Basics of Accounting

Unit 1: Introduction to
Accounting
Accounting
• Accounting is the process of identifying, measuring, and
communicating economic information to permit informed judgments
and decisions. Put more simply, accounting is the “language of
business.”

• “Accounting is 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 financial character, and interpreting the
results thereof”
Users of Accounting Information

Owners Management Lenders

Employees Government Society

Types of Business Organizations

Types of
Business
Organizations

i. Sole
Proprietorsh i. Partnership Companies
ip

i. Limited Private
i. General One Person Public Limited
Liability Limited
Partnership Company Company
Partnership Company
Financial Statements

i.Statement of
i.Balance i.Income
Shareholder’
Sheet Statement
s Equity

i.Cash Flow i.Notes to

Statement Accounts
Elements of Income Statement

Statement of
Profit & Loss

Income Expenses

Manufacturing,
Operating & Non Administrative,
Income from Cash & Non-Cash
Other Income Operating Selling &
Operations Expenses
Expenses Distribution
Expenses
The Income Statement and Terms
An income statement reports a
company’s revenues and expenses.
Matching Principle – Expenses should be recorded in the
period resources are used to generate revenues
Revenue – An Expense – A
increase in decrease in
resources Terms resources
resulting from resulting from
the sale of the sale of
goods or goods or
services services
Revenue Recognition Principle – A revenue should be
recorded when a resource has been earned
Elements of Balance Sheet
Assets = Liabilities + Shareholders’ Equity

Balance
Sheet

Assets Liabilities Equity

Non-Current and Tangible and Non-Current Current Reserves &

Share Capital
Current Assets Intangible Assets Liabilities Liabilities Surplus

Non-Current Current Tangible Intangible

Assets Assets Assets Assets
Reporting Financial Position: The Balance
Sheet and Related Terms
Asset: An Liability: An
Cost principle:
economic resource obligation of a
The principle
that is objectively business that results
that assets
measurable, that from a past
should be
results from a transaction and will
recorded and
prior transaction, require the sacrifice
reported at the
and that will of economic
cost paid to
provide future resources at some
acquire them.
economic benefit. future date.

Equity: The difference

Contributed capital: The
between a company’s assets
resources that investors
and liabilities, representing
contribute to a business in
the share of assets that is
exchange for ownership
claimed by the company’s
interest.
owners.
 Terms Used to Identify and Describe
Economic Information
Term Definition Reported on the
Asset A resource of a business Balance sheet
Liability An obligation of a business Balance sheet
Equity The difference between assets and liabilities Balance sheet

Contributed Capital Equity resulting from contributions from Balance sheet

owners

Retained Earnings Equity resulting from profitable operations Balance sheet and
statement of
shareholder’s equity
Revenue An increase in assets resulting from selling a Income Statement
good or providing a service

Expense A decrease in assets resulting from selling a Income Statement

good or providing a service

Dividend A distribution of profits to owners Statement of

shareholder’s equity
Principles Used to Measure Economic Information
Principle Definition Ramification
Accrual Incomes and expenses are The receipt of cash is not
recorded as and when required to record
they are accrued transactions
irrespective of payment or
receipt of cash.
Revenue Revenues are recorded The receipt of cash is not
Recognition when they are earned. required to record a
revenue.
Matching Expenses are recorded in For many assets, the cost of
the time period when they the asset must be spread
are incurred to generate over the periods that it is
revenues. used.

Cost Assets are recorded and Except in a few cases,

maintained at their market values are not used
historical costs. for reporting asset values.
 Assumptions Made When Communicating
Economic Information
Assumption Definition
Economic entity The financial activities of a
business can be accounted
for separately from the
business's owners.
Monetary unit The rupee, unadjusted for
inflation, is the best means currencies are converted to
of communicating
accounting information in the
India.
Time period Accounting information can
be communicated effectively
over short periods of time.
Going concern The company for which we
are accounting will continue
its operations indefinitely.
Ramification
We have to worry that the
financial information of the
owner is mixed with the
financial information of the
business.
All transactions in foreign
rupees.
Most businesses prepare
quarterly and annual
financial statements.
If an entity is not selling its
assets, then the cost
principle is appropriate.
Qualitative Characteristics of Accounting
Information
Term Definition Ramification

Understandability Accounting information should be Users must spend a reasonable

comprehensible by those willing amount of time studying
to spend a reasonable amount of accounting information for it to
time studying it. be understandable.

Relevance The capacity of accounting Information should have

information to make a difference predictive or feedback value
in decisions. and should be timely.
Qualitative Characteristics of Accounting
Information (continued)
Term Definition Ramification

Reliability The extent to which accounting Information should be free from

information can be depended error, a faithful representation, and
upon to represent what it neutral.
purports to represent, both in
description and in number.

Comparability The ability to use accounting Entities must disclose the

information to compare or accounting methods that they use
contrast the financial activities so that comparisons across
of different companies. companies can be made.
Qualitative Characteristics of Accounting
Information (Continued)
Terms Definition Ramifications

Consistency Accounting information An entity should use the same

should be comparable accounting
across different time periods methods year to year and
within a company. disclose when they change
methods.

Materiality The threshold over which an When an amount is small

item could begin to affect enough, normal
decisions. accounting procedures are not
always followed.
Qualitative Characteristics of
Accounting Information (Continued)
Terms Definition Ramifications

Conservatism When uncertainty exists, An entity should choose

accounting information accounting techniques
should present the least that guard against
optimistic alternative. overstating revenues or
assets.
Unit 2: Accounting Process
Double-Entry Bookkeeping

 The principle of double entry bookkeeping is that for

every debit (written as Dr.), there is a credit (Cr.).

 Therefore, if the economic effects of transactions and

events for a particular period (say, accounting year) are
recorded correctly, the total of amounts in debit and
total of the amounts in credit at the end of the period
shall agree.

 This is the beauty of double-entry bookkeeping.

Double Entry Rules
Double Entry Rules
(Contd.)
 According to the accounting convention, asset account
is debited for increase in the amount of asset.

 Every debit has a credit. Therefore, there should be

corresponding credit to either the equity account or the
liability account.

 It implies that increase in liability should be credit.

 Similarly, increase in equity should be credit.

 Double Entry Rules
(Contd.)

 If increase in asset is debit, logically, decrease in asset

should be credit.

 With the same logic, decrease in liability should be debit

and decrease in equity should be debit.

 Incomes increase equity, therefore, income is credit.

Similarly, expenses decrease equity, therefore, expense
is debit.
Double Entry Rules
(Contd.)
S. No. Elements Increase Decrease

1 Asset Debit Credit

2 Equity Credit Debit

3 Liability Credit Debit

4 Income Credit Debit

5 Expense Debit Credit

Accounting Cycle

 Accounting involves recording of transactions and other

events in a manner that facilitates preparation and
presentation of financial statements.

 Accounting cycle refers to the cycle starting with

recording of opening entries (balances carried forward
from the previous reporting period) in the general
ledger, and ends with the preparation of financial
statements.
Accounting Cycle (cont.)
 Following steps are involved in the preparation of financial
statements:

 Recording of opening entries in the general ledger

 Recording of transactions and events in the journal

(journalisation)

 Posting journal entries in appropriate accounts in the general

ledger

 Balancing the accounts in the general ledger

 Preparing the trial balance

 Recording closing entries to prepare financial statements

Journal and General
Ledger
 Journal is known as book of original entry

 Transactions are recorded in journal based on the rules

of debit & credit.

 The General Ledger is the principal book of accounts.

 Journal entries are the bases for preparing the General

Ledger.

 After recording transactions in journals, the next phase

in the accounting process is to post entries in
appropriate account heads in the General Ledger.
Journal Entries
The following standardized format indicates the
accounts and amounts, with debits on the first line
and credits (indented) on the second line:

Date Account Debited…………………… Amount Debited

Account Credited…………….. Amount
Credited
Recording Transactions
Into the Accounting System
Accounting transactions are first recorded in a journal.

GENERAL
JOURNAL
Date Description Debit Credit
Dec 1 Cash 1,350
Unearned Rent Revenue 1,350

Dec 31 Unearned Rent Revenue 450

Rent Revenue 450
General Ledger and Trial
Balance
 The general ledger is the principal book of accounts.

 Account heads (e.g., Purchase of raw materials

Account, Sale of goods Account, Employee benefits
Account and Vehicles Account) to record transactions
and economic consequences of events related to
assets, equity, liabilities, incomes and expenses are
maintained in the general ledger.
Posting to Ledger
GENERAL
JOURNAL
Da te De s c riptio n De bit Cre dit
Dec 1 Cash 1,350
Unearned Rent Revenue 1,350

Dec 31 Unearned Rent Revenue 450

Rent Revenue 450

Cash Unearned Rent Rent Revenue

Revenue 450
1,350 450 1,350 450
1,350 900

Accounting Process:
Step 1 – What accounts are affected and how are they affected?
Step 2 – What debit and credit entries are required?
Step 3 – Record the journal entry.
Step 4 –Post the information to the ledger.
 General Ledger and Trial
Balance (Contd.)
 Periodically, net balance (amount) in different accounts
in the general ledger are calculated.

 If the total of amounts in debit is higher than the total

amounts in credit, it is said the account has a debit
balance.

 Similarly, if the total of amounts in credit is higher than

the total amounts in debit, it is said the account has a
credit balance.
General Ledger and Trial
Balance (cont.)
 Periodically, accounts in the General Ledger are balanced.

 For example, if in a particular account the total of the debit

side comes to ` 10,000 and the total of the credit side comes
to ` 8,000, the account shows a debit balance of ` 2,000.

 Thus, a debit balance of ` 2,000 reflects that the total of the

debit side exceeds the total of the credit side by ` 2,000.

 Financial statements are prepared on the basis of balances in

ledger accounts at the end of the accounting period.
General Ledger and Trial
Balance (Contd.)

 After balancing the accounts in the general ledger, a

statement listing the debit and credit balances in
various account heads is prepared.

 This statement is known as the “Trial Balance”.

 The total of the debit balances agree with the total of

the credit balances.

 Preparation of the Trial Balance is the starting point for

preparing financial statements.
Trial Balance
Trial Balance
Debit Credit
Asset Account(s) amount
Liability Account(s) Amount
Equity Account(s) Amount
Revenue Account(s) amount
Expense Account(s) Amount
Dividends amount

Total debits Total Credits

Unit 3: Final Accounts
Accounting Cycle: Final
Phase
 The final phase in the accounting cycle is the
preparation of the profit and loss account, and the
balance sheet. The profit and loss account is prepared
by matching income and expenses.

 The balance sheet is prepared by listing out assets

and liabilities.

 The trial balance provides the raw data that are

analysed and adjusted for preparing the profit and
loss account, and the balance sheet.
Adjustments

 In the accrual system of accounting, a firm recognises revenue

immediately on completion of the earning process without waiting
for actual receipt of cash or other assets.

 Similarly, it recognises expenditure when it is probable that

economic benefits will outflow the enterprise, without waiting for
actual cash outflow or outflow of other economic benefits.

 Therefore, the accrual system of accounting requires

adjustments for accrued income and outstanding expenses
(accruals).
Adjustments (cont.)
 Moreover, preparation of a profit and loss account requires
matching of income and expenses.

 These require adjustments for income received in advance and

prepaid expenses.

 Some more adjustments are required to present a true and fair

view of the operating result and the financial position

 Adjustment entries are passed through the journal proper and

an ‘adjusted trial balance’ is drawn incorporating the
adjustments.
 The adjusted trial balance forms the basis of preparing
financial statements.
Treatment of Adjustments in Final
Accounts
Adjustment Income Statement Balance Sheet

Accrued expense Added to respective expense Shown as liability

Accrued Income Added to respective income Shown as asset
Deferred expense Deducted from respective expense Shown as asset
Deferred Income Deducted from respective income Shown as liability
Closing Stock Added to Income side in Trading Account Shown as asset
Depreciation Shown on expense side of P&L Account Shown as deduction from Asset

Provision for depreciation Shown on expense side of P&L Account Added to accumulated
depreciation and shown as
deduction from Asset
Provision for bad debts Shown on expense side of P&L Account (as Shown as deduction from Debtors
a claim on profits)
Provision for Discount on Discount is given to only sound debtors. Shown as deduction from Debtors
debtors Therefore, first provision for bad debts is
deducted from debtors and then discount
rate is applied to calculate the discount, to
be shown as expense
Trading Account
Trading Account is prepared to assess the gross profit made by the
business in an accounting period. Gross profit is calculated as the
difference between sales and cost of goods sold (CoGS):

Gross Profit = Sales – CoGS

Where, CoGS is the manufacturing cost of goods sold by the firm.

CoGS includes material cost and all manufacturing expenses.
Cost of Goods Sold (CoGS) = Material Cost + Manufacturing Expenses

CoGS= (opening stock + purchases -closing stock) + Wages + Power &

Fuel + Carriage Inward + any other manufacturing expense
Profit and Loss Account
• Profit & Loss Account is prepared to calculate the Net Profit of
business by deducting all expenses other than manufacturing
expenses from gross profit.
• These expenses include administrative expenses, selling &
distribution (S&D) expenses, finance cost etc.
• Finally, if there is any income from sources other than Sales then
it is added to arrive at net profit. The example of other income
includes interest received, dividend received, any capital gains,
rent received etc.

Net Profit = Gross Profit +Net Other Income – Expenses Other than
Manufacturing Expenses
Balance Sheet

• Balance sheet is prepared to assess the financial position of

business at the end of accounting period.

• All the assets, liabilities and equity values given in trial balance
are posted to balance sheet.

• The net profit calculated in P&L account is added to equity in

balance sheet.
Assets = Liabilities + Shareholders’ Equity