Introduction to Accounting

In early stage of human life, there was no need of keeping scientific accounting system, because business
transactions were very few & it was possible to remember them orally. However, with the passage of time,
the size of business units has grown considerably. Innumerable business transactions take place everyday
in a business unit. All these transactions cannot be remembered orally, hence a need arose to keep a
scientific record of each & every business transactions in order to know profit or loss of the business,
proper financial position, tax payable & for taking various business decisions.

The Italian monk Luca Pacioli, for the first time presented double entry accounting system in
1494 A.D. Accounts were properly written in India since ancient time. In Valmiki Ramayana, there is an
evidence of proper accounting system maintained by Bharat. In Mahabharat, king Yudhisthir asked Nakul
to see the accounts of his army. We found various detailed accounting instructions in the book
“Arthashashtra” written by ‘Kautilya’ , the prime minister of Chandra Gupta Maurya.

Meaning:
“Accounting is the process of recording, classifying, analyzing & interpreting the business transactions
which can be measured in terms of money in such a way that it helps users in taking correct decisions.”

Characteristics:
1) Financial characteristic : In accounting, only those transactions, which can be measured in terms of
money, are recorded. Transactions which can not be measured in terms of money or non-business
transactions can not be recorded in accounts. E.g. appreciation given by head to his subordinate through
words, placing of an order, etc.
2) Money as a medium of exchange : Transactions or events recorded in accounting come into existence
through the usage of money. A person can sell his product or services against money and from money so
received, he can buy another product or service. Thus, money is a medium of exchange.
3) Classification: After recording business transactions, they are classified in to different heads or groups.
These transactions are classified and analyzed on basis of their nature which is derived from debit credit
rules of accounting (which are discussed here after). Due to characteristic of classification and analysis,
transactions of prescribed time can be seen together at one place.
4) Interpretation of transactions : After recording all business transactions systematically, they are analyzed
& proper conclusions are drawn regarding profit or loss, financial position etc. E.g. the difference between
incomes & expenses is the profit earned.
5) Quantitative information : Information recorded in accounts is in the monetary form. So. this information
is known as quantitative information.
6) Economic decisions : Different stakeholders take their decisions based on accounts prepared by
accounting. e.g. creditors make decision to lend money to the company. Company itself makes decision
for its own development. All these decisions are based on money, thus are known as economic decisions.
Thus, accounting assists to make economic decisions.
7) Historical information : In accounting all past transactions and events are recorded. These past
transactions or events become history. Accounts prepared on the basis of history represent historical
information and results.
8) Chronological: Accounts are maintained in a chronological manner (date wise).
9) A separate book: Accounts are maintained in a separate book of accounts.
10) Art & science: Art requires special skill & knowledge. In the same way accounts also requires special skill
& knowledge of accounting rules, hence accounting is an art. It is also a science, because like science,
account also based on certain rules & regulations.
 Objectives:
1) Permanent Record: The main objective of accounting is to keep permanent record of the business
transactions. So that it can provide complete information as & when required.
2) To know the effect of each transaction : Each transaction has its effect on overall profitability or economic
condition of the business. Thus accounting helps in obtaining this information.
3) To know influential factors : The information of factors affecting profit or loss as well as economic
condition of the business can be obtained by preparing accounts. This objective plays vital role in the
preparation of accounts.
4) To determine tax liability : Generally, the tax payment liability is determined on the basis of prepared
accounts. The burden of tax is determined on the basis of income of a tax payer.
5) To know quantum (size) of payables : In business, payment of credit transaction of purchase is to be made
in future & till the nonpayment of this transaction, it is treated as liability. At the end of the year, what is
the quantum of liability can be ascertained from accounts.
6) To know quantum of receivables : Payment of credit transaction of sale is to be received in future & till
the nonpayment of this transaction, it is treated as receivables. At the end of the year, what is the quantum
of receivables can be ascertained from accounts.
7) To measure profitability of business : The significant objective of accounts is to measure earned profit or
incurred loss for respective period. The measurement of profitability is made available by accounting.
8) To know economic status of the business : At the end of the year what is the size of liabilities, assets and
receivables of the business can be seen from the accounts under accounting system. When assets and
receivables are more than liabilities, it can be said that it is a good economic condition or company is
solvent.
9) Guidance for future: It is one of the objectives to get proper guidance with the help of accounting for
future planning of the business.
10) To detect and avoid frauds & errors: Accounting is needed to keep control over various business activities
& to prevent or minimize wastage. Corrective measures can be taken to rectify past faulty decisions.

Accounting is just like a weather guide for the business. It is a log chart of the past, a barometer of the
present & a forecast of the future. Followings are the advantages & limitations of accounting:

Advantages:
1) To know profit or loss: The main goal of any business unit is to earn profit. Accounting helps to determine
profit or loss at the end of accounting period.
2) To get information: Accounting is very useful to get accounting information of the business as & when
required. Total sales, purchase, expenses, incomes etc. can be known easily with the help of accounting.
3) To know financial position: Financial position of the business at the end of specified period can be known
easily with the help of accounting. Assets, liabilities, amount receivables, amount payables etc can be
known with the help of Balance Sheet.
4) To determine taxes: Accounting helps to determine taxes payable by business unit such as sales tax, vat,
income tax, excise duty, custom duty etc.
5) To take decisions: Future business decisions can be taken, if accounts are properly maintained.
6) As evidence: Books of accounts can be produce as an evidence of business transactions.
7) For comparison: Accounting helps to compare current year’s result with past year’s & necessary decisions
can be taken.
8) To determine value of business: When whole business is sold out, it is required to find purchase
consideration (price of the business). Accounting helps to determine purchase consideration with the help
of assets & liabilities of the business.
9) To keep control: Accounting helps to keep control over workers & employees & there by theft, frauds or
wastages can be controlled.
10) Corrective measures: Accounting is useful to keep control over various business activities & to prevent or
minimize wastage. Corrective measures can be taken to rectify past faulty decisions.
11) To outsiders: Accounting is also useful to outsiders such as creditors, bank, government, shareholders etc.
to maintain relation with the business unit.

Limitations:
Accounts have no limitations unless they are created by human. Followings are the limitations of
accounts:
1) Non-financial transactions: Non-financial transactions are not recorded in accounts though they are
important. E.g. loss that will occur in future on retirement of an efficient manager is not recorded in
accounts.
2) Stable value of Money: Accounting assumes that the value of money remains stable, but practically it is
not true. Value of money changes at two different time period due to inflation, which is not considered in
accounting.
3) Historical Transaction: Accounts show only the information of past. It does not show the information
regarding changes that are going to take place in future.
4) Avoidance of market value: In accounting assets are recorded at actual cost price, but practically its market
value goes on changing which is ignored.
5) Money-common unit of measurement: In accounts, all transactions are recorded which can be measured
in terms of money. Hence, money is the common unit of measurement for all transactions. E.g. If goods
of 500kg purchased at Rs.20 per kg, then this transaction is recorded at Rs.10,000 & not at 500kg.
6) Dual standard: Sometimes, accounts do not reflect true & fair financial position of the business. E.g. fixed
assets are shown in books at cost less depreciation & not at its market price while in Profit & Loss account,
current prices are considered.
7) Use of estimates: Many transactions of business are based on estimates, which are not always correct. E.g.
estimates regarding depreciation, reserve for bad & doubtful debts, etc.
8) Personal bias of accountant: Sometimes, accountant estimates the figures of loss etc with his personal
bias. These estimates may not be true. E.g. Accountant has to estimate the loss of bad debts that may arise
in future. But such estimate may not be true.
9) Incomplete transaction: In accounts, transactions can not be recorded unless it is completed.
10) Dishonesty: Accounts do not provide protection against fraudulence (dishonesty). If transactions are made
fraudulently, then accounts will not reflect true picture of the business. E.g. expenses are recorded even if
they are not actually incurred.

Qualitative characteristics of accounting, which are very useful for taking various decisions, are as follows:
1) Understandability: Accounting information should be presented in a simple & clear manner so that it can
be understood clearly.
2) Relevance: All information related with the objective of the business should be provided in accounts.
Accounting statements prepared at the end of the year should satisfy the required objectives.
3) Reliability: Accounting information should be reliable, free from any error or false presentation.
4) Comparability: Accounting information should be such that information of different years of the same
firm or of different firms can be compared easily.
 Accounting terms
1) Transactions: Any exchange of goods & services against money between two or more persons or firms
is called business transaction.
2) Capital: Cash, goods or any assets brought by the owner from his private property into the business is
called capital. It is the excess of business assets over its liabilities. It is also called net assets or net
worth. E.g. if owner brings cash or personal furniture into the business from his personal assets is
called capital. (Net assets = Business assets – business liabilities)
3) Drawings: Cash, goods or any assets withdrawn by the owner from business for his private use is called
Drawings. Capital decreases due to drawings. (Capital & drawings are the two accounts of the owner.)
4) Assets: Items or any right owned by business unit & having monetary value is called asset. Asset helps
the business to run smoothly.
Types of Assets

  
(i) (ii) (iii)
Non-Current Assets Current Assets Fictitious Assets /
(which can be used (which are changing Differed Revenue Exp
for long period (More than frequently & easily (Expenses incurred
one year) & do not change converted into cash) on a large scale & its
frequently. e.g. land, building, e.g. cash, debtors, benefit can be availed
machinery, goodwill, Patent, stock of goods, bank.. for more than one year)
vehicles, Furniture etc. e.g. advertisement campaign
 expenses, Preliminary expenses…
 
Tangible Assets Intangible Assets
(Which can be touched or seen (Which cannot be touched or seen
& having physical existence) & not having physical existence)
E.g. Land, Building, Macvhinery, E.g. Goodwill, Patent, Copy Right.
Furniture etc.
5) Liability: Any amount payable from the business is called liability. E.g. liability for purchase of goods,
liability for loan taken, liability for outstanding expenses etc. Capital of owner is called Internal
liability, whereas amount payable to outsiders for purchase of good / services or for borrowed loan is
called External Liabilities.
Types of liabilities

 
(i) (ii)
Current liabilities Non current liability.
(amount payable within 1 year) (amount payable after 1 year)
E.g. Amount payable to creditors, Bank Overdraft, Amount payable for borrowed loan, Debenture
Expenses to be paid (Outstanding),

6) Revenue: Amount received or receivable on selling the goods or rendering any services is called
Revenue. Other incomes like interest, rent, commission, dividend, etc are also included in revenue.
7) Receipts / Income: Amount received due to any business transaction like selling the goods / assets or
rendering services is known as receipt / income.
 Types of Receipts

 
(i) (ii)
Revenue receipt Capital receipts
[Incomes received regularly from day-to-day [Incomes received occasionally & not regularly
transactions of the business. E.g. amount received is called capital incomes. E.g. income from sale
from sale of goods, interest received, dividend of assets, long term debt (loan) received, debenture
received, discount received etc.] issued etc.]

8) Loss & Gain: Any amount lost without getting any benefit is called “Loss”. E.g. loss by theft, loss by
fire, loss on sale of assets etc. The excess of revenue expenditure over revenue income is also termed as
“Loss”.
Profit made in course of business transactions is called gain. E.g. profit on sale of asset or
investments.
The excess of revenue income over revenue expenses is also termed as “Gain” or “Profit”.
9) Opening stock: The stock of goods lying unsold at the beginning of the financial year (i.e. on 1st April)
is called opening stock.
10) Closing stock: The stock of goods lying unsold at the end of the financial year (i.e. on 31st March) is
called opening stock.
11) Debtors: The person, from whom any amount is receivable for the sale of goods or services, is known
as Debtors (Customers).
12) Creditors: The person, to whom any amount is payable for purchase of goods or services, is called
Creditors (Traders).
13) Good debts: The amount which is sure to be received from the debtors is called good debts. No reserve
is required for good debts.
14) Bad debts: The amount which is recoverable from an insolvent debtor is called Bad debts. It is loss for
the business.
15) Bad debts recovered: The amount written off as bad debts, if received back from such debtor, it is called
Bad debts recovered. It is income for the business.
16) Solvent: The person who is capable to pay his debts or whose assets are more than liabilities, is known
as Solvent person.
17) Insolvent: The person who is not capable to pay his debts or whose liabilities are more than assets, is
known as Insolvent person.
18) Trade Discount: Reduction in the catalogue price allowed to retailer in order to sell the goods in bulk
quantity is called Trade Discount. It deducted but never recorded in the books as expense.
19) Cash Discount: Reduction in price allowed to customer to encourage prompt payment is called cash
discount. It is calculated only on amount actually paid or received whether by cash or by cheque. It is
deducted from the price arrived after deducting Trade discount & recorded in the books as expense or
income.
20) Allowance: Small amount ignored at the time of settlement of account is called Allowance. It is
recorded in the books of account just like cash discount. E.g. when customer settles his account by
paying Rs.6000 against his bill of Rs.6005.50, the difference amount Rs.5.50 is allowance given to him
which is expense for trader.
21) Purchase: The process of buying the goods on cash or on credit is called Purchase. (Buying of asset is
not termed as purchase).
22) Sales: The process of selling the goods on cash or on credit is called Sales. (Selling of assets is not
termed as Sales).
23) Voucher: A documentary wriiten evidence supporting business transaction is known as voucher. E.g.
pass book for bank transaction, bill, invoice, etc.
 Different methods / systems of accounting.
There are three methods of accounting:
1) Double Entry System: The method of accounting, in which each & every transactions have at least two
effects such that amount of debit & credit side is equal, is called Double entry system. This method is
used in many countries including India because it is a scientific method.
2) Single Entry system: It is nothing but incomplete record of double entry system. Generally it is kept by
small traders.
3) Deshi Nama system (Bahi Khata): It is the ancient method of accounting in India. Even to-day, small
traders keep their accounts by this method. Its rules are similar to double entry system but it differs in its
structure. There are two main books in this system: Rojmel & Khatavahi.

Difference between Single entry system & Double entry system.

Single entry system Double entry system

1) It is incomplete records of accounts. 1) It is complete records of accounts.
2) Each & every transactions may not have 2) Each & every transactions have two effects.
two effects.
3) In ledger, only personal accounts are 3) In ledger, all accounts are opened.
opened. 4) Profit can be found out systematically by
4) Profit can not be found out systematically preparing Profit & Loss A/c.
but it can be found out by comparing 5) There are negligible chances of arithmetical
capitals. errors in accounts.
5) There are more chances of arithmetical 6) Frauds or manipulation can not be made
errors in accounts. easily.
6) Frauds or manipulation can be made easily. 7) Medium & large businessmen keep their
7) Only small traders & hawkers keep their accounts by this method.
accounts by this method. 8) Loans for business can be easily borrowed
8) There arises difficulty in borrowing loans with the help of systematic presentation of
for business. accounts.

Choose the correct answer:

1) Trade discount is given to _____.
a) retailer, b) wholesaler, c) customer, d) supplier.
2) Differed revenue expenditure are also known as ____.
a) current assets, b) fixed assets, c) tangible assets, d) fictitious assets.
3) Who presented first double entry system?
a) Kautilya, b) Chanakya, c) Mr. Tally, d) Luca Pacioli.
4) Assets which are changing frequently are called _____.
a) current assets, b) fixed assets, c) tangible assets, d) fictitious assets.
5) Vehicle of the business is called _____.
a) current assets, b) fixed assets, c) intangible assets, d) fictitious assets.
6) Which discount is deducted but not recorded in the books of accounts?
a) Trade discount, b) cash discount, c) allowance, d) Kasar.
7) Which discount is given in order to sell the goods in bulk quantity or to give sufficient margin to retailer?
a) Trade discount, b) cash discount, c) allowance, d) Kasar.
8) Who wrote Arthashashtra?
a) Chandragupt Maurya, b) Kautilya, c) Marshal, d) Luca Pacioli.
9) The double entry system was presented ib _____A.D.
a) 1449, b) 1949, c) 1944, d) 1494.
 Two fold effects of the transactions & Types of A/c
Economic & Non-economic transactions & give difference between them.
Any transaction related with the business & which can be measured in terms of money, is called Economic
transaction. Such transactions are recorded in business. E.g. purchased goods of Rs. 1000, paid salary of
Rs.2000 to accountant etc.
Any transaction not related with the business or which can not be measured in terms of money, is called
Non-economic transaction. Such transactions are not recorded in the books of accounts. E.g. Placed an
order for purchase of goods of Rs.1000, Appointed typist with monthly salary of Rs.5000, invited friend
for dinner party etc.
Economic Transactions Non-economic transactions
1 Any transaction related with the business & Any transaction not related with the business
which can be measured in terms of money, is or which can not be measured in terms of
called Economic transaction. money, is called Non-economic transaction
2 Such transactions are recorded in business. Such transactions are not recorded in the books
of accounts
3 They are related with business. They may or may not be related with business.
4 They can be measured in terms of money. They may not be measured in terms of money.
5 e.g. purchase of goods, sale of goods, e.g. placing of an order, appointment of an
payment of any expenses, receipt of income employee, invitation for personal party etc.
etc.

Cash & credit transactions & state the difference between them.
A transaction in which receipt or payment of cash or cheque is involved is called cash transaction. E.g.
paid Rs. 1000 to Ashok, purchased goods of Rs.2000 by cheque etc.
A transaction in which receipt or payment of cash or cheque is not involved is called credit transaction.
E.g. Sold goods of Rs. 1000 to Ashok, Purchased machinery of Rs.20000 from Rohit Machines Ltd on
credit etc.

Cash Transaction Credit Transaction

1 A transaction in which receipt or payment of A transaction in which receipt or payment of
cash or cheque is involved is called cash cash or cheque is not involved is called credit
transaction transaction.
2 Debtor or creditor relationship does not come Debtor or creditor relationship comes in to
in to existence in cash transaction. existence in credit transaction.
3 Cash or bank balance is affected by such Cash or bank balance is not affected by such
transaction. transaction.
4 Cash transactions are recorded in cash book. Credit transactions are recorded in Journal
proper, purchase book, sales book, purchase
return book or sales return book.
5 “Cash” or “cheque” word is specified in such “Cash” or “cheque” word is not specified in
transaction or name of person is not such transaction & name of person is
mentioned. mentioned.

➢ If “cash or cheque” word is given, then it is a cash transaction. (e.g. purchased goods of Rs.1000 from
Ashok for cash/cheque)
➢ If “cash or cheque” word is not given and name of person or firm is also not mentioned, then also it is a
cash
transaction. (e.g. purchased goods of Rs.1000.)
➢ If “cash or cheque” word is not given but name of person or firm is mentioned, then it is a credit
transaction.
(e.g. Purchased goods of Rs.1000 from Ashok.)
Voucher
A written evidence supporting the business transaction is called Voucher. A transaction is not recorded, if it is
not supported by any voucher. Bill or invoice is the voucher for purchase or sale, pass book or bank statement is
the voucher for transactions with bank, salary register is the voucher for salary paid to employees.

Accounting equation / balance sheet equation.

Assets (A) = Liabilities (L) + Capital (C).
The total of both the side of accounting equation always remains equal. Any change on the left hand side of the
equation will bring the same change on the right hand side of the equation & hence total of both the sides will
remain same. E.g. purchased goods of Rs.1000 to Ajay for cash. Here goods come in, hence stock increases
hence asset increases, on the other hand cash goes out, hence cash balance decreases, and hence asset decreases.
Thus total of both the sides of the equation will remain unaffected.

Two-fold effects of the transactions giving example.

In double entry system, each & every accounting transactions have at least two effects. These effects are
recorded in accounts. E.g. Paid salary Rs.1000. 1st effect → Salary is an expense because business gets services
of the employee hence “Salary account” is affected, 2nd effect → cash goes out, and hence “Cash account” is
affected. Thus, at least two accounts are involved in any business transaction.

Determine two-fold effects

In double entry system, each & every accounting transactions have two-fold effects. In order to determine two
fold effects, find:
→ Whether any asset comes in or goes out,
→ Whether the person is a receiver or giver,
→ Whether it is an expense or income.

Account?
A summery of business transactions affecting particular aspect / matter, when recorded in the books of accounts
in a systematical manner, it is called an account. Each & every account has two sides, left hand side is called
Debit side & right hand side is called Credit side.
e.g. Cash paid to Amit Rs.1000. Here cash is paid which affects cash account and hence it will be recorded on
one side of “Cash Account”.
 Different types of accounts with accounting rules
Accounts are classified in to two types: Personal Accounts & Impersonal Accounts. Further, Impersonal
Accounts are classified in to two types: Real Accounts & Nominal Accounts.

Types of Accounts


(i)
Personal Accounts
(Includes name of persons, firms,
company, institutions, shops, bank etc)  
(ii) (iii)
Real Accounts Nominal Accounts /
 Income & Expenditure Accounts
  (Includes incomes like: discount
(i) (ii) or commission received, interest
Goods Accounts Assets Accounts apprentice premium, dividend..
(Includes Purchase, (Includes Fixed Assets & current & Expenses like: salary, rent,
Sales, Purchase return, Assets like: machinery, land, stock stationery, telephone exp,
Sales return, Goods A/c) of goods, cash, etc.) electricity Expenses etc)
  
Accounting Rule Accounting Rule Accounting Rule
“Dr. the receiver, “Dr. what comes in, “Dr. Expenses & losses,
Cr. the giver.” Cr. What goes out.” Cr. Incomes & profits.”

M.C.Q.
1) A commercial deal involving receipt or payment either immediately or at a later stage can be termed as
___.
a) Economic transaction, b) Non-economic transaction, c) Exchange, d) None.
2) Which of the following transactions is of special nature?
a) Cash purchase of goods, b) Credit purchase of goods, c) Purchase of goods by cheque, d) goods
destroyed by fire.
3) Rent paid is _____.
a) Cash transaction of asset, b) Non-cash transaction of services, c) Cash transaction of services, d) Cash
transaction of liability.
4) Which transaction discloses relation of debtor & creditor?
a) Purchased goods of Rs.8000, b) Purchased goods of Rs.8000 from B, c) Purchased goods of Rs.8000
through cheque, d) Goods of Rs.8000 destroyed by fire.
5) The transaction in which receipt or payment of money is not involved is known as ____.
a) Economic transaction, b) Non-economic transaction, c) Exchange, d) None.
6) When on the spot receipt or payment by cash or cheque is involved, it is called _____transaction.
a) Exchange, b) Credit, c) Non-economic, d) Cash.
7) Which of the following characteristic is not applicable to economic transaction?
a) Cash transaction, (b) Credit transaction, (c) External transaction, (d) Transaction without monetary
value.
8) In double entry system, every transaction has at least ____effects.
a) one, b) two, c) three, d) four.
9) Under double entry system, sum of liabilities & capital is equal to _____.
a) debts, b) receivable, c) payables, d) assets.
10) Credit transactions will not have effects on _____balance.
a) bank overdraft, b) bank, c) cash & bank, d) cash.
11) In a transaction, when receipt or payment is suspended off then it is known as ____transaction.
a) Exchange, b) Credit, c) Non-economic, d) Cash.
12) How many types of accounts are there in double entry system?
a) one, b) two, c) three, d) four.
13) Balance sheet is a _____.
a) statement, b) account, c) voucher, d) none.
14) Impersonal accounts involved accounts of ____.
a) Personal & Real, b) Personal & Nominal, c) Personal, d) Real & Nominal.
15) Systematic summery of business transactions of a particular class or aspect is called ____.
a) ledger, b) account, c) statement, d) voucher.
16) Accounts of living persons, institutions or artificial identity are known as _____accounts.
a) personal, b) impersonal, c) real, d) Nominal.
17) Accounts relating to goods or assets come under _____accounts.
a) personal, b) real, c) Nominal, d) None.
18) Royalty is ____account.
a) personal, b) Nominal, c) real, d) None.
19) Unpaid / outstanding expense / pre paid expense is ____account.
a) personal, b) Nominal, c) real, d) None.
20) Stationery is ____type of account.
a) personal, b) Nominal, c) real, d) None.
21) Stationery stock is ____type of account.
a) personal, b) Nominal, c) real, d) None.
22) Shares of Reliance Industries is ____type of account.
a) personal, b) Nominal, c) real, d) None.
23) Reliance Industries Ltd. is ____type of account.
a) personal, b) Nominal, c) real, d) None.
24) Dead stock, loose tools, spare parts etc are _____accounts.
a) personal, b) Nominal, c) real, d) None.
25) General Reserve is ____type of account.
a) personal, b) Nominal, c) real, d) None.

Answer in one sentence:

1) What is dual effect?
➢ Each & every business transaction has at least two effects in double entry accounting system, which is
known as duel effects.
2) What is cash transaction?
➢ A business transaction in which money is paid / received for exchange of goods, assets or services is
known as Cash transaction.
3) What is credit transaction?
➢ A business transaction in which money is not paid / received immediately for exchange of goods,
assets or services but it is paid / received in future is known as Credit transaction. It creates debtor –
Creditor relationship.
4) Give illustration of cash transaction of goods.
➢ Purchased goods of Rs.5000.
5) Give illustration of credit transaction of goods.
➢ Purchased goods of Rs.5000 from B.
6) Give illustration of cash transaction of services.
➢ Paid salary to accountant Ramesh Rs.5000.
7) Give illustration of credit transaction of services.
➢ Salary of Rs.5000 is due but not paid to Ramesh.
8) What is non-economic transaction?
 ➢ A transaction whose value can not be measured in terms of money is called Non-Economic
transaction.
9) Explain internal & external Transaction.
➢ A transaction which takes place within business without involvement of third party is called internal
transaction. E.g. Depreciation provided on asset, loss by fire etc.
➢ A transaction which takes place between business & third party is called External transaction. E.g.
sale of goods to customers, payment of wages to workers, receipt of interest from bank, payment of
insurance premium
10) Explain other Transaction.
➢ A business transaction which is not a credit or cash transaction is known as other transaction. E.g.
Goods destroyed by fire, goods given as charity, depreciation on assets etc.

ACCOUNTING EQUATION
(Dr.) (Cr.)
➢ Accounting / Balance sheet Equation : A = C + L (Assets = Capital + Liabilities)

➢ Any expense paid in cash / cheque = Cash - bank / asset decreases, Capital decreases.
➢ Any income received in cash / cheque = Cash - bank / asset increases, Capital increases.
➢ Goods purchased by cash / cheque = Stock of goods/assets increases, Cash-bank / asset decreases,
➢ Goods purchased on credit = Stock of goods/assets increases, Creditors / Liability increases.
➢ Purchase Return = Stock of goods/assets decreases, Creditors / Liability decreases.
➢ Goods sold on cash/cheque at profit = Cash-Bank / Assets increases (S.P.), Stock of goods / assets decreases
(C.P.), By profit earned Capital increases.
➢ Goods sold on credit = Debtors / asset increases (S.P.), Stock of goods / assets decreases (C.P.), By profit
earned Capital increases.
➢ Sales Return = Stock of goods/assets increases, Debtors / Assets decreases.
➢ Machinery - Furniture purchased on cash-cheque = Machinery - Furniture / Assets increases, Cash – Bank /
Assets decreases.
➢ Machinery - Furniture purchased on credit = Machinery – Furniture /assets increases, Creditors / Liability
increases.
➢ Started business with assets-cash-liabilities = Cash bal. /Assets increases, Liability increases, Capital
increases. (Assets, cash – Liabilities)
➢ Withdrawn cash-goods from business for personal use = Drawings /Capital decreases, cash-stock of goods /
Assets decreases.
➢ Withdrawn cash from bank for personal use = Drawings /Capital decreases, Bank bal. / Assets decreases.
➢ Withdrawn cash from bank for shop expenses = Cash bal. / Assets increases, Bank bal. / Assets decreases.
➢ Cash deposited in bank = Bank bal. / Assets increases, Cash bal. / Assets decreases.
➢ Goods given as free samples = Advertisement Exp / Capital decreases, Stock of goods/Assets decreases.
➢ Goods given as charity = Charity Exp / Capital decreases, Stock of goods/Assets decreases.
➢ Goods destroyed by fire & insurance co. accepted claim for less amount = Loss by fire / Capital decreases,
Claim receivable from Insurance co. / Assets increases, Stock of goods/Assets decreases.
➢ Loan borrowed = Cash-Bank bal./Assets increases, Loan / Liabilities increases.
➢ Loan Repaid = Loan / Liabilities decreases, Cash-Bank bal./Assets decreases,
➢ If we settled Creditor’s A/c with discount = Creditors/Liability decreases (with full amt.), Cash-bank/Assets
decreases with amt. paid after discount, Discount received /Capital increases.
If Customer settled his A/c with discount = Cash-bank/Assets increases with amt. received after discount,
Discount allowed /Capital decreases, Debtors/Assets decreases (with full amt.)
 Journal – Journalising
Journal & Journalising and its characteristics.
A primary book of account in which all business transactions are recorded systematically &
chronologically, applying rules of Dr. & Cr. is called Journal. It is the basic / primary book or book of
original entry because each & every business transaction is first recorded in Journal. Journal word is
originated in Latin, where its meaning is ‘record’ or ‘diary’.
The process of recording business transactions systematically in Journal applying accounting
rules is called Journalising.
Characteristics:
1) Primary Book: Journal is the basic / primary book or book of original entry because each & every
business transaction is first recorded in Journal.
2) Dual Effects: In journal, dual effects of accounting transactions are recorded applying rules of Dr. & Cr.
3) Chronological: All business transactions are recorded in chronological order (date wise).
4) Two columns for amount: In journal, two columns are kept for amount: Dr. & Cr. Dr amount is
recorded in Dr. column & Cr. Amount is recorded in Cr. Column.
5) Narration: A brief explanation of transaction is written below each entry in journal which is known as
narration.

Importance / advantages of Journal.

A primary book of account in which all business transactions are recorded systematically & chronologically,
applying rules of Dr. & Cr. is called Journal. There are many advantages of journal which are as under:
1) Record of all transactions: In journal, all business transactions are recorded chronologically (date
wise), hence, no transaction is left unrecorded.
2) Useful information: Journal provides useful information regarding business transactions as & when
required, because all transactions are recorded systematically in Journal.
3) Use of narration: Narration written at the end of each entry in Journal is helpful to identify
transaction even after very long period.
4) Useful for posting amounts: Journal is the base for posting the transactions in Ledger. As two
columns of amount are kept in Journal, it becomes easy to post every transaction from Journal on
Dr or Cr side.
5) Useful for posting in relevant account: Posting can be done directly from Journal to the relevant
account, because all transactions are recorded in Journal as per the principle of dual effect.
6) Errors are minimized: Arithmetical errors in writing the accounts are minimized because all
transactions are recorded in Journal as per the principles of Accountancy. Due to dual effects of
each & every transactions, total of Dr. side & Cr. Side should be equal.

Combined Entry
A Journal entry in which more than one accounts are debited or credited is called Combined
Entry. Generally, separate entry is passed for different transactions, but when same account is there in
different transactions, a combined entry is passed. E.g. Paid salary Rs.1000, wages Rs.500 & Rent
Rs.2000. Here all expenses are paid in cash, hence cash account is common in all the three transactions.
Its combined entry will be as under: Salary A/c Dr. 1000
Wages A/c Dr. 500
Rent A/c Dr. 2000
To Cash A/c 3500
[Being amount paid for salary, wages & rent]
Difference between Trade Discount & Cash Discount.

Sr. Trade Discount Cash Discount

No.
1 A discount is given to retailer to provide him A discount given to customer to encourage
sufficient margin of profit or discount given to prompt payment within stipulated time period
customer if he purchases goods in bulk is called Cash discount.
quantity, it is called Trade discount.
2 It is calculated on printed price or catalogue It is calculated on net price after deducting
price. trade discount.
3 It is not recorded in the books of accounts. It is recorded in the books of accounts.
4 It is allowed on cash as well as credit It is allowed only on cash transaction.
transactions.
5 It is deducted while preparing bill or invoice. It is not deducted while preparing bill or
invoice.
6 It encourages the customer/retailer to purchase It encourages the customer to pay the amount
the goods in large quantity. of bill promptly.

Q. 5 M.C.Q.
1) The record of accounting transactions in the books of accounts is known as _____.
a) entry, b) posting, c) journal, d) ledger.
2) A brief explanation of the transaction written in bracket below journal entry is known as ____.
a) entry, b) posting, c) suggestion, d) narration.
3) By depositing cash or cheque in the bank, bank balance of the customer _____.
a) decreases, b) increases, c) remains unchanged, d) none.
4) _____is not recorded in the books of accounts.
a) Allowance, b) trade discount, c) cash discount, d) economic transaction.
5) When goods or cash or any asset is taken by owner / proprietor for his personal use, _____A/c is debited.
a) Cash a/c, b) Goods A/c, c) capital A/c, d) Drawings A/c.
6) When amount is withdrawn from bank for office expense, _____A/c is debited.
a) Office expense, b) capital, c) Drawings, d) Cash A/c.
7) When goods are received as free sample, ____account is debited.
a) Goods, b) No, c) Purchase, d) Sales.
8) When goods received as free sample are sold out, ____account is credited.
a) Goods received as free sample, b) Purchase, c) Sales, d) None of these.
9) When goods are given as free samples to customer, ____A/c is denited.
a) Advertisement, b) customer’s, c) Drawings, d) None of these.
10) When amount written off as bad debts are received back from Amit, _____A/c is credited.
a) Cash, b) bad debts recovered, c) Amit’s, d) Bad debts.
11) When LIC premium is paid, _____A/c is debited.
a) LIC premium, b) Premium, c) Drawings, d) capital.
12) When income tax is paid by cheque, ____A/c is debited.
a) Income Tax, b) Sundry Expense, c) Drawings, d) capital.
13) Wages paid for installing machinery is debited to _____A/c.
a) Wages, b) Machinery, c) Sundry Expense, d) Cash.
 Capital and Revenue Expenditures and Receipts
The main functions of accounting include the ascertainment of profit/loss for an accounting period and financial
position as at the end of that period. The distinction between capital and revenue items is important both from
the Income Statement (Profit and Loss Account) as well as the Position Statement (Balance Sheet) point of view.
For example, if a depreciable asset is purchased, the depreciation on that asset is charged to the Profit and Loss
Account, and the written down value of the asset (or original cost of the asset less accumulated depreciation) is
shown in the Balance Sheet. If the purchase of a depreciable asset, which is a capital expenditure, is treated as
revenue expenditure it will understate the profit of the current year and overstate the profits of the subsequent
years. Similarly, the Balance Sheet will not give a true and fair view of the assets and equity of the enterprise till
the useful life of the asset is over assuming that the asset is not sold earlier.

Capital and revenue item is divided into

1. Capital and revenue expenditure;
2. Capital and revenue receipts.

Capital and Revenue Expenditure

According to Guidance Note on terms used in financial statements issued by ICAI, “Expenditure is incurring a
liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods or services”. Thus
expenditure may or may not involve outflow of cash. It includes the purchase of capital or long-lived asset, goods
for the purpose of sale or for getting services. Expenditures are divided into three categories :
1. capital expenditure
2. revenue expenditure, and
3. deferred revenue expenditure

Capital Expenditure
Expenditure that acquires a capital asset is capital expenditure. If it acquires stock-in-trade, then it is revenue
expenditure. A capital asset is one that is used in or for the purposes of the business and not meant for sale in the
ordinary course of business of the enterprise. Purchase of stock-in-trade is not capital expenditure as it is sold in
the ordinary course of business. Expenditure on the purchase and installation of machinery is a capital
expenditure. Further when an expenditure is made with a view to bringing into existence an asset or advantage
for the enduring benefit of trade is a capital expenditure in the absence of special circumstances leading to the
opposite conclusion.
Asset or advantage of enduring nature means that it must not be fully consumed or used up in the accounting
period in which it is incurred. Capital expenditure increases the earning capacity or reduces the operating
expenses of a business.
According to Kohler the term capital expenditure is “generally restricted to expenditures that add fixed asset units
or that have the effect of increasing the capacity, efficiency, life span, or economy of operation of an existing
fixed asset.”
The following are the examples of capital expenditure :
1. Expenditure incurred for acquisition of fixed tangible assets such as land, building, machinery, furniture,
motor vehicle etc.
2. Expenditure incurred for improvement or extension of fixed assets such as increasing the seating capacity
of a theatre.
3. Expenditure incurred to bring the fixed assets to the place of their use and expenditure incurred on their
installation or erection such as freight on fixed assets, wages paid for installation.
4. Expenditure incurred for the purchase of intangible assets such as goodwill, patent rights, and trademarks,
copyright, etc.
5. Expenditure incurred for reconditioning of old fixed assets such as expenditure incurred on repairing or
overhealing of secondhand machinery.
6. Major repairs and replacement of plant which increase the efficiency of the plant.
 7. The cost of shifting a plant to another place is a capital expenditure [Sultanpur Sugar Works
Ltd. vs. CIT (1963) 49 ITR 160 SC]
• Treatment of Capital Expenditure. Capital expenditure is capitalised. It is written off over the
estimated useful life of the asset. For example, when machinery is purchased, Machinery Account is
debited at the price paid for it and later shown in the Balance Sheet as an asset after deducting
depreciation. Similarly, wages paid for the installation of machinery is capitalised by debiting the
Machinery Account.
• Rules for Determining Capital Expenditure. The following are the rules for determining capital
expenditure :
1. An expenditure is capital expenditure, if it is incurred for acquiring a long term asset (having a useful life
of more than one year) for use in the business to earn revenue and not meant for sale.
2. An expenditure is capital expenditure, if it is incurred to put an asset into working condition. For example,
the transportation and installation charges are added to the cost of machine. Similarly, the legal charges
like registration and stamp duty is added to the cost of land and building. Again, architect fee paid for
supervising construction of building is capitalised.
3. An expenditure incurred for putting an old asset into working condition is treated as capital expenditure
and added to the cost of the asset.
4. An expenditure incurred to increase the earning capacity of a business is treated as capital expenditure.
For example, expenditure incurred for shifting the factory to convenient site is a capital expenditure.
5. Borrowing costs (e., interest and other costs incurred by an enterprise in connection with the borrowing
of funds) that are directly attributable to the acquisition, construction or production of a qualifying asset
should be capitalised as part of the cost of that asset till the asset is ready for its intended use or sale as per
AS-16 : Borrowing costs.

Revenue Expenditure
If an expenditure is made not for the purpose of bringing into existence any capital asset or advantage of enduring
nature but for running the business or working it with a view to produce the profits is revenue expenditure. Such
expenditure benefits the current period only. It is incurred to maintain the existing earning capacity of the
business. For example, the amount spent on purchase of stock-in-trade is of revenue nature. Administrative
expenses and selling and distribution expenses are other examples of revenue expenditure.
• Rules for Determining Revenue Expenditure. The following are the rules for determining revenue
expenditure :
1. An expenditure incurred for the purpose of acquiring goods purchased for resale, consumable items, etc.
is a revenue expenditure. For example, purchase of raw material in the case of manufacturing unit and
purchase of merchandise meant for the purpose of resale. At the end of the year, closing stock and opening
stock of these items adjusted to match cost with revenue for calculating profit.
2. Expenditures incurred on other direct expenses, e., expenses on production and purchase of goods such as
wages, power, freight etc. are revenue expenditure.
3. Expenditure incurred for maintaining fixed assets in working order is revenue expenditure. For example,
amount spent on repairs and renewals is revenue expenditure.
4. Depreciation on fixed assets is revenue expenditure.
5. Expenditures incurred on office and administrative and selling and distribution departments (not covered
above) in the normal course of business are revenue expenditures. These include salaries, rent, telephone
expenses, electricity, postage, advertisement, travelling expenses, commission to salesmen.
6. Expenditures incurred on non-operating expenses and losses are revenue expenditures. For example,
interest on loan taken after commencement of commercial production, loss on sale of a long term asset,
loss by theft, loss by fire are revenue expenditures.
7. Expenditure incurred by an enterprise to discharge itself from recurring liability is of revenue nature. For
example, a lump sum amount paid to a pensioner by the employer is revenue expenditure.
8. Expenditure incurred for protecting the business is a revenue expenditure. For example, the amount spent
on propaganda campaign to oppose the threatened nationalisation of industry is of revenue nature.
9. Expenditure incurred to maintain the existing efficiency or the earning capacity is of revenue type.
 Distinction Between Capital Expenditure and Revenue Expenditure
The following are the points of distinction between capital expenditure and revenue expenditure :
1. Enduring benefit : Capital expenditure is meant for enduring benefit, e., for more than one accounting
period. Revenue expenditure benefits one accounting period only.
2. Nature of asset : Capital expenditure relates to the acquisition of fixed asset and revenue expenditure
relates to the acquisition of stock-in-trade.
3. Effect on net profit : Capital expenditure is capitalised while revenue expenditure is transferred to the
Trading or Profit and Loss Account. Unexpired portion of the capital expenditure is shown as an asset in
the Balance Sheet. Revenue expenditure is expired cost.
4. Nature of liability discharged : Expenditure incurred by an assessee to free himself from a capital liability,
for instance, disadvantageous lease is a capital expenditure, while the amount spent in discharging himself
from a recurring liability is of revenue nature.
5. Periodicity of occurrence : Capital expenditure is usually of non-recurring nature while revenue
expenditure is usually of recurring nature.
6. Earning capacity : Capital expenditure helps to increase the earning capacity of the business or to reduce
the operating cost. Revenue expenditure is incurred to maintain the existing earning capacity of the
business.
7. Matching : Capital expenditure are not matched against capital receipts. Revenue expenditures are
matched against revenue receipts for income determination.
8. Commencement of business : Capital expenditures may be incurred even before the commencement of
business. Revenue expenditures are incurred only after the commencement of business.

Deferred Revenue Expenditure

Deferred revenue expenditure is a revenue expenditure by nature but it is not treated as revenue expenditure on
the ground that its benefit is not fully exhausted in the accounting period in which it is incurred. The Guidance
Note on ‘Terms used in Financial Statement’, issued by the Institute of Chartered Accountant of India, states that
“Deferred revenue expenditure is that expenditure for which payment has been made or a liability incurred but
which is carried forward on the presumption that it will benefit over a subsequent period or periods.”
Deferred revenue expenditure is, for the time being, deferred from being charged against revenue. The unwritten
off portion of the deferred revenue expenditure is shown on the asset side of the Balance Sheet. A portion of the
total deferred revenue expenditure is charged as revenue expenditure. Deferred revenue expenditure should be
written off over a certain number of years.

• AS-26 “Intangible Assets” has diluted the concept of deferred revenue expenditure.
According to it, if expenditure is incurred to provide future economic benefits to an
enterprise, but no intangible asset or other asset is acquired that can be recognised, then
expenditure should be recognised when it is incurred. For example, preliminary expenses in
establishing a legal entity, expenditure on training activities and expenditure on relocating
or reorganising an enterprise, expenditure on launching of new products, expenditure on
advertising and promotional activities should be recognised as expenses in the year in which
these are incurred. However, share issue expenses and discount on issue of shares/debentures
can be written off over a certain number of years.

Deferred revenue expenditure should be distinguished from prepaid expenses. In case of deferred revenue
expenditure the benefits available cannot be precisely estimated but in case of prepaid expenses, like payment of
insurance in advance, benefits available can be precisely estimated. In case of prepaid insurance, insurance
protection will be available for a definite period after close of the financial year.

Illustration
Classify the following into capital or revenue expenditure :
(a) Overhaul expenses of ` 10,000 spent on second hand machinery purchased.
(b) Carriage of ` 1,000 spent on machinery purchased.
(c) Legal fees of ` 5,000 paid to acquire property.
(d) ` 1,500 paid for servicing the company’s car including ` 500 paid for change of oil.
(e) ` 1,000 paid for replacement of a worn out part of a machine.
(f) ` 18,000 spent for construction of temporary huts, which were necessary for construction of the cinema house
and were demolished when the cinema house was ready.

Solution:
(a) Overhaul expenses spent on second hand machinery purchased is a capital expenditure.
(b) Carriage paid on machinery is a capital expenditure.
(c) Legal fees paid to acquire property is a capital expenditure.
(d) Amount spent on servicing entity’s car is a revenue expenditure.
(e) Amount spent on replacement of worn part of a machine is a revenue expenditure.
(f) Amount spent on construction of temporary huts is a capital expenditure.

Illustration
Classify the following into capital or revenue expenditure :
(a) ` 5,000 spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the plaintiff’s
land.
(b) ` 1,50,000 spent on the repairs and white-washing for the first time on purchase of an old building.
(c) ` 15,000 spent in connection with obtaining a licence for starting a factory.
(d) ` 6,000 paid as compensation to two employees who were retrenched.
(e) ` 8,000 custom duty paid on import of machinery for modernisation of factory production.

Solution:
(a) Lawyer’s fee to defend the impugned suit is a revenue expenditure.
(b) Amount spent on repairs and white-washing for the first time on purchase of old building is a capital
expenditure.
(c) Amount spent in connection with obtaining licence for starting a factory is a capital expenditure.
(d) Amount paid as compensation to the employees is a revenue expenditure.
(e) Custom duty paid on import of machinery for modernisation of factory is a capital expenditure.

Capital and Revenue Receipts

The distinction between capital receipt and revenue receipt is important because capital receipt is taken to the
Balance Sheet and revenue receipt is taken to the Trading and Profit and Loss Account.
Capital receipts are the receipts which are not obtained in course of normal business activities of the enterprise.
The examples of capital receipts are :
1. capital contributed by the owner(s),
2. secured or unsecured loans taken,
3. receipts from sale of fixed assets and non-current investments.

In case of not for profit organisation, legacy and life membership are capital receipts.
Revenue receipts are the receipts which are obtained in course of normal business activities. They include
proceeds from sale of goods, fee received from the services rendered in the ordinary course of business, receipts.

The nature of receipt is decided from the point of view of the person receiving it.
• The following broad principles may be laid down as guide for determining whether a particular
receipt is of capital nature or of revenue nature :
1. A receipt on account of fixed assets is a capital receipt whereas a receipt on account of current assets or
circulating capital is a revenue receipt. For example, sale proceeds from sale of fixed assets is a capital
receipt while proceeds from sale of stock-in-trade is a revenue receipt. Capital profit from sale of fixed
asset is to be shown in Profit and Loss Accounts.
 2. A receipt in substitution of source of income is a capital receipt whereas a receipt in substitution of income
alone is a revenue receipt. For example, compensation for loss of employment or agency is a capital receipt
(though taxable) whereas damages for breach of business contract is a revenue receipt.
3. An amount received for surrender of certain right under an agreement is a capital receipt whereas amount
received by way of compensation of loss of future profits is a revenue receipt. For example, pension is a
revenue receipt whereas lump sum received in commutation of pension is a capital receipt (though
taxable).
4. The nature of a receipt is determined exclusively by its character in the hands of the receiver.
5. Where an asset is held as an investment, the sale proceeds of such asset is a capital receipt. But where an
asset is held as stock-in-trade, the sale proceeds of such asset is a revenue receipt. For example, profit on
sale of shares to a dealer in shares is a revenue receipt.

Distinction between Capital Receipts and Revenue Receipts

1. Capital receipts are not obtained in the course of normal business activities of the enterprise whereas
revenue receipts are obtained in the course of normal business activities.
2. Capital receipts are usually obtained in case of a company from issue of shares, debentures, borrowings
and sale of fixed assets or investments. Revenue receipts are usually obtained from sale of goods,
rendering of services or use of enterprise resources yielding interest, royalties and dividend.
3. Capital receipts are usually of non-recurring nature and revenue receipts are usually of recurring nature.
4. Capital receipts from financing activities such as issue of shares, debentures and borrowings are shown
on the liabilities side of the balance sheet as these receipts create liabilities payable at a future date whereas
interest on borrowings is shown as a charge in the Profit and Loss Account and dividends to shareholders
are shown as appropriation of profit in the appropriation section of Profit and Loss Account. Interest
accrued/outstanding will also be shown as a liability.

Illustration
State with reasons whether the following are capital or revenue receipts :
(a) Introduction of capital by the owner ` 10,00,000.
(b) Amount realised from sale of old machinery ` 50,000 (book value ` 48,000).
(c) Sale of goods for cash ` 10,000.
(d) Cash received from debtors ` 20,000.
(e) Sale of investments for ` 40,000 (book value ` 44,000).
(f) Interest received on investments ` 3,000.

Solution:
(a) Introduction of capital by the owner ` 10,00,000 is a capital receipt as it creates a claim on the business to
repay it.
(b) Amount realised from sale of old machinery : ` 50,000 is a capital receipt. Capital profit on sale of ` 2,000 is
to be shown in Profit and Loss Account.
(c) Sale proceeds from sale of goods ` 10,000 is a revenue receipt as it is a receipt in the course of normal business
activities of the enterprise.
(d) Cash received from debtors ` 20,000 is a revenue receipt as this is in the course of normal business activities
of the enterprise.
(e) Sale proceeds from investments ` 40,000 is a capital receipt and capital loss of ` 4,000 is to charged in the
Profit and Loss Account.
(f) Interest on investments ` 3,000 is a revenue receipt as use of enterprise resources yielding interest is revenue.
 Reserves, Reserve Fund and Provisions
Meaning of Provision:
➢ An amount appropriated from profit to honor probable liabilities which can be identified but the amount
of which can not ascertained accurately.
➢ E.g. Provision for depreciation, provision for bad debt, provision for repairs and renewals, provision for
taxation, provident fund, pension fund, workers profit sharing fund, provision for voluntary retirement
scheme etc.
➢ It is created out of P & L A/c even if there is a loss.

MEANING OF RESERVE:
The amount set apart from the profit, to meet the future contingent loss or expenses in order to strengthen the
financial and liquid position of the business is known as RESERVE.

Reserve is created out of P & L Appropriation A/c.

OBJECTIVES OF RESERVES:
* To meet the further contingent loss or expenses.
* To make the provision for the payment to be made in future.
* To strengthen the financial and liquid position of the business.

Types of Reserves

1 2
Revenue Reserve Capital Reserve

1) General Res. Created out of Capital Profit

Created for
general purpose
from P&L app. a/c
2) Specific Reserve
Created for specific
Purpose out of P & L A/c.
3) Secrete Reserve
Hidden Reserve, not
Shown in P & L A/c.

(A) REVENUE RESERVE: Reserve created out of revenue profit is known as Revenue Reserve. Revenue
Reserve Profit generated out of purchase and sale of goods and other regular activities of business.
Revenue reserves include: (i) General Reserve, (ii) Specific Reserve & (iii) Secrete Reserve.

1) GENERAL RESERVE:
"When the reserve is created not for any specific purpose but to strengthen the financial position of business,
then it is called General Reserve." Thus, such reserve can be utilized for any general purpose of the business.

Following Journal entry is passed for creating General Reserve:

Profit and Loss Appropriation A/c .........Dr
To General Reserve A/c
Purpose or objectives (advantages) of creating general Reserve:

(1) To meet with future contingency. For e.g. : claim by an employee or third party.
(2) To pay known liability. For e.g. : loan of financial institute, payment of debentures, etc.
(3) To strengthen the financial position.
(4) To increase the efficiency of business.
(5) To maintain equality in dividend.
(6) To give bonus shares.

2) SPECIFIC RESERVE:
When the amount of profit is kept aside with specific purpose, then such reserve is called special reserve or
provision. It is debited to P&L a/c It is created even though there is no profit. The provision for accepted
liability is called current liability but reserve created for uncertain amount or the expenses which are not
certain but probable is called provision.

Objectives of creating special reserve or provisions :

(a) To meet with specific purpose. For e.g. : provision for deprecation, repairs and renovations of
assets etc.
(b) To meet with future losses. For e.g. : provision for taxation, provision for graduating.
(c) To give effects of adjustments. For e.g. : Bad debts reserve, Discount reserve on debtors, etc.
Such a reserve can be utilized only for the purpose for which it is created.

Examples of specific reserves:

(i) Dividend equilization fund: The purpose of creating this reserve is to distribute dividend to shareholders
in the year in which the profit is not sufficient or even to maintain dividend in the year of loss.
(ii) Debenture redemption reserve or debenture redemption fund : Debenture is a long term debt For the
company which is to be repaid on expiry of its period. For the purpose of redeeming debentures out of
profit, a specific amount is appropriated from profit every year and transferred to debenture redemption
fund (reserve), and the balance of debenture redemption fund. is transferred to general reserve after
redeeming debentures.
(iii) Investment fluctuation fund: When market value of investments is already reduced or there is possibility
of reduction in the market price, sonic amount is transferred investnient fluctuation fund out of profit. After
sale of investments, a loss amount on this investment deducted from this reserve and balance amount of
investment fluctuation fund is transferred to general reserve.
(iv) Workers accident compensation reserve or workers accident compensation fund: This reserve is created
to compensate workers or employees when they meet with an accident during working hours.
(v) Sinking fund : The reserve which is created out of profit for the purpose of the payment of long term debt
or regular payment of interest or purchase of fixed assets is called as sinking fund. e.g. Depreciation fund
for purchase of fixed asset, debenture redemption reserve for redeeming debentures.

Effect in Balance Sheet : General reserve and specific reserves are shown in the balance sheet the heading of
Reserves and Surplus on liabilities side.

3) SECRETE RESERVE:

The reserve, which is not openly disclosed in the books of accounts, is called secret reserve. An excess
reserve created than the requirement or presenting the assets at lesser value or liabilities at higher value than
its actual value, is known as secrete reserve or hidden reserve. It is also known as hidden profit. Such
reserve is not shown in the balance sheet or in P & L Appro. A/c.
 Purpose of creating secret reserve:
(a) To strengthen the financial position of the business.
(b) To maintain the stable rate of dividend. And
(c) To show less profits.

Secrete Reserve is created as under:

(i) By making more provisions for depreciation
(ii) By undervaluing closing stock
(iii) By making more provision for bad debt and contingencies than required.
(iv) By recording capital expenditure in profit and loss account.
(v) By showing contingent liability as actual liability.
(vi) By showing more expenses than actual.

Generally secret reserve can not he created except certain exceptions.

(B) CAPITAL RESERVE:

The profit, which is not earned from revenue income, is known as capital profit and reserve created from
such capital profit is known as capital reserve. Capital profit cannot be used to distribute dividend.

Capital reserve can be created from the following capital profits:

(a) Profit on sale of fixed assets.
(b) Profit realized by revaluation of any of the fixed assets.
(c) Profit prior to incorporation of a company.
(d) Profit arising on business purchases.
(e) Amount of forfeited shares.
(f) Profit on repayment of debentures.
(g) Premium received at the time of issues of shares or debentures.

Uses of Capital reserve are as follows:

(a) For writing off capital losses
(b) For writing off fictitious assets like preliminary expenses, Discount on shares and debentures
(c) For writing off intangible assets like Goodwill, Trade mark, Patents etc.
(d) Issue of fully paid bonus share, etc.
The amount of capital reserve is shown under the heading 'Reserve and Surplus' on the capital and liability
side of the balance sheet separately form the General Reserve.

State whether the following are reserves or provisions:

1.. Depreciation Fund → Provision
2.. Dividend Equalization fund → Reserve
3.. Bad Debts Reserve → Provision
4.. Workmen’s accident compensation Fund → Reserve
5.. Investment Fluctuation fund → Reserve
6.. Debenture Redemption Fund → Reserve
7.. Provision for Taxation → Provision
8.. Proposed Dividend → Reserve
9.. Discount reserve on debtors → Provision
10.. Capital reserve → Provision
11.. Workers profit sharing fund → Provision
12.. General reserve → Reserve
13..Capital redemption reserve → Reserve
Distinguish between General Reserve and Provision:

1. The reserve which is created for any general The reserve which is created for any specific
purpose of business is called general reserve. purpose is called provision.
2. It is created by debiting Profit and Loss It is created by debiting Profit and Loss A/c.
Appropriation A/c.
3. It can be utilized for giving bonus shares and It can be used strictly only for the purpose for which
declaring dividend. it is created.
4. It can be created only in the year of profit. Provision is to be created even in the year of loss.
5. The amount of General Reserve is uncertain. The amount to be transferred to Provision is certain.
6. General Reserve is shown in final accounts in Provision is shown in final accounts in balance
balance sheet on capital and liability side under the sheet either by deducting form the assets or on
heading of Reserve and Surplus. Liability side under the heading of short term
Provisions under Current liabilities.
7. Reserves can be invested outside the business. Provision can not be invested outside the business.

Difference between General Reserve & Capital Reserve:

Points General Reserve Capital Reserve

1) Created G.R. is created out of Profit & Loss Capital Reserve is created out of capital
out of Appropriation A/c. profit.
2) Use General reserve can be used for any Capital reserve can be used to write off
purpose like to meet any contingent capital loss or to write off intangible and
expenses or losses or for distribution of fictitious assets like goodwill, preliminary
dividend. expenses, discount on issue of shares or
debentures etc.
3) General reserve can be used for Dividend can be paid out of capital reserve
Dividend distribution of dividend. only under specific circumstances subject to
certain conditions.
4) Bonus General reserve can be used for Capital Reserve can be used for distribution
share distribution of bonus shares to share of fully paid bonus shares only if there is
holders. provision in Articles of Association of the
company and that too subject to certain
conditions.
M.C.Q:
1) General reserve is created by debiting _____account.
(a) Profit and loss account (b) Profit and loss appropriation account
(c) Trading account (d) Capital account
2) Provision is created out of ______account.
(a) Profit and loss account (b) Profit and loss appropriation account
(c) Trading account (d) Capital account
3) ______account shows that reserves are invested outside the business.
(a) General reserve (b) Provision (c) Reserve fund (d) Capital reserve
4) _______balance is generally not used for distribution of dividend.
(a) General reserve (b) Provision (c) Reserve fund (d) Capital reserve
5) _______is not advisable to create for business.
(a) General reserve (b) Provision (c) Secret reserve (d) Capital reserve
6) Which reserve is crested to repay the long term debts?
(a) General reserve (b) Sinking Fund (c) Capital reserve (d) Secrete Reserve
7) Due to which reserve balance sheet does not reflect true and fair financial position?
(a) General reserve (b) Sinking Fund (c) Capital reserve (d) Secret reserve
Answer in one sentence:
1) State types of reserves.
➢ There are mainly two types of Reserves: Revenue Reserve & Capital Reserve.

2) What is reserve fund ?

➢ The amount of reserve invested outside the business is known as Reserve Fund.

3) What is secret reserve ?

➢ The reserve created without showing in P & L A/c for the purpose of strengthening financial position of
the business is known as Secret Reserve.

4) Which reserve is used to write off loss on sale of fixed assets ?

➢ Capital Reserve is used to write off loss on sale of fixed assets.

5) Give four illustrations of capital reserve.

Illustration of Capital Reserve:
➢ Profit on sale of fixed assets and investments.
➢ Profit on revaluation of fixed assets.
➢ Premium received by the company on issue of shares or debentures.
➢ Balance of share for forfeiture account after reissue of shares forfeited by the company.
➢ Profit prior to incorporation of the company.
➢ Capital redemption reserve for redeeming preference shares.
➢ Profit on redemption of debentures at discount.

6) Give four illustrations of provision.

Illustration of Provision:
➢ Provision for depreciation,
➢ provision for bad debt,
➢ provision for repairs and renewals,
➢ provision for taxation,
➢ provident fund,
➢ pension fund,
➢ workers profit sharing fund,
➢ provision for voluntary retirement scheme etc.
 ACCOUNTING CONCEPTS
ACCOUNTING PRINCIPLES & CONVENTIONS
The concepts or principals followed in various accounting situation are known as Accounting concepts
principles or conventions. Generally Accepted Accounting Principles (GAAP) refers to the rules or guidelines
adopted for recording and reporting of business transactions, in order to bring uniformity in the preparation and
the presentation of financial statements. Because of concepts, principles & conventions accountancy becomes
discipline. Accounts written by following accounting concepts, principles & conventions are more reliable. The
principles of accounting are not static in nature. These are constantly influenced by changes in the legal, social
and economic environment as well as the needs of the users.

Business Entity Concept:

The concept of business entity assumes that business has a distinct and separate entity from its owners. It
means that for the purposes of accounting, the business and its owners are to be treated as two separate entities.
Keeping this in view, when a person brings in some money as capital into his business, in accounting records, it
is treated as liability of the business to the owner. Similarly, when the owner withdraws any money from the
business for his personal expenses(drawings), it is treated as reduction of the owner’s capital and consequently a
reduction in the liabilities of the business. The accounting records are made in the book of accounts from the
point of view of the business unit and not that of the owner.

Money Measurement Concept:

The concept of money measurement states that only those transactions which can be expressed in terms of
money are to be recorded in the book of accounts. E.g. sale of goods or payment of expenses or receipt of
income, etc. All such transactions or happenings which can not be expressed in monetary terms are not recorded
in the books of accounts. E.g. the appointment of a employee, capabilities of its human resources or creativity of
its research. Similarly Goods or assets are recorded in the books in terms of money, i.e. in Rupees & paisa and
not in terms of kg, quintal, liter, square meter etc.

Going Concern Concept:

The concept of going concern assumes that a business firm would continue to carry out its operations
indefinitely, i.e. for a fairly long period of time and would not be liquidated in the nearest future. That is why
when asset is purchased, its total cost is not considered as revenue expense of the year of purchase, but its cost
is divided into its useful life and only proportionate amount is considered as revenue expense every year. As per
this concept, assets are shown in B/s after depreciation and not at market value, BDR is deducted from Debtors
etc…

Accounting Period Concept:

Life span of business is divided in to small parts, i.e. one year. Accounting period refers to the span of time at
the end of which the financial statements of an enterprise are prepared, to know profits or losses and to know
the position of its assets and liabilities at the end of that period. The financial statements are prepared at regular
interval, normally after a period of one year, so that timely information is made available to the users. This
interval of time is called accounting period. It is also compulsory to prepare annual accounts at the end of each
financial year.

Cost Concept:
The cost concept requires that all assets are recorded in the book of accounts at their purchase price, which
includes cost of acquisition, transportation, installation and making the asset ready to use.
Dual Aspect Concept:
Dual aspect is the foundation or basic principle of accounting. It provides the very basis for recording business
transactions into the book of accounts. This concept states that every transaction has a dual or two-fold effect.
The duality principle is commonly expressed in terms of fundamental Accounting Equation, which is as
follows:
Assets = Liabilities + Capital
In other words, the equation states that the assets of a business are always equal to the claims of owners and the
outsiders. The claims also called equity of owners is termed as Capital (owners’ equity) and that of outsiders, as
Liabilities (creditor’s equity). The two-fold effect of each transaction affects in such a manner that the equality
of both sides of equation is maintained.

Revenue Recognition (Realisation) Concept:

The concept of revenue recognition requires that the revenue for a business transaction should be included in
the accounting records only when it is realised. In case of goods & services, revenue is recorded when goods are
delivered or services are rendered even if cash is not received. Some incomes like rent, interest etc are based on
time & recorded as revenue as per time. E.g. rent of March, 2020 received in April 2020, but recorded as
revenue in the year 2019-20.

Matching Concept:
The matching concept states that expenses incurred in an accounting period should be matched with revenues
during that period. It follows from this that the revenue and expenses incurred to earn these revenues must
belong to the same accounting period. An expense is recognised not when cash is paid but when an asset or
service has been used to generate revenue. For example, expenses such as salaries, rent, insurance are
recognised on the basis of period to which they relate and not when these are paid. Similarly, costs like
depreciation of fixed asset is divided over the periods during which the asset is used.

Full Disclosure Concept:

Information provided by financial statements are used by different groups of people such as investors, lenders,
suppliers and others in taking various financial decisions. According to this principle, all material information
of business should be disclosed in the financial statement. Hence a foot note is shown below liability side in B/s
for contingent liability & market value of investment is shown in bracket in B/s & Joint life policy is shown at
its surrender value.

Consistency Concept:
According to this principle, consistency should be maintained in writing the accounts. That is why method of
stock valuation or method of depreciation should not be changed frequently. The concept of consistency is
followed in preparation of financial statements so that the results of two accounting periods are comparable.
Consistency eliminates personal bias and helps in achieving results that are comparable.

Conservatism Concept (Prudence):

The concept states that a conscious approach should be adopted in ascertaining income so that profits of the
enterprise are not overstated. The concept of conservatism requires that profits should not to be recorded until
realised but all losses, even those which may have a remote possibility, are to be provided for in the books of
account. As per this concept, reserves are provided for future contingent expenses & losses. E.g. valuing closing
stock at cost or market value whichever is lower; creating provision for doubtful debts, discount on debtors;
writing of intangible assets like goodwill, patents,etc. from the book of accounts are some of the examples of
the application of the principle of conservatism.
Materiality Concept:
Only transactions having material importance are shown in financial statements. Non-material information are
not shown in accounts. Thus, separate account for pencil, eraser etc are not opened but they are included in
“Stationery” A/c. If any expense exceeds 1 % of total sales value, then a separate account is opened for such
expense. Purchase of dust bin of ` 10 is recorded as expense & not as Asset.
Any fact would be considered as material if it is reasonably believed that its knowledge would influence the
decision of informed user of financial statements. For example, money spent on creation of additional capacity
of a theatre would be a material fact as it is going to increase the future earning capacity of the enterprise.

Objectivity Concept:
The concept of objectivity requires that accounting transaction should be recorded only with the help of
documentary proof (voucher) & free from the bias of accountants and others.

1) ____concept suggests that method of valuation of stock should not be changed year after year.
(a) Materiality (b) Cost (c) Consistency (d) Dual Aspect
2) Fixed assets are depreciated based on the Principle of _____.
(a) Materiality (b) Money Measurement (c) Accounting Entity (d) Going Concern
3) Based on Concept ____ provision for outstanding salary for the month of March is made in the month
of March while finalising the accounts even though the salary for that month is actually paid in April
next.
(a) Accrual (b) Cost (c) Money Measurement (d) Dual Aspect
4) Based on _____Concept, amount paid for personal travelling expenses of proprietor from the firm is
debited by firm to the drawings account of proprietor.
(a) Materiality (b) Accounting Entity (c) Periodicitv (d) Dual Aspect
5) Based on ____Concept, no accounting entry is made in the books of accounts for advantage of having a
team of sincere, honest, hardworking and efficient employees with the firm.
(a) Materiality (b) Full Disclosure (c) Money Measurement (d) Dual Aspect
6) Based on _____Concept, Profit and Loss Account and Balance Sheet are prepared at thc end of each
accounting period.
(a ) Materiality (b) Cost (c) Money Measurement (d) Periodicity
7) Whenever there is change in method of providing depreciation, the impact of such change on the profit
or loss and in the value of asset should be disclosed in financial statements based on ____Concept.
(a) Full Disclosure (b) Cost (c) Going Concern (d) Dual Aspect
8) Instead of preparing separate accounts for items like pen, erasers, rough writing pads, pencil and other
stationery items, they are all grouped tinder one Stationery Expense Account based on ___ Concept.
(a) Dual Aspect (b) Materiality (c) Consistency (d) Accounting Entity
9) Based on ____Concept, provision may be made liw contingent liabilities in books & account but not for
contingent assets.
(a) Materiality (b) Cost (c) Dual Aspect (d) Prudence or Conservatism
10) Krupa Corporation entered into agreement on 01-06-2016 for purchase of a Factory Building for 5 crores
from Anil Enterprise. Actual payment of 5 crores was made and deed for this transaction was executed
on 15-06-201 6 when the market value of this factory building had gone up to 6 crores. Even though the
value has increased to 6 crores, ths transaction will have to be recorded only at 5 crores in the books of
accounts based on ____ Concept.
(a) Materiality (b) Dual Aspect (c) Consistency (d) Cost
11) Fundamental Accounting equation or Balance Sheet equation i.e. Assets = Liabilities + Cap is based on_
(a) Materiality (b) Cost (c) Dual Aspect (d) Consistency

12) The reason for valuing work in process on the basis of the cost incurred thereon is ____ Concept.
(a) Materiality (b) Going Concern (c) Full disclosure (d) Accounting Entity
Name the concept:
1) Revenue expenses paid in advance are shown on the asset side of balance sheet. – Going concern.
2) Semi finished goods or work-in-progress is valued at cost incurred thereon and not at their realisable
value. – Going concern
3) Financial statements arc prepared at the end of accounting period. – Periodicity.
4) If depreciation is provided by straight line method in a year, the same method should be followed
consistently every year. – Consistency.
5) Frequent changes in the methods of depreciation or stock valuation should be avoided. – Consistency.
6) When goods are purchased on credit from a supplier, the Purchase should be recorded in accounts
immediately, even though cash is not yet paid for such purchase as the amount becomes payable once
the goods are purchased. – Accrual Concept.
7) When partner of a partnership firm withdraws any amount from the firm, the partnership firm will debit
this amount to partner’s drawings account. – Entity.
8) No accounting entry is recorded for death of a key employee of the firm even if it is an important event
affecting business. – Money measurement.
9) In absence of any contrary information, life of the business is assumed to be indefinite or for a very- long
period and hence such life is divided into convenient accounting periods to ascertain performance and
position of entity at the end of each such accounting period. - Periodicity.
10) Any item of income or expenditure which does not exceed one percent of the revenue from operations
or 1,00,000 whichever is higher is not required to be shown separately in Statement of Profit and Loss
of a company, unless specifically required otherwise. – Materiality.
11) Information about the change in method of stock or inventory valuation and its impact should be
disclosed in financial statements. – Full Disclosure.
12) Information about the change in method of providing depreciation and its impact should be disclosed in
financial statements. - Full Disclosure.
13) Provision for discount reserve on debtors is made in the accounts but Provision for discount reserve on
creditors is not usually made in the accounts. – Prudence / Conservatism.
14) Provision for loss of theft of uninsured machinery will be made in the books of accounts soon after the
theft even if there is possibility of recovery of this machinery if police catches the thief. - Prudence /
Conservatism.
15) Trial balance gets tallies. – Duality concept.
16) Independent branch prepares its own trial balance separately. – Entity.
17) Capital is shown on liability side in B/s. – Entity.

SUMMARY
1.. Dual aspect: At least two effects are there in each transaction Dr. & Cr. Therefore Trial Balance gets tallied
& B/s gets tallied.
2.. Entity: The business unit is different from the owner. Therefore capital and drawings a/c. are opened
for the owner.
3.. Objectivity: Each transaction should have documentary proof and a/c prepared must be free from prejudice.
4.. Prudence: A provision on reserve is created for future probable loss, but future profit is not considered &
closing stock is recorded at book value or market price whichever is less. BDR and Discount
reserve is provided on Debtors.
5.. Accounting period: The life of business is divided into time intervals generally of one year. Therefore
accounts are prepared at the end of one year.
6.. Accrual / Revenue recognition: At what time revenue income should be recorded is cleared by this concept.
7.. Matching: Total revenue income and revenue expenses are matched to find profit or loss.
8.. Going concern: The business firm is going to be continued and is not to be closed in near future. Therefore
Fixed assets are shown in B/s at cost less depreciation & not at market value.
9.. Full Disclosure: All information should be disclosed in accounts. Therefore contingent liability though not
actually arises are shown as foot note in B/s.
10.. Money measurement: Non-monetary transactions are not recorded in the books.
11.. Consistency: Method of valuation of stock or depreciation should not be changed every year.
12.. Materiality: Only material information are presented in books. Pencil is recorded as stationery and not as
Pencil A/c & purchase of dust bin is recorded as expense and not as asset.

Money Measurement: According to this concept, only those transactions which can be measured in terms of
money are recorded in the books of accounts. Therefore if any efficient manager retires, it will have the great
impact on the business even though it is not recorded in the books of accounts.

Timeliness: According to this principle, accounting information should be disclosed monthly, quarterly or half
yearly to enable investors, management & other parties to take correct decisions.

Substance Over Form: According to this principle, accounts should be prepared as per legal requirements.
E.g. company’s accounts are prepared as per requirements of Schedule VI of Company’s Act, 1956.

ACCOUNTING STANDARDS
Meaning of Accounting Standards and
➢ Accounting standards are written statements of uniform accounting rules and guidelines issued by the
accounting bodies (like ICAI or 1ASR) to be followed while preparing and presenting the financial
statements. The rules, policies or guidelines stated by Accounting Standards are usually for
measurement, valuation and disclosure of accounting information in the financial statements.
➢ According to Kohlar, Accounting Standards are a Code of Conduct imposed on accountants by custom,
law and a professional body.
➢ Accounting standards are not rigid. They also permit adoption of a particular practice out of various
options available.
➢ Accounting standards are prepared keeping in view the business environment and laws of the country.
Therefore, when business environment or law change, the accounting standards are revised.

Objective and utility of accounting standards.

Objectives and Uses of Accounting Standards:
➢ The objective of setting accounting standards is to bring uniformity in accounting policies and practices
and to ensure transparency, consistency and comparability.
➢ It is also an objective of accounting standard to allow flexibility of adopting a particular practice or
method with suitable disclosure to entities out of various acceptable accounting methods or practices
available.
➢ Accounting standards have objective to enhance the reliability of financial statements among their users.
➢ Accounting standards provide rides and guiding principles for preparation and presentation financial
statements.
➢ When financial statements are prepared in compliance with accounting standards and auditors have
certified such compliance, it enhances the reliability of financial statements.
Very short questions
(1) In which year International Accounting Standards Committee (IASC) was established ?
➢ International Accounting Standards Committee (IASC) was established in 1973.
(2) In which year ASB was set up by 1CAI?
➢ ASB (Accounting Standard Board) was setup by ICAI on 21st April, 1977.
(3) For what purpose ASB was set up?
➢ ASB was setup to formulate accounting standards.