Introduction to Accounting

1
:
Accounting is the language of business. Accounting, as any language is used for
communication. The business communicates to internal as well external parties the
information about the position as well as performance of the business. It helps in making
decisions. All the stakeholders-current and prospective shareholders, bankers, current and
prospective lenders, government, suppliers, customers, managers, employees are
interested to know about the financial performance and financial position of the business.
Accounting helps us to record the transactions of the business in a systematic manner,
analyse the transactions to prepare the financial statements and interpret the statements.
Every business transaction involves two way effects on the business- receiving and
giving effect. usiness undertakes all activities with the ob!ective of maximising the
wealth of the owners "shareholders#. $wners invest in the business with the expectation
of profit and therefore the resources provided by the owners and borrowed from others
are used in business activities to make the profit.
%ike any other language it also has three components vi&. 'ocabulary, grammar and
punctuation marks. As stated earlier, every transaction involves give and take of some
resources by the business( we need to record these changes under the proper head
"account#. )o we need to identify the accounting heads involved in each transaction so
that the transactions can be properly and accurately recorded. Thus we need to use the
correct accounting heads for each transaction similar to the fact that we need to use the
right words to express what we need to communicate. Thus, one needs to have the proper
understanding of the accounts affected in each transaction. The accounting head
represents the transaction and usually, it is used as the title for accounting head.
%ike when salaries are paid in cash, salaries and cash are involved in the transaction so
the accounting head involved will be *)alaries+ and *,ash+. -hen owner invests in
business "rings cash to the business# then the investment by the owner and cash are
involved. The investment by owner in the business is called as his capital, so the accounts
involved are *,apital+ and *,ash+. Thus, to record a transaction we need to ascertain the
accounting heads involved.
Even if we know the right words for what we need to communicate, we can not
communicate by !ust saying these words, since, these words are re.uired to be properly
organised into sentences using the correct verbs, prepositions and articles. )imilarly we
need to ascertain the effect of each transaction on the accounting heads "involved in the
transactions# on the business so that these can be properly recorded. As stated earlier,
each transaction involves receiving and giving, thus the transactions are to be recorded
under each accounting head on the basis of its effect on the accounting heads. The
receiving aspect is recorded as debit and the credit aspect is recorded as credit in the
respective accounting heads. Each transaction will result in an e.ual amount of debit
and credit. Thus this system is called double entry book keeping system. %ike grammar
helps us in the correct use of verbs, articles and prepositions and making the correct
sentences to communicate accurately, the grammar of accounting helps us in ascertaining
which account is to be debited and which to be credited.
/
0unish, This handout is for private circulation only.
-e analyse the effect of a transactions on the concerned accounts to determine the
accounts to be debited or credited. 1or this purpose all the accounting heads are divided
into two primary categories vi&. Assets and %iabilities.
Assets2 Assets are the economic resources owned3controlled by the business which have
future economic benefits. Assets received by the business from owners or outsiders will
result in increase in assets and when ever these are given to owners or outsiders will
result in decrease in assets. Thus in any transaction if any asset is received will represent
the receiving aspect and when ever it is given will represent the giving aspect.
%iabilities2 %iabilities are the future obligations as a result of past or current transactions.
The amounts owed by business to other parties are called liabilities. The other parties
may be the owners, lenders, and suppliers of goods and services to the business. The
amounts owed to any party other than owners are called external liabilities "usually called
liabilities# and the amounts due to owners are called internal liability "owners+ e.uity#.
At any given time the assets of the business will be e.ual to owners+ e.uity plus
liabilities. Alternatively we can say owners+ e.uity is e.ual to assets minus liabilities
"owners+ e.uity is e.ual to assets minus liabilities or residual interest# and is expressed as
given in the e.uations below2
Assets 4 %iabilities 5 $wners+ e.uity or
$wners+ E.uity 4 Assets 6 %iabilities
Any increase in assets, or decrease in owners+ e.uity and liabilities represent the
receiving aspect and any decrease in assets or increase in owners+ e.uity or liabilities
represents the giving aspect of a transaction.
Any account showing the receiving aspect is debited and the account showing the giving
aspect is credited. ased on this the rules of debit and credit can be stated as below2
/. All increases in assets are debited and all decreases in assets are credited.
7. All increases in liabilities are credited and all decreases in liabilities are debited.
8. All increases in owners+ e.uity are credited and all decreases in owners+ e.uity are
debited.
The third component of the language is punctuation marks. 9unctuation marks help us in
giving right emphasis on a given part in the sentence to convey the correct meaning. -e
may have sentences with the same order of words but the use of punctuation marks can
make the difference in the meaning of the same sentence. The two similar sentences
given below having punctuation marks at different places have diagrammatically opposite
meaning2
*:usband, without wife, is useless.+
*:usband without, wife is useless.+
9rocess of ;ecording the Transactions2
1irst of all, we need to analy&e each transaction taking place in the business to ascertain
whether it will be recorded in the accounting books or not. All those transactions which
involve exchange of cash, goods, or services with third party or affect the assets,
liabilities and3or owners+ e.uity and the effect can be at least in part ascertained in money
value. The transactions which can not be measured in money values are not recorded in
the books of accounts. $nce a transaction has been identified, we need to prepare the
voucher "also called source documents# for the same and keep the documentary evidence
of happening of the transaction. The vouchers can be categori&ed into three categories on
the basis of the transactions.
These are given below2
'ouchers for Transactions involving receipt of cash or payment of cash2-
Debit Voucher: 1or every transaction involving payment of cash a debit voucher is to be
prepared. 9ayment of cash results in decrease in cash "Asset#, therefore the cash account
will be credited. The account involved for the purpose of paying cash needs to be debited.
In this voucher the name of the account to be debited is mentioned, therefore, it is called
<ebit 'oucher.
Credit Voucher: 1or every transaction involving receipt of cash a credit voucher is to be
prepared. ;eceipt of cash results in increase in cash "Asset#, therefore the cash account
will be debited. The account involved for the purpose of receiving cash needs to be
credited. In this voucher the name of the account to be credited is mentioned, therefore, it
is called ,redit 'oucher.
'ouchers for =on-,ash Transactions2-
ournal Voucher: -hen in a transaction cash is not involved, like credit purchases or
credit sales, then we need to ascertain the accounts to be debited and credited. 1or such
transactions we prepare the !ournal voucher and the account"s# to be debited as well as to
be credited are mentioned.
All these vouchers are to be signed by the competent authority which means the
transactions have been authorised.
$nce the source documents have been prepared, these are given to the accounts
department for recording the transactions. There is a particular way of recording the
transactions of the business. 1irst, all the transactions "irrespective of their nature# are
recorded in chronological order in a book which is named as *>ournal+. The !ournal is also
called the book of original entry and the process of recording the transactions in a !ournal
is called !ournalising the transactions. -e also briefly describe the transaction after each
!ournal entry, which is called narration. The basic purpose of the !ournal is to record all
the transactions of the business in chronological order.
The basic drawback of these records is that it is not possible to know the current status of
any account, for example from !ournal, we can not ascertain the amount due from a
customer, or owed to supplier, purchases made, sales, assets etc. Therefore, we need to
classify these transactions and record them at the same place "ledger accounts# so that we
can know the net amount for each account. The transactions are again recorded according
to the nature. )ince in each transaction two or more accounts are involved, so the
recording is to be made in each of the account involved. This process is called posting of
transactions to the ledger. -e record against each !ournal entry the page number of ledger
account to which this entry is posted. -e also record in the ledger account the page
number of !ournal from where this entry has been posted.
A closer %ook at Accounting E.uation2
Accounting E.uation has three basic elements vi&. Assets, %iabilities and $wners+ E.uity.
Assets: Assets are the economic resources owned or controlled by the business which
have potential future benefits. Assets are used by the business to carry out the business
activities. These may be divided into different categories as fixed or long term assets and
current assets. %ong term assets can further be divided into tangible assets "property plant
and e.uipment and long term investments# and intangible assets. The examples of such
assets are machinery, land ? buildings, furniture ? fittings etc. Intangible assets do not
have physical existence( these assets do not have intrinsic value as their value is owner
dependent and the benefits from such assets are highly uncertain in terms of magnitude
and period. %ong term assets give benefits over a period of more than one year or
operating cycle and held by the business to carry out the activities and not for the purpose
of resale. ,urrent assets give the benefits over a period of less than one year or operating
cycle. The examples are raw material, finished goods, debtors, cash etc.
!iabilities: %iabilities are the obligations to other parties which are to be met in future.
The liabilities are the amounts owed as a result of past or current transactions. )ettlement
of liabilities will result in outflow of assets. The examples are creditors, outstanding
expenses etc.
"#ners$ %&uity: This represents the owners+ stake in the business. The assets brought by
the owners are also called capital of the owner or Investment by owners. :is stake
changes when ever business makes any profit or loss or he brings more assets into the
business or withdraws some assets from the business "called as distribution to owners for
example drawings or distribution of dividends#. -e will discuss some more terms before
discussing about owners+ e.uity.
;evenues2 The revenues result inflow of assets or settlement of liabilities or the
combination of both as a result of ma!or activities of the business. The examples are cash
received or receivable from the sale of goods3 services for which the business is incepted.
Expenses2 Expenses result in outflow of assets or incurrence of liabilities or a
combination of both as a result of ma!or activities of the business. The examples are
payment of salaries, rent, cost of goods sold etc.
@ains2 @ains result in increase of net assets from activities other than ma!or activities of
the business or receiving assets from the owners. The examples are gain from sale of old
furniture.
%osses2 %osses result in decrease of net assets from activities other than ma!or activities
of the business or distribution of assets to the owners. The examples are loss on sale of
old machinery.
The net result of revenues and gains minus expenses and losses is stated as net income
"loss#. The net income will increase the owners+ e.uity while net loss will decrease the
owners+ e.uity. The owners+ e.uity will increase when ever the owner brings more assets
to the business and will decrease when ever he withdraws some assets from the business.
Thus, investment made by owners, revenues and gains will increase owners+ e.uity while
distribution to owners, expenses and losses will decrease the owners+ e.uity. This may be
stated in the form of following e.uations2
=et Income "%oss# 4 ;evenues 5 @ains 6 Expenses 6 %osses
$wners+ E.uity 4 Investment by $wners 5 =et Income 6 <istribution to owners
"$r 6 =et %oss#
Thus when ever an asset is exchanged with another asset having e.uivalent value it will
only change the composition of assets but not the total assets and hence the owners+
e.uity will not be affected. )imilarly, when a liability is settled by giving some asset, the
amount of assets and liabilities will decrease without any effect on owners+ e.uity. ut in
case of revenues, expenses, losses and gains the owners+ e.uity is affected. -hile earning
the revenues we also make expense and thus from each revenue the owners+ e.uity will
increase by the net amount of revenues less expenses. It will not be practically possible to
find out the income from revenue earned on individual basis, therefore, we record the
revenues as and when earned and find ascertain the income at the end of the period,
usually one year. Therefore, the revenues will be credited as and when they are earned
and expenses will be debited as and when they accrue.
Analysis of Transactions to ascertain the Accounting 'eads to be debited and
credited:
%et us look at the following transactions2
0r. ;am Ashray started the business of manufacturing polythene bags. :e was managing
the business and looking after the purchases ? sales and maintaining the accounts, and
appointed some persons to look after the manufacturing of bags. :e follows the practice
of making all payments through bank except petty cash expenses and to receive all
amounts through bank only.
/. 0r. ;am Ashray brings ;upees ABB,BBB as his capital to start business in the
name of the firm *:onest 0anufacturing ,ompany+.
7. <eposited ;upees. CDA,BBB in bank account opened in the name of the business.
8. %and purchased for ;upees /BB,BBB.
C. 9aid to the contractor ;upees /7A,BBB for construction of buildings
A. 9urchased 1urniture for ;upees 8A,BBB and 9lat ? 0achinery for ;upees EA,BBB.
F. 9aid ;upees /A,BBB for installation of E9G and the telephone and A<)% at the
premises.
D. Appointed one supervisor at ;upees /B,BBB per month, four machine operators at
;upees F,BBB per month, one technician at ;upees D,ABB per month and one
helper at ;upees 8,BBB per month.
E. 9urchased raw materials for ;upees 7A,BBB on cash and ;upees /E,BBB on credit
from =ew -ave Traders.
H. 9aid ;upees CC,ABB as salaries to the employees through bank.
/B. 9aid ;upees 7A for tea and snacks for the staff at the month end meeting.
$n analysing the above transactions, we find that all the transactions except Transaction
=o. D have affected the elements of financial statements of :onest Trading ,ompany.
Transaction =o. D will affect its elements of financial statements only when the salaries
will be due. Therefore, the entry relating to this transaction will be made every month
when the salaries are due3 paid.
Analysis of Transactions2
/. This transaction results in increase in asset ",ash received by the business# and
increase in owners+ e.uity ",apital brought by owner#. This may be stated as
increase in asset-,ash Account to be debited and increase in owners+ e.uity-
,apital Account to be credited
7. This transaction results in increase in one asset ",ash deposited in bank account
resulting in increase in bank balance# and decrease in another asset ",ash paid to
bank#. This may be stated as increase in asset-ank Account to be debited and
decrease in asset-,ash Account to be credited.
8. This transaction results in increase in one asset "%and purchased by the business#
and decrease in another asset "amount paid by che.ue resulting in decrease in
bank balance#. This may be stated as increase in one asset-%and Account to be
debited and decrease in another asset-ank Account to be credited.
C. This transaction results in increase in one asset "uildings constructed by the
business# and decrease in another asset "amount paid by che.ue resulting in
decrease in bank balance#. This may be stated as increase in one asset-uildings
Account to be debited and decrease in another asset-ank Account to be credited.
A. This transaction can be analysed in two parts, one for purchase of furniture and
the other for purchase of plant ? machinery. The first part of the transaction
results in increase in one asset "1urniture purchased by the business# and decrease
in another asset "amount paid by che.ue resulting in decrease in bank balance#.
This may be stated as increase in one asset-1urniture Account to be debited and
decrease in another asset-ank Account to be credited. The second part of the
transaction results in increase in one asset "9lant ? 0achinery purchased by the
business# and decrease in another asset "amount paid by che.ue resulting in
decrease in bank balance#. This may be stated as increase in one asset-9lant and
0achinery Account to be debited and decrease in another asset-ank Account to
be credited.
F. This transaction results in increase in one asset "E9G Installed by the business#
and decrease in another asset "amount paid by che.ue resulting in decrease in
bank balance#. This may be stated as increase in one asset-E9G Account to be
debited and decrease in another asset-ank Account to be credited.
D. As explained above no entry is re.uired now. Each month the entry will be
recorded for the total salaries paid. This will results in increase in expenses
")alaries# and decrease in asset "decrease in bank balance due to payment of
salaries#. This may be stated as decrease in $wners+ E.uity-)alaries Expenses
Account to be debited and decrease in Asset- ank Account to be credited.
E. This transaction can be analysed in two parts, one for purchase of raw material on
cash the other for purchase of raw material on credit. The first part of the
transaction results in increase in one asset ")tock of ;aw material by the business#
and decrease in another asset "amount paid by che.ue resulting in decrease in
bank balance#. This may be stated as increase in one asset-9urchases Account to
be debited and decrease in another asset-ank Account to be credited. The second
part of the transaction results in increase in one asset ")tock of ;aw material by
the business# and increase in liability "amount owed to =ew -ave Traders#. This
may be stated as increase in one asset-9urchases Account to be debited and
increase in another liability 6 =ew wave Traders or )undry ,reditors Account to
be credited.

H. This transaction results in increase in )alaries expenses "decrease in owners+
e.uity# and decrease in another asset "amount paid by che.ue resulting in
decrease in bank balance#. This may be stated as increase in expenses - )alaries
Expenses Account to be debited and decrease in another asset-ank account to be
credited.
/B. This transaction results in increase in petty expenses "decrease in owners+ e.uity#
and decrease in another asset "amount paid by cash resulting in decrease in cash
balance#. This may be stated as increase in expenses - 9etty Expenses Account to
be debited and decrease in another asset-,ash account to be credited.
(or)at of ournal:
>$I;=A% of 03) JJJJJJJJJ.
<ate 9articulars %.1. Amount Amount
/ ,ash A3, <r
To ,apital A3,
",ash brought by $wner#
ABB,BBB
ABB,BBB
7 ank A3, <r
To ,ash A3,
",ash deposited in ank Account#
CDA,BBB
CDA,BBB
8 %and A3, <r
To ank A3,
"9urchased land and paid by che.ue#
/BB,BBB
/BB,BBB
C ank
uildings
"9aid for buildings constructed#
/7A,BBB
/7A,BBB
A 1urniture
9lant and 0achinery
ank
"9urchased 1urniture ? 9lant ?
0achinery( paid by che.ue#
8A,BBB
EA,BBB
/7B,BBB
F E9G
ank
"Installed 9AG and paid by che.ue#
/A,BBB
/A,BBB
E 9urchases
ank
). ,reditors
"9urchased raw material for 7A,BBB
on cash and for /E,BBB on credit from
=ew -ave Traders#
C8,BBB
7A,BBB
/E,BBB
H )alaries
ank
"9aid salaries for the month by
che.ue#
CC,ABB
CC,ABB
/B 9etty Expenses
,ash
"9aid cash for petty expenses#
7A
7A
It is clear from the above recordings that though, each transaction has been recorded
but we can not ascertain net amount for any type of transactions. Therefore, we need
to record the similar transactions at one place and this process is called posting of
transactions to %edger. The ledger contains all the accounts involved in the
transactions and we record the entries in each of the ledger account.
(or)at of !edger:
%edger of 03) JJJJJJJJJJJJJJ
Cash Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
/ ,apital ABB,BBB 7 ank CDA,BBB
/B 9etty Expenses 7A
alance c3d 7C,HDA
Total *++,+++ Total *++,+++
Capital Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
alance c3d ABB,BBB / ,ash ABB,BBB
Total *++,+++ Total *++,+++
,an- Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
7 ,ash CDA,BBB 8 %and /BB,BBB
C uildings /7A,BBB
A 1urniture 8A,BBB
A 9lant ? 0achinery EA,BBB
F E9G /A,BBB
E 9urchases 7A,BBB
H )alaries CC,ABB
alance c3d CA,ABB
Total ./*,+++ Total ./*,+++
!and Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
8 ank /BB,BBB alance c3d /BB,BBB
1++,+++ 1++,+++
,uildings Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
C ank /7A,BBB alance c3d /7A,BBB
Total 10*,+++ Total 10*,+++
(urniture Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
A ank 8A,BBB alance c3d 8A,BBB
1*,+++ 1*,+++
2lant 3 4achinery Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
A ank EA,BBB alance c3d EA,BBB
5*,+++ 5*,+++
%2,6 Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
F ank /A,BBB alance c3d /A,BBB
1*,+++ 1*,+++
2urchases Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
E ank 7A,BBB
E ). ,reditors /E,BBB alance c3d C8,BBB
.1,+++ .1,+++
7. Creditors Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
alance c3d /E,BBB E 9urchases /E,BBB
Total 15,+++ Total 15,+++
7alaries Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
H ank CC,ABB alance c3d CC,ABB
..,*++ ..,*++
2etty %8penses Account
<ate 9articulars >.1. Amount <ate 9articulars >.1. Amount
/B ,ash 7A alance c3d 7A
0* 0*
T9IA! ,A!A:C% "( 4;7 <<< ("9 T'% =%A9 %:D%D <<<
9articulars Amount 9articulars Amount
,ash 7C,HDA ,apital ABB,BBB
ank CA,ABB ). ,reditors /E,BBB
%and /BB,BBB
uildings /7A,BBB
1urniture 8A,BBB
9lant ? 0achinery EA,BBB
E9G /A,BBB
9urchases C8,BBB
)alaries CC,ABB
9etty Expenses 7A
Total *15,+++ Total *15,+++