Notes

Accounting and Its Terminology

1) Accounting: As per American Institute of Certified Public Accountants (AICPA), "Accounting is

an art of recording, 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."
2) Characteristics of Accounting:

1) Financial characteristic: Business Transactions must be measurable in monetary

terms.
2) Money as a medium of exchange: The use of money is fundamental to financial
transactions.
3) Classification and analysis of transactions: Transactions are categorized based on
their nature (cash, credit, income, expense, asset, liability etc.) for effective analysis.
4) Interpretation of transactions: Accounts are analyzed to understand their financial
implications and results.
5) Quantitative information: Information in accounts is presented in monetary form.
6) Economic decisions: Stakeholders use accounting information for economic decisions.
7) Historical information: Accounting records past transactions and events.
3) Accounting Process:

1) Identification and measurement of transactions and events in money.

2) Recording, classification, analysis, and interpretation of financial transactions.
3) Presentation of the report (accounts) to users of financial information.
4) Objectives of Accounting:

1) Permanent records: Transactions are recorded permanently for future reference and
evaluation.
2) Understanding the effect of each transaction: Each transaction's impact on the overall
profitability and financial health of the business is assessed.
3) Identifying influential factors: Accounting helps identify factors affecting profit, loss,
and the economic condition of the business.
4) Determining tax liability: Tax calculations are often based on prepared accounts,
ensuring compliance with tax regulations.

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 5) Monitoring Payables and Receivables: Accounts reflect outstanding payments and
Outstanding receivables, enabling effective financial management.
6) Measuring profitability of the business: A key objective is to determine the net profit or
loss incurred during a specific period.
7) Assessing Financial Status: The financial health of the business can be assessed based
on accounts.
8) Detecting and Preventing errors and frauds: Accounting helps identify financial
mistakes or fraudulent activities through analysis of accounts.
5) Advantages of Accounting:

1) Readily Available Information: Prepared financial information is readily available for

various uses by the owner.
2) Profitability Assessment: Accounting reveals the profitability or loss incurred by the
business during a specific period aiding in financial planning.
3) Financial Status Analysis: Accounts provide valuable insights into the financial health
of the business at the end of a period.
4) Tax planning: Accounting information aids in determining tax liabilities and facilitates
tax planning for tax payments.
5) Business Valuation: Accounting helps determine the fair market value of a business by
considering factors like profitability and economic condition.
6) Decision making: Accounts are used by different business entities for making informed
decisions about investments, etc.
7) As evidence: Accounts prepared following established rules are considered reliable and
can be used as evidence in case of legal disputes.
8) Comparison with past operations: Accounts allow for comparing past and present
performance to identify areas for improvement and implement corrective measures.
9) Moral control: Written accounts serve as a warning against employee fraud.
10) Corrective measures: By analyzing past financial performance, accounting helps
identify mistakes in past decisions, allowing for corrective actions to be taken and
improved future performance.
6) Limitations of Accounting:

1) Non-financial transactions: It does not consider non-monetary factors like employee

loyalty or brand reputation that contribute to business success.
2) Stable value of money: Accounting assumes a stable value of money, which is not
always the case due to inflation. This can lead to discrepancies between the historical
cost of assets reflected in accounts and their current market value.
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 3) Historical transactions and events: Accounting primarily focuses on past transactions
and events, and may not fully incorporate potential future changes that could impact
the business.
4) Avoidance of market value: The market value of assets is often ignored, and only the
actual cost is considered.
5) Use of estimates: Accounting relies on estimates for certain items (e.g., bad debts),
which can introduce inaccuracies.
6) Dual standards: Profit and Loss Accounts are prepared using current prices, while
Balance Sheets often reflect historical prices.
7) Accounting as a Language of Business
1) Accounting serves as the universal language of business, facilitating effective
communication of financial information among stakeholders.
2) Accounting follows predetermined rules and principles, similar to a language's grammar
and syntax.
3) Accounting can adapt to changes over time, just like a language evolves.
8) Is Accounting a Science or an Art?
Accounting exhibits characteristics of both science and art.
• As a science, it is based on universally accepted rules and principles that guide the
classification and recording of economic transactions. The process is standardized, so
accounts prepared by different individuals will yield the same results.
• As an art, it requires skill in presenting financial information effectively, especially within
its various branches like Financial, Cost, and Management Accounting. The ability to
present data effectively, while adhering to its true nature, demonstrates the artistic
aspect of accounting.
9) Qualitative Characteristics of Accounting Information
1) Reliability: Accounting information must be accurate, error-free, and unbiased,
maintaining the trust of users.
2) Relevance: Accounting information should meet the needs of users, helping them
evaluate past, present, and future decisions.
3) Understandability: Accounting Information should be should be clear, easily
understood, and presented in a way that users can interpret.
4) Comparability: Accounting data should allow users to compare financial results across
different periods, aiding in decision-making.

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 10) Various Users of Accounting Information
1) Management: Uses accounts to evaluate policy decisions, measure efficiency, and
identify variances for corrective actions.
2) Shareholders: Legally entitled to receive accounts; use them to review investments and
make decisions about holding or selling shares.
3) Potential Shareholders: Analyze accounting information to evaluate potential return on
investment before buying shares.
4) Creditors: Use published accounts to assess the company's financial health and ability
to repay debts.
5) Employees: Evaluate accounts for salary improvements, bonuses, job security, and the
overall economic condition of the company.
6) Tax Authorities: Use accounts to determine tax liabilities and ensure compliance with
budgetary provisions.
7) Customers: Use accounting information to understand product/service pricing and
exercise their rights as buyers.
8) Foreign Entrepreneurs: Analyze accounts for decisions on selling products, services, or
entering into amalgamations with other companies.
9) Regulatory Bodies: SEBI and IRDA use accounts to prepare rules, guidelines, and ensure
compliance with norms.
10) Professional Bodies: ICAI and others develop guidelines and accounting standards to
maintain uniformity in accounting practices.
11) Researchers and Analysts: Conduct research on profitability and solvency to benefit
companies and investors, with significant contributions to economic understanding.
12) Government: Uses accounting information to develop national policies, economic
development initiatives and ensure effective management.

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 Accounting Terminology

1) Business Transaction: An exchange of goods or services between two or more persons for
cash or on credit. It has economic value i.e. can be measured in terms of money.
2) Event: The result or situation created from a transaction. (e.g., Sale leads to revenue)
3) Capital: The investment made by the owner to start the business. It can be cash, assets, or
anything measurable in terms of money.
a. For sole proprietorship, capital word is used, which owner provides.
b. For partnership, partners' capital word is used which partners provide.
c. For company, share capital word is used, which is provided by shareholders. (Equity
share capital word is more popular)
4) Drawings: When the owner withdraws assets (cash or goods) for personal use, it reduces
capital, this is known as drawings.
5) Liability: Amount payable by the business for credit purchase of goods / asset or amount
payable for borrowed money is known as liability. This amount is payable in the future. It is
treated as liability till it is not paid by the business.
a. Internal Liability: Liability towards owners (Capital is a liability of business towards
owner)
b. External Liability: Liability towards third parties (credit purchase of goods / assets /
services or payable amount for borrowed money)
6) Current Liability: A liability that needs to be paid within one year (e.g., outstanding bills, short-
term loans).
7) Non-Current Liability: A liability that needs to be paid over a period exceeding one year (e.g.,
long-term loans).
8) Assets: Tangible or intangible items owned by the business with economic value. They are
expected to benefit the business in the future.
a. Non-Current Assets: Assets held for more than one year (e.g., land, buildings, Plant,
machinery, Furniture, trademark, copy right, patent, goodwill).
i. Tangible Assets: Physical assets that can be seen and touched (e.g., land,
building, plant, machineries, furniture).
ii. Intangible Assets: Assets with no physical form, cannot be seen and touched
but have value (e.g., Trade mark, copyrights, patent, goodwill).

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 b. Current Assets: Assets that can be converted to cash within one year (e.g., cash
balance, bank balance, debtors, bills receivable, raw material stock, finished stock). For
day-to-day transactions of business, these assets are used.
i. Liquid Assets: Current assets (excluding stock) that can be quickly converted to
cash (e.g., debtors, bills receivable).
ii. Real Assets: Assets with market value that can be converted to cash (includes
tangible, intangible, and current assets).
c. Fictitious Assets:
i. Expenses that benefit the business for more than one year
ii. have no realizable value, hence cannot be converted into cash.
iii. do not have physical form (existence)
iv. This is non-recurring expense.
v. They are written off over a certain period, thus shown as an asset.
vi. Every year predetermined amount is written off and shown as an expense.
vii. also known as Spread Revenue expenses or differed revenue expenses.
viii. e.g., issue cost of shares and debentures, preliminary expense
9) Receipts: When money is received due to consequence of business transactions, it is known
as receipt.
a. Capital Receipts: Non-Regular receipts (e.g., Sale of Assets or issuing debentures)
b. Revenue Receipts: Regular receipts from day-to-day business activities during the year
(e.g., receipt of the sale, receipt of commission, receipt of dividend, Rent Income).
10) Payments: Money paid due to consequence of business transactions is known as payments.
a. Capital Expenditure: Non-Regular payments (e.g., Purchase of Assets).
b. Revenue Expenditure: Regular payments for running the business (e.g., salaries, wages,
telephone exp.).
11) Deferred Revenue Expenses: also known as fictitious assets.
12) Expense: The amount spent and benefit of which is available to the respective accounting year
is expense. (e.g., salary, wages, rent paid).
13) Revenue: Income earned from selling goods or services, including outstanding credit sales.
Besides other incomes - interest, rent, commission, dividend received for the respective period
and even outstanding are included in revenue.
14) Profit: The excess of revenue income over revenue expenses for a period.

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15) Loss: The situation where revenue income is less than revenue expenses for a period.
a. In another type of loss, there can be happening of loss without doing any kind of
activity. This is also recorded in books of accounts. e.g.; Goods destroyed by fire, Goods
stolen, destroyed in transit due to accident, goods destroyed due to rain etc, are
illustrations of these sorts of loss.
b. If any asset meets with an accident, this event is also treated as loss. Any asset is
sold less than book value; amount which is not received is also called loss. This is
known as capital loss.
16) Gain : Profit and gain are popular as synonyms.
17) Purchase: A businessman does the business of goods, purchase of that goods is treated
as purchase in accounting. Buying goods or services specifically for business purposes in
cash or in credit form. (e.g., a grain merchant buying grain).
18) Sales: A businessman does the business of goods, sales of that goods is treated as
sales in accounting. Selling goods or services specifically for business purposes in cash or in
credit form. (e.g., a grain merchant selling grain).
19) Stock: Unsold goods which are purchased for business purposes.
20) Debtors: When a businessman sales goods on credit to customers, those customers are called
as debtors. Debtors are treated as current assets.
21) Bills Receivable: Bills receivable is a written document where there are two parties, one
is the bill writer and other is the bill acceptor. Where bill writer acquires right to receive certain
amount as per predetermined date (on maturity date) in the future from Bill acceptor; it
becomes receivable. Bill is a bill receivable for the bill writer & Bills Payable for bill acceptor.
(arises from debtors).
22) Receivables: Any amount to be received by businessman in the future from any person or
entity is known as receivables. (includes debtors, bills receivable, outstanding incomes, Pre-
paid Expenses, Loans & Advances given).
23) Creditors: A person from whom goods or services are purchased on credit, that particular
person becomes creditor of business. Creditors are treated as current liability.
24) Bills Payable: Written documents where the business promises to pay a specific amount on a
future date (arises from creditors).
25) Payables: Any amount to be paid by the business person in the future to any person or entity
is known payables. (includes creditors, bills payable, Outstanding expenses, Income received
in advance).
26) Cost: The total expenses incurred to produce a product or provide a service. Generally, in cost;
raw material cost, labor cost and other costs are included.

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27) Voucher: A written document that records a business transaction. (business transaction like
cash transaction, credit transaction, purchase transaction, sales transaction, transaction with
bank, expense transaction, income transaction, asset transaction, liability transaction)
28) Discount: A reduction in the total amount of a purchase or sale.
a. Trade Discount: A percentage or amount deducted from the sales price at the time of
sale. Trade Discount is not recorded in the books.
b. Cash Discount: An incentive offered to encourage quicker payment of credit sales. Cash
Discount is recorded in books).
29) Discount Received [Cash Discount]: A reduction in the amount paid for a purchase due to early
payment. It's recorded as income.

30) Discount Allowed [Cash Discount]: A reduction in the amount received for a sale due to early
payment. It's recorded as an expense.

31) Depreciation: A non-cash business expense that reflects the decrease in value of assets over
time.
32) Bad Debts: When a customer who has purchased goods on credit is unable to pay the full
amount due to his weak financial condition and If the amount is not collected even after the
necessary efforts; the amount which is not received is known as bad debts. It's considered
a loss for the business.
33) Solvent: A person who can pay their financial obligations regularly and has assets greater than
liabilities.
34) Insolvent: A person who cannot pay their financial obligations regularly and has liabilities
greater than assets.
35) Debit: The left side of an account is called as debit side.

36) Credit: The right side of an account is called as credit side.

37) Account: Account is a record of all business transactions having debit effect or credit effect
or both related to a specific item or person. It helps summarize and analyze transactions.

38) Accounting Systems: There are two types of accounting systems in practice.

1) Desi Nama System: An older method used by small businesses like sole proprietor and
partnership firms, gradually being replaced.

2) Double-Entry System: More popular method, uses debits and credits for transactions.

39)Bases of Accounting Methods used with Double Entry System:

1) Mercantile (Accrual) Base:
• Considers all transactions of pertaining to receipts, payments, liability and assets of
the current accounting year only.
• Considers also all income earned/expenses incurred in accounting year but not yet
received/paid in current accounting year. (outstanding income, expenses paid in
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 advance, expenses outstanding, incomes received in advance etc.) in short, It
includes the receivable incomes of the current year and the payable expenses of the
current year.
• Cash incomes and expenses related transactions of previous year or next year are
not considered. The transactions of the previous year are recorded in the previous
year and the transactions of the next year will be recorded in the next year.
• Most popular method
• In India, generally, the companies mainta.in their accounts under the mercantile
system.
2) Cash Base:
• Only considers cash receipts and payments within the current accounting year.
• The cash transactions of the previous year and the current year are also considered.
• The use of this method is very limited.
3) Hybrid or Mixed Base:
• This method is identified as modified method of mercantile system.
• It is known as mixture of the mercantile system and the cash system.
• This method is not popular.
40) Steps to Prepare Accounts

Steps Description
1. Voucher A written document recording a business transaction.
2. Identification of Transactions Determine the type of the transaction (economic or non-
economic, cash or credit).
3. Recording of Transaction Record economic transactions chronologically in
Journal or Subsidiary Books journals or in subsidiary books.
4. Posting in Ledger Classify and summarize transactions by posting them to
the ledger.
5. Trial Balance Prepare a list of all account balances to ensure equality
of debits and credits.
6. Adjusted Trial Balance Prepare a revised Trial Balance after Considering any
necessary adjustments (e.g., depreciation, accrued
income, prepaid expenses etc.)
7. Annual Accounts (Trading Prepare financial statements:
Account, Profit and Loss Account, • Trading Account: Calculates Gross profit or Gross
Balance Sheet) loss from business operations for the period.
• Profit and Loss Account: Calculates the overall
Net profit or Net loss for the period.
• Balance Sheet: Presents the financial position
(assets, liabilities, and capital) of the business at
a specific point in time.

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