BASICS OF ACCOUNTING

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Contents
Introduction to accounting ................................................................................................................................2
Introduction ...................................................................................................................................................2
Meaning of accounting ..................................................................................................................................2
Functions of accounting.................................................................................................................................2
Accounting Cycle............................................................................................................................................3
Book-keeping, accounting and accountancy .................................................................................................4
Objectives of accounting................................................................................................................................5
Sub-disciplines within accounting..................................................................................................................6
Financial accounting ..................................................................................................................................6
Cost accounting..........................................................................................................................................6
Management accounting...........................................................................................................................6
Accounting is an art as well as science ..........................................................................................................6
Advantages of accounting..............................................................................................................................7
Disadvantages of accounting .........................................................................................................................7
Types of Accounting Information ..................................................................................................................8
Basic accounting terms ......................................................................................................................................9
Accounting principles.......................................................................................................................................13
Bases of accounting .........................................................................................................................................16
Accounting equation........................................................................................................................................17
Rules of debit and credit..................................................................................................................................19
Journal..............................................................................................................................................................22
Ledger ..............................................................................................................................................................31
Subsidiary books ..............................................................................................................................................35
Cash book.........................................................................................................................................................40
Trial balance and rectification of errors ..........................................................................................................46
Financial statement of sole proprietorship .....................................................................................................58

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Introduction to accounting
Introduction
The main objective of every business is to earn profit.

At end of each year, every business wants to know how much profit they have earned or losses
occurred, how much stock they have in their warehouse, how much is business liabilities, how
much is owed to them and by whom, etc.

So many other such questions which a businessman wants to know on a daily, monthly or annual
basis.

In order to attain such information, it is essential to keep a complete and systematic record of each
and every business transaction entered into during the year.

Meaning of accounting
Accounting is the process of identifying, recording, classifying, summarising, interpreting and
communicating financial information of business to its users for judgement and decision making.

money, transactions and events, which are, in part atleast, of a financial character, and interpreting the
American Institute of Certified Public Accountants

Functions of accounting

1. Identifying: Identifying the business transactions of a financial character from the source
documents such as invoice, agreements, cash memos etc. and measure them in terms of
money.
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2. Recording: The next function of accounting is to keep a systematic record of all business
transactions, which are identified in chronological order of their occurrence in the journal or
subsidiary books.
3. Classifying: Classification of the recorded business transactions so as to group the transactions
of similar type at one place. i.e., in ledger accounts. In order to verify the arithmetical accuracy
of the accounts, trial balance is prepared.
4. Summarising: The classified information available from the trial balance is used to prepare
profit and loss account and balance sheet in a manner useful to the users of accounting
information.
5. Analysing: It establishes the relationship between the items of the profit and loss account and
the balance sheet. The purpose of analysing is to identify the financial strength and weakness
of the business. It provides the basis for interpretation.
6. Interpreting: It is concerned with explaining the meaning and significance of the relationship
so established by the analysis. Interpretation should be useful to the users, so as to enable
them to take correct decisions.
7. Communicating: The results obtained from the summarised, analysed and interpreted
information are communicated to the interested parties.

Accounting Cycle
The accounting cycle is the holistic process of recording and processing all financial transactions of a
company, from when the transaction occurs, to its representation on the financial statements, to closing
the accounts. One of the main duties of a bookkeeper is to keep track of the full accounting cycle from
start to finish. The cycle goes on continued till the business ends.

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1. Transactions- the first task of accounting is to identify the transactions of financial

character and measure them in terms of money. Transactions may include a debt payoff,
any purchases or acquisition of assets, sales revenue, or any expenses incurred.
2. Journal Entries- With the transactions set in place, the next step is to record these
l order. In debiting one or more
accounts and crediting one or more accounts, the debits and credits must always
balance.
3. Posting to the General Ledger (GL) -The journal entries are then posted to the general
ledger where a summary of all transactions to individual accounts can be seen.
4. Trial Balance - At the end of the accounting period (which may be quarterly, monthly, or
yearly, depending on the company), a total balance is calculated for the accounts.
5. Financial Statements- The balance sheet, income statement, and cash flow statement
can be prepared using the correct balances.

Book-keeping, accounting and accountancy

Book-Keeping Book-keeping is recording the business transaction of monetary aspects in books of

accounts. It is mainly concerned with record keeping or maintenance of books of accounts. It
includes identifying, measuring, recording and classifying functions of accounting. The book-keeping
function is routine and clerical in nature and can be performed by a person having limited knowledge
of accounting.

Accounting - Accounting is considered as a system which collects and processes financial information
of a business. Accounting starts where bookkeeping ends. It includes summarising, analysing,
interpreting and communicating functions of accounting.

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Accountancy - Accountancy refers to a systematic knowledge of accounting, concerned with the

principles and techniques which are applied in accounting. Accountancy is collection of theory and
practices of accounting.

Basis Book-keeping Accounting

Objective To maintain systematic To ascertain the net results and the
records of transactions of financial position of the business
financial nature
Phase It is the recording phase of It is the summarizing phase of an
an accounting system accounting system
Stage It is a primary stage and It is secondary stage which begins
basis for accounting where the book-keeping process
ends.
Skills required It is routine in nature and It is analytical in nature and require
does not require any special special skill or knowledge
skill or knowledge
Who performs It is done by junior staff It is done by senior staff called
called book keepers accountants

Objectives of accounting
The following are the main objectives or utility of accounting:

1. Keep systematic record of business transaction- The main objective of accounting is to keep
complete record of business transactions according to specified rules. Complete record of business
transactions helps to avoid the possibility of omission and frauds. For this purpose, all the business
transactions are first of all recorded in journal or subsidiary books and then posted into ledger.

2. Calculate profit or loss The second main objective of accounting is to ascertain the net profit
earned on loss suffered on account of business transactions during a particular period. For this
purpose trading and profit & loss account of the business is prepared at the end of each accounting
period.

3. To ascertain the financial position of the business - After preparing the profit & loss account a
statement called balance sheet is prepared which shows the assets and their values on one hand
and liabilities and capital on the other. A balance sheet is actually a screen picture of financial
position of the business.

4. To provide information to various parties- The objective of the accounting is to communicate the
accounting information to various interested parties like owners, creditors, banks, government etc.

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Sub-disciplines within accounting

Financial accounting
Financial accounting assists in keeping a systematic record of financial transactions, the preparation and
presentation of financial reports in order to arrive at a measure of organisational success and financial
soundness. The financial accounting is useful for ascertaining profit or loss made for a given period and
financial position at the end of the given period and also the sources and uses of cash for the given period.

Cost accounting
Cost accounting assists in analysing the expenditure for ascertaining the cost of various products
manufactured or services rendered by the firm. It also helps in controlling the costs and providing
necessary costing information to management for decision-making.

Management accounting
Management accounting draws the relevant information mainly from financial accounting and cost
accounting which helps the management in budgeting, assessing profitability, taking pricing decisions,
capital expenditure decisions and so on.

Accounting is an art as well as science

Accounting, like science follows a systematic and organized path to understand the economic status of an
entity.

Science is obtaining knowledge by a systematic pattern including observation, study, practice, experiments
and investigation. Like Science, Accounting requires gaining knowledge about the economic status of an
entity by systematic study. An accountant finalizes the economic results by identifying, analyzing,
classifying using the method of double entry book-keeping system.

So, Accounting is a science that comprises of rules, principles, concepts, conventions and standards in
science.

Art is the application of techniques and methods. Accounting is an art because it presents the financial
findings by following and implementing universally accepted principles (GAAP).

Art is the study of application of scientific method to practical use. Accounting is an art as the established
rules and principles of accounting are applied to bookkeeping process of an economic entity.

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Advantages of accounting

Protecting business assets

Facilitates settlement of tax liabilities: A systematic accounting record immensely helps settlement
of taxes as it is good evidence of the correctness of transactions.
Replaces memory: A systematic and timely recording of transactions obviates the necessity to
remember the transactions. The accounting record provides the necessary information.
Facilitates comparative study:
results with those of other years and locate significant factors leading to the change, if any.
Facilitates loans: Loan is granted by the banks and financial institutions on the basis of growth
potential which is supported by the performance. Accounting makes the information available with
respect to performance.
Facilitates sale of business: If someone desires to sell his business, the accounts maintained by him
will enable the ascertainment of the proper purchase price.

Disadvantages of accounting

Accounting ignores the qualitative element: Since accounting is confined to monetary matters
only, qualitative elements like the quality of staff, industrial relations and public relations are
ignored.
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Accounting may lead to window dressing: The term window dressing means manipulation of
accounts in a way so as to conceal vital facts and present the financial statements in a way to show
a better position than what it is actually.
Accounting is based on historical costs: Accounting often uses historical costs to measure the
values. This fails to take into consideration factors such as inflation, price changes, etc. This skews
the relevance of such accounting records and information. This is one of the major limitations of
accounting.
Accounting is not fully exact: Although most of the transactions are recorded on the basis of
evidence such as sale or purchase or receipt of cash, yet some estimates are also made for
ascertaining profit or loss. Examples of this are providing depreciation on the basis of the estimated
useful life of an asset, possible bad debts, the probable market price of the stock of goods, etc.

Types of Accounting Information

Information relating to profit or surplus: The income statement i.e., profit and loss account makes
available the accounting information about the profit earned or loss incurred as a result of business
operations or otherwise during an accounting period.

Information relating to financial position: The position statement, i.e., the balance sheet makes the
information available about the financial position of the entity.
In the case of not-for-

Information about cash flow: Cash flow statement is a statement that shows flow, both inflow and
outflow, of cash during a specific period. It is of immense use as many decisions such as payment of
liabilities, payment of dividend and expansion of business etc., are based on the availability of cash.

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Basic accounting terms

Capital: refers to the amount invested by the proprietor in a business enterprise.

Capital is also known as

Assets = Liability + Capital

Drawings: any cash or value of goods withdrawn by the owner for personal use or any private payments
made out of business funds.

Liabilities: It refers to the amount which the firm owes to outsiders.

Example: Unpaid wages, Creditors, etc.

Classification of liabilities
Internal: which business entity has to pay to the proprietor or owners.

External: which a business entity has to pay to outsiders.

Also classified as:

- Non- current liabilities (to be paid after more than 1 year)
- Current liabilities (to be paid within 1 year)

Case Study: Mr. X invests Rs.10000 in his business and takes a loan of Rs.25,000 from SBI Bank for a period
of 10 years. Then he buys goods worth Rs.2000 from Mr. Y on credit for 2 months.

Internal Liability: Rs.10000

External liability: Rs.25000
Non- current liability: Rs.25000
Current Liability: Rs.2000

Distinction between business transaction and event

A Business Transaction is an economic activity of the business that changes its financial position.
(The change should be capable of being expressed in terms of money)

An event is the result of a transaction.

Example:
Ram purchased goods worth Rs.2 lacs and sold them for Rs.2.5 lacs. Thus, he earned a profit of Rs.50
thousand.
Transactions - Economic activity of purchasing goods, selling goods.
Event - Profit of Rs 50,000 earned due to the transactions taking place.

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