ACCOUNTING BASICS

Business
It is any activity undertaken with a view to make profit.
Types of Business
(A) By Ownership
1) Sole Tradership
One man controls and operates the business.
2) Partnership
Business is controlled and operated by 2 to 20 persons (2 to 10 in banking business)
3) Company
Controlled and operated by many persons. Can be a public company or private company
(B) By Nature
1) Manufacturing
These organizations manufacture goods and then sell them at a profit e.g. Honda, Toyota, Bata etc.
2) Trading
These organizations buy already manufactured goods and resell them at a profit e.g. super stores, car dealers,
cloth stores etc.
3) Services
These organizations provide services at a profit e.g. colleges, hospitals, restaurants, law firms, CA firms etc.
Accounting
Accounting is the process of recording transactions pertaining to a business.

Transaction
Whenever goods or property changes hands it is called transaction e.g. sale and purchase of goods/property,
payment of expenses etc. It can be either of the following.
Cash Transaction
Here buyer pay cash to the seller at the time of exchange of goods/services.
Credit Transaction
Here buyer pays cash to the seller at a later date, not at the time of exchange of goods/services.
ACCOUNTING
Accounting is the systematic process of recording, classifying, summarizing and reporting useful accounting
information to the users to make correct economic decisions.

Functions of Accounting

Recording: Keeping a detailed and chronological record of all financial transactions.

Classification: Organizing recorded financial data into categories or accounts for easier analysis.

Measurement: Assigning monetary value to business transactions and financial events.

Stewardship: Managing and safeguarding an organization's resources and reporting on how they are used.

Information for decisions: Providing financial data to help stakeholders make informed business decisions.

Monitoring & Control: Tracking financial performance and ensuring that financial resources are used efficiently
and according to the plan.

Performance evaluation & compensation: Assessing financial and operational results to evaluate staff and
business performance, often linked to compensation.

Communication: Sharing relevant financial information with stakeholders like investors, creditors, and regulators.

Users of Accounting Information

Suppliers (External) Suppliers need information about a company's liquidity and ability to pay for goods and
services. They are particularly interested in short-term financial health.
Employees (Internal) Employees are concerned with job security, potential for pay raises, and the overall financial
health of the organization.
Company Shareholders (External) Shareholders are interested in profitability, dividends, growth prospects, and
return on their investments.
Company Directors and Management (Internal) They need detailed financial and non-financial information for
planning, controlling, decision-making, and evaluating company performance.
Banks and Other Lenders (External) Lenders need to assess a company's solvency, liquidity, and long-term
financial stability to determine the risk of lending.
The Government (External) The government is interested in accurate financial information for taxation,
compliance with regulations, and economic planning.
Customers (External) Customers may seek information about a company's financial stability to ensure that the
company can continue supplying products and services reliably.
Competitors (External) Competitors may look for financial data to benchmark their performance or gather
insights into a rival’s strategy and market position.
The Public & Tax Authorities (External) The general public and tax authorities are interested in a company’s
financial impact on the community, environmental sustainability, and whether taxes are being paid appropriately.
Qualities of good accounting information
1. Relevance

 Definition: Financial information must be capable of influencing decisions by helping users assess past,
present, or future events.
 Example: A company's profit forecast helps investors decide whether to buy shares, as it is relevant to
future earnings potential.

2. Faithful Representation

 Definition: Information should accurately reflect the economic reality of transactions, being complete,
neutral, and free from error.
 Example: A company correctly reports its liabilities without understating debt, ensuring the balance sheet
faithfully represents its financial position.

3. Comparability

 Definition: Users should be able to compare financial information across time periods or between different
companies to make informed decisions.
 Example: A business consistently applies the same depreciation method, enabling investors to compare
this year’s financials with previous years.

4. Verifiability

 Definition: Different knowledgeable and independent observers should be able to reach the same
conclusion about the financial information provided.
 Example: Auditors verify a company's financial data by examining supporting documents like invoices and
bank statements.

5. Timeliness

 Definition: Financial information must be available to users in time for it to influence their decisions.
 Example: A company releases its quarterly earnings report shortly after the quarter ends, allowing
investors to make timely decisions.

6. Understandability

 Definition: Financial information should be presented clearly and concisely so users can understand it
easily, provided they have basic knowledge.
  Example: A company's financial report uses simple language and clear headings to explain key financial
figures, making it easy for investors to interpret.

Branches of Accounting
1) Financial Accounting
This branch of accounting focuses on the preparation, reporting, and analysis of financial statements for external
stakeholders, such as investors, creditors, and regulatory bodies. It follows specific standards (like GAAP or IFRS)
to ensure accuracy and comparability of financial information.

2) Management Accounting
This branch provides financial and non-financial information to managers within the organization for decision-
making, planning, and controlling operations. It is primarily used internally, and it is flexible, without the need to
adhere to external standards.
DIFFERENCES BETWEEN FINANCIAL ACCOUNTING & MANAGEMENT ACCOUNTING

Purpose:

 Financial Accounting provides information to external stakeholders (e.g., investors, regulators).

 Management Accounting focuses on internal use for decision-making and operational control.

Regulation:

 Financial Accounting is governed by standards like GAAP or IFRS.

 Management Accounting is flexible, with no mandatory external standards.

Time Focus:

 Financial Accounting is historical, reporting past financial performance.

 Management Accounting is future-oriented, aiding in planning and forecasting.

Report Frequency:

 Financial Accounting usually involves periodic reports (e.g., quarterly or annually).

 Management Accounting can involve frequent, even daily, reports as needed by managers.

Detail:

 Financial Accounting provides aggregated information on the company's financial position.

 Management Accounting offers detailed, specific insights tailored to various departments or operations.

Elements of financial statements

(1) Assets
Resources owned by a business which are expected to benefit in the future operations of a business.
Types of Assets
Non- Current Assets
Assets which have a long life and are expected to benefit for more than one accounting period are called non-
current or fixed assets. For example Plant and Machinery, Land and Building, Moto Vehicles, Furniture and
fixtures, Office Equipment’s, Properties, Premises, Long Term Investments etc.
Current Assets
Assets which have a short life and which can converted into cash quickly to meet short term obligations are called
current assets. Their benefit is for one accounting period only. For example Cash, Bank Balance, Stocks
(Inventory), Debtors (Receivables), Bills Receivables, Short Term Investments etc.
Intangible Assets
Assets which have no physical existence and which cannot be seen, touched and felt are intangible assets. For
example Goodwill, Trade Mark, Copy Rights, Software, Brands, Licenses, Patents (Exclusive rights) etc.

(2) Liabilities
Liabilities are the obligations of the business. The business is legally bound to pay this amount to the outsiders.
Types of Liabilities
Non-Current Liabilities
These are payable after one year (i.e. after one accounting period). For example long term loans, Debentures,
Mortgages, Redeemable Preference Shares etc.
Current Liabilities
These are payable within one year e.g. Bank Overdraft, Creditors (Payables), Bills Payable, etc.
(3) Capital/Owner’s Equity
These are the funds supplied by the owner. It is the internal liability of a business.
(4) Expenses
It is the cost of goods and services used up in process of obtaining revenue.
Types of Expenses
Direct Expenses
Expenses related with the purchase or manufacturing of goods are all direct expenses. For example Purchase
Price, Wages, Carriage & Transportation in, Freight in, Taxes on Purchases etc.
Indirect Expenses
These expenses are related mainly with administration selling and distribution activities. For example Rent,
Salaries, Telephone charges, printing and Stationery, Advertisement, Insurance, Discounts Allowed, Bad Debts,
Audit Fees, Director Remuneration, Carriage Outwards, Depreciation, etc.
(5) Income
It is the value generated through customers on providing them goods and services (or) the value generated by
business through its business activities
Types of Income
Direct Income
It is the income earned through business related activities. For example sale proceeds from goods and services.
Indirect income
It is the income earned through sources other than normal business activities. For example Commission Received,
Interest Received, Rent Received, Discounts Received, Investment income etc.
Accounting Equation
Resources of the Business = Sources of funds (or)
Assets = Capital + Liabilities
Accounting Cycle
It is the movement (process) of an accounting transaction.

Journal à Ledger à Trail Balance à Financial Statements

Journal (Recording Book)

Journal is a book where the first entry of a transaction is made. It is also called Books of Original/Principal Entry.

Ledger (Classification Book)

The book in which T-accounts are maintained is called ledger. It is also known as books of double entry.

Trail Balance (Summarizing document)

It is a list of account titles and their balances in the books on a specific date, shown in debit and credit columns.

Financial Statements (Interpretation document)

These are as follows.
(1) Income Statement/Statement of comprehensive income
Income Statement is a statement which shows the financial performance of a business over a particular
accounting period. It contains two accounts:
a) Trading Account
b) Profit & Loss Account

Trading Account shows the gross profit/loss for the period

Profit & Loss Account shows the net profit/loss for the period

(2) Balance Sheet /Statement of financial position

Balance Sheet is a statement which shows the financial position of a business, on a particular day.
Assets = Liabilities + Owner’s Equity/Capital
(3) Statement of Cash Flows
Cash flow statement is a single document to analyze the cash and cash equivalents movements of a business.
Duality concept
Every accounting transaction has got two effects.
i. Debit effect
ii. Credit effect
Classes Debit Credit
Expenses

Incomes

Assets

Liabilities

Capital
Debit
The Left Hand Side of an account in double entry.
Credit
The Right Hand Side of an account in double entry.
Double Entry Book Keeping
A system where each transaction is entered twice. Once on the debit side and once on the credit side of the
account.
ACCOUNTING CONCEPTS

1. Understandability

 Definition: Financial information should be presented clearly so that users with reasonable knowledge can
comprehend it easily.
 Example: Simple, clear headings in a balance sheet for non-current & current assets and also non-current &
current liabilities makes easy for investors to understand the company’s assets and liabilities.

2. Completeness

 Definition: Financial information must be complete, providing all necessary details to ensure a full
understanding of the financial position.
 Example: A financial statement that includes all income, expenses, and liabilities provides a complete
picture of the company’s performance.

3. Going Concern

 Definition: The assumption that a business will continue to operate in the foreseeable future without the
need for liquidation.
 Example: A business is preparing its financial statements assuming it will operate next year, not winding
down operations.

4. Accruals

 Definition: Transactions are recorded when they occur, not when cash is exchanged, to match revenues
with expenses.
  Example: A company records a sale in December, even though payment will be received in January.

5. Matching

 Definition: Expenses should be matched to the revenues they help generate in the same period.
 Example: A business records depreciation of machinery as an expense in the same year that the machinery
is used to generate revenue.

6. Consistency

 Definition: The same accounting methods should be applied across periods to ensure comparability.
 Example: A company consistently uses the straight-line method for depreciation over several years to allow
for comparison.

7. Prudence

 Definition: Caution should be exercised in financial reporting, ensuring that assets or income are not
overstated, and liabilities or expenses are not understated.
 Example: A company sets aside provisions for potential bad debts, reflecting a cautious approach to future
uncertainties.

8. Business Entity

 Definition: The business is treated as separate from its owners, with its own set of financial records.
 Example: The personal expenses of the owner, like a home mortgage, are not included in the company’s
financial statements.

9. Duality

 Definition: Every financial transaction affects two accounts, reflecting the principle that assets must always
equal liabilities plus equity.
 Example: If a business buys equipment for £1,000, it increases its equipment (asset) by £1,000 and
decreases cash (asset) by £1,000.

10. Materiality

 Definition: Only information that would influence the decision of a reasonable person should be included
in financial statements.
 Example: A business may choose not to record the purchase of £10 worth of stationery as an asset due to
its immaterial effect on financial decisions.

11. Objectivity

 Definition: Financial information should be based on verifiable evidence, free from bias or personal
opinions.
 Example: Recording the value of equipment based on an invoice or receipt rather than an estimate ensures
objectivity in reporting.

12. Money Measurement

 Definition: Only transactions that can be measured in monetary terms are recorded in the financial
statements.
 Example: The company records the purchase of a van for £15,000 but does not record the value of
employee morale, as it cannot be quantified in money.

13. Cost

 Definition: Assets are recorded at their original purchase price, rather than their current market value.
 Example: A building purchased for £100,000 is recorded at this cost on the balance sheet, even if its market
value increases to £120,000 over time.
14. Realization

 Definition: Revenue is recognized when goods or services are delivered, not when cash is received.
 Example: A company records revenue from a sale in November when the goods are delivered, even though
payment is received in December.

15. Periodicity

 Definition: The life of a business is divided into regular intervals (e.g., months, quarters, or years) for
reporting purposes, ensuring consistent financial statements over time.
 Example: A company prepares its financial statements annually, reporting income and expenses for the
period ending December 31 each year.