Chapter 1

Accounting: The Language of Business

What is accounting?

The language of business

Measures financial aspects of a business Communicates this information to decision makers

1- 2

The Need for Accounting

Managers, investors, and other internal groups want the answers to two important questions:

How well did the organization perform?

Where does the organization stand?

The Need for Accounting

Accountants answer these questions with three major financial statements:

Income statement

Balance sheet

Statement of cash flows

Introduction

Accounting - a process of identifying, recording, summarizing, and reporting economic information to decision makers in the form of financial statements Financial accounting - focuses on the specific needs of decision makers external to the organization, such as stockholders, suppliers, banks, and government agencies

The Nature of Accounting

The accounting system is a series of steps performed to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their effects on an organization and to prepare the financial statements.

The Nature of Accounting

Accounting systems are designed to meet the needs of the decisions makers who use the financial information. Every business has some sort of accounting system.

These accounting systems may be very complex or very simple, but the real value of any accounting system lies in the information that the system provides.

Accounting as an Aid to Decision Making

Accounting information is useful to anyone who makes decisions that have economic results.

Managers want to know if a new product will be profitable. Owners want to know which employees are productive. Investors want to know if a company is a good investment. Creditors want to know if they should extend credit, how much to extend, and for how long. Government regulators want to know if financial statements conform to requirements.

Accounting as an Aid to Decision Making

Fundamental relationships in the decisionmaking process:

Event

Accountants analysis & recording

Financial Statements

Users

Financial and Management Accounting

The major distinction between financial and management accounting is the users of the information.
Financial accounting serves external users. Management accounting serves internal users, such as top executives, management, and administrators within organizations.

Financial and Management Accounting

The primary questions about an organizations success that decision makers want to know are: What is the financial picture of the organization on a given day? How well did the organization do during a given period?

Financial and Management Accounting

Accountants answer these primary questions with three major financial statements. Balance Sheet - financial picture on a given day Income Statement - performance over a given period Statement of Cash Flows - performance over a given period

Financial and Management Accounting

Annual report - a document prepared by management and distributed to current and potential investors to inform them about the companys past performance and future prospects.

The annual report is one of the most common sources of financial information used by investors and managers.

Financial and Management Accounting

The annual report usually includes:

a letter from corporate management a discussion and analysis of recent economic events by management footnotes that explain many elements of the financial statements in more detail the report of the independent auditors a statement of managements responsibility for preparation of the financial statements other corporate information

The Balance Sheet

What are the different sections of the Balance Sheet?

Balance Sheet
The balance sheet (also called statement of financial position or statement of financial condition) is a snapshot of the financial status of an organization at a point in time.

Balance Sheet
Assets are economic resources that are expected to benefit future activities of the organization.

Liabilities are the entitys economic obligations to others.

Owners equity is the excess of the assets over the liabilities.

Balance Sheet
The owners equity of a corporation is called shareholders equity.

Shareholders equity
Paid-in capital Retained earnings

The Balance Sheet

Sections of the balance sheet:

Assets - resources of the firm that are expected to increase or cause future cash flows (everything the firm owns) Liabilities - obligations of the firm to outsiders or claims against its assets by outsiders (debts of the firm) Owners Equity - the residual interest in, or remaining claims against, the firms assets after deducting liabilities (rights of the owners)

The Balance Sheet

The balance sheet equation:

Assets = Liabilities + Owners Equity or Owners Equity = Assets - Liabilities

Four Basic Financial Statements

Balance Sheet

Assets = Liabilities + Equity

Income Statement (also called Statement of Operations,

Earnings Statement, Profit/Loss (or P&L) Statement

Revenues - Expenses = Net income (or Net Earnings) Beginning of period total equity + Stock issued + Net income - Dividends = End of period total equity Cash inflow - Cash outflow = Net cash flow

Statement of Changes in Stockholders Equity

Statement of Cash Flows

1- 21

Users of Accounting Information

Different categories of users need different
kinds of information for making decisions.

These users can be divided into :

Internal Users; and External Users.

Internal Users
These are the persons who manage the
business, i.e. management at the top,

middle, and lower levels. Their requirements

of information are different because they

make different types of decisions.

Internal Users

continue

The top level is more concerned with planning; the middle level is concerned equally with planning and control; and the lower level is concerned more with controlling operations. Information is supplied on different aspects, e.g. cash resources, sales estimates, results of operations, financial position, etc.

External Users
All persons other than internal users come in the group of external users. External users can be divided into two groups:

those having direct interest; and

those having indirect interest

in a business organization.

External Users

continue

The main sources of information for external users are annual reports of business organizations, which state the financial position and performance and give the auditors report, directors report and other information.

External Users

continue

Investors and creditors are the external users having direct interest. Tax authorities, regulatory agencies, customers, labour unions, trade associations, stock exchanges, investors, etc are indirectly interested in the companys financial strength, its ability to meet short-term and long-term obligations, its future earning power, etc for making various decisions.

ASSETS
These are economic resources of an enterprise that can be usefully expressed in monetary terms. Assets are things of value used by the business in its operations.
Fixed Assets

Current Assets

ASSETS

continue

Fixed Assets are assets held on a longterm basis.

e.g. Land, Building, Machinery, Plant, Furniture and Fixtures, etc.

ASSETS

continue

Current Assets are assets held on a short-term basis.

e.g. Debtors, Bills receivable, Stock(Inventory), Cash and Bank balances, etc.

LIABILITIES
These are obligations or debts that the
enterprise must pay in money or services at

some time in the future.

Long-term liabilities Short-term liabilities

LIABILITIES

continue..

Long-term liabilities are those that are

usually payable after a period of one year.

e.g. A term loan from a financial institution,

debentures (bonds) issued by a company.

LIABILITIES

continue..

Short-term liabilities are obligations that

are payable within a period of one year.

e.g. Creditors, bills payable, overdraft from

a bank for a short period.

CAPITAL
Investment by the owner for use in the firm
is known as capital. Owners equity is the

ownership claim on total assets. It is equal

to total assets minus total liabilities.

REVENUES
These are the amounts the business earns
by selling its products or providing services

to customers. Other titles and sources of

revenue common to many businesses are:

sales, fees, commission, interest, dividends,

royalties, rent received, etc.

EXPENSES
These are costs incurred by a business in the process of earning revenue. Generally, expenses are measured by the cost of assets consumed or services used during an accounting period. The usual titles of expenses are: depreciation, rent, wages, salaries, interest, costs of heat, light and water, telephone, etc.

PURCHASES
Purchases are total amount of goods procured by a business on credit and for cash, for use or sale. In a trading concern, purchases are made of merchandise for resale with or without processing. In a manufacturing concern, raw materials are purchased, processed further into finished goods and then sold. Purchases may be cash purchase or credit purchase.

SALES
Sales are total revenues from goods or
services sold or provided to customers.

Sales may be cash sales or credit sales.

STOCK
Stock (Inventory) is a measure of

something on hand goods, spares and

other items in a business.

It is called stock on hand.

STOCK: continue
In a trading concern, the stock on hand is
the amount of goods which have not been

sold on the date on which the balance sheet

is prepared. This is also called closing

stock.

STOCK
comprises closing date. raw

continue

In a manufacturing concern, closing stock

materials,

semi-finished

goods and finished goods on hand on the

Similarly, opening stock is the amount of stock at the beginning of the accounting year.

DEBTORS
Debtors are persons and/or other entities who
owe to an enterprise an amount for receiving goods and services on credit. The total amount standing against such persons and/or entities on the closing date, is shown in the Balance Sheet as Sundry Debtors on the asset side.

CREDITORS
Creditors are persons and/or other entities who have to be paid by an enterprise an amount for providing the enterprise goods and services on credit.
The total amount standing to the favour of such persons and/or entities on the closing date, is shown in the Balance Sheet as Sundry Creditors on the liability side.

ACCOUNTING PRINCIPLES
Accounting principles can be subdivided into two categories:

Accounting Concepts; and

Accounting Conventions.

ACCOUNTING PRINCIPLES
Accounting principles can be subdivided into two categories:

Accounting Concepts; and

Accounting Conventions.

ACCOUNTING PRINCIPLES
Accounting Concepts

Accounting Conventions

The term concept is used to connote accounting postulates, that is necessary assumptions and conditions upon which accounting is based. The term convention is used to signify customs and traditions as a guide to the presentation of accounting statements.

ACCOUNTING PRINCIPLES
Accounting Concepts
Business Entity Concept Money Measurement Concept

Cost Concept
Going Concern Concept Dual Aspect Concept Realization Concept Accounting Period Concept

ACCOUNTING PRINCIPLES
Accounting Conventions
Convention of Consistency Convention of Disclosure

Convention of Conservation

ACCOUNTING PRINCIPLES
Accounting Concepts
The term concept is used to connote accounting postulates, that is necessary assumptions and conditions upon which accounting is based.

Business Entity Concept

Business is treated as a separate entity or unit apart from its owner and others. All the transactions of the business are recorded in the books of business from the point of view of the business as an entity and even the owner is treated as a creditor to the extent of his/her capital.

Money Measurement Concept

In accounting, we record only those

transactions which are expressed in terms

of money. In other words, a fact which can

not be expressed in monetary terms, is not

recorded in the books of accounts.

Cost Concept
Transactions are entered in the books of accounts at the amount actually involved. Suppose a company purchases a car for Rs.1,50,000/- the real value of which is Rs.2,00,000/-, the purchase will be recorded as Rs.1,50,000/- and not any more. This is one of the most important concept and it prevents arbitrary values being put on transactions.

Going Concern Concept

It is persuaded that the business will exists
for a long time and transactions are

recorded from this point of view.

Dual Aspect Concept

Each transaction has two aspects, that is,
the receiving benefit by one party and the

giving benefit by the other. This principle is

the core of accountancy.

Dual Aspect Concept continue

For example, the proprietor of a business starts his business with Cash Rs.1,00,000/-, Machinery of Rs.50,000/- and Building of Rs.30,000/-, then this fact is recorded at two places. That is Assets account (Cash, Machinery & Building) and Capital accounts. The capital of the business is equal to the assets of the business.

Dual Aspect Concept continue

Thus, the dual aspect can be expressed as under
Capital + Liabilities = Assets or Capital = Assets Liabilities

Realization Concept
Accounting is a historical record of

transactions. It records what has happened.

It does not anticipate events. This is of

great important in preventing business firms

from inflating their profits by recording sales

and income that are likely to accrue.

Accounting Period Concept

Strictly speaking, the net income can be measured by comparing the assets of the business existing at the time of its liquidation. But as the life of the business is assumed to be infinite, the measurement of income according to the above concept is not possible. So a twelve month period is normally adopted for this purpose. This time interval is called accounting period.

ACCOUNTING PRINCIPLES
Accounting Conventions
The term convention is used to signify

customs and traditions as a guide to the

presentation of accounting statements.

Convention of Consistency
In order to enable the management to draw important conclusions regarding the working of the company over a few years, it is essential that accounting practices and methods remain unchanged from one accounting period to another. The comparison of one accounting period with that of another is possible only when the convention of consistency is followed.

Convention of Disclosure
This principle implies that accounts must be honestly prepared and all material information must be disclosed therein. The contents of Balance Sheet and Profit and Loss Account are prescribed by law. These are designed to make disclosure of all material facts compulsory.

Convention of Conservation
Financial statements are always drawn up on rather a conservative basis. That is, showing a position better than what it is, not permitted. It is also not proper to show a position worse than what it is. In other words, secret reserves are not permitted.

FUNCTIONS OF ACCOUNTING
Keeping systematic records
Protecting properties of the business

Communicating the results

Meeting legal requirements

Keeping systematic records

The first function of accounting is to keep a
systematic record of financial transactions,

to post them to the ledger accounts and

ultimately prepare final statements.

Protecting properties of the business

The second important function is to protect
the property of the business. The system

accounting is designed in such a way that it

protects its assets from an unjustified and

unwarranted use.

Meeting legal requirements

The fourth and
is

the
to

last
meet

function
the

of

accounting

legal

requirements under the Companies Act,

Income Tax Act, Sales Tax Act and so on.

THE ACCOUNTING CYCLE

Recording transactions in subsidiary books.
Classifying data by posting from subsidiary books to the accounts. Closing the books and preparation of final accounts.

CLASSIFICATION OF ACCOUNTS
Accounts in the names of persons are known as Personal Accounts
Accounts in the names of assets are known as Real Accounts Accounts in respect of expenses and incomes are known as Nominal Accounts

CLASSIFICATION OF ACCOUNTS
ACCOUNTS

PERSONAL ACCOUNTS

IMPERSONAL ACCOUNTS

REAL ACCOUNTS

NOMINAL ACCOUNTS

PERSONAL ACCOUNTS
Accounts in the name of persons are known as personal accounts.
Eg: Babu A/C, Babu & Co. A/C, Outstanding Salaries A/C, etc.

REAL ACCOUNTS
These are accounts of assets or properties. Assets may be tangible or intangible. Real accounts are impersonal which are tangible or intangible in nature.
Eg:- Cash a/c, Building a/c, etc are Real Accounts related to things which we can feel, see and touch. Goodwill a/c, Patent a/c, etc Real Accounts which are of intangible in nature.

NOMINAL ACCOUNTS
These accounts are impersonal, but invisible and intangible. Nominal accounts are related to those things which we can feel, but can not see and touch. All expenses and losses and all incomes and gains fall in this category.
Eg:- Salaries A/C, Rent A/C, Wages A/C, Interest Received A/C, Commission Received A/C, Discount A/C, etc.

DEBIT AND CREDIT

Each accounts have two sides the left side and
the right side. In accounting, the left side of an account is called the Debit Side and the right side of an account is called the Credit Side. The entries made on the left side of an account is

called a Debit Entry and the entries made on the

right side of an account is called a Credit Entry.

RULES FOR DEBIT AND CREDIT

Personal Account Debit the Receiver Credit the Giver Debit what comes in Real Accounts Credit what goes out Debit all Expenses and Losses Credit all Incomes and Gains

Nominal Accounts

Steps for finding the debit and credit aspects of a particular transaction
Find out the two accounts involved in the
transaction. Check whether it belongs to Personal, Real or Nominal account. Apply the debit and credit rules for the two accounts.

Exercise
Purchased a Building for Rs.20,000/-.
Paid Cash Rs.1,000/- to Satheesh.

Paid Salary Rs.1000/-.

Received Commission Rs.250/-.

Sold goods for Cash Rs.3500/-.

Subsidiary Books
General Journal Special Journals Purchase Book Sales Book Purchase Return Book Sales Return Book Bills Receivable Book Bills Payable Book Cash Book Petty Cash Book

Journal
Journal is the prime or original book of entry which all transactions are recorded in the form entries. Journalising is an act of recording entering transactions in a Journal in the order date.
Date Particulars LF Debit Amount Credit Amount

in of or of

Journal Entry
Jan 1, 1981 Prakash Started a business Rs. 15,000/Date 1981 Jan 1 Particulars Cash a/c Dr. To Prakashs Capital a/c (Being cash invetsed to business) LF Debit Amount 15,000 15,000 Credit Amount