Chapter 1

Accounting: The Languageof Business

What is accounting?

• The language of business

– Measures financial aspects of a business

– Communicates this information to decision makers

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The Need for Accounting

Managers, investors, and other internal groupsManagers, investors, and other internal groupswant the answers to two important questions: want the answers to two important questions:

How well didHow well didthe organizationthe organization

perform?perform?

Where doesWhere doesthe organizationthe organization

stand?stand?

The Need for Accounting

Accountants answer these questionsAccountants answer these questionswith three major financial statements:with three major financial statements:

IncomeIncomestatementstatement

BalanceBalancesheetsheet

Statement ofStatement ofcash flowscash flows

Introduction• Accounting - a process of identifying, recording,

summarizing, and reporting economic information to decision makers in the form of financial statements

• Financial accounting - focuses on the specific needs of decision makers external to the organization, such as stockholders, suppliers, banks, and government agencies

The Nature of Accounting• The accounting system is a series of steps

performed to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their effects on an organization and to prepare the financial statements.

The Nature of Accounting• Accounting systems are designed to meet the

needs of the decisions makers who use the financial information.

• Every business has some sort of accounting system.– These accounting systems may be very complex or

very simple, but the real value of any accounting system lies in the information that the system provides.

Accounting as an Aid toDecision Making

• Accounting information is useful to anyone who makes decisions that have economic results.• Managers want to know if a new product will be

profitable.• Owners want to know which employees are productive.• Investors want to know if a company is a good

investment.• Creditors want to know if they should extend credit,

how much to extend, and for how long.• Government regulators want to know if financial

statements conform to requirements.

Accounting as an Aid toDecision Making

• Fundamental relationships in the decision-making process:

EventAccountant’s

analysis &recording

FinancialStatements Users

Financial and Management Accounting• The major distinction between financial and

management accounting is the users of the information.– Financial accounting serves external users.– Management accounting serves internal users,

such as top executives, management, and administrators within

organizations.

Financial and Management Accounting

The primary questions about an organization’s success that decision makers want to know are:

What is the financial picture of the organization on a given day?

How well did the organization do during a given period?

Financial and Management AccountingAccountants answer these primary questions with three major financial statements.

• Balance Sheet - financial picture on a given day• Income Statement - performance over a given

period• Statement of Cash Flows - performance over a

given period

Financial and Management Accounting• Annual report - a document prepared by

management and distributed to current and potential investors to inform them about the company’s past performance and future prospects.– The annual report is one of the most common

sources of financial information used by investors and managers.

Financial and Management Accounting• The annual report usually includes:– a letter from corporate management– a discussion and analysis of recent economic events

by management– footnotes that explain many elements of the financial

statements in more detail– the report of the independent auditors– a statement of management’s responsibility for

preparation of the financial statements– other corporate information

The Balance Sheet• What are the different sections of the

Balance Sheet?

Balance Sheet

The The balance sheetbalance sheet (also called (also called statement ofstatement offinancial positionfinancial position or or statement of financialstatement of financial

conditioncondition) is a snapshot of the financial) is a snapshot of the financialstatus of an organization at a point in time.status of an organization at a point in time.

Balance Sheet

AssetsAssets are economic resources that are economic resources thatare expected to benefit futureare expected to benefit futureactivities of the organizationactivities of the organization..

LiabilitiesLiabilities are the entity’s economic are the entity’s economicobligations to others.obligations to others.

Owners’ equityOwners’ equity is the excessis the excessof the assets over the liabilities.of the assets over the liabilities.

Balance Sheet

Shareholders’ equityShareholders’ equity

Paid-inPaid-incapitalcapital

RetainedRetainedearningsearnings

The owners’ equity of a corporationThe owners’ equity of a corporationis called is called shareshareholders’ equityholders’ equity..

The Balance SheetSections of the balance sheet:• Assets - resources of the firm that are expected to

increase or cause future cash flows (everything the firm owns)

• Liabilities - obligations of the firm to outsiders or claims against its assets by outsiders (debts of the firm)

• Owners’ Equity - the residual interest in, or remaining claims against, the firm’s assets after deducting liabilities (rights of the owners)

The Balance SheetThe balance sheet equation:

Assets = Liabilities + Owners’ Equityor

Owners’ Equity = Assets - Liabilities

Four Basic Financial Statements• Balance Sheet– Assets = Liabilities + Equity

• Income Statement (also called Statement of Operations, Earnings Statement, Profit/Loss (or P&L) Statement– Revenues - Expenses = Net income (or Net Earnings)

• Statement of Changes in Stockholders’ Equity– Beginning of period total equity + Stock issued + Net

income - Dividends = End of period total equity

• Statement of Cash Flows– Cash inflow - Cash outflow = Net cash flow

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Users of Accounting Information

Different categories of users need different kinds of information for making decisions. These users can be divided into :

•Internal Users; and

•External Users.

Internal Users

These are the persons who manage the business, i.e. management at the top, middle, and lower levels. Their requirements of information are different because they make different types of decisions.

Internal Users continue…

The top level is more concerned with planning; the middle level is concerned equally with planning and control; and the lower level is concerned more with controlling operations. Information is supplied on different aspects, e.g. cash resources, sales estimates, results of operations, financial position, etc.

External Users

All persons other than internal users come in the group of external users. External users can be divided into two groups:       those having direct interest; and       those having indirect interest

in a business organization.

External Users continue…

The main sources of information for external users are annual reports of business organizations, which state the financial position and performance and give the auditor’s report, director’s report and other information.

External Users continue…

Investors and creditors are the external users having direct interest. Tax authorities, regulatory agencies, customers, labour unions, trade associations, stock exchanges, investors, etc are indirectly interested in the company’s financial strength, its ability to meet short-term and long-term obligations, its future earning power, etc for making various decisions.

ASSETS

These are economic resources of an enterprise that can be usefully expressed in monetary terms. Assets are things of value used by the business in its operations.        Fixed Assets         Current Assets

ASSETS continue…

    Fixed Assets are assets held on a long-term basis.e.g. Land, Building, Machinery, Plant,

Furniture and Fixtures, etc.

ASSETS continue…

   Current Assets are assets held on a short-term basis.e.g. Debtors, Bills receivable, Stock(Inventory), Cash and Bank balances, etc.

LIABILITIES

These are obligations or debts that the enterprise must pay in money or services at some time in the future.

• Long-term liabilities

• Short-term liabilities

LIABILITIES continue..

Long-term liabilities are those that are usually payable after a period of one year.

e.g. A term loan from a financial institution, debentures (bonds) issued by a company.

LIABILITIES continue..

Short-term liabilities are obligations that are payable within a period of one year.

e.g. Creditors, bills payable, overdraft from a bank for a short period.

CAPITAL

Investment by the owner for use in the firm is known as capital. Owner’s equity is the ownership claim on total assets. It is equal to total assets minus total liabilities.

REVENUES

These are the amounts the business earns by selling its products or providing services to customers. Other titles and sources of revenue common to many businesses are: sales, fees, commission, interest, dividends, royalties, rent received, etc.

EXPENSES

These are costs incurred by a business in the process of earning revenue. Generally, expenses are measured by the cost of assets consumed or services used during an accounting period. The usual titles of expenses are: depreciation, rent, wages, salaries, interest, costs of heat, light and water, telephone, etc.

PURCHASESPurchases are total amount of goods procured by a business on credit and for cash, for use or sale. In a trading concern, purchases are made of merchandise for resale with or without processing. In a manufacturing concern, raw materials are purchased, processed further into finished goods and then sold. Purchases may be cash purchase or credit purchase.

SALES

Sales are total revenues from goods or services sold or provided to customers. Sales may be cash sales or credit sales.

STOCK

Stock (Inventory) is a measure of something on hand – goods, spares and other items – in a business.

It is called stock on hand.

STOCK: continue…

In a trading concern, the stock on hand is the amount of goods which have not been sold on the date on which the balance sheet is prepared. This is also called closing stock.

STOCK continue… In a manufacturing concern, closing stock comprises raw materials, semi-finished goods and finished goods on hand on the closing date.

Similarly, opening stock is the amount of stock at the beginning of the accounting year.

DEBTORS

Debtors are persons and/or other entities who owe to an enterprise an amount for receiving goods and services on credit.

The total amount standing against such persons and/or entities on the closing date, is shown in the Balance Sheet as Sundry Debtors on the asset side.

CREDITORS

Creditors are persons and/or other entities who have to be paid by an enterprise an amount for providing the enterprise goods and services on credit. The total amount standing to the favour of such persons and/or entities on the closing date, is shown in the Balance Sheet as Sundry Creditors on the liability side.

ACCOUNTING PRINCIPLES

Accounting principles can be subdivided into two categories:

        Accounting Concepts; and        Accounting Conventions.

ACCOUNTING PRINCIPLES

Accounting principles can be subdivided into two categories:

        Accounting Concepts; and        Accounting Conventions.

ACCOUNTING PRINCIPLES

        Accounting Concepts        Accounting ConventionsThe term ‘concept’ is used to connote accounting postulates, that is necessary assumptions and conditions upon which accounting is based. The term ‘convention’ is used to signify customs and traditions as a guide to the presentation of accounting statements.

ACCOUNTING PRINCIPLES

Accounting Concepts• Business Entity Concept• Money Measurement Concept• Cost Concept• Going Concern Concept• Dual Aspect Concept• Realization Concept• Accounting Period Concept

ACCOUNTING PRINCIPLES

Accounting Conventions• Convention of Consistency• Convention of Disclosure• Convention of Conservation

ACCOUNTING PRINCIPLES

Accounting Concepts The term ‘concept’ is used to connote accounting postulates, that is necessary assumptions and conditions upon which accounting is based.

Business Entity Concept

Business is treated as a separate entity or unit apart from its owner and others. All the transactions of the business are recorded in the books of business from the point of view of the business as an entity and even the owner is treated as a creditor to the extent of his/her capital.

Money Measurement Concept

In accounting, we record only those transactions which are expressed in terms of money. In other words, a fact which can not be expressed in monetary terms, is not recorded in the books of accounts.

Cost Concept

Transactions are entered in the books of accounts at the amount actually involved. Suppose a company purchases a car for Rs.1,50,000/- the real value of which is Rs.2,00,000/-, the purchase will be recorded as Rs.1,50,000/- and not any more. This is one of the most important concept and it prevents arbitrary values being put on transactions.

Going Concern Concept

It is persuaded that the business will exists for a long time and transactions are recorded from this point of view.

Dual Aspect Concept

Each transaction has two aspects, that is, the receiving benefit by one party and the giving benefit by the other. This principle is the core of accountancy.

Dual Aspect Concept continue…

For example, the proprietor of a business starts his business with Cash Rs.1,00,000/-, Machinery of Rs.50,000/- and Building of Rs.30,000/-, then this fact is recorded at two places. That is Assets account (Cash, Machinery & Building) and Capital accounts. The capital of the business is equal to the assets of the business.

Dual Aspect Concept continue…

Thus, the dual aspect can be expressed as under Capital + Liabilities = AssetsorCapital = Assets – Liabilities

Realization Concept

Accounting is a historical record of transactions. It records what has happened. It does not anticipate events. This is of great important in preventing business firms from inflating their profits by recording sales and income that are likely to accrue.

Accounting Period Concept

Strictly speaking, the net income can be measured by comparing the assets of the business existing at the time of its liquidation. But as the life of the business is assumed to be infinite, the measurement of income according to the above concept is not possible. So a twelve month period is normally adopted for this purpose. This time interval is called accounting period.

ACCOUNTING PRINCIPLES

Accounting Conventions

The term ‘convention’ is used to signify customs and traditions as a guide to the presentation of accounting statements.

Convention of Consistency

In order to enable the management to draw important conclusions regarding the working of the company over a few years, it is essential that accounting practices and methods remain unchanged from one accounting period to another. The comparison of one accounting period with that of another is possible only when the convention of consistency is followed.

Convention of Disclosure

This principle implies that accounts must be honestly prepared and all material information must be disclosed therein. The contents of Balance Sheet and Profit and Loss Account are prescribed by law. These are designed to make disclosure of all material facts compulsory.

Convention of Conservation

Financial statements are always drawn up on rather a conservative basis. That is, showing a position better than what it is, not permitted. It is also not proper to show a position worse than what it is. In other words, secret reserves are not permitted.

FUNCTIONS OF ACCOUNTING

• Keeping systematic records • Protecting properties of the business • Communicating the results • Meeting legal requirements

Keeping systematic records

The first function of accounting is to keep a systematic record of financial transactions, to post them to the ledger accounts and ultimately prepare final statements.

Protecting properties of the business

The second important function is to protect the property of the business. The system accounting is designed in such a way that it protects its assets from an unjustified and unwarranted use.

Meeting legal requirements

The fourth and the last function of accounting is to meet the legal requirements under the Companies Act, Income Tax Act, Sales Tax Act and so on.

THE ACCOUNTING CYCLE

Recording transactions in subsidiary books.Classifying data by posting from subsidiary books to the accounts.Closing the books and preparation of final accounts.

CLASSIFICATION OF ACCOUNTS

• Accounts in the names of persons are known as “Personal Accounts”

• Accounts in the names of assets are known as “Real Accounts”

• Accounts in respect of expenses and incomes are known as “Nominal Accounts”

CLASSIFICATION OF ACCOUNTS

ACCOUNTS

PERSONALACCOUNTS

IMPERSONALACCOUNTS

REALACCOUNTS

NOMINALACCOUNTS

PERSONAL ACCOUNTS

Accounts in the name of persons are known as personal accounts. Eg: Babu A/C, Babu & Co. A/C, Outstanding Salaries A/C, etc.

REAL ACCOUNTS

These are accounts of assets or properties. Assets may be tangible or intangible. Real accounts are impersonal which are tangible or intangible in nature. Eg:- Cash a/c, Building a/c, etc are Real

Accounts related to things which we can feel, see and touch.

Goodwill a/c, Patent a/c, etc Real Accounts which are of intangible in nature.

NOMINAL ACCOUNTS

These accounts are impersonal, but invisible and intangible. Nominal accounts are related to those things which we can feel, but can not see and touch. All “expenses and losses” and all “incomes and gains” fall in this category. Eg:- Salaries A/C, Rent A/C, Wages A/C, Interest Received A/C, Commission Received A/C, Discount A/C, etc.

DEBIT AND CREDIT

Each accounts have two sides – the left side and the right side. In accounting, the left side of an account is called the “Debit Side” and the right side of an account is called the “Credit Side”. The entries made on the left side of an account is called a “Debit Entry” and the entries made on the right side of an account is called a “Credit Entry”.

RULES FOR DEBIT AND CREDIT

Personal Personal AccountAccount

Debit the ReceiverDebit the Receiver

Credit the GiverCredit the Giver

Real AccountsReal Accounts Debit what comes inDebit what comes in

Credit what goes Credit what goes outout

Nominal Nominal AccountsAccounts

Debit all Expenses Debit all Expenses and Lossesand Losses

Credit all Incomes Credit all Incomes and Gainsand Gains

Steps for finding the debit and credit aspects of a particular transaction

• Find out the two accounts involved in the transaction.

• Check whether it belongs to Personal, Real or Nominal account.

• Apply the debit and credit rules for the two accounts.

Exercise

• Purchased a Building for Rs.20,000/-. • Paid Cash Rs.1,000/- to Satheesh. • Paid Salary Rs.1000/-. • Received Commission Rs.250/-.• Sold goods for Cash Rs.3500/-.

Subsidiary Books

• General Journal• Special Journals

• Purchase Book• Sales Book• Purchase Return Book• Sales Return Book• Bills Receivable Book• Bills Payable Book• Cash Book• Petty Cash Book

Journal

Journal is the prime or original book of entry in which all transactions are recorded in the form of entries. Journalising is an act of recording or entering transactions in a Journal in the order of date.DateDate ParticularsParticulars LFLF DebitDebit

AmountAmountCredit Credit

AmountAmount

Journal Entry

Jan 1, 1981 Prakash Started a business Rs. 15,000/-DateDate ParticularsParticulars LFLF DebitDebit

AmountAmountCredit Credit

AmountAmount19811981Jan 1Jan 1

Cash a/c Cash a/c Dr.Dr. To Prakash’s Capital To Prakash’s Capital a/ca/c(Being cash invetsed to (Being cash invetsed to business)business)

15,00015,00015,00015,000