salary Rs. 35,000 per month to an accountant
of the firm.
6. I took away goods worth Rs. 10,000from the
business for my personal use.
7. Paid rent of my house from my own funds.
1. It is a transaction. It changed the financial position
of my business. Cash (assets) increases by
Rs.500,000 and Owner’s equity also increases by an
equal amount.
2. It is a transaction. It changed the financial position
of my business. Furniture (asset) increase by Rs.
100,000 and cash (asset) decreases by an equal
amount.
3. It is not a transaction. It did not change the financial
position of my business.
4. It is not a transaction. Mere appointment of the
cashier did not change the financial position of my
business.
5. It is a transaction. It changed the financial position of
my business. Cash(asset) decrease by Rs. 35.000
and an expense (salary) decreases by an equal
amount.

6. It is a transaction. Goods decreases by Rs. 10, 000

and Equity also decreases by an equal amount.
7. It is not a transaction.
 The Accounting Cycle

Transaction is the starting point and producing the

Financial Statements is the End point. In between there
is an accounting process:

TRANSACTION JOURNAL LEDGER

FINANCIAL
TRIAL BALANCE
STATEMENYS
 Rules of Debit & Credit
This explains that when we have to write something in the
debit side and when in the credit side.

ASSETS
BALANCE SHEET’s
LIABILITIES &
ACCOUNTS
OWNER's EQUITY

REVENUE & INCOME STATEMENT

EXPENSE ACCOUNTS
Rules of Debit & Credit
This explains that when we have to write something in
the debit side and when in the credit side.

Increases are Recorded

ASSETS & as Debits
EXPENSES Decreases are Recorded
as Credits

LIABILITIES Increases are Recorded

OWNER’s EQUITY & as Credits
REVENUE Decreases are Recorded
as Debits
The Journal
The information about each business transaction is
initially recorded in an accounting record called the
Journal.

The journal is chronological (day by day) record of

business transactions.

At convenient intervals, the debit and credit amounts

recorded in the journal are transferred (posted) to the
Ledger. The journal is an internal document.
Date Account Titles and explanation Debit Credit
2008

Nov 1 Cash 80,000

McBryan Capital 80,000
McBryan invested cash
Nov 3 Land 52000
Cash 52000
Purchased land for cash
Nov 5 Building 36,000
Cash 6,000
Notes Payable 30,000
Purchased Building for cash 6000 &
Notes payable 36000
Nov 17 Tools & Equipment 13,800
Accounts Payable 13,800
Purchased Tool & Equipment on
accounts
Date Account Titles and explanation Debit Credit
2008

Nov 20 Accounts Receivables 18,000

Tools & Equipment 18,000
Sold some of tools & equipment on
accounts
Nov 25 Cash 600
Accounts Receivables 600
Received Cash on Accounts
Nov 26 Accounts Payable 6,800
Cash 6,800
Paid Cash on Accounts
Remember that:
• No currency sign is to be shown in Journal, Ledger
and Trial Balance.
• Currency sign is to be shown in all the four Financial
Statements, being the external documents.
• Every debit amount has an equal credit amount
• Posting simply means updating the ledger.
The Ledger
An accounting system includes a separate record for each item
that appears in the financial statements.
For example, a separate record is kept for the asset “cash,”
showing all increases and decreases in cash resulting from the
money transactions in which cash is received or paid.
A similar record is kept for every other asset, for every liability,
for owner’s equity etc. The record used to keep track of the
increases and decreases in the financial statement items is termed
as ledger account or simply account.
The entire group of accounts is kept together in an
accounting record called a Ledger.
An account has three sections:
1. a title;
2. a left side, called as debit side; and
3. a right side called as credit side;
This form of an account is called a T- account because
of its resemblance to the T-letter.

Title of Accounts

Debit Side Credit Side

Receipts are recorded on the left side and payments are
placed on the right side and then we see the net impact
of these transactions.
Examples
Nov.1: McBryan invested cash $ 80,000 in OAS
Analysis: The cash is increased by $ 80,000 & the
McBryan Equity is increased by the same amount.
Debit / Credit Rules: Increase in assets is recorded by
debits; Increase in owner’s equity is recorded by credits.
 Cash Owner’s Equity

1/11 80,000 3/11 52,000 1/11 80,000

5/11 6,000

Nov.3: Purchased land for cash $ 52,000

Analysis: The asset land is increase by $ 52,000 and the
asset cash is decreased by $ 52,000
Debit / Credit Rule: Increase in assets are recorded by
debits; Decrease in assets is recorded by credits.
 Building Notes Payables
Land
1/11 52,000 5/11 36,000 5/11 30,000

Nov.5: Purchased building for $36,000,

paid cash $ 6000 & Notes Payable $ 3,000.
Analysis: the asset building is increased: Cash is decreased &
Notes Payable is increased.

We see that equality of debits & credits is maintained in all

transactions. Now we do Trial Balance to check the arithmetical
accuracy of ledger and to further ensure that equality of debit &
credit is maintained.
 Overnight Auto Service
Trial Balance
On November 26, 2009
Debit Credit
Cash
Accounts Receivables
Land Building
Tools & Machinery
Notes Payable
Accounts Payable
McBryan Capital
117,000 117,000
 Trial Balance
Trial Balance is an internal document and not an
external document. Now if the total of two columns
agree, we say that we have done the recording in the
ledger correctly. From the ledger, we prepare the
Balance Sheet.
Types of Business
There are three main types of businesses: those selling
services (such as dry cleaners, auto workshops, beauty
saloons, airline companies etc); those selling goods
(such as food sellers, automobile dealers etc);those
manufacturing goods (such as automobile manufactures,
sugar mills, textile mills etc).
A business entity is an economic unit which enters into
business transactions that must be recorded,
summarized and reported.
The entity (business organization) is regarded as
separate from its owner or owners; the entity owns its
own property; the entity has its own debts.
The purpose of accounting is to provide useful
information about an organization (an entity) to people
who need such information but not about the personal
affairs of the owner or owners.
Forms of Business Organization
There are three main forms of business organizations:
Sole Proprietorships
The simplest form of business organization “to organize
and operate "is a single or sole proprietorship. This is
the most common type of ownership and is founded in
businesses such as small retail shops, service stations
etc. This unincorporated business, owned by one person,
is called a sole proprietorship. The owner is personally
responsible for the debts of the business. If the business
becomes insolvent, creditors can force the owner to sell
his or her personal assets to pay the business debts.
The advantage is its simplicity whereas the unlimited
liability is a disadvantage to the owner.
Partnership
An incorporated business owned by two, or more,
persons voluntarily acting as partners (co-workers), who
agree to share their property and/or skills etc to operate
the business is called partnership. Like the sole
proprietorship, a partnership business is simple to
organize. The owners of a partnership are personally
responsible for all debts of the business.
Joint Stock Companies (Corporations)
This is the only type of business organization
recognized under the law as an entity separated from its
owners. Therefore the owners of a Joint Stock Company
are not personally responsible / liable for the debts of
the business. The owners can loose no more than the
amounts they have invested in the business—a concept
known as limited liability. Because of this concept, the
corporations are the most attractive form of business
organizations to many investors.
Ownerships of a corporation is divided into transferable
shares of capital stock and the owners are called
stockholders. Stock certificates are issued by the
corporation to each stockholder showing the number of
shares that he or she owns. The stockholders are free to
sell some or all of these shares to other investors at any
time. This transferability of ownership adds to the
attractiveness of the corporate form of organization,
because the investors can more easily get their money
out of the business.
Balance Sheet in case of Sole Proprietorship
Owner’s Equity
McBryan Capital $ 80,000
Balance Sheet in case of Partnership
Partner’s Equity
McBryan Capital $ 100.000
Smith Capital 80,000
Total Partner’s Capital 180,000
Balance Sheet in case of Corporation
Stockholder’s Equity
Capital Stock
80000 shares of $ 10 each $ 800,000
Retained Earning 100,000
Total Shareholder’s Equity 980,000
 Capital Stock
Capital Stock represents the amount that the
stockholders originally invested in the business in
exchange for shares of the company’s stock.
Retained Earning
Retained Earning represents the increase in
stockholder’s equity that has accumulated over the years
as a result of profitable operations.
Assignment
Assume that Michael McBrown, an experienced auto
engineer, opens his own automotive repair business
“Overnight Auto Service.” A distinctive feature of
overnight's operations is that all repair work is done at
night. This strategy offers customers the convenience of
dropping off their cars in the evening and picking them
up the following morning.
McBryan started business on November 1,2008.
Following are the transactions:
Nov 1: McBryan started the business by
depositing $ 80,000 in a company’s bank
account.
Nov 3: Purchased Land for $ 5,2000 paying cash.
Nov 5: Purchased a building for $ 36,000 paying
$ 6,000 in cash and issuing a note payable
for the remaining $ 30,000.
Nov 17: Purchased tools & machinery on
accounts for $ 13,800.
 Nov 20: Sold some of the tools & machinery on
accounts for $ 1,800.
Nov 25: Received cash $ 600 on account.
Nov 26: Paid cash on account $ 6,800.
Nov 30: Received cash $ 2,200 from customers
for repair service provided during the month.
Nov 30: Paid cash $ 1400 for expense ($ 200 for
utilities & $ 1200 for salaries).
Develop a Balance Sheet showing the company’s
financial position, transaction wise.