PRC 4 Introduction to Accounting Topic 1: Accounting basics Daniyal Zahid Butt, ACA

Topic 1: Accounting basics

1. Fundamentals
1.1 Organization
An organization is a group of people who work together
1.2 Types of organizations
Business
An organization selling goods or services with an objective of profit maximization

Non-profit organization
Nonprofit organizations are formed for a public benefit other than generating profit for owners

1.3 Types of business activities

Manufacturing business
In manufacturing business, raw materials are used to make a finished goods. The finished products are
then sold to customer
Trading business
In trading business, finished goods are purchased and sold to customer without changing shape or
design of the product

Service providing business

Service is provided to customers and fee is charged for services

1.4 Types of business structures

Sole trader
A business which has a single owner

Partnership
A business which has two or more owners

Company
A business which has registered itself as a company. Company may have one owner or multiple owners

1.5 Accounting
Accounting is the process of recording financial transactions related to a business.

1.5 Business Transaction

A transaction is an event that has a monetary impact on a business.

Activity 1
Identify which of the following events should be classified as transactions:
1. A business purchased goods amounting to Rs. 20,000 for resale purpose
2. Business sold goods for Rs. 30,000

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3. Business purchased a new machine for Rs. 200,000

4. Business sold old furniture for Rs. 20,000
5. Interviewing candidates for position of sales man
6. Selected suitable candidate
7. Paid salary Rs. 70,000 to employee
8. Negotiated with bank for acquiring the loan of Rs. 800,000
9. Loan of Rs. 800,000 received from bank
10. Received letter from bank to repay loan on time
11. 50% loan was repaid by the business

1.3 Separate entity concept

 Owner and business are separate from each other
 In accounting, we record transactions of business only
 Personal transactions of owner are not recorded in business
 If owner invest something (cash or valuable item) then this transaction shall be recorded because it
has an impact on business
 If owner withdraws something (cash or valuable item) then this transaction shall also be recorded
because it has an impact on business

Activity 2
Identify which of the following transactions should be recorded by an accountant
1. Owner purchased new furniture for Rs. 80,000 for his residence
2. Owner deposited Rs. 100,000 in business bank account
3. Proprietor invested Rs. 30,000 cash in the business
4. Proprietor brought his personal car worth Rs. 1,500,000 in the business
5. Owner paid electricity bill of Rs. 20,000 for his residence
6. Owner withdrew Rs. 20,000 from business bank account
7. Owner took some equipment of Rs. 30,000 from the business for his personal use
8. Owner’s friend gifted him a watch of Rs. 30,000

2. Heads of accounting
D Drawings C Capital
E Expenses L Liabilities
A Assets I Income
D C

2.1 Capital
 Cash / valuable item invested by owner in the business is known as capital.
 In other words, capital is the total investment by the owner in the business.

2.2 Drawings
 Cash / valuable item withdrawn by owner from the business is known as drawings.
 In other words, drawing is the share that owner has taken out from the business.

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2.3 Assets
 Resources or valuable items
 Owned and controlled by the business
 Which will provide future benefit to the business, are known as assets

There are two types of assets

Non-current assets Current assets

There assets provide future benefit for more There assets provide future benefit up to
than one year one year
Examples: Examples:
1. Land 1. Closing stock/ closing inventory
2. Premises 2. Trade receivables/ debtors
3. Buildings 3. Other receivables
4. Plant 4. Cash in hand
5. Machinery 5. Cash at bank
6. Equipment
7. Furniture
8. Fixtures and fittings
9. Vehicles

2.4 Liabilities
 Financial obligations of business are known as liabilities
 Financial obligation means any cash or valuable item shall be transferred by the business to fulfil the
obligation

There are two types of liabilities

Non-current liabilities Current liabilities

These obligations shall be fulfilled after one These obligations shall be fulfilled within one
year year
Examples: Examples:
1. Loan from bank payable after 3 years 1. Loan from bank payable within 6
months 2.5
2. Trade payables / creditors
3. Other payables
4. Bank overdraft
Expenses
Money spend to run business activities in order to generate income is known as expense

There are two types of expenses

Purchase expense Other expense

Money spend to purchase goods for resale All expenses other than purchase expense shall
purpose is known as purchase expense be called other expenses
Note: Examples:
1. Rent expense

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 PRC 4 Introduction to Accounting Topic 1: Accounting basics Daniyal Zahid Butt, ACA

Delivery charges, shipment cost, carriage inward, 2. Utility bills cost

transportation inward etc. are also known as 3. Salaries and wages
purchase expense 4. Commission
5. Carriage outward
6. Communication charges
7. Printing and stationery
8. Travelling expenses
9. Advertisement cost
10. Finance cost
11. Insurance premium
12. Repairs and maintenance

Activity 3
Distinguish between purchase expense and asset in following transactions
1. Purchased vehicle costing Rs. 800,000 by a business for resale purpose
2. Purchased vehicle costing Rs. 600,000 by a business for delivery of goods to customer
3. Purchased air conditioner costing Rs. 60,000 by a business for future benefit
4. Purchased land costing Rs. 1,000,000 by a business for resale purpose
5. Purchased machinery costing Rs. 900,000 by a business for production of goods
6. Purchased vehicle costing Rs. 400,000 by the business
7. Purchased equipment costing Rs. 200,000 by the business
8. Purchased goods costing Rs. 50,000 by the business

Activity 4
Distinguish between asset, purchase expense and other expense in following transactions
1. Bought goods amounting to Rs. 10,000 for cash
2. Bought furniture amounting to Rs. 50,000 paying through cheque
3. Delivery charges of Rs. 5,000 were paid for purchasing goods
4. Paid Rs. 2,000 commission to sales agent
5. Paid rent of shop Rs. 40,000
6. Rs. 20,000 were spent on repairs of vehicle
7. Spent Rs. 10,000 for fueling of vehicles
8. Paid carriage inward of Rs. 4,000
9. Paid carriage outward of Rs. 5,000
10. Purchased equipment of Rs. 80,000 for resale purpose

Remember:

 As a practical expedient,
 immaterial items are not recognised as non-current assets
 even if they meet the definition criteria,
 for example, staplers and calculators etc.

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2.6 Incomes
Money earned by the business is known as income

There are two types of incomes

Sales / revenue Other incomes

Income earned from main business activity. All incomes other than sales / revenue shall be
In other words, income earned by selling “goods called other incomes
for resale” Examples:
1. Rent income
2. Interest received from bank

Activity 5
Distinguish between sales and other income in following transactions
1. Sold goods to customer for Rs. 30,000
2. College received Rs. 200,000 fees from students
3. College sold books for Rs. 50,000 to students
4. Profit of Rs. 2,000 was received on amount deposited in saving account

3. Identification of accounting heads

Scenario 1: Investment in business
Cash (current asset)↑

Capital ↑ Bank (current asset) ↑

Non current asset ↑

1. Owner invested Rs. 20,000 cash in business

2. Owner invested Rs. 5,000,000 in business through cheque
3. Owner invested his personal car worth Rs. 900,000 in the business
4. Owner brought furniture worth Rs. 60,000 for business use

Scenario 2: withdrawals from business

Cash (current asset) ↓

Drawings ↑ Bank (current asset) ↓

Non current asset ↓

1. Owner withdrew Rs. 10,000 cash from business

2. Owner withdrew Rs. 50,000 from business bank account
3. Owner withdrew vehicle worth Rs. 700,000 from the business

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Scenario 3: Purchase of goods

Cash (current asset) ↓
On cash
Bank (current asset) ↓
Purchases ↑

On credit Trade payables (current liability) ↑

1. Purchased goods costing Rs. 20,000 for cash

2. Purchased goods costing Rs. 10,000 and payment was made through cheque
3. Purchased goods on credit worth Rs. 50,000 from Ali and amount shall be paid afterwards
4. Purchased goods on credit worth Rs. 30,000 from Umair and amount shall be paid afterwards

Scenario 4: Sale of goods

Cash (current asset) ↑
On cash
Bank (current asset) ↑
Sales ↑

On credit Trade receivables (current asset) ↑

1. Sold goods to customer for Rs. 30,000 and received cash

2. Sold goods to customer and received cheque of Rs. 40,000
3. Sold goods on credit to Ahmed for Rs. 50,000
4. Sold goods on credit to Nureed for Rs. 60,000

Scenario 5: Payment made to credit suppliers

Cash (current asset) ↓
Trade payables (current liability) ↓
Bank (current asset) ↓

1. Paid Ali Rs. 25,000 through cheque against goods purchased on credit
2. Paid Rs. 20,000 in cash to Umair against goods purchased on credit

Scenario 6: Payment received from credit customers

Cash (current asset) ↑
Trade receivables (current asset) ↓
Bank (current asset) ↑

1. Received cash Rs. 40,000 from Ahmed against goods sold on credit
2. Received cheque of Rs. 40,000 from Nureed against goods sold on credit

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Scenario 7: Purchase return

Cash (current asset) ↑
On cash
Bank (current asset) ↑
Purchases ↓

On credit Trade payables (current liability) ↓

1. Purchased goods costing Rs. 5,000 for cash were returned to supplier
2. Purchased goods through cheque Rs. 3,000 were returned to supplier
3. Goods costing Rs. 25,000 purchased from Ali were returned
4. Goods costing Rs. 10,000 purchased from Umair were returned

Scenario 8: Sale return

Cash (current asset) ↓
On cash
Bank (current asset) ↓
Sales ↓

On credit Trade receivables (current asset) ↓

1. Customer returned goods sold to him for Rs. 12,000 and we paid him in cash
2. Customer returned goods sold to him for Rs. 20,000 and we returned payment through cheque
3. Goods of Rs. 10,000 sold on credit to Ahmed were returned by him
4. Goods of Rs. 20,000 sold on credit to Nureed were returned by him

Scenario 9: Purchase of non-current asset

Cash (current asset) ↓
On cash
Bank (current asset) ↓
Non-current asset ↑

On credit Other payables (current liability) ↑

1. Purchased building costing Rs. 2,000,000 and paid through cheque

2. Rs. 30,000 cash paid to purchase furniture
3. A plant for Rs. 400,000 was purchased on credit from Astore Limited
4. Purchased machinery for Rs. 200,000 on credit from Rupal Limited

Scenario 10: Payment for other expenses

Cash (current asset) ↓
other expenses ↑
Bank (current asset) ↓

1. Paid utility bills of Rs. 50,000 though bank account

2. Paid rent of shop Rs. 40,000 in cash

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3. Paid Rs. 100,000 through cheque to advertisement agency

4. Salaries of Rs. 80,000 were paid through cheque

Scenario 11: Loan obtained from bank

Loan (current/non current liability) ↑ Bank (current asset) ↑

1. Obtained bank loan of Rs. 500,000 payable within one year

2. Obtained bank loan of Rs. 2,000,000 payable after 2 years

Scenario 12: Loan repaid to bank

Loan (current/non current liability) ↓ Bank (current asset) ↓

1. loan of Rs. 500,000 which was obtained 6 months before was repaid to bank.
2. A long-term loan of Rs. 1,500,000 was returned to bank after 3 years

4. Double entry bookkeeping

4.1 Rules of debit and credit

Drawings Capital
Expenses
↑ Debit Liabilities
↑ Credit
Assets ↓ Credit Income ↓ Debit

Debit amount = Credit amount

Activity 6

Complete the following table by entering ‘true’ or ‘false’ for each statement.

Statement True/False
1 If an asset increases, the asset account should be debited.
2 If a liability increases, the liability account should be debited.
3 If an asset decreases, the asset account should be debited.
4 If a liability decreases, the liability account should be credited.
5 If capital increases, the capital account should be debited.

Activity 7

A business provides the information shown below. Copy and complete the table by filling in the names
of the accounts to be debited and credited.

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Activity 8

A business provides the information shown below. Copy and complete the table, naming
the accounts to be debited and credited in the business’ books.

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Activity 9

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 PRC 4 Introduction to Accounting Topic 1: Accounting basics Daniyal Zahid Butt, ACA

4.2 Recording in general journal

General journal
Date Description Debit (Rs.) Credit (Rs.)
1-Oct-21 Cash 20,000
Capital 20,000
Step 1: Write date in date column
Step 2: Write maximum possible detail of accounting head in description column
Step 3: Write debit account head in first row and credit account head in second row
Step 4: Write debit and credit amounts in debit and credit column

Activity 10
Record following transactions in general journal
1. Started business with Rs. 75,000 cash and Rs. 900,000 in the bank.
2. Received a loan of Rs. 200,000 from UBL Bank by cheque.
3. Bought an equipment for cash Rs. 30,000.
4. Bought an equipment on credit from Crystal Ltd Rs. 42,000.
5. Took Rs. 20,000 out of the bank and put it in the cash till.
6. Repaid part of UBL Bank loan by cheque Rs. 50,000.
7. Paid amount owing to Crystal Ltd Rs. 42,000 by cheque.
8. Repaid part of UBL Bank loan by cash Rs. 25,000.
9. Bought a machine on credit from Tech Traders for Rs. 20,000.
10. Bought goods on credit from ABC for Rs. 10,000
11. Sold goods on credit to XYZ for Rs. 12,000
12. Owner took cash from bank of Rs. 7,000 for his personal use.

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4.3 Recording in general ledger (T account form)

Cash
Date Description Debit (Rs.) Date Description Credit (Rs.)
1-Oct-21 Capital 20,000

Capital
Date Description Debit (Rs.) Date Description Credit (Rs.)
1-Oct-21 Cash 20,000

How to open a T account

Step 1: Open a T account, if not already opened
Step 2: Post debit and credit amount in T account
Step 3: Write opposite account name in description column
Step 4: Write date in date column

Cash
Date Description Debit (Rs.) Date Description Credit (Rs.)
1-Oct-21 Capital 20,000
31-Oct-21 Balance c/d 20,000
20,000 20,000
1-Nov-21 Balance b/d 20,000
Capital
Date Description Debit (Rs.) Date Description Credit (Rs.)
1-Oct-21 Cash 20,000
31-Oct-21 Balance c/d 20,000
20,000 20,000
1-Nov-21 Balance b/d 20,000
How to close a T account
Step 1: Add up both sides
Step 2: Leave a line and write greater amount on both sides
Step 3: Write balance c/d (carried down) on shorter side
Balance c/d = Greater amount – Shorter amount
Note: Balance c/d reflects the remaining balance in account at the period end
Date of balance c/d shall be the last date of the period
Step 4: Write balance b/d (brought down) on the opposite side of balance c/d
Note: Previous period balance shall be called balance b/d
Date of balance b/d shall be the first date of the period

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Activity 11:
The following information relates to Hamza & Co., a retailer of television sets for the month of December
2010:
Date Transaction Rs. 000
1 Started business with a capital:
(i) in cash 870
(ii) at bank 1,330
3 Bought television sets from Amin & Co., on credit. 2,200
3 Paid to Fast Motors for purchase of delivery van through cheque. 540
4 Televisions sold to Ahmed Brothers on credit. 1,880
8 Paid shop's rent to Mrs. Ali through cheque. 680
11 Payment received from Ahmed Brothers and deposited in the bank. 1,340
12 Paid cheque to Amin & Co. 784
18 Paid carriage by cash on purchases. 38
19 Defected televisions returned by Ahmed Brothers. 220
22 Bought LCD televisions on credit from Amin & Co. 1,230
28 Sold LCD televisions to Ahmed Brothers on credit. 810
30 The owner withdraws one television set for his personal use. 25
Required:
(a) Prepare journal entries of the above transactions.
(b) Post the information in the ledger accounts.
(c) Extract a trial balance as at December 31, 2010.

Activity 12:
The following transactions in May 2021 are those of a new business entity, Garden Traders.
Date Transactions
1 Set up the entity with capital in cash Rs. 2,500,000.
2 Bought goods on credit from the following suppliers: The Bushes Company Rs. 540,000, Flower
City Rs. 870,000, D Gibson Rs. 250,000
4 Sold goods on credit to: The Office Company Rs. 430,000, Texas Chain Stores Rs. 1,760,000.

6 Paid rent Rs. 120,000.

9 The Office Company paid the Rs. 430,000 that it owed.
10 Texas Chain Stores paid Rs. 1,500,000.
12 The following payments were made to D Gibson Rs. 250,000 and to The Bushes Company Rs.
540,000.

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15 Advertising costs of Rs. 230,000 were paid to the local newspaper publisher.
18 Bought goods on credit from the following suppliers: The Bushes Company Rs. 430,000, Flower
City Rs. 1,100,000.
21 Sold goods on credit to Office Company Rs. 670,000
31 Paid rent Rs. 180,000.
Required:
a) Use T accounts to show how these transactions should be recorded in the main ledger accounts
of the entity.
b) Prepare a trial balance as at 31 May 2021.

5. Cost of “goods sold”

Cost of goods sold or cost of sales is the actual cost incurred for purchasing the goods sold in the period

Cost of goods sold = opening stock + purchases – closing stock

Closing stock
 Goods remained unsold at period end is closing stock
 Cost of these goods was included in purchases at the time when they were purchased
 These goods were not sold during the period so the cost of closing stock should not be included
in cost of sales
 Closing stock is a valuable item so it is considered as current asset

Opening stock
 Closing stock of previous period shall be considered opening stock of current period
 It is assumed that the opening stock units were sold in current period so its cost is added in cost
of sales

Activity 13
Calculate the cost of sales given the following information
Purchases 2560
Opening inventory 1400
Carriage inwards 120
Purchases returns 100
Closing inventory 2100

Activity 14
Complete the table below, using the cost of sales formula to help you fill in the blank

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6. Equity
Equity is the share of owner in the business

Equity = capital + net profit - drawings

7. Financial statements
Activity 15

Selma, a sole trader, extracted the following trial balance from her books of accounts at 31 December
2018:

Additional information: Closing inventory: $6 000.

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Classification of business transactions

1 Simple transactions Complex transactions

A transaction is simple where a buyer sells goods A simple transaction becomes complex when
and services and the buyer pays for it the buyer buys something in a credit or qualifies
immediately in cash. for a discount.

2 One-off transactions Ongoing transactions

A transaction occurring on a single occasion is Ongoing transaction is a transaction of

called one-off transaction. continuing nature.

for example, buying land and building for setting for example, payment of monthly rent or
up a factory. electricity bill.

3 Capital transactions Revenue transactions

A transaction that has a long-term effect is called day to day transactions are called revenue
capital transactions. transactions.

As a business, you might purchase some Similarly, you might purchase some goods on a
machinery. This machinery can be used for a long daily basis, as such transactions are incurred
time (4-6 years), therefore such a transaction is daily, they are called revenue transaction.
called capital transaction.

Capital expenditure
Revenue expenditure
expenditure made to acquire or improve long
term assets  expenditure on day-to-day operating
expenses, or
Improvement means:
 expenditure which is not a capital
1. Increase in useful life
expenditure
2. Increase in capacity
Revenue receipts
3. Increase in product quality
4. Reduction in operating cost  Revenue income is income arising from the
normal operations of a business from its
Capital receipts investments, for example, revenue from
sale of goods or interest received
Capital receipts are receipts of ‘long term’
nature, such as money from a bank loan, or new  Receipt which is not a revenue receipt
money invested by the business owner (which is
called ‘capital’).

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Activity 16

Classify the following transactions as either ‘capital’ or ‘revenue’.

Sr. # Transaction Capital /Revenue

(i) Vehicle A engine is repaired
(ii) Vehicle B engine is replaced
(iii) Loan borrowed from bank for five years
(iv) Interest paid on loan
(v) Cash received from customer
(vi) Cash paid to employees for their wages
(vii) Wages paid by a building contractor to his own staff for construction of
an office room
(viii) The purchase of machinery for use in the business
(ix) Carriage paid to bring the above-mentioned machinery to the factory

(x) Monthly electricity bill paid

(xi) The purchase of a soft drinks vending machine for the canteen
(xii) The stock of soft drinks purchased for resale, along with above-
mentioned vending machine
(xiii) Annual motor vehicle tax paid for existing car
(xiv) Annual motor vehicle tax paid for new car
(xv) Cost of alteration in office van to increase carrying capacity
(xvi) Small but expensive alterations to a manufacturing machine which
increased the output of that machine by 15%

8. Accounting concepts
1) Separate Entity Accounting Concepts :
 Separate Entity Accounting concepts means that business enterprise is a separate entity with its
own identity, apart from its owner.
 For accounting purpose, Business enterprises and its Owners are not same.
 Accountants should treat a business as distinct from its owner.
 Financial transactions which affect the business are recorded in the business books of accounts
and should not include owner’s personal transactions in the business books of accounts.
2) Accrual Accounting Concepts :
 As per this concept, revenues and expenses should be recognized when they are earned or
incurred and not when cash or a cash equivalent is received or paid.
 Most Business entities maintain books of account on an accrual basis.

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3) Matching Concept :
 As per this concept, all expenses for an accounting period are matched with the revenue of that
period.
 The result of this matching is net profit or net loss.
 This concept does not concentrate on actual inflow or outflow of cash.
4) Duality Concept :
 As per this concept, every transaction which is recorded in the books of account has two-sided
effect.
 This concept is the base of double entry accounting system.
 Every transaction has two aspects:
a) It increases one Asset and decreases other Asset;
b) It increases an Asset and simultaneously increases Liability;
c) It decreases one Asset, increases another Asset;
d) It decreases one Asset, decreases a Liability.
e) It increases one Liability, decreases other Liability;
f) It increases a Liability, increases an Asset;
g) It decreases Liability, increases other Liability;
h) It decreases Liability, decreases an Asset.

5) Prudence Concept :
As per this concept, an entity must not overestimate its revenues, assets and profits, besides this it must
not underestimate its liabilities, losses and expenses.

6) Consistency :
 The consistency principle states that, once you adopt an accounting principle or method,
continue to follow it consistently in future accounting periods so that the results reported from
period to period are comparable.
 Example – Methods of depreciation such as written-down-value method, straight-line method,
etc or Methods of valuation of inventories such as FIFO or Average cost etc.

7) Materiality :
 According to materiality concept, all the items having significant importance on the business
entity should be disclosed in the financial statements and any insignificant or irrelevant item
should not be disclosed in the financial statements.
 Whether item is significant or not is a matter of judgement.

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8) Substance over form:

 Financial statements of a business should reflect the underlying realities of accounting
transactions.
 Even if the information appearing in the financial statements not comply with the legal form in
which they appear.

9) Completeness:
 Financial statements are complete and include every item that should be included in the
statement for a given accounting period.

10) True and fair view:

 True and fair view in accounting (specifically auditing) means that a
 financial statement is free from material misstatements and
 faithfully represents the financial performance and positioning of an entity

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