Basic Principles of Accounting

Accounting provides useful information to different users which may be insiders or outsiders.
Every business is engaged in various trading, manufacturing or service activities. They are
also involved in taking various short term and long term decisions, for this purpose,
accounting help them by providing information on timely basis in a presentable form.

Accounting is an information system that measures, processes, and communicates financial

information about a business. Being an owner of a business, you will always be interested to
know how your business is performing. Accounting provides you information about your
business success and failure as well as comparative information on monthly, quarterly and
annual basis.

Accounting measures business activities by recording all information in the form of data
about business activities that may be used in future. The data are recorded in proper way with
proper reference and headings so that whenever needed in future may be used. This data is
communicated to various users internally and externally through various reports for decision
making process. On the basis of this information from accounting, decision makers take
actions that affect future business activities.

In other words, data about business activities are the input to the accounting system,and useful
information for decision makers is the output.

Before going to basic concepts, it is important to understand what we can measure in

accounting?

For measurement purpose concept of Business transactions need to understand. Business

transactions are economic events that affect business’s financial position. Any exchange of
value in business is considered as business transactions. For example buying goods, selling
goods, providing services, borrowing money, paying expenses and many other activities in
which business is engaged on day to day basis. Some economic event that does not involve an
exchange but recorded in business books of accounts. Examples are losses from fire, theft;
physical wear and tear on machinery and equipment. Transactions mostly have two parties but
recorded in business how it is impacting on business, for example if your business is buying
something, it means some other business is selling but your business will treat it as buying
activity and not as selling activity.

All business transactions are recorded in terms of money. Of course, nonfinancial

information may also be recorded, but a business’s transactions and activities are measured
through the recording of monetary amounts.

To understand accounting, it is necessary to understand basic terms which will be used

throughout accounting subject as well as help to understand overall business language. There
are various definitions given in text books, we are taking here most simple one to help new
learner and keep their life easy.
Basic concepts: (Nature of Accounts)

1. Assets:

All economic resources owned by a business to get future benefits. It is important to

understand that only those things that could be measured in monetary terms may be classified
as assets. When you plan to start a business, there are various things that you need to start and
run the business. You will plan what things you need, for example, if you are planning to start
a medical store, you will prepare a brief list of items which will be required to start this
business. Here we are giving you a simple idea; you can go in detail as your business
progress.

In our example, we will take small amount so that you can concentrate only on concept
rather than confused in figures. To start a medical store, following things will be required.
The total value of all these things will be called “Assets”:

Shop Rs 500,000
Furniture and Fixtures 200,000
Medicine 200,000
Cash 100,000
Total Assets 1,000,000
This total amount of Rs. 1,000,000 will be called assets of this business. In similar way,
different businesses calculate assets; of course, form of assets may vary from business to
business.

The business uses its assets in carrying out such activities as production and sales.
Certain kinds of assets, for example, cash and money that customers owe to the company
(Called accounts receivable) are monetary items. Other assets like inventories (goods held for
sale), land, plant, buildings, and equipment are nonmonetary, physical items. There are other
assets that are only available in non physical form like rights granted by patents, trademarks,
and copyrights. We call it intangible assets.

Assets may be classified as Current Assets and Fixed Assets. Generally assets that change its
value within a year is classified as current assets like Cash, A/c Receivable, Inventory etc.
Those assets that business kept for long term purposes is classified as fixed or non-current
assets like Machinery, Plant, Building and equipment.

The following is a sample chart of accounts. It does not represent a comprehensive chart of all
the accounts used in this textbook but rather those accounts that are commonly used. This
sample chart of accounts is for a company that generates both service revenue as well as sales
revenue.
ASSETS LIABILITIES OWNER’S REVENUE EXPENSES
EQUITIES
Current Assets Current Liabilities
Cash and Accounts Payable Common Stock Sales Revenue Cost of Goods Sold
equivalent shares
Marketable Wages Payable Preferred Stock Service Revenue Salaries Expense
Securities
Short term Accrued Expenses Treasury Stock Interest Revenue Rent Expense
investment
A/c Receivable Short Term loan Share Rent Revenue Utilities Expense
Premium/Paid in
Capital in Excess
of Par
Allowance for bad Short Term Notes Retained Earnings/ Commission/Fees Telephone Expense
debts/ Doubtful Payable Accumulated earned
Profit
Note Receivable Income Tax Payable Stock Dividends Revenue from Advertising
Investment in Expense
Associates
Accrued income Unearned Revenue Capital Reserve Dividend Revenue Travel Expense
Prepaid Advance from Contributed Gain on Disposal Freight-Out/Selling
Customers Capital- of assets Exp
Reacquisition of
Shares
Un use supplies Unpaid Utilities General Reserve Repairs and
Maintenance
Expense
Merchandise Bad Debt Expense
Inventory
Supplies Expense
Fixed Depreciation
Assets/ Expense
NonCurrent
Assets
Tangible Assets Amortization
Expense
Land Loss on Disposal of
asset
Plant/Machinery
Buildings Impairment Loss
Equipment Fixed Liabilities/Non- Insurance Expense
Current Liability
Vehicle Notes Payable (Long Interest Expense
term)
Intangible Bank Loan Payable Bank Charges
Assets (Long term) Expense
Copyrights Bonds Payable Income Tax
Expense
Goodwill Mortgage Payable Property Tax
Expense
Patents Pensions payable Professional Fees
Expense
Trademark Development
Expense
Computer software Sales Returns and
Allowances
2. Expenses:

When firm takes services from other people for its business operation and pay for it will be
called expense for the business. For example, salaries, rent, insurance, repair and maintenance
etc. It is possible that expense incurred and firm did not pay it, it does not mean that it will not
be recorded in accounting record. It will be recorded as expense in the month when it incurred
irrespective of payment made or not. For example, electricity is consumed during a quarter
but the electricity bill does not arrive until after the end of the quarter. An employee may have
worked for a week but not yet have received a cash payment for that work. The unpaid
expense of the business is called an accrued expense and must be recorded as part of the
accounting information relevant to the period of time in which the expense was incurred.

On other occasions an expense may be paid for in advance of being used by the business. For
example, a fire insurance premium covering the business premises is paid annually in
advance. Such expenditure of cash will benefit a future time period and must be excluded
from any profit calculation until that time. In the meantime it is recorded as a prepaid expense
or a prepayment.

There are certain expenses for which cash outflow is not necessary but also recorded as
expense like depreciation, uncollectable expenses, loss of sale/disposal of assets etc., these
will be discussed in much detail in various chapters.
Expenses can also be regarded as outflows or other using up of assets or incurrences of
liabilities (or a combination of both) during a period from delivering or producing goods,
rendering services, or carrying out other activities that constitute the entity’s ongoing major or
central operations.

Revenue:

Source of income of any business is called revenue. Revenue will be recorded in accounting
records whether firm received amount immediately or not. If business is engaged in service
sector then relevant to service revenue title will be established like service revenue,
commission revenue, consulting fee revenue and so on. On the other hand if business is
engaged in trading and manufacturing activities then generally use Sales revenue or Turnover
as title of revenue.
Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a
combination of both) during a period from delivering or producing goods, rendering services,
or other activities that constitute the entity’s ongoing major or central operations.
Liabilities:

Amount due on business due to any services taken from any company or borrowed loan or
bought good on credit from suppliers.
A liability is defined as: ‘a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits’.

The most familiar types of liabilities arise in those situations where specific amounts of
money are owed by an entity to specific persons called creditors. There is usually no doubt
about the amount of money owed and the date on which payment is due. Such persons may be
trade creditors, the general name for those suppliers who have provided goods or services in
return for a promise of payment later. Amounts due to trade creditors are described as trade
payables (we usually use title A/c Payable). Other types of creditors include bankers or
other lenders who have lent money to the entity.

There are also situations where an obligation is known to exist but the amount due is
uncertain. That might be the case where a court of law has found an entity negligent in failing
to meet some duty of care to a customer. The company will have to pay compensation to the
customer but the amount has yet to be determined.

Even more difficult is the case where an obligation might exist if some future event happens.
Neither the existence nor the amount of the obligation is known with certainty at the date of
the financial statements. An example would arise where one company has guaranteed the
overdraft borrowing of another in the event of that other company defaulting on repayment.
At the present time there is no reason to suppose a default will occur, but it remains a
possibility for the future.

Liability is generally classified in two types i.e. (1) Current liability which will be paid within
a year like trade payables, accrued wages and (2) Fixed or Non Current liability which will be
paid after one year like Long term loan, Bonds payable and Mortgage payable etc.

Capital:

Amount invested by owner in business. Alternate title may be owner’s equity. It is not necessary
that amount should be invested in the form of cash. For example if a business man has some
machinery, furniture as well as cash which he is planning to invest, then total value of all these
assets will be called capital. A Capital account indicates the owner’s investment in the company
which could be increased by more investment by owner or profit of the firm. A Drawing
account tracks withdrawals by the owner and reduce owner’s overall investment in business.

Basic Accounting Functions

Before discussing accounting equation, it is better to understand basic accounting functions.
In order to accomplish its main objective of communicating information to the users,
accounting embraces the following functions.

Identifying:

Accountant identifies the business transactions from the source documents in business.

Recording:
The next function of accounting is to keep a systematic record of all business
transactions, which are identified in an orderly manner, soon after their occurrence in
the journal or subsidiary books.

Classifying:
This is concerned with the classification of the recorded business transactions so as to group
the transactions of similar type at one place. i.e. in ledger accounts. In order to verify the
arithmetical accuracy of the accounts, trial balance is prepared.

Summarizing :
The classified information available from the trial balance are used to prepare profit and loss
account and balance sheet in a manner useful to the users of accounting information.

Analyzing:
It establishes the relationship between the items of the profit and loss account and the balance
sheet. The purpose of analyzing is to identify the financial strength and weakness of the
business. It provides the basis for interpretation.

Interpreting:
It is concerned with explaining the meaning and significance of the relationship so established
by the analysis. Interpretation should be useful to the users, so as to enable them to take
correct decisions.

Communicating:
The results obtained from the summarized, analyzed and interpreted information are
communicated to the interested parties

Accounting Equation
Financial position refers to a company’s economic resources, such as cash, inventory, and
buildings, and the claims against those resources at a particular time. Another term for claims
is equities.

To understand owner’s equities and fund taken from creditors, we keep separate title for these
sources like fund invested by owner is termed as owner’s equity and fund taken from creditors
are considered as liability. Overall company has two types of equities: creditors’ equities, such
as bank loans, and owner’s equity.

The sum of these equities equals a company’s resources:

In accounting terminology, economic resources are called assets and creditors’ equities are
called liabilities.

So the equation can be written like this:

Assets =Liabilities +Owner’s Equity

This equation is known as the Accounting Equation (A = L + OE).

The two sides of the equation must always be equal balance. To evaluate the financial effects
of business activities, it is important to understand their effects on this equation.

Assets are Left hand side of equation and liabilities and owner’s equities are on Right hand side
of equation.

It is very important to understand that we use term DEBIT for Left hand side (LHS) and term
CREDIT for Right hand side (RHS). Hence from now on, rather than using term LHS and
RHS we will use term DEBIT (Dr) and CREDIT (Cr).