MODULE 1: INTRODUCTION TO ACCOUNTING

ORIGIN AND GROWTH OF ACCOUNTING

Accounting is as old as money itself. However, the act of accounting was not as developed as it is
today because in the early stages of civilization, the number of transactions to be recorded were so
small that each businessman was able to record and check for himself all his transactions.
Accounting was practiced in India twenty-three centuries ago as is clear from the book named
"Arthashastra" written by Kautilya, King Chandragupta's minister. This book not only relates to
politics and economics, but also explain the art of proper keeping of accounts.
However, the modern system of accounting based on the principles of double entry system owes
it origin to Luco Pacioli who first published the principles of Double Entry System in 1494 at
Venice in Italy. Thus, the art of accounting has been practiced for centuries but it is only in the late
thirties that the study of the subject 'accounting' has been taken up seriously.

MEANING OF ACCOUNTING
The main purpose of accounting is to ascertain profit or loss during a specified period, to show
financial condition of the business on a particular date and to have control over the firm's property.
Such accounting records are required to be maintained to measure the income of the business and
communicate the information so that it may be used by managers, owners and other interested
parties. Accounting is a discipline which records, classifies, summarizes and interprets financial
information about the activities of a concern so that intelligent decisions can be made about the
concern. The American Institute of Certified Public Accountants has defined the Financial
Accounting as "the art of recording, classifying and summarizing in as significant manner and in
terms of money transactions and events which in part, at least of a financial character, and
interpreting the results thereof". American Accounting Association defines accounting as "the
process of identifying, measuring, and communicating economic information to permit informed
judgments and decisions by users of the information.

From the above the following attributes of accounting emerge:

(i) Recording: It is concerned with the recording of financial transactions in an orderly manner,
soon after their occurrence in the proper books of accounts.
(ii) Classifying: It Is concerned with the systematic analysis of the recorded data so as to
accumulate the transactions of similar type at one place. This function is performed by maintaining
the ledger in which different accounts are opened to which related transactions are posted.
(iii) Summarizing: It is concerned with the preparation and presentation of the classified data in
a manner useful to the users. This function involves the preparation of financial statements such
as Income Statement, Balance Sheet, Statement of Changes in Financial Position, Statement of
Cash Flow, Statement of Value Added.
(iv) Interpreting: Nowadays, the aforesaid three functions are performed by electronic data
processing devices and the accountant has to concentrate mainly on the interpretation aspects of
accounting. The accountants should interpret the statements in a manner useful to action. The
accountant should explain not only what has happened but also (a) why it happened, and (b) what
is likely to happen under specified conditions.

OBJECTIVES OF ACCOUNTING
1. To keep systematic records: Accounting is done to keep a systematic record of financial
transactions. In the absence of accounting there would have been terrific burden on human memory
which in most cases would have been impossible to bear.
2. To protect business properties: Accounting provides protection to business properties from
unjustified and unwarranted use. This is possible on account of accounting supplying the following
information to the manager or the proprietor:
(i) The amount of the proprietor's funds invested in the business.
(ii) How much the business has to pay to others?
(iii) How much the business has to recover from others?
(iv) How much the business has in the form of (a) fixed assets, (b) cash in hand, (c) cash at bank,
(d) stock of raw materials, work-in-progress and finished goods?
Information about the above matters helps the proprietor in assuring that the funds of the business
are not necessarily kept idle or under-utilized.
3. To ascertain the operational profit or loss: Accounting helps in ascertaining the net profit
earned or loss suffered on account of carrying the business. This is done by keeping a proper record
of revenues and expense of a particular period. The Profit and Loss Account is prepared at the end
of a period and if the amount of revenue for the period is more than the expenditure incurred in
earning that revenue, there is said to be a profit. In case the expenditure exceeds the revenue, there
is said to be a loss. Profit and Loss Account will help the management, investors, creditors, etc. in
knowing whether the business has proved to be remunerative or not. In case it has not proved to
be remunerative or profitable, the cause of such a state of affairs will be investigated and necessary
remedial steps will be taken.
4. To ascertain the financial position of the business: The Profit and Loss Account gives the
amount of profit or loss made by the business during a particular period. However, it is not enough.
The businessman must know about his financial position i.e. where he stands?, what he owes and
what he owns? This objective is served by the Balance Sheet or Position Statement. The Balance
Sheet is a statement of assets and liabilities of the business on a particular date. It serves as
barometer for ascertaining the financial health of the business.
5. To facilitate rational decision making: Accounting these days has taken upon itself the task of
collection, analysis and reporting of information at the required points of time to the required levels
of authority in order to facilitate rational decision-making. The American Accounting Association
has also stressed this point while defining the term accounting when it says that accounting is the
process of identifying, measuring and communicating economic information to permit informed
judgements and decisions by users of the information. Of course, this is by no means an easy task.
However, the accounting bodies all over the world and particularly the International Accounting
Standards Committee, have been trying to grapple with this problem and have achieved success in
laying down some basic postulates on the basis of which the accounting statements have to be
prepared.
6. Information System: Accounting functions as an information system for collecting and
communicating economic information about the business enterprise. This information helps the
management in taking appropriate decisions. This function, as stated, is gaining tremendous
importance these days.

ROLE AND IMPORTANCE OF ACCOUNTING

Accounting plays an important and useful role by developing the information for providing
answers to many questions faced by the users of accounting information:
(1) How good or bad is the financial condition of the business?
(2) Has the business activity resulted in a profit or loss?
(3) How well the different departments of the business have performed in the past?
(4) Which activities or products have been profitable?
(5) Out of the existing products which should be discontinued and the production
of which commodities should be increased?
(6) Whether to buy a component from the market or to manufacture the same?
(7) Whether the cost of production is reasonable or excessive?
(8) What has been the impact of existing policies on the profitability of the business?
(9) What are the likely results of new policy decisions on future earning capacity of the business?
(10) In the light of past performance of the business how should it plan for future to ensure desired
results?

Above mentioned are few examples of the types of questions faced by the users of accounting
information. These can be satisfactorily answered with the help of suitable and necessary
information provided by accounting.
Besides, accounting is also useful in the following respects:
a. Increased volume of business results in large number of transactions and no businessman can
remember everything. Accounting records obviate the necessity of remembering various
transactions.
b. Accounting records, prepared on the basis of uniform practices, will enable a business to
compare results of one period with another period.
c. Taxation authorities (both income tax and sales tax) are likely to believe the facts contained in
the set of accounting books if maintained according to generally accepted accounting principles.
d. Accounting records, backed up by proper and authenticated vouchers, are good evidence in a
court of law.
e. If a business is to be sold as a going concern, then the values of different assets as shown by the
balance sheet helps in bargaining proper price for the business.

MEANING AND FEATURES OF ACCOUNTING PRINCIPLES

For searching the goals of the accounting profession and for expanding knowledge in this field, a
logical and useful set of principles and procedures are to be developed. We know that while driving
our vehicles, follow a standard traffic rules. Without adhering traffic rules, there would be much
chaos on the road. Similarly, some principles apply to accounting.
Thus, the accounting profession cannot reach its goals in the absence of a set rules to guide the
efforts of accountants and auditors. The rules and principles of accounting are commonly referred
to as the conceptual framework of accounting.
Accounting principles have been defined by the Canadian Institute of Chartered Accountants as
“The body of doctrines commonly associated with the theory and procedure of accounting serving
as an explanation of current practices and as a guide for the selection of conventions or procedures
where alternatives exist. Rules governing the formation of accounting axioms and the principles
derived from them have arisen from common experience, historical precedent statements by
individuals and professional bodies and regulations of Governmental agencies”. According to
Hendriksen (1997), Accounting theory may be defined as logical reasoning in the form of a set of
broad principles that (i) provide a general frame of reference by which accounting practice can be
evaluated, and (ii) guide the development of new practices and procedures. Theory may also be
used to explain existing practices to obtain a better understanding of them. But the most important
goal of accounting theory should be to provide a coherent set of logical principles that form the
general frame of reference for the evaluation and development of sound accounting practices.
The American Institute of Certified Public Accountants (AICPA) has advocated the use of the
word” Principle” in the sense in which it means “rule of action”. It discuses the generally accepted
accounting principles as follows:
Financial statements are the product of a process in which a large volume of data about aspects of
the economic activities of an enterprise are accumulated, analysed and reported. This process
should be carried out in conformity with generally accepted accounting principles. These
principles represent the most current consensus about how accounting information should be
recorded, what information should be disclosed, how it
should be disclosed, and which financial statement should be prepared. Thus, generally accepted
principles and standards provide a common financial language to enable informed users to read
and interpret financial statements.
Generally accepted accounting principles encompass the conventions, rules and procedures
necessary to define accepted accounting practice at a particular time....... generally accepted
accounting principles include not only broad guidelines of general application, but also detailed
practices and procedures.
According to ‘Dictionary of Accounting’ prepared by Prof. P.N. Abroal, “Accounting standards
refer to accounting rules and procedures which are relating to measurement, valuation and
disclosure prepared by such bodies as the Accounting Standards Committee (ASC) of a particular
country”. Thus, we may define Accounting Principles as those rules of action or conduct which
are adopted by the accountants universally while recording accounting transactions. Accounting
principles are man-made. They are accepted because they are believed to be useful. The general
acceptance of an accounting principle usually depends on how well it meets the following three
basic norms:
a) Usefulness b) Objectiveness, and c) Feasibility
ACCOUNTING SUB-DIVISION
In order to understand the subject matter with clarity, let us study some of the definitions which
depict the scope, content and purpose of accounting. The field of accounting is generally sub-
divided into:
(a) Book-keeping
The most common definition of book-keeping as given by J. R. Batliboi is “Book-keeping is an
art of recording business transactions in a set of books.” As can be seen, it is basically a record
keeping function. One must understand that not all dealings are, however, recorded. Only
transactions expressed in terms of money will find place in books of accounts. These are the
transactions which will ultimately result in transfer of economic value from one person to the other.
Book-keeping is a continuous activity, the records being maintained as transactions are entered
into. This being a routine and repetitive work, in today’s world, it is taken over by the computer
systems. Many accounting packages are available to suit different business organizations. It is also
referred to as a set of primary records. These records form the basis for accounting. It is an art
because, the record is to be kept in such a manner that it will facilitate further processing and
reporting of financial information which will be useful to all stakeholders of the business.

(b) Financial Accounting

It is commonly termed as Accounting. The American Institute of Certified Public Accountants
defines Accounting as “an art of recoding, classifying and summarizing in a significant manner
and in terms of money, transactions and events which are in part at least of a financial character,
and interpreting the results thereof.” The first step in the cycle of accounting is to identify
transactions that will find place in books of accounts. Transactions having financial impact only
are to be recorded. E.g. if a businessman negotiates with the customer regarding supply of
products, this will not be recorded. The negotiation is a deal which will potentially create a
transaction and will have exchange of money or money’s worth. But unless this transaction is
finally entered into, it will not be recorded in the books of accounts. Secondly, the recording of the
business transactions is done based on the Golden Rules of accounting (which are explained later)
in a systematic manner. Transaction of similar nature are grouped together and recorded
accordingly. e.g. Sales Transactions, Purchase Transactions, Cash Transactions etc. One has to
interpret the transaction and then apply the relevant Golden Rule to make a correct entry thereof.
Thirdly, as the transactions increase in number, it will be difficult to understand the combined
effect of the same by referring to individual records. Hence, the art of accounting also involves the
step of summarizing them. With the aid of computers, this task is simplified in today’s accounting
world. The summarization will help users of the business information to understand and interpret
business results. Lastly, the accounting process provides the users with statements which will
describe what has happened to the business. Remember the two basic questions we talked about,
one to know whether business has made profit or loss and the other to know the position of
resources that are used by the business. It can be noted that although accounting is often referred
to as an art, it is a science also. This is because it is based on universally applicable set of rules.
However, it is not a pure science as there is a possibility of different interpretation.

(c) Cost Accounting

According to the Chartered Institute of Management Accountants (CIMA), Cost Accountancy is
defined as “application of costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control and the ascertainment of profitability as well as the
presentation of information for the purpose of managerial decision-making.” It is a branch of
accounting dealing with the classification, recording, allocation, summarization and reporting of
current and prospective costs and analyzing their behaviours. Cost Accounting is frequently used
to facilitate internal decision making and provides tools with which management can appraise
performance and control costs of doing business. It primarily involves relating the costs to the
different products produced and sold or services rendered by the business. While Financial
Accounting deals with business transactions at a broader level, Cost Accounting aims at further
breaking it up to the last possible level to indentify costs with products and services. It uses the
same Financial Accounting documents and records. Modern computerized accounting packages
like ERP systems provide for processing Financial as well as Cost Accounting records
simultaneously. This branch of accounting deals with the process of ascertainment of costs. The
concept of cost is always applied with reference to a context. Knowledge of cost concepts and their
application provide a very sound platform for decision making. Cost Accounting aims at equipping
management with information that can be used for control on business activities.

(d) Management Accounting

Management Accounting is concerned with the use of Financial and Cost Accounting information
to managers within organizations, to provide them with the basis in making informed business
decisions that would allow them to be better equipped in their management and control functions.
Unlike Financial Accounting information (which, for public companies, is public information),
Management Accounting information is used within an organization (typically for decision-
making) and is usually confidential and its access available only to a selected few. According to
the Chartered Institute of Management Accountants (CIMA), Management Accounting is “the
process of identification, measurement, accumulation, analysis, preparation, interpretation and
communication of information used by management to plan, evaluate and control within an entity
and to assure appropriate use of and accountability for its resources. Management Accounting also
comprises the preparation of financial reports for non-management groups such as shareholders,
creditors, regulatory authorities and tax authorities” Basically, Management Accounting aims to
facilitate management in formulating strategies, planning and constructing business activities,
making decisions, optimal use of resources, and safeguarding assets of business.
These branches of accounting have evolved over years of research and are basically synchronized
with the requirements of business organizations and all entities associated with them.

BASIS OF ACCOUNTING
There are mainly three basis or methods of accounting in common usage, namely
(i) Cash basis:
Under the cash basis of accounting, actual cash receipts and actual cash payments are recorded. In
this basis, revenue is recognised when cash is received and expenses are recognised when cash is
paid. e.g. (i) Any income received, (ii) Any expense paid. Such a method of accounting is usually
followed by professionals such as Doctors, Lawyers, Chartered Accountant (CA) and Not for Profit
Organisations.
(ii) Accrual or Mercantile basis:
Under accrual basis of accounting, the revenue whether received or not, but has been earned or
accrued during the accounting period and expenses incurred whether paid or not are recorded. In
other words, revenue is recognised when it is earned or accrued and expenses are recognised when
these are incurred. e.g. (i) Any income earned whether received or not, (ii) Any expense incurred
whether paid or not.
(iii) Mixed or Hybrid basis:
It is a combination of cash basis and accrual basis of accounting. Under mixed basis of accounting,
both cash basis and accrual basis are followed. Revenues and assets are generally recorded on cash
basis whereas expenses are generally taken on accrual basis. The laws in India prohibits the use of
this method.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

A widely accepted set of rules, conventions, standards, and procedures for reporting financial
information, as established by the Financial Accounting Standards Board are called Generally
Accepted Accounting Principles (GAAP). These are the common set of accounting principles,
standards and procedures that companies use to compile their financial statements. GAAP are a
combination of standards (set by policy boards) and simply the commonly accepted ways of
recording and reporting accounting information. GAAP is to be followed by companies so that
investors have a optimum level of consistency in the financial statements they use when analyzing
companies for investment purposes. GAAP cover such aspects like revenue recognition, balance
sheet item classification and outstanding share measurements.
ACCOUNTING CONCEPTS AND CONVENTIONS
As seen earlier, the accounting information is published in the form of financial statements. The
three basic financial statements are
(i) The Profit & Loss Account that shows net business result i.e. profit or loss for a certain periods
(ii) The Balance Sheet that exhibits the financial strength of the business as on a particular date
(iii) The Cash Flow Statement that describes the movement of cash from one date to the other.
As these statements are meant to be used by different stakeholders, it is necessary that the
information contained therein is based on definite principles, concrete concepts and well accepted
convention.
Accounting principles are basic guidelines that provide standards for scientific accounting
practices and procedures. They guide as to how the transactions are to be recorded and reported.
They assure uniformity and understandability. Accounting concepts lay down the foundation for
accounting principles. They are ideas essentially at mental level and are self-evident. These
concepts ensure recording of financial facts on sound bases and logical considerations. Accounting
conventions are methods or procedures that are widely accepted. When transactions are recorded
or interpreted, they follow the conventions. Many times, however, the terms-principles, concepts
and conventions are used interchangeably.
Professional Accounting Bodies have published statements of these concepts. Over years, many of
these concepts are being challenged as outlived. Yet, no major deviations have been made as yet.
Path breaking ideas have emerged and the accounting standards of modern days do require
companies to record and report transactions which may not be necessarily based on concepts that
are in vogue for long. It is essential to study accounting from the basic levels and understand these
concepts in entirety.

ACCOUNTING CONCEPTS
1. Business Entity
As per this concept, the business is treated as distinct and separate from the individuals who own
or manage it. When recording business transactions, the important question is how will it affect
the business entity? How they affect the persons who own it or run it or otherwise associated with
it is irrelevant. Application of this concept enables recording of transactions of the business entity
with its owners or managers or other stakeholders. For example, if the owner pays his personal
expenses from business cash, this transaction can be recorded in the books of business entity. This
transaction will take the cash out of business and also reduce the obligation of the business towards
the owner.
At times it is difficult to separate owners from the business. Consider an individual, who runs a
small retail outlet. In the eyes of law, there is no distinction made between financial affairs of the
outlet with that of the individual. The creditors of the retail outlet can sue the individual and collect
his claim from personal resources of the individual. However, in accounting, the records are kept
as distinct for the retail outlet and the individual respectively. For certain forms of business entities,
such as limited companies this distinction is easier. The limited companies are separate legal
persons in the eyes of law as well.
The entity concept requires that all the transactions are to be viewed, interpreted and recorded from
‘business entity’ point of view. An accountant steps into the shoes of the business entity and decides
to account for the transactions. The owner’s capital is the obligation of business and it has to be
paid back to the owner in the event of business closure. Also, the profit earned by the business will
belong to the owner and hence is treated as owner’s equity.

2. Going Concern
The basic principles of this concept are that business is assumed to exist for an indefinite period
and is not established with the objective of closing it down. So, unless there is good evidence to
the contrary, the accountant assumes that a business entity is a ‘going concern’ - that it will continue
to operate as usual for a longer period of time. It will keep getting money from its customers, pay
its creditors, buy and sell goods, use assets to earn profits in future. If this assumption is not
considered, one will have to constantly value the worth of the assets and resource. This is not
practicable. This concept enables the accountant to carry forward the values of assets and liabilities
from one accounting period to the other without asking the question about usefulness and worth
of the assets and recoverability of the receivables. Focus on foreseeable future. The going concern
concept forms a sound basis for preparation of a Balance Sheet.

3. Money Measurement
A business transaction will always be recoded if it can be expressed in terms of money. The
advantage of this concept is that different types of transactions could be recorded as homogenous
entries with money as common denominator. A business may own ` 3 Lacs cash, 1500 kg of raw
material, 10 vehicles, 3 computers etc. Unless each of these is expressed in terms of money, we
cannot find out the assets owned by the business. When expressed in the common measure of
money, transactions could be added or subtracted to find out the combined effect. In the above
example, we could add values of different assets to find the total assets owned.
The application of this concept has a limitation. When transactions are recorded in terms of money,
we only consider the absolute value of the money. The real value of the money may fluctuate from
time to time due to inflation, exchange rate changes, etc. This fact is not considered when recording
the transaction.

4. Periodicity / The Accounting Period Concept

We have seen that as per the going-concern concept the business entity is assumed to have an
indefinite life. Now if we were to assess whether the business has made profit or loss, should we
wait until this indefinite period is over? Would it mean that we will not be able to assess the
business performance on an ongoing basis? Does it deprive all stakeholders the right to the
accounting information? Would it mean that the business will not pay income tax as no income
will be computed?
To circumvent this problem, the business entity is supposed to be paused after a certain time
interval. This time interval is called an accounting period. This period is usually one year, which
could be a calendar year i.e. 1st January to 31st December or it could be a fiscal year in India as
1st April to 31st March. The business organizations have the freedom to choose their own
accounting year. For certain organizations, reporting of financial information in public domain are
compulsory. In India, listed companies must report their quarterly unaudited financial results and
yearly audited financial statements. For internal control purpose, many organizations prepare
monthly financial statements. The modern computerized accounting systems enable the companies
to prepare real-time online financials at the click of button.
Businesses are living, continuous organisms. The splitting of the continuous stream of business
events into time periods is thus somewhat arbitrary. There is no significant change just because
one accounting period ends and a new one begins. This results into the most difficult problem of
accounting of how to measure the net income for an accounting period. One has to be careful in
recognizing revenue and expenses for a particular accounting period. Subsequent section on
accounting procedures will explain how one goes about it in practice.

5. Accrual
The accrual concept is based on recognition of both cash and credit transactions. In case of a cash
transaction, owner’s equity is instantly affected as cash either is received or paid. In a credit
transaction, however, a mere obligation towards or by the business is created. When credit
transactions exist (which is generally the case), revenues are not the same as cash receipts and
expenses are not same as cash paid during the period.
When goods are sold on credit as per normally accepted trade practices, the business gets the legal
right to claim the money from the customer. Acquiring such right to claim the consideration for
sale of goods or services is called accrual of revenue. The actual collection of money from
customer could be at a later date.
Similarly, when the business procures goods or services with the agreement that the payment will
be made at a future date, it does not mean that the expense effect should not be recognized. Because
an obligation to pay for goods or services is created upon the procurement thereof, the expense
effect also must be recognized. Today’s accounting systems based on accrual concept are called as
Accrual System or Mercantile System of Accounting.
6. Matching
As we have seen the sale of goods has two effects: (i) a revenue effect, which results in increase
in owner’s equity by the sales value of the transaction and (ii) an expense effect, which reduces
owner’s equity by the cost of goods sold, as the goods go out of the business. The net effect of
these two effects will reflect either profit or loss. In order to correctly arrive at the net result, both
these aspects must be recognized during the same accounting period. One cannot recognize only
the revenue effect thereby inflating the profit or only the expense effect which will deflate the
profit. Both the effects must be recognized in the same accounting period. This is the principle of
matching concept. To generalize, when a given event has two effects – one on revenue and the
other on expense, both must be recognized in the same accounting period.

7. Realisation
While the conservatism concept states whether or not revenue should be recognized, the concept
of realisation talks about what revenue should be recognized. It says amount should be recognized
only to the tune of which it is certainly realizable. Thus, mere getting an order from the customer
won’t make it eligible to recognize as revenue. The reasonable certainty of realizing the money
will come only when the goods ordered are actually supplied to the customer and he is billed. This
concept ensures that income unearned or unrealized will not be considered as revenue and the
firms will not inflate profits.

8. Historical Cost
Business transactions are always recorded at the actual cost at which they are actually undertaken.
The basic advantage is that it avoids an arbitrary value being attached to the transactions.
Whenever an asset is bought, it is recorded at its actual cost and the same is used as the basis for
all subsequent accounting purposes such as charging depreciation on the use of asset, e.g. if a
production equipment is bought for ` 1.50 crores, the asset will be shown at the same value in all
future periods when disclosing the original cost. It will obviously be reduced by the amount of
depreciation, which will be calculated with reference to the actual cost. The actual value of the
equipment may rise or fall subsequent to the purchase, but that is considered irrelevant for
accounting purpose as per the historical cost concept.
The limitation of this concept is that the Balance Sheet does not show the market value of the
assets owned by the business and accordingly the owner’s equity will not reflect the real value.
However, on an ongoing basis, the assets are shown at their historical costs as reduced by
depreciation.

9. Fair Value
Fair Value refers to the actual value of an asset, a product, stock, or security that is agreed upon by
both the seller and the buyer. Fair Value is applicable to a product that is sold or traded in the
market under normal conditions. It is a value that is fair to the buyer without making the seller to
suffer. Fair Value is at times considered as the market value of the given product under normal
conditions. It is in contradiction with Historical Cost Accounting of Fixed Assets.
Under Fair Value Concept, Fixed Assets are expected to be recorded at its 'Fair Values'. Whereas
under Historical Cost Concept, Fixed Assets are expected to be recorded on the basis of its books
value arrived at on the basis of historical cost of the asset paid for at the time of acquisition of the
said asset. Though Fair Value appears to a 'Fair' method of accounting of Fixed Assets in the books
of accounts of the business, we as a conventional practice still continue to record and account for
Fixed Assets in the books of the business on the basis of Historical Cost Concept.

10. Dual Aspect

The assets represent economic resources of the business, whereas the claims of various parties on
business are called obligations. The obligations could be towards owners (called as owner’s equity)
and towards parties other than the owners (called as liabilities).
When a business transaction happens, it will involve use of one or the other resource of the business
to create or settle one or more obligations. e.g. consider Mr. Suresh starts a business with the
investment of Rs. 25 lacs. Here, the business has got a resource of cash worth Rs. 25 lacs (which
is its asset), but at the same time it has created an obligation of business towards Mr. Suresh that
in the event of business closure, the money will be paid back to him. This could be shown as:
Assets = Liabilities + Capital
In other words,
Cash brought in by Mr. Suresh (Rs.25 lacs) = Liability of business towards Mr. Suresh (Rs.25 lacs)
We know that liability of the business could be towards owners and parties other than owners, this
equation could be re-written as:
Assets = Liabilities + Owner’s equity
Cash Rs.25,00,000 = Liabilities ` nil + Mr. Suresh’s equity Rs.25,00,000

This is the fundamental accounting equation shown as formal expression of the dual aspect
concept. This powerful concept recognizes that every business transaction has dual impact on the
financial position. Accounting systems are set up to simultaneously record both these aspects of
every transaction; that is why it is called as Double-entry system of accounting. In its present form
the double entry system of accounting owes its existence to an Italian expert Mr. Luca Pacioli in
the year 1495.
Continuing with our example of Mr. Suresh, now let us consider he borrows Rs.15 lacs from bank.
The dual aspect of this transaction-on one hand the business cash will increase by Rs.15 lacs and
a liability towards the bank will be created for Rs.15 lacs.

Assets = Liabilities + Owner’s equity

Cash Rs. 40,00,000 = Liabilities Rs.15,00,000 + Mr. Suresh’s equity Rs.25,00,000

The student must note that the dual aspect concept entails recognition of the two effects of each
transaction. These effects are of equal amount and reverse in nature. How to decide these two
aspects?
The golden rules of accounting are used to arrive at this decision. After recording both aspects of
the transaction, the basic accounting equation will always balance or be equal.
The above concepts find the application in preparation of the Balance Sheet which is the statement
of assets and liabilities as on a particular date. We will now see some more concepts that are
important for preparation of Profit and Loss Account or Income Statement.

11. Full Disclosure Concept

As per this concept, all significant information must be disclosed. Accounting data should properly
be clarified, summarized, aggregated and explained for the purpose of presenting the financial
statements which are useful for the users of accounting information. Practically, this principle
emphasizes on the materiality, objectivity and consistency of accounting data which should
disclose the true and fair view of the state of affairs of a firm. This principle is going to be popular
day by day as per Companies Act major provisions for disclosure of essential information about
accounting data and as such, concealment of material information, at present, is not very easy.
Thus, full disclosure must be made for such material information which are useful to the users of
accounting information.

ACCOUNTING CONVENTIONS

1. Conservatism
Accountants who prepare financial statements of the business, like other human being, would like
to give a favourable report on how well the business has performed during an accounting period.
However, prudent reporting based on skepticism builds confidence in the results and in the long
run best serves all the divergent interests of users of financial statements. This philosophy of
prudence leads to the conservatism concept.
The concept underlines the prudence of under-stating than over-stating the net income of an entity
for a period and the net assets as on a particular date. This is because business is done in situations
of uncertainty. For years, this concept was meant to “anticipate no profits but recognize all losses”.
This can be stated as
(i) Delay in recognizing income unless one is reasonably sure
(ii) Immediately recognize expenses when reasonably sure
This, of course, does not mean to overdo and create window dressing in reporting. e.g. if the
business has sold Rs.20 Lacs worth goods on the last day of accounting period and also received
a cheque for the same, one cannot argue that the revenue should not be recognized as it is not
certain whether the cheque will be cleared by the bank. One cannot stretch the conservatism
concept too much. But at the same time, if the business has to receive Rs.5 lacs from a customer
to whom goods were sold quite some time ago and no payments are forthcoming, then while
determining the net income for the period, the accountant must judge the likelihood of the
recoverability of this money and the prudence will prevail to make a provision for this amount as
doubtful debtors.
Let us take another example. A business had purchased goods for Rs.10 lacs before the end of an
accounting period. If sold at the usual selling price, the goods would fetch the price of Rs.12.50
lacs. Due to innovative product introduced by the competition, the goods are likely to be sold for
Rs.9 lacs only. At what value should the goods be shown in the balance sheet? Would it be at Rs.10
lacs being the actual cost of buying? Or would it be at Rs.9 lacs? Here, the conservatism principle
will come in play. The stock of goods will be valued at Rs.9 lacs, being the lower of cost or net
realisable value, as per AS-2.

2. Materiality
This is more of a convention than a concept. It proposes that while accounting for various
transactions, only those which may have material effect on profitability or financial status of the
business should have special consideration for reporting. This does not mean that the accountant
should exclude some transactions from recording. e.g. even Rs.20 worth conveyance paid must be
recorded as expense. What this convention claims is to attach importance to material details and
insignificant details should be ignored while deciding certain accounting treatment. The concept
of materiality is subjective and an accountant will have to decide on merit of each case. Generally,
the effect is said to be material, if the knowledge of an event would influence the decision of an
informed stakeholder.
The materiality could be related to information, amount, procedure and nature. Error in description
of an asset or wrong classification between capital and revenue would lead to materiality of
information. Say, If postal stamps of Rs.500 remain unused at the end of accounting period, the
same may not be considered for recognizing as inventory on account of materiality of amount.
Certain accounting treatments depend upon procedures laid down by accounting standards. Some
transactions are by nature material irrespective of the amount involved. e.g. audit fees, loan to
directors.

3. Consistency
This concept advocates that once an organization decides to adopt a particular method of revenue
or expense recognition in line with the other concepts, the same should be consistently applied
year after year, unless there is a valid reason for change in the method. Lack of consistency would
result in the financial information becoming non-comparable between the different accounting
periods. The insistence of this concept would result in avoidance of window dressing the results
by choosing the accounting method by convenience and thereby either inflating or understating
net income.
Consider an example. An asset of ` 10 lacs is purchased by a business. It is estimated to have useful
life of 5 years. It will follow that the asset will be depreciated over a period of 5 years at the rate
of ` 2 lacs every year. The estimate of useful life and the rate of depreciation cannot be changed
from one period to the other without a valid reason. Suppose the firm applies the same depreciation
rate for the first three years and due to change in technology the asset becomes obsolete, the whole
of the remaining amount could be expensed out in the fourth year.
However, it may be difficult to be consistent if the business entities have two factories in different
countries which have different statutory requirement for accounting treatment.

4. Uniformity
Convention of Uniformity is like Convention of Consistency with the only difference that
Convention of Consistency is applicable to a particular business from the given industry, whereas
Convention of Uniformity is applicable to all the businesses in the given industry.
In other words, Convention of Uniformity means that accounting practices, policies and methods
for similar transactions by different businesses within the given industry are followed consistently
and continuously across different financial years by the same business concern. If frequent changes
are made in these accounting practices, policies and methods used for a given area of accounting,
it becomes difficult to compare financial statements of different years of the same business
concerns of the given Industry.

For example:
Method of Depreciation Accounting on Fixed Assets:
If different businesses from the given industry chooses written down value method or straight-line
method for depreciation to fixed assets, then they should follow the same methods consistently
year after year without any change unless and until the change in method is compulsory and
inevitable for the better presentation of financial statements of the business.

Convention of consistency facilitates the comparison of different businesses within the industry in
terms of their performance of the same period of time.

IMPORTANT TERMS
1. Contingent Assets
A contingent asset is a potential asset or economic benefit due to business. It does not currently
exist but may arise in the near future, as a occurrence or non-occurrence of a particular uncertain
events, which may or may not. take place. The business itself does not have full control over such
an uncertain event. Such an asset or economic interest arises from an unpredictable event.
For example
1) If the company is locked in a legal dispute and has the possibility of winning the case and being
entitled to a claim or damages.
2) If the company is anticipating economic benefit out of a merger.
3) A company is expecting to be paid on account of a warranty
Due to their uncertainty and in accordance with some accounting concepts, contingent assets do
not find themselves on the balance sheet of a company.
Let us understand the reasons as to why contingent asset is not recognized as an asset,
1. Uncertain Event:
The occurrence of such a benefit is not a given. Since the outcome of the event is not fully in
control of the company we cannot guarantee its occurrence. There may be a case where we might
recognize a contingent asset that never realizes. Hence, they are kept off the balance sheet of the
company.
2. Conservatism:
The conservatism principle clearly states that any uncertain future expense must be recognized
immediately. But any future uncertain income must not be recognized. A contingent asset will
come under the latter.

The AS 29 states that a contingent asset should not be disclosed in the financial statements
following the accounting concept of prudence.
However, the approving authorities can make a mention of the asset in their report. In the case of
a company, this will be the report by the Board of Directors.
But such a disclosure can be made in the report only if,
a) The economic benefit is probable, i.e. more than likely to happen
b) The amount of such an asset/benefit can be estimated reliably

Contingent assets are to be monitored very closely. Once it becomes certain that the economic
benefit will arise, only then can they be included in the financial statements of the company. Then
the asset is not a contingent asset anymore.

For Example:-
A court orders that ABC Co. must pay PQR Co. 55,000/- as damages. PQR Co. has not yet received
the money. Here the contingent asset becomes an asset. Although the payment is not received, the
court has ordered the payment. So the income has become virtually certain and can now be
recognized as an asset
2. Contingent Liabilities
A Contingent Liability is not an actual liability of the business and hence in does not appear on the
face of the balance sheet of the business. A Contingent Liability is a liability the occurrence of
which depends on a future uncertain and unpredictable event which may or may not take place.
The features of Contingent Liability are:
1. It is not a actual liability, hence not shown in the balance sheet of the business
2. It is a conditional liability
3. Its occurrence depends on future uncertain and unpredictable event
4. Where such future uncertain and unpredictable may or may not take place

Disclosure of Contingent Liability:

Contingent liability not being an actual liability is always shown below the balance sheet of the
business as a part of Notes to Accounts

Examples of Contingent Liability:

1. Bills discounted with the banks by the business
2. Arrears of preference dividend payable on cumulative type of preference shares
3. Claim against the business pending in the court of law
4. Penalty payable on an incomplete contract towards non-completion of the same in time
5. Amount payable on partly paid up shares held as an investment

3. Provisions v/s Reserves

Provision means amount provided in the books of accounts towards an anticipated expenses or
losses. It is made in accordance with the Convention of Conservatism (explained herein below),
as a provision for anticipated expenses and losses estimated by the business.
For making provision in the books of accounts there need not be profit with the business. Even if
there is loss made by the business, provision for anticipated expense and loss needs to be provided
for in the books of the account.

For Example:
[Link] for depreciation on fixed assets
[Link] for reserve for bad and doubtful debts
[Link] for outstanding expenses
Reserves means an amount set aside out the accumulated balance of profits with definite purpose.
necessarily needs profits of the business to be set aside for an identified purpose. In case of losses
made the business, reserves amounts cannot be set aside. Only profit-making business can set aside
amounts in the name of different reserves

For Example:
1. General Reserve
2. Dividend Equalization Reserve
3. Capital Reserve
4. Capital Redemption Reserve
5. Debenture Redemption Reserve
6. Statutory Reserve
7. Investment Allowance Reserve

4. Charge v/s Appropriation

Charge means an obligation on the business that is to be met by the business irrespective of profit
or loss made by it during a particular year. 'Charge' is also termed charge against profit'. It means
such an amount is compulsorily debited to profit and loss account of the business. It does not
depend upon the profitability of the business.
All provisions (as given herein below in Provisions and Reserves) are always created as a charge
against profit.
Appropriation means amount set aside out of profit balance in the name of an identifiable reason.
It necessarily needs profit on the part of the business.
No business can make appropriations out of losses incurred by it. It is a share taken out of profit
balance, so it calls for profitability on the part of the business.
All reserves created (as given herein below) are always made as a part of appropriation of profits.

Illustration 1
State with reasons whether the following events are transactions or not to Mr. Nikhil, Proprietor,
Delhi Computers
(i) Mr. Nikhil started business with capital (brought in cash)Rs. 40,000.
(ii) Paid salaries to staff Rs. 5,000.
(iii) Purchased machinery for Rs. 20,000 in cash.
(iv) Placed an order with Sen & Co. for goods for Rs. 5,000.
(v) Opened a Bank account by depositing Rs. 4,000.
(vi) Received pass book from bank.
(vii) Appointed Sohan as Manager on a salary of Rs. 4,000 per month.
(viii)Received interest from bank Rs. 500.
(ix) Received a price list from Lalit.

Solution :
Here, each event is to be considered from the view point of Mr. Nikhil's business. Those events
which will change the financial position of the business of Mr. Nikhil, should be regarded as
transaction.
(i) It is a transaction, because it changes the financial position of Mr. Nikhil's business. Cash will
increase by Rs. 40,000 and Capital will increase by Rs. 40,000.
(ii) It is a transaction, because it changes the financial position of Mr. Nikhil's business. Cash will
decrease by Rs. 5,000 and Salaries (expenses) will increase by Rs. 5,000
(iii) It is a transaction, because it changes the financial position of Mr. Nikhil's business.
Machinery comes in and cash goes out.
(iv) It is not a transaction, because it does not change the financial position of the business.
(v) It is a transaction, because it changes the financial position of the business. Bank balance will
increase by Rs. 4,000 and cash balance will decrease by Rs. 4,000.
(vi) It is also not a transaction, because it does not change the financial position of Mr. Nikhil.
(vii) It is also not a transaction, because it does not change the financial position of Mr. Nikhil.
(viii) It is a transaction, because it changes the financial position of Mr. Nikhil's business.
(ix) It is not a transaction, because it does not change the financial position of the business of Mr.
Nikhil.

METHODS OF RECORDING ACCOUNTING INFORMATION / ACCOUNTING

SYSTEM

1. Indian System:
Indian system maintains, records in Indian languages, such as Marathi, Hindi, Urdu, Gujrati etc. It
is called Mahajani Deshinama system. In this system transactions are recorded or maintained in
long books, known as Bahi-Khata and Kird. This system of accounting is not based on Double
Entry system of accounting. Thus, is not a scientific accounting system. Even today this system is
used in India for small business organization.

2. English System:
A) Single Entry System:
This system of accounting records only Cash book and Personal accounts. It is unscientific method
and also known as an incomplete recording system, because it changes with the convenience of
business for recording transactions. This system of accounting does not provide accurate
information about the financial position of business and it is suitable for small business.
B) Double Entry System:
Double Entry System is the most scientific method of recording all business transactions in the
books of accounts. Under this system double or two fold effects of each transaction is recorded.
According to Double Entry Book-keeping System, one account is to be debited and another
account is to be credited with equal amount. Every debit has an equal and corresponding credit of
the same amount is the basic principle of Double Entry System.
DOUBLE ENTRY SYSTEM
DEFINITION OF DOUBLE ENTRY SYSTEM
“Every business transaction has a twofold effect and that it affects two accounts in opposite
directions and if a complete record is to be made of each such transaction it would be necessary to
debit one account and credit another account. It is this recording of two-fold effect of every
transaction that has given rise to the term Double Entry.” – J.R. Batliboi.

PRINCIPLES OF DOUBLE ENTRY BOOK-KEEPING SYSTEM:

1) In every business transaction there must be minimum two effects i.e debit and credit.
2) Two Accounts means one is the Receiver of the benefit and other is the Giver of the benefit.
3) If one account is debited other account must be credited.
4) Every debit has a equal and corresponding credit of the same amount.

ADVANTAGES OF DOUBLE ENTRY BOOK-KEEPING SYSTEM:

1) Complete Record:
Under this system all business transactions are recorded. This method is scientific and records
both the aspects of each transaction.
2) Accuracy:
In this system both aspects are recorded in the books of accounts so it gives complete accuracy
in accounting work. It also checks arithmetical accuracy.
3) Business Results:
All expenses, losses, income, gains, liabilities, assets, debtors and creditors all these transactions
are recorded, therefore it helps to find out accurate business results of particular accounting
period.
4) Common Acceptance:
It is widely accepted since it follows universal accounting principles. Double Entry System is
accepted by financial institutions, government authorities etc.

CLASSIFICATION OF ACCOUNTS (TRADITIONAL APPROACH)

MEANING OF ACCOUNT
An account is a summarized record of transactions relating to a particular person, asset, liability,
particular head of expense or income recorded at one place. In day-to-day business activity large
number of business transactions takes place. It affects the several accounts. At the end of certain
period of time, it is necessary for the businessman to balance the accounts to find out the
information. like total capital, total liabilities and assets, total incomes and expenses etc. of the
business.

DEFINITION OF ACCOUNT
“An account is summarized record of transactions affecting one person, one kind of property or
one class of gain or loss.” – [Link]
“An account is a ledger record in a summarized form of all the transactions that have taken place
with the particular person or thing specified.” – Carter
Each type of accounts is explained below with examples-
1) Personal Accounts :
This account represents a person and group of persons with whom business deals. These accounts
are classified into following three categories:-
a) Natural Person's Account:
Accounts relating to individual human beings. for e.g. Rajesh’s A/c, Sumit's A/c, Sushma's
A/c, Vaibhav’s A/c etc.

b) Artificial Person's Account:

Artificial persons means includes accounts of organizations, associations which are
created by law, for
E.g. Bank of Maharashtra A/c, ABC & Co A/c, Recreation Club A/c.

c) Representative Personal Account:

These Accounts represent a certain person or group of person in business dealing. Accounts
relating to outstanding and prepaid items are called representative personal account
E.g. Outstanding Rent A/c, Income received in advance A/c, Prepaid Wages A/c etc.

2) Impersonal Account:
Impersonal Accounts are classified into following two categories;-

1. Real Accounts:
This account represents assets and properties owned by the business. The following are the types
of Real Account.
a) Tangible Real Account:
Tangible real account means the Assets and properties, which can be seen, touched and
felt. e.g. Machinery A/c, Motor Car A/c, Stock of Goods A/c etc.
b) Intangible Real Account:
Intangible Real account means assets which cannot be seen, touched, or felt but they can
be measured in terms of money e.g. Goodwill A/c, Patents A/c, Trademark A/c, Copyright
A/c etc.

2. Nominal Accounts:
The account of expenses, losses, income and gains are called as Nominal accounts e.g. Wages
A/c, Stationery A/c, Salary A/c, Depreciation A/c Commission Received A/c, Discount Received
A/c etc.

CLASSIFICATION OF ACCOUNTS (MODERN APPROACH)

In the given chart different types of accounts have been summarized. All accounts are divided into
five categories for the purpose of recording the transaction.
Namely –
1) Assets
2) Liabilities
3) Capital
4) Expenses/Losses
5) Revenues/Gains

Two fundamental rules to be followed to record the changes in these accounts:

1) For recording changes in Assets / Expenses / Losses.
I) Increase in asset is debited and decrease in asset is credited.
II) Increase in expenses/losses is debited and decrease in expenses/ losses is credited.
2) For recording changes in liabilities and capital / revenues / Gains.
I) Increase in liabilities is credited and decrease in liabilities is debited.
II) Increase in capital is credited and decrease in capital is debited.
III) Increase in revenues/gains is credited and decrease is revenue/gains is debited.

ACCOUNTING CYCLE
When complete sequence of accounting procedure is done which happens frequently and repeated
in same directions during an accounting period, the same is called an accounting cycle.
Steps/Phases of Accounting Cycle The steps or phases of accounting cycle can be developed as
under:

(a) Recording of Transaction:- As soon as a transaction happens it is at first recorded in

subsidiary book.
(b) Journal : The transactions are recorded in Journal chronologically.
(c) Ledger: All journals are posted into ledger chronologically and in a classified manner.
(d) Trial Balance: After taking all the ledger account’s closing balances, a Trial Balance is
prepared at the end of the period for the preparations of financial statements.
(e) Adjustment Entries : All the adjustments entries are to be recorded properly and adjusted
accordingly before preparing financial statements.
(f) Adjusted Trial Balance: An adjusted Trail Balance may also be prepared.
(g) Closing Entries : All the nominal accounts are to be closed by the transferring to Trading
Account and Profit and Loss Account.
(h) Financial Statements : Financial statement can now be easily prepared which will exhibit the
true financial position and operating results.

USERS OF ACCOUNTING INFORMATION

Accounting provides information both to internal users and the external users. The internal users
are all the organizational participants at all levels of management (i.e. top, middle and lower).
Generally top level management requires information for planning, middle level management
which requires information for controlling the operations. For internal use, the information is
usually provided in the form of reports, for instance Cash Budget Reports, Production Reports,
Idle Time Reports, Feedback Reports, whether to retain or replace an equipment decision reports,
project appraisal report, and the like. There are also the external users (e.g. Banks, Creditors). They
do not have direct access to all the records of an enterprise, they have to rely on financial statements
as the source of information. External users are basically, interested in the solvency and
profitability of an enterprise.
The basic objective of accounting is to provide information which is useful for persons inside the
organisation and for persons or groups outside the organisation. Accounting is the discipline that
provides information on which external and internal users of the information may base decisions
that result in the allocation of economic resources in society

I. External Users of Accounting Information

External users are those groups or persons who are outside the organization for whom accounting
function is performed. Following can be the various external users of accounting information:
1. Investors
Those who are interested in investing money in an organization are interested in knowing the
financial health of the organization of know how safe the investment already made is and how safe
their proposed investment will be. To know the financial health, they need accounting information
which will help them in evaluating the past performance and future prospects of the organisation.
Thus, investors for their investment decisions are dependent upon accounting information included
in the financial statements. They can know the profitability and the financial position of the
organisation in which they are interested to make that investment by making a study of the
accounting information given in the financial statements of the organisation.
2. Creditors
Creditors (i.e. supplier of goods and services on credit, bankers and other lenders of money) want
to know the financial position of a concern before giving loans or granting credit. They want to be
sure that the concern will not experience difficulty in making their payment in time i.e. liquid
position of the concern is satisfactory. To know the liquid position, they need accounting
information relating to current assets, quick assets and current liabilities which is available in the
financial statements.
3. Members of Non-profit Organisations
Members of non-profit organisations such as schools, colleges, hospitals, clubs, charitable
institutions etc. need accounting information to know how their contributed funds are being
utilised and to ascertain if the organisation deserves continued support or support should be
withdrawn keeping in view the bad performance depicted by the accounting information and
diverted to another organisation. In knowing the performance of such organisations, criterion will
not be the profit made but the main criterion will be the service provided to the society.
4. Government
Central and State Governments are interested in the accounting information because they want to
know earnings or sales for a particular period for purposes of taxation. Income tax returns are
examples of financial reports which are prepared with information taken directly from accounting
records. Governments also needs accounting information for compiling statistics concerning
business which, in turn helps in compiling national accounts.
5. Consumers
Consumers need accounting information for establishing good accounting control so that cost of
production may be reduced with the resultant reduction of the prices of goods they buy. Sometimes,
prices for some goods are fixed by the Government, so it needs accounting information to fix
reasonable prices so that consumers and manufacturers are not exploited. Prices are fixed keeping
in view fair return to manufacturers on their investments shown in the accounting records.
6. Research Scholars
Accounting information, being a mirror of the financial performance of a business organisation, is
of immense value to the research scholars who wants to make a study to the financial operations
of a particular firm. To make a study into the financial operations of a particular firm, the research
scholar needs detailed accounting information relating to purchases, sales, expenses, cost of
materials used, current assets, current liabilities, fixed assets, long term liabilities and shareholders'
funds which is available in the accounting records maintained by the firm.

II. Internal Users of Accounting Information

Internal users of accounting information are those persons or groups which are within the
organisation.
1. Owners
The owners provide funds for the operations of a business and they want to know whether their
funds are being properly used or not. They need accounting information to know
the profitability and the financial position of the concern in which they have invested their funds.
The financial statements prepared from time to time from accounting records depicts them the
profitability and the financial position.
2. Management
Management is the art of getting work done through others, the management should ensure that
the subordinates are doing work properly. Accounting information is an aid in this respect because
it helps a manager in appraising the performance of the subordinates. Actual performance of the
employees can be compared with the budgeted performance they were expected to achieve and
remedial action can be taken if the actual performance is not upto the mark. Thus, accounting
information provides "the eyes and ears to management".
The most important functions of management are planning and controlling. Preparation of various
budgets, such as sales budget, production budget, cash budget, capital expenditure budget etc., is
an important part of planning function and the starting point for the preparation of the budgets is
the accounting information for the previous year. Controlling is the function of seeing that
programmes laid down in various budgets are being actually achieved i.e. actual performance
ascertained from accounting is compared with the budgeted performance, enabling the manager to
exercise controlling case of weak performance. Accounting information is also helpful to the
management in fixing reasonable selling prices. In a competitive economy, a price should be based
on cost plus a reasonable rate of return. If a firm quotes a price which exceeds cost plus a
reasonable rate of return, it probably will not get the order. On the other hand, if the firm quotes a
price which is less than its cost, it will be given the order but will incur a loss on account of price
being lower than the cost. So, selling prices should always be fixed on the basis of accounting data
to get the reasonable margin of profit on sales.
3. Employees
Employees are interested in the financial position of a concern they serve particularly when
payment of bonus depends upon the size of the profits earned. They seek accounting information
to know that the bonus being paid to them is correct.

Let us now see which are different stakeholders of the business and what do they seek from
the accounting information. This is shown in the following table.
Stakeholder Interest in business Accounting Information
Owners / Investors / existing Profits or losses Financial statements, Cost
and potential Accounting records,
Management Accounting
reports
Lenders Assessment of capability of Financial statement and
the business to pay interest analysis thereof, reports
and principal of money lent. forming part of accounts,
Basically, they monitor the valuation of assets given as
solvency of business security
Customers and suppliers Stability and growth of the Financial and Cash flow
business statements to assess ability of
the business to offer better
business terms and ability to
supply the products and
services
Government Whether the business is Accounting documents such
complying with various legal as vouchers, extracts of books,
requirements information of purchase,
sales, employee obligations
etc. and financial statements
Employees and trade unions Growth and profitability Financial statements for
negotiating pay packages
Competitors Performance and possible tie- Accounting information to
ups in the era of mergers and find out possible synergies
acquisitions
BASIC ACCOUNTING TERMS
In order to understand the subject matter clearly, one must grasp the following common
expressions always used in business accounting. The aim here is to enable the student to understand
with these often used concepts before we embark on accounting procedures and rules. You may
note that these terms can be applied to any business activity with the same connotation.

(i) Transaction: It means an event or a business activity which involves exchange of money or
money’s worth between parties. The event can be measured in terms of money and changes the
financial position of a person e.g. purchase of goods would involve receiving material and making
payment or creating an obligation to pay to the supplier at a future date. Transaction could be a
cash transaction or credit transaction. When the parties settle the transaction immediately by
making payment in cash or by cheque, it is called a cash transaction. In credit transaction, the
payment is settled at a future date as per agreement between the parties.

(ii) Goods/Services : These are tangible article or commodity in which a business deals. These
articles or commodities are either bought and sold or produced and sold. At times, what may be
classified as ‘goods’ to one business firm may not be ‘goods’ to the other firm. e.g. for a machine
manufacturing company, the machines are ‘goods’ as they are frequently made and sold. But for
the buying firm, it is not ‘goods’ as the intention is to use it as a long term resource and not sell it.
Services are intangible in nature which are rendered with or without the object of earning profits.

(iii) Profit: The excess of Revenue Income over expense is called profit. It could be calculated for
each transaction or for business as a whole.

(iv) Loss: The excess of expense over income is called loss. It could be calculated for each
transaction or for business as a whole.

(v) Asset: Asset is a resource owned by the business with the purpose of using it for generating
future profits. Assets can be Tangible and Intangible. Tangible Assets are the Capital assets which
have some physical existence. They can, therefore, be seen, touched and felt, e.g. Plant and
Machinery, Furniture and Fittings, Land and Buildings, Books, Computers, Vehicles, etc. The
capital assets which have no physical existence and whose value is limited by the rights and
anticipated benefits that possession confers upon the owner are known as lntangible Assets. They
cannot be seen or felt although they help to generate revenue in future, e.g. Goodwill, Patents,
Trade-marks, Copyrights, Brand Equity, Designs, Intellectual Property, etc.
Assets can also be classified into Current Assets and Non-Current Assets.
Current Assets – An asset shall be classified as Current when it satisfies any of the following :
(a) It is expected to be realised in, or is intended for sale or consumption in the Company’s normal
Operating Cycle,
(b) It is held primarily for the purpose of being traded ,
(c) It is due to be realised within 12 months after the Reporting Date, or
(d) It is Cash or Cash Equivalent unless it is restricted from being exchanged or used to settle a
Liability for at least 12 months after the Reporting Date.
Non-Current Assets – All other Assets shall be classified as Non-Current Assets. e.g. Machinery
held for long term etc.

(vi) Liability: It is an obligation of financial nature to be settled at a future date. It represents

amount of money that the business owes to the other parties. E.g. when goods are bought on credit,
the firm will create an obligation to pay to the supplier the price of goods on an agreed future date
or when a loan is taken from bank, an obligation to pay interest and principal amount is created.
Depending upon the period of holding, these obligations could be further classified into Long Term
on non-current liabilities and Short Term or current liabilities.
Current Liabilities –
A liability shall be classified as Current when it satisfies any of the following :
(a) It is expected to be settled in the Company’s normal Operating Cycle,
(b) It is held primarily for the purpose of being traded,
(c) It is due to be settled within 12 months after the Reporting Date, or
(d) The Company does not have an unconditional right to defer settlement of the liability for at
least 12 months after the reporting date (Terms of a Liability that could, at the option of the
counterparty, result in its settlement by the issue of Equity Instruments do not affect its
classification)
Non-Current Liabilities – All other Liabilities shall be classified as Non-Current Liabilities. E.g.
Loan taken for 5 years, Debentures issued etc.

(vii) Internal Liability : These represent proprietor’s equity, i.e. all those amount which are
entitled to the proprietor, e.g., Capital, Reserves, Undistributed Profits, etc.

(viii) Working Capital : In order to maintain flows of revenue from operation, every firm needs
certain amount of current assets. For example, cash is required either to pay for expenses or to
meet obligation for service received or goods purchased, etc. by a firm. On identical reason,
inventories are required to provide the link between production and sale. Similarly, Accounts
Receivable generate when goods are sold on credit. Cash, Bank, Debtors, Bills Receivable, Closing
Stock, Prepayments etc. represent current assets of firm. The whole of these current assets form
the working capital of a firm which is termed as Gross Working Capital.
Gross Working Capital = Total Current Assets
= Long term internal liabilities plus long term debts plus the current
liabilities minus the amount blocked in the fixed assets.
There is another concept of working capital. Working capital is the excess of current assets over
current liabilities. That is the amount of current assets that remain in a firm if all its current
liabilities are paid. This concept of working capital is known as Net Working Capital which is a
more realistic concept.
Working Capital (Net) = Current Assets – Currents Liabilities.

(ix) Contingent Liability : It represents a potential obligation that could be created depending on
the outcome of an event. E.g. if supplier of the business files a legal suit, it will not be treated as a
liability because no obligation is created immediately. If the verdict of the case is given in favour
of the supplier then only the obligation is created. Till that it is treated as a contingent liability.
Please note that contingent liability is not recorded in books of account, but disclosed by way of a
note to the financial statements.

(x) Capital : It is amount invested in the business by its owners. It may be in the form of cash,
goods, or any other asset which the proprietor or partners of business invest in the business activity.
From business point of view, capital of owners is a liability which is to be settled only in the event
of closure or transfer of the business. Hence, it is not classified as a normal liability. For corporate
bodies, capital is normally represented as share capital.

(xi) Drawings : It represents an amount of cash, goods or any other assets which the owner
withdraws from business for his or her personal use. e.g. if the life insurance premium of proprietor
or a partner of business is paid from the business cash, it is called drawings. Drawings will result
in reduction in the owners’ capital. The concept of drawing is not applicable to the corporate bodies
like limited companies.

(xii) Net worth : It represents excess of total assets over total liabilities of the business.
Technically, this amount is available to be distributed to owners in the event of closure of the
business after payment of all liabilities. That is why it is also termed as Owner’s Equity. A profit
making business will result in increase in the owner’s equity whereas losses will reduce it.

(xiii) Non-current Investments : Non-current Investments are investments which are held beyond
the current period as to sale or disposal. e. g. Fixed Deposit for 5 years.

(xiv) Current Investments : Current investments are investments that are by their nature readily
realizable and are intended to be held for not more than one year from the date on which such
investment is made. e. g. 11 months Commercial Paper.
(xv) Debtor : The sum total or aggregate of the amounts which the customer owe to the business
for purchasing goods on credit or services rendered or in respect of other contractual obligations,
is known as Sundry Debtors or Trade Debtors, or Trade Receivable, or Book-Debts or Debtors. In
other words, Debtors are those persons from whom a business has to recover money on account of
goods sold or service rendered on credit. These debtors may again be classified as under:
(i) Good debts : The debts which are sure to be realized are called good debts.
(ii) Doubtful Debts : The debts which may or may not be realized are called doubtful debts.
(iii) Bad debts : The debts which cannot be realized at all are called bad debts. It must be
remembered that while ascertaining the debtors balance at the end of the period certain adjustments
may have to be made e.g. Bad Debts, Discount Allowed, Returns Inwards, etc.

(xvi) Creditor : A creditor is a person to whom the business owes money or money’s worth. e.g.
money payable to supplier of goods or provider of service. Creditors are generally classified as
Current Liabilities.

(xvii) Capital Expenditure : This represents expenditure incurred for the purpose of acquiring a
fixed asset which is intended to be used over long term for earning profits there from. e. g. amount
paid to buy a computer for office use is a capital expenditure. At times expenditure may be incurred
for enhancing the production capacity of the machine. This also will be a capital expenditure.
Capital expenditure forms part of the Balance Sheet.

(xviii) Revenue expenditure : This represents expenditure incurred to earn revenue of the current
period. The benefits of revenue expenses get exhausted in the year of the incurrence. e.g. repairs,
insurance, salary & wages to employees, travel etc. The revenue expenditure results in reduction
in profit or surplus. It forms part of the Income Statement.

(xix) Balance Sheet : It is the statement of financial position of the business entity on a particular
date. It lists all assets, liabilities and capital. It is important to note that this statement exhibits the
state of affairs of the business as on a particular date only. It describes what the business owns and
what the business owes to outsiders (this denotes liabilities) and to the owners (this denotes
capital). It is prepared after incorporating the resulting profit/losses of Income Statement.

(xx) Profit and Loss Account or Income Statement : This account shows the revenue earned by
the business and the expenses incurred by the business to earn that revenue. This is prepared
usually for a particular accounting period, which could be a month, quarter, a half year or a year.
The net result of the Profit and Loss Account will show profit earned or loss suffered by the
business entity.

(xxi) Trade Discount : It is the discount usually allowed by the wholesaler to the retailer computed
on the list price or invoice price. e.g. the list price of a TV set could be ` 15000. The wholesaler
may allow 20% discount thereof to the retailer. This means the retailer will get it for ` 12000 and
is expected to sale it to final customer at the list price. Thus the trade discount enables the retailer
to make profit by selling at the list price. Trade discount is not recorded in the books of accounts.
The transactions are recorded at net values only. In above example, the transaction will be recorded
at ` 12000 only.

(xxii) Cash Discount : This is allowed to encourage prompt payment by the debtor. This has to be
recorded in the books of accounts. This is calculated after deducting the trade discount. e.g. if list
price is Rs 15000 on which a trade discount of 20% and cash discount of 2% apply, then first trade
discount of Rs 3000 (20% of Rs 15000) will be deducted and the cash discount of 2% will be
calculated on Rs 12000 (Rs 15000 – Rs 3000). Hence the cash discount will be Rs 240/- (2% of
Rs 12000) and net payment will be Rs 11,760 (Rs 12,000 - Rs 240)
THE ACCOUNTING PROCESS OVERVIEW: ACCOUNTING PROCESS.

Accounting Process: It includes the recording of financial transactions, ledger posting, preparation
of financial statements and analyzing and interpretation of them.

BOOKS OF ORIGINAL RECORD: JOURNAL - LEDGER - TRIAL BALANCE

JOURNAL
Introduction :
Everyday businessmen performs large number of transactions. These transactions cannot be
remembered at a glance. Therefore these transactions must be recorded in different types of books.
He keeps different accounting records. The number of books depends upon the size and nature of
business and volume of transactions but important books of accounts which must be maintained
by every businessmen are Journal and Ledger. Journal is a book employed to classify or sort out
transaction in a form convenient for their subsequent entries in Ledger Journal keeps record of
daily financial transaction . It is also known as Book of Original Entry. When the Journal
transactions are recorded in the Journal it becomes Journal entry .Journal entries consist of the
name of debit and name of credit involved in the financial transaction with a brief narration.
Journal is a book in which the business transactions are first recorded in a chronological order i.e.
Date wise in the order in which they take place.
Generally the different types of Books of Accounts are maintained by a businessman for recording
the business transactions. He maintain primary books and secondary books, Primary books
includes Journal proper and special Journal which includes Purchases Books ,Sales Book,
Purchase Return Book, Sales Return Book, Bills Receivable Book, Bills Payable Book and
Secondary Book includes Journal Ledger.

Meaning:
The word “Journal” is derived from the French word “JOUR” which means a “Day”. Therefore
journal means a “daily record”. A journal contains a daily record of business transactions and hence
it has been named so, as soon as a transaction takes place its debit and credit aspects are analyzed
and first of all recorded chronologically i.e. In the order of their occurrence (taking place). Journal
is a book of original entry or primary entry.
Importance and utility of Journal:
Journal is an important book in Book-keeping. All business organisations, keep the Journal. The
importance and utility is as follows:-
1) This is the principal book of account. It includes all types of accounts of business
2) It shows all necessary information regarding transactions.
3) The Journal has date wise record of all the transactions with details about accounts it helps to
understand the events when its took place.
4) The Journal is subsidiary book in which all the day to day transactions are recorded first in
chronological order in debit and credit form and with the amount of each transaction.
5) Accounting procedure is followed on the basis of accounting documents.
6) The narration provides a brief explanation about the transactions .It helps to increase the clarity
of every transactions.
7) It helps to find and prevent errors.
8) It helps to check arithmetical accuracy of the transactions.
9) It helps in preparation of Final Accounts.
Specimen/ Format/ Ruling/ Proforma of Journal is given below-

Problem
Journalise the following transactions in the books of Raymond for the Month of April 2019

2019
01 : Purchased goods from Kajal worth Rs 2,00,000 at 5% Trade Discount and @ 18% GST
and ½ amount paid by cheque.
04 : Purchased Shares of Mahindra Company Rs 60,000 and Rs 1,000 paid as Brokerage.
09 : Sold goods to Ravikant worth Rs 60,000 at 10% Trade Discount and @ 18% GST 1/3
amount received by cash at 5% Cash Discount.
10 Paid College Fees of proprietor’s son Rs 1,000.
12 Purchased Computer of Rs 50,000 @ 18% GST
15 Paid Transport charges on the above computer of Rs 2,000.
20 Paid for Salary Rs 15,000.
26 Paid for Rent Rs 5,000 and Advertisement Rs 15,000.
27 Sold goods to Salman Rs 20,000 @ 18% GST .
30 Purchased Goods for Rs 1,00,000 @ 12%GST and paid by cheque.
30 Wages Outstanding Rs 20,000.
Solution
LEDGER

Introduction
In the process of accounting, all the business transactions are recorded in chronological order in
Journal. These business transactions are recorded in proper books of accounts. We are aware that
all types of business transactions are recorded in Journal e.g. Transactions related to assets,
liabilities, expenses, income, cash or credit etc.
At the end of the particular period if we want to know what is the total amount spent on particular
type of expense, or what is the amount payable to particular person /party? These types of questions
cannot be answered easily through Journal. So to overcome these limitations of Journal we need
Ledger. A Ledger is called as the main Book of Accounts. Once the transactions are recorded in
Journal or Subsidiary books the next stage is the transfer of those transactions in their respective
accounts opened in the Ledger.

Meaning
Ledger is the Principal Book of accounts. It is also called as book of final entry. It is summarised
record which contains all the accounts e.g. Assets A/c, Liabilities A/c, Capital A/c, Revenue A/c,
Expenses A/c.

Importance of Ledger
1. It is the summarised record of all the transactions in form of Asset A/c, Liabilities A/c, Expenses
A/c, Income A/c etc.
2. The ultimate object of Book-Keeping is to ascertain with the least trouble, what is the amount
owed to the supplier, what is the amount receivable from the customer and so on. In the process of
posting information collected is condensed in form of Debtors A/c ,Creditors A/c to get the ready
results
3. It is necessary for preparation of Trial Balance.
4. The financial position of the business can be easily known with the help of various types of
Assets A/c and Liabilities A/c
5. It is possible to prepare various types of income statement on the basis of balances shown by
different ledger Accounts.
6. Ledger can be used as a control tool as it shows accounts of various expenses with the balance.
7. On the basis of the results shown in the Ledger it is useful for the management to forecast or
plan the future plan of action.
Specimen of Ledger

Trial Balance
A Trial balance is an abstract or list of all the ledger accounts as on a specific date showing debit
and credit balances of all Ledger Accounts. Usually, Trial Balance is prepared at the end of the
financial year. However it can be prepared periodicaly depending upon requirement of the
business. It is prepared to ascertain the arithmetical accuracy of Books of Accounts.

Types of Trial Balance:

(1) Gross Trial Balance: In this type of Trial Balance total of debit side of a particular account is
shown in the debit column of the Trial Balance and total of credit side of a particular account is
shown in the credit column of the Trial Balance. It is not in common use as it does not disclose the
balance of each account.
(2) Net Trial Balance: In this type of Trial Balance only the balances of each ledger account are
shown against its name. If an account shows a credit balance then its balance is recorded in the
credit amount column and vice versa. this Trial Balance is used in practice

Methods of preparing Trial Balance:

There are two methods of preparing Trial Balance
(1) Vertical or Journal form of Trial Balance
(2) Horizontal or Ledger form of Trial Balance
Problem
The following balances appeared in the ledger of Karan on 1st January 2018.
Debit balances Amount
Cash Account : 60,000
Purchases Account : 80,000
Bank of Maharashtra A/c : 1,00,000
Credit Balances Amount
Karan's Capital A/.c : 2,00,000
Sales A/c : 40,000

January
5 Bought goods from Rushi Rs 10,000.
10 Drew from Bank Rs 20,000 for office and Rs 6,000 for self use.
17 Return goods to Rushi 2,000.
19 Cash Purchases Rs 14,000.
22 Cash Sales Rs 20,000.
26 Deposited into Bank Rs 16,000.
28 Interest collected by Bank Rs 7,000 on our behalf.

Pass Journal Entries, prepare necessary Ledger Accounts and prepare a Trial Balance as on 31st
January 2018
Utility of a Trial Balance:
1) It shows balances of different Ledger accounts.
2) It proves arithmetical accuracy of Books of Accounts.
3) It helps to prepare Final Accounts of a business.
CLASSIFICATION OF CAPITAL AND REVENUE EXPENSES –

The concepts of capital and revenue are of fundamental importance to the correct determination of
accounting
profit for a period and recognition of business assets at the end of that period.
Capital Transactions:
Transactions having long-term effect are known as capital transactions.
Revenue Transactions:
Transactions having short-term effect are known as revenue transactions.

Capital Expenditure
Capital expenditure can be defined as expenditure incurred on the purchase, alteration or
improvement of fixed assets. For example, the purchase of a car to be use to deliver goods is capital
expenditure. Included in capital expenditure are such costs as:
Delivery of fixed assets;
Installation of fixed assets;
Improvement (but not repair) of fixed assets;
Legal costs of buying property;
Demolition costs;
Architects fees;

Revenue Expenditures
Revenue expenditure is expenditure incurred in the running/management of the business. For
example, the cost of petrol or diesel for cars is revenue expenditure. Other revenue expenditure:
Maintenance of Fixed Assets;
Administration of the business;
Selling and distribution expenses.

Capitalized Expenditure
Expenditure connected with the purchase of fixed asset are called capitalized expenditure e.g.
wages paid for the installation of machinery.

The Treatments of Capital and Revenue Expenditures

Capital expenditures are shown in the Balance Sheet Assets Side while Revenue Expenditures are
shown in the Trading and Profit And Loss Account debit side.

Revenue Receipts
Amount received against revenue income are called revenue receipt.

Capital Receipts and Revenue Receipts:

Revenue Receipts:
The receipts or income which are received by the business organization in the course of normal
activities are revenue receipts.

Capital Receipts:
Receipts which are not of revenue nature are capital receipts.
The Receipts which are not received now and then can be treated as capital receipt.

Capital and Revenue Receipts Examples:

Capital Receipts:
1. Capitals contributed by members.
2. Share capital contributed by the share holders/ members.
3. Loans raised
4. Proceeds from sale of fixed assets.
5. Life membership fees in the case of clubs and associations.
6. Legacies.
7. Government grants for specific purpose.
8. Donations for specific purpose
Revenue Receipts:
1. Receipts from sale of goods or services.
2. Discounts, commissions received.
3. Interest on Bank Deposits.
4. Annual Subscriptions in the case of clubs and associations.
5. Donations which are general in nature.
6. Entrance fee.
7. Sale of old news papers.
8. Locker rent.

Capital Profits
Capital profit which is earned on the sale of the fixed assets.

Revenue Profit
The profit which is earned during the ordinary course of business is called revenue profit.

Capital Loss
The loss suffered by a company on the sale of fixed assets.

Revenue Loss
The loss suffered by the business in the ordinary course of business is called revenue loss.

Rules for Determining Capital Expenditure

An expenditure can be recognized as capital if it is incurred for the following purposes:
An expenditure incurred for the purpose of acquiring long term assets (useful life is at least more
than one accounting period) for use in business to earn profits and not meant for resale, will be
treated as a capital expenditure. For example, if a second hand motor car dealer buys a piece of
furniture with a view to use it in business; it will be a capital expenditure. But if he buys second
hand motor cars, for re-sale, then it will be a revenue expenditure because he deals in second hand
motor cars.
When an expenditure is incurred to improve the present condition of a machine or putting an
old asset into working condition, it is recognised as a capital expenditure. The expenditure is
capitalized and added to the cost of the asset. Likewise, any expenditure incurred to put an asset
into working condition is also a capital expenditure.
For example, if one buys a machine for ` 5,00,000 and pays ` 20,000 as transportation charges
and ` 40,000 as installation charges, the total cost of the machine comes upto ` 5,60,000. Similarly,
if a building is purchased for ` 1,00,000 and ` 5,000 is spent on registration and stamp duty, the
capital expenditure on the building stands at ` 1,05,000.
If an expenditure is incurred, to increase earning capacity of a business will be considered as of
capital nature. For example, expenditure incurred for shifting ‘the ‘factory for easy supply of raw
materials. Here, the cost of such shifting will be a capital expenditure.
Preliminary expenses incurred before the commencement of business is considered capital
expenditure. For example, legal charges paid for drafting the memorandum and articles of
association of a company or brokerage paid to brokers, or commission paid to underwriters for
raising capital.
Thus, one useful way of recognising expenditure as capital is to see that the business will own
something which qualifies as an asset at the end of the accounting period.

Some examples of capital expenditure:

(i) Purchase of land, building, machinery or furniture; (ii) Cost of leasehold land and building; (iii)
Cost of purchased goodwill; (iv) Preliminary expenditures; (v) Cost of additions or extensions to
existing assets; (vi) Cost of overhauling second-hand machines; (vii) Expenditure on putting an
asset into working condition; and (viii) Cost incurred for increasing the earning capacity of a
business.
Rules for Determining Revenue Expenditure
Any expenditure which cannot be recognised as capital expenditure can be termed as revenue
expenditure. A revenue expenditure temporarily influences only the profit earning capacity of the
business. An expenditure is recognised as revenue when it is incurred for the following purposes:
Expenditure for day-to-day conduct of the business, the benefits of which last less than one year.
Examples are wages of workmen, interest on borrowed capital, rent, selling expenses, and so on.
Expenditure on consumable items, on goods and services for resale either in their original or
improved form. Examples are purchases of raw materials, office stationery, and the like. At the
end of the year, there may be some revenue items (stock, stationery, etc.) still in hand. These are
generally passed over to the next year though they were acquired in the previous year.

Expenditures incurred for maintaining fixed assets in working order. For example, repairs,
renewals and depreciation.

Some examples of revenue expenditure

(i) Salaries and wages paid to the employees;
(ii) Rent and rates for the factory or office premises;
(iii) Depreciation on plant and machinery;
(iv) Consumable stores;
(v) Inventory of raw materials, work-in-progress and finished goods;
(vi) Insurance premium;
(vii) Taxes and legal expenses; and
(viii) Miscellaneous expenses.

Deferred Revenue Expenditures

Deferred revenue expenditures represent certain types of assets whose usefulness does not expire
in the year of their occurrence but generally expires in the near future. These type of expenditures
are carried forward and are written off in future accounting periods. Sometimes, we make some
revenue expenditure but it eventually becomes a capital asset (generally of an intangible nature).
If one undertakes substantial repairs to the existing building, the deterioration of the premises may
be avoided. We may engage our own employees to do that work and pay them at prevailing wage-
rate, which is of a revenue nature. If this expenditure is treated as revenue expenditure and the
current year’s-profit is charged with these expenses, we are making the current year to absorb the
entire expenses, though the benefit of which will be enjoyed for a number of accounting years. To
overcome this difficulty, the entire expenditure is capitalised and is added to the asset account.
Another example is an insurance policy. A business can pay insurance premium in advance, say,
for a 3 year period. The right does not expire in the accounting period in which it is paid but will
expire within a fairly short period of time (3 years). Only a portion of the total premium paid
should be treated as a revenue expenditure (portion pertaining to the current period) and the
balance should be carried forward as an asset to be written off in subsequent years. Now,
Preliminary Expenses are not shown in the balance Sheet as per para 56 of AS-26, it is a part of
other expenses which is shown in the Profit and Loss A/c (Part I of Schedule III in case of a
Company). It is a part of revenue expenditure, e.g., expenditure incurred on Scientific Research is
recognized as an expense when it is incurred”. In short, the whole amount of expenditure is treated
as expense for the current year only and will not proportionately be transferred as deferred charge.

Treatment of Revenue Expenditure as Capital Expenditure:

The following are some of the instances where an item of expenditure which is in the nature of
revenue expenditure will be treated as capital expenditure.
1. Repairs: Repairs expenditure is revenue in nature, but huge amount incurred on a second hand
machinery in order to bring it to working condition can be treated as capital expenditure and should
be added to the cost of Machinery.
2. Wages: Normally, wages are revenue in nature. But wages paid to the workers for the
construction or installation of fixed assets, will be treated as capital expenditure and added to the
cost of that asset.
3. Preliminary Expenses: All the expenses paid in the process of formation of a company should
be treated as capital expenditure and recorded in the balance sheet on asset side.
4. Brokerage, Government Stamp Duty and Legal Expenses: All the expenses paid on the
purchase of a property will be regarded as capital expenditure.
5. Raw Materials and Stores: These are generally revenue in nature, but if raw materials and
stores consumed in the making of a fixed asset, the same should be treated as capital expenditure.
6. Development Expenditure: All the expenditure incurred for the development of mines and
plantations should be treated as capital expenditure.

CASH BOOK AND OTHER SUBSIDIARY BOOKS.

A small business may be able to record all transactions in single Journal but as the business expands
the number of transactions becomes so large, that the Journal is required to be sub-divided
into Special Journals which are called Subsidiary Books.
Meaning :
The sub division of Journal on the basis of nature of transaction is known as Subsidiary Books.
These books are also called as Books of Original entries or Prime entries because the transactions
are first recorded in Subsidiary Books and then posted in the Ledger.

Need for maintaining Subsidiary Books :

1) Specialisation : When the staff is appointed for same type of work it leads to specialisation and
increase in efficiency.
2) Time saving and economical : Different accounting procedures can be taken up at the same
time. This will save time and prove to be economical.
3) Division of work : The writing of Subsidiary Books can be conveniently divided among
different clerks. Hence it is easy to keep the Books upto date.
4) Quick information and future reference : Subsidiary Books gives quick information relating
to the accounts and makes future reference easy.
5) Internal check : Verification of correctness can be made more effectively.
Following are the important Subsidiary Books.
(i) Cash Book: It records all those transactions which are in cash or by cheques.
(ii) Purchases Book: It records all transactions relating to goods purchased on credit.
(iii) Sales Book: It records all transactions relating to goods sold on credit.
(iv) Purchases Return Book: It records return of goods to suppliers.
(v) Sales Return Book: It records return of goods by the customers.
(vi) Bills Receivable Book: It records entries regarding bills receivables. The details of bills are
given in this book.
(vi) Bills Payable Book: All bills which are accepted and payable by a business house are recorded
in this book.
(viii) Journal Proper: Those transactions which are not recorded in any of the above mentioned
books are recorded in the Journal Proper.

Advantages
The advantages of using Special Journals are as under:
(a) Facilitates division of work:
The accounting work can be divided among many persons.
(b) Time and labour saving in journalising and posting:
For instance, when a Sales Book is kept, the name of the Sales Account will not be required to be
written down in the Journal as many times as the sales transactions occur and at the same time,
Sales Account will not be required to be posted again and again since, only a periodic total of Sales
Book is posted to the Sales Account.
(c) Permits the use of specialised skill:
The accounting work requiring specialised skill may be assigned to a person possessing the
required skill. With the use of a specialised skill, prompt, economical and more accurate supply of
accounting information may be obtained.
(d) Permits the installation of internal check system:
The accounting work can be divided in such a manner that the work of one person is automatically
checked by another person. With the use of internal check, the possibility of occurrence of
error/fraud may be avoided.

CASH BOOK
A Cash Book is a special journal which is used for recording all cash receipts and cash
payments. If a cash book is maintained, there is no need for preparing a cash account in the
ledger. However, the other aspects of the transactions will be recorded in the ledger. Cash Book
serves dual role of journal as well ledger. Cash Book is the book of original entry (Journal)
since transactions are recorded for the first time from the source documents. It is a ledger in the
sense that it is designed in the form of Cash Account and records cash receipts on the debit side
and cash payments on the credit side.

Features
• Only cash transactions are recorded in the Cash Book.
• It performs the functions of both journal and the ledger at the same time.
• All cash receipts are recorded on the debit side and all cash payments are recorded on the credit
side.
• The Cash Book, recording only cash transactions can never show a credit balance.

Kinds of Cash Book

Cash Book can be of several kinds:
(a) Single Column Cash Book- For recording cash transactions only.
(b) Double (Two) Column Cash Book- For recording cash transactions involving gain or loss on
account of discount.
(c) Triple (Three) Column Cash Book- For recording cash and bank transactions involving gain
or loss on account of discount.
(d) Petty Cash Book- For recording petty expenses.
PETTY CASH BOOK
In every business organisation, there are a number of payments which involve small amounts e.g.
payments for postage, telegrams, carriage, cartage etc. If all these transactions are recorded in the
Cash Book, it will increase the head cashier’s work manifold and it will make the Cash
Book unnecessarily bulky and uneasy. Normally, one person is handed over a small amount to
meet the petty expenses of a given period (say, week, fortnight or month) and is authorised to make
such payments and to record them in a separate Cash Book. Such person, amount and Cash Books
are called as “Petty Cashier”, ‘Imprest’ and ‘Petty Cash Book’ respectively. The Petty Cash
Book may or may not be maintained on ‘Imprest System’. Under both the systems (i.e. Imprest
and Non-imprest), the petty cashier submits the Petty Cash Book to the Head Cashier who
examines the Petty Cash Book. Under the Imprest system, the Head Cashier makes the
reimbursement of the amount spent by the Petty Cashier but under Non-imprest system, the
Head Cashier may handover the Cash to the Petty Cashier equal to/more than/less than the amount
spent. Usually, the Petty Cash Book is maintained on the basis of imprest system.

Advantage of the Imprest System: The system of petty cash payments along with the imprest
system offers the following advantages:
(1) The money in the hands of the petty cashier is limited to the imprest amount.
(2) As the periodical reimbursements are the actual expenses paid and not mere advances on
account only, they are as such brought prominently to the notice of Chief Cashier.
(3) The Chief Cashier, by handing over a fixed sum, is relieved of the cumbersome work of petty
disbursements.
(4) The main cash book is not unnecessarily clogged with the large number of small items. Even
in the ledger, only the totals are posted.
(5) At all time, the amount of cash in hand plus expenses not reimbursed must equal the imprest
amount, thus, facilitating a simple check.
(6) The maximum liability of the petty cashier can never exceed the imprest amount.
(7) The regular check of the petty cash book creates a sense of responsibility in the petty cashier.

All the heads of expenses are totalled periodically and such periodic totals are individually posted
to the debit side of the concerned ledger accounts in the ledger by writing ‘To Petty Cash A/c’ in
the particulars column. The Petty Cash Account in the ledger is credited with the total expenditure
incurred during the period by writing ‘By Sundries as per Petty Cash Book’ in the particulars
column. The ledger folio number is written under every total amount of expense to indicate
that the entry has been posted in the ledger. In the folio column of the ledger account, the page
number of the petty cash book is written.

PURCHASE BOOK
Purchases Book (also known as Invoice Journal/Bought Journal/Purchases Journal) is used for
recording only the credit purchases of goods and merchandise in which the business is dealing in,
i.e. goods purchased for resale purpose for earning revenue. It records neither the cash purchases
of goods nor the purchase of any asset other than the goods or merchandise.
When we purchase goods on credit we receive a statement from the supplier giving the particulars
of the goods supplied by him. The statement is known as an Invoice. The invoice states the
quality, price and the value of goods supplied. It also states the discount allowable (trade and
cash) and the condition under which payment is expected. The entries in the purchase book are
made on the basis of invoices received from the supplies with the amounts net of trade
discount/quantity discount. Trade discount is a reduction granted by the supplier from the list
price of goods and services on business consideration such as quantity bought, trade practices
other than for prompt payment. The object of allowing trade discount is to enable the retailer to
sell the goods to the customer at list price and still leaving margin for meeting business expenses
and his profit. Entries in the books of both supplier as well as retailer are made on the basis of net
amount i.e. invoice price less trade discount.
After recording transactions in the Purchases Book, the posting in ledger accounts will be made.
The posting from the Purchases Book is made as follows:
a) Debit the Purchases Account with the periodical totals of the Purchases Book. On the debit side
of the Purchases Account, write “To total as per Purchase Book” or “To Sundries” in the particulars
column.
b) Personal accounts of each individual supplier is credited with the net amount of Inward Invoice
recorded in Purchases Book by writing “By Purchases”.

SALES BOOK
Sales Book or Sales Journal is written up to record all the credit sales. Sales Book records only
those goods which are sold on credit and the goods in question must be those, which the firm
generally deals in. If there are cash sales they are recorded in Cash Book and sale of assets are
recorded in the Journal proper.
The entries in the Sales Book are made from the copies of the invoice which have been sent to
customers along with the goods. Such copies of the invoices may be termed as Outward Invoice.
Each such outward invoice should be numbered consecutively and the reference be given in the
Sales Book along with the entry.
The Sales book is totalled periodically. The net amount of the invoices in Sales Book is posted to
the ledger as follows:
(a) Debit the personal accounts of the customers with the value of sales to them.
(b) Credit Sales Account with the periodical total.

PURCHASE RETURN BOOK

In every business, it is not uncommon to find that the goods are returned by a business enterprise
to the suppliers because of many reasons such as goods are defective, goods are not according
to order. If the returns are frequent in a business, in that case a separate book may be maintained
to record this type of transactions which is known as Purchases Returns Book or Returns Outward
Book.
The entries in the Purchases Returns Book are usually made on the basis of debit notes issued
to the suppliers. When a firm returns some goods to it suppliers, it prepares a debit note in
duplicate. The original copy is sent to the supplier to whom the goods are returned. The Debit
Note is so called because the supplier’s account is debited with the amount of the goods
returned.
After recording the transaction in Purchases Returns Book, posting to the ledger involves the
following:
(a) The periodical total of the Purchases Return Book is posted to the credit of the Purchases Return
Account in the ledger.
(b) The personal account of each individual suppliers is debited with the amount of Debit Note.

SALES RETURN BOOK

Sales Return Book or Returns Inwards Book is meant for recording return of goods sold on credit.
The goods which are sold for cash if returned are either exchanged for new goods or parties are
paid in cash do not find a place in the Sales Return Journal. The columns used in this book are
similar to Sales Book except that in place of Invoice No. the Credit Note number is recorded.
Credit Note is just reverse of Debit Note and is sent by the seller to the buyer. It is an
acknowledgment of the goods returned as well as information to the debtor that his account is
being credited with the amount mentioned in it. Thus, the party to whom a Credit Note is sent
become a creditor.
The posting from the Sales Return Book will be done periodically to the debit side of the Sales
Returns Account in the ledger and the individual accounts of the customers will be credited with
their respective amounts.

BILLS RECEIVABLE BOOK

Where a payment for a business transaction is not made immediately but is deferred or postponed
for a few months, a bill of exchange payable some time ahead may be drawn by the creditor (seller)
on his debtor (purchaser). The bill of exchange is then accepted by the debtor indicating that he
would pay the amount specified therein on the expiry of the period stated on the bill. To the
creditor, who draws the bill upon his customer, it is termed as Bills Receivable representing money
to be received at a future date; to the debtor, the bill on acceptance becomes a Bills Payable
indicating that the money has to be paid at a future date.
Transactions involving the drawing, the acceptance and negotiation of bills are recorded in Bills
Receivable and Bills Payable Books respectively.
Bills Receivable Book is used to record the details of bills receivable on which the business
enterprise will receive the amounts from other parties in future. The entries to be made in this book
include the name of the acceptor (debtor), the terms, due date, the amount and other details.
Posting: The total of the amount column of the Bills Receivable Book is debited to the Bills
Receivable Account while the amount of each bills receivable is posted to the credit of the account
of the party from whom it is received.

BILLS PAYABLE BOOK

This is also a book of original entry and is used to record the particulars of all the bills payable
accepted by the business enterprise for the purpose of paying at a future date amounts due by it
(the business enterprise or trader) to its or his creditors. The entries to be made in this book relate
to the name of the drawer, the name of the payee, the period, the due date, and other particulars.
Then the acceptance is duly returned to the drawer.
Posting: The amount of each bill is posted to the debit side of the drawer’s account in the ledger
and the total of the amount column of the Bills Payable Book is posted to the credit of Bills
Payable Account in the ledger.

JOURNAL PROPER
Journal Proper is a residuary book in which those transactions are recorded which cannot be
recorded in any other subsidiary book such as
(a)Cash Book, (b) Purchases Book, (c) Sales Book, (d) Purchases Returns Book, (e) Sales Returns
Book, (f) Bills Receivable Book, and (g) Bills Payable Book.

The various examples of transactions entered in a Journal Proper are given below:
(i) Opening entry: An Opening Entry is passed in the journal for bringing the balances of various
assets, liabilities and capital appearing in the Balance Sheet of the previous accounting period, in
the books of current accounting period.
(ii) Closing entries: Closing Entries are passed in the journal for closing the nominal accounts
by transferring them to the Trading and Profit and Loss Account. These are needed at the end
of the accounting year, when the final accounts are prepared.
(iii) Transfer entries: Transfer Entries are passed in the journal for transferring an amount from one
account to another account, i.e. Transfer of Total Drawings from Drawings Account to Capital
Account.
(iv) Adjusting entries: Adjusting Entries are passed in the journal to bring into the books of
accounts certain unrecorded items like closing stock, depreciation on fixed assets, outstanding and
prepaid items. These are needed at the time of preparing the final accounts.
(v) Rectifying entries: Rectifying Entries are passed in the journal to rectify the various errors
committed while posting, totalling, balancing etc.
(vi) Miscellaneous entries: This include the following:
(a) Capital brought in kind. If the proprietor of the business brings in his capital contribution in
kind and not in cash, such transaction can be recorded only in the Journal Proper and not in the
Cash Book since this transaction does not involve any cash inflow.
(b) Purchase of Assets (other than Stock-in-trade) on credit (e.g., land, building, plant and
machinery, furniture and fixture). Such transactions can neither be recorded in the Purchase
Book (since no goods have been purchased) nor recorded in the Cash Book (since this transaction
does not involve any cash outflow).
(c) Sales of Assets (other than Stock-in-trade) which were sold on credit. Such transaction can
neither be recorded in the Sales Book (since no goods have been sold) nor can be recorded in the
Cash Book (since this transaction does not involve any cash inflow).
(d) Return of Assets (other than Stock-in-trade) which were sold on credit. Such transactions
cannot be recorded in the Return Inwards Book since no goods have been returned.
(e) Return of Assets (other than Stock-in-trade) which were bought on credit. Such transactions
cannot be recorded in the Return Outwards book since, no goods have been returned.
(f) Endorsement of Bills Receivable to a creditor.
(g) Dishonour of Bills Receivables (not discounted with bank).
(h) Cancellation of Bills Payable.
(i) Abnormal Loss of Stock-in-trade/other assets by theft, accident, fire, etc.
(j) Writing-off Bad Debts.