Business is an economic activity undertaken with the motive of earning profits and to maximize the

wealth for the owners. Business cannot run in isolation. Largely, the business activity is carried out by
people coming together with a purpose to serve a common cause. This team is often referred to as an
organization, which could be in different forms such as sole proprietorship, partnership, body corporate
etc.

The business activities require resources (which are limited & have multiple uses) primarily in terms of
material, labour, machineries, factories and other services. The success of business depends on how
efficiently and effectively these resources are managed. Therefore, there is a need to ensure the
businessman tracks the use of these resources. The resources are not free and thus one must be careful
to keep an eye on cost of acquiring them as well.

Two basic questions would have to be answered:

(a) What is the result of business operations? This will be answered by finding out whether it has made
profit or loss.

(b) What is the position of the resources acquired and used for business purpose? How are these
resources financed? Where the funds come from?

The answers to these questions are to be found continuously and the best way to find them is to record
all the business activities. Recording of business activities has to be done in a scientific manner so that
they reveal correct outcome. The science of book-keeping and accounting provides an effective solution.
It is a branch of social science.

DEFINITIONS Definition of Accounting Definition by the American Institute of Certified Public

Accountants (Year 1961): “Accounting is the art of recording, classifying and summarizing in a significant
manner and in terms of money, and interpreting the result thereof”

Definition by the American Accounting Association (Year 1966): “The process of identifying, measuring
and communicating economic information to permit informed judgments and decisions by the users of
accounting”.

Objectives of Accounting

(i) Providing Information to the Users for Rational Decision-making The primary objective of
accounting is to provide useful information for decision-making to stakeholders such as
owners, management, creditors, investors, etc. Various outcomes of business activities such
as costs, prices, sales volume, return of investment, etc. are measured in the accounting
process. All these accounting measurements are used by stakeholders (owners, investors,
creditors/bankers, etc.) in course of business operation. Hence, accounting is identified as
‘language of business’.
(ii) Systematic Recording of Transactions To ensure reliability and precision for the accounting
measurements, it is necessary to keep a systematic record of all financial transactions of a
business enterprise which is ensured by bookkeeping. These financial records are classified,
 summarized and reposted in the form of accounting measurements to the users of
accounting information i.e., stakeholder.
(iii) Ascertainment of Results of above Transactions ‘Profit/loss’ is a core accounting
measurement. It is measured by preparing profit and loss account for a particular period.
Various other accounting measurements such as different types of revenue expenses and
revenue incomes are considered for preparing this profit and loss account. Difference
between these revenue incomes and revenue expenses is known as result of business
transactions identified as profit/loss. As this measure is used very frequently by stockholders
for rational decision making, it has become the objective of accounting. For example,
Income Tax Act requires that every business should have an accounting system that can
measure taxable income of business and also explain nature and source of every item
reported in Income Tax Return.
(iv) Ascertain the Financial Position of Business ‘Financial position’ is another core accounting
measurement. Financial position is identified by preparing a statement of ownership i.e.,
Assets and Owings i.e., liabilities of the business as on a certain date. This statement is
popularly known as balance sheet. Various other accounting measurements such as
different types of assets and different types of liabilities as existed at a particular date are
considered for preparing the balance sheet. This statement may be used by various
stakeholders for financing and investment decision.
(v) To Know the Solvency Position Balance sheet and profit and loss account prepared as above
give useful information to stockholders regarding concerns potential to meet its obligations
in the short run as well as in the long run.
Function of Accounting
The main functions of accounting are as follows:
(a) Measurement: Accounting measures past performance of the business entity and
depicts its current financial position.
(b) Forecasting: Accounting helps in forecasting future performance and financial position of
the enterprise using past data.
(c) Decision-making: Accounting provides relevant information to the users of accounts to
aid rational decision-making.
(d) Comparison & Evaluation: Accounting assesses performance achieved in relation to
targets and discloses information regarding accounting policies and contingent liabilities
which play an important role in predicting, comparing and evaluating the financial results.
(e) Control: Accounting also identifies weaknesses of the operational system and provides
feedbacks regarding effectiveness of measures adopted to check such weaknesses.
(f) Government Regulation and Taxation: Accounting provides necessary information to the
government to exercise control on die entity as well as in collection of tax revenues.

Accounting – Classification

The various sub-fields of the accounting are:

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 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.
BASIC ACCOUNTING TERMS

In order to understand the subject matter clearly, one must grasp the following common expressions
always used in 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.
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.

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

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.

Asset: 'an asset is a present economic resource controlled by the entity as a result of past event. An
economic resource is a right that has the potential to produce economic benefits.
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.
Examples of assets:
land and buildings: factories, office buildings, storage and distribution centres
(warehouses)
motor vehicles
plant and machinery
fixtures and fittings: computer equipment, office furniture and shelving
cash: in a bank account or held as notes and coins
inventory: goods held in store awaiting sale to customers, and raw materials and components held in store
by a manufacturing business for use in production
receivables: amounts owed by customers and others to the entity
prepayments. These are amounts of money paid by the business in one reporting period for benefits which
have not yet been enjoyed, but which will be enjoyed within the next reporting period. For example, a business
pays an annual insurance premium of £240, and the premium is payable annually in advance on 1 December. If
the business has an accounting year end of 31 December, it will pay £240 on 1 December but only enjoy one
month's insurance cover by the year end. The remaining 11 months' cover (£220 cost, at £20 per month) will
be enjoyed in the next year. The prepayment of £220 is shown in the statement of financial position, at 31
December.

Liability: 'a liability is a present obligation of the entity to transfer an economic resource as a result of past
events. 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
Non-Current Liabilities – All other Liabilities shall be classified as Non-Current Liabilities. E.g. Loan taken
for 5 years, Debentures issued etc
Examples of liabilities:
a bank loan or overdraft. The liability is the amount eventually repaid to the bank.
payables: amounts owed to suppliers for goods purchased but not yet paid for (purchases
'on credit'). For example, a boatbuilder buys some timber on credit from a timber merchant, so that the
boatbuilder does not pay for the timber until some time after it has been delivered. Until the boatbuilder pays
what he owes, the timber merchant is a creditor for the amount owed.

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. Profits are added to owner's capital while Losses are deducted from owner's
capital.

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.

The statement of financial position or Balance Sheet, by recognising assets, liabilities and
equity/capital; (b) in the statement(s) of financial performance/Income Statement/Profit & Loss
Account, by recognising income and expenses; and

Expenses: Decreases in assets or increases in liabilities that result in decreases in equity, other than those
relating to distributions to holders of equity claims.

Capital expenditure: Expenditure which results in the acquisition of non-current assets or an

improvement or enhancement of their earning capacity. Capital expenditure on non-current assets is
presented in the statement of financial position.
Worked example: Capital expenditure
A business purchases a building for £300,000. It then adds an extension to the building at a cost of £100,000.
After a few months the building needs to have a few broken windows mended, its floors polished and some
missing roof tiles replaced. These cleaning and maintenance jobs cost £900.In this example, the original
purchase (£300,000) and the cost of the extension (£100,000) are capital expenditure, because they are
incurred to acquire and then improve a non-current asset. The other costs of £900 are revenue expenditure,
because these merely maintain the building and thus its 'earning capacity'.

Revenue expenditure: Expenditure which is incurred either:

for trade purposes. This includes purchases of raw materials or items for resale, expenditure on wages and
salaries, selling and distribution expenses, administrative expenses and finance costs, or
to maintain the existing earning capacity of non-current assets.
Revenue expenditure is charged to the statement of profit or loss of a period, provided that it relates to the
trading activity and sales of that particular period.
Worked example: Revenue expenditure
If a business buys 10 steel bars for £200 (£20 each) and sells eight of them during a reporting period, it will
have two steel bars left at the end of the period. The full £200 is revenue expenditure but only £160 is the cost
of the goods sold during the period. The remaining £40 (cost of two units) will be included in the statement of
financial position as 'inventory' valued at £40.

Income: 'Increases in assets or decreases in liabilities that result in increases in equity (capital),
other than those relating to contributions from holders of equity claims. It can include both revenue and gains
Capital income and revenue income
Definition
Capital income: Proceeds from the sale of non-current assets.
The profits (or losses) from the sale of non-current assets are included in the statement of profit
or loss for the reporting period in which the sale takes place. For instance, the business may sell
machinery or property which it no longer needs.
Definition
Revenue income: Income derived from:
the sale of trading assets, such as goods held in inventory
the provision of services
interest and dividends received from business investments

Trade receivables represent customers who owe money for goods or services bought on credit in the course of
the trading activities of the business.
Other receivables are due from anyone else owing money to the business, such as an insurance company,
loan to employee.

trade payables represent suppliers to which the business owes money for goods or services bought on credit
as part of the business's trading activities.
other payables due to anyone else to whom the business owes money, such employees in respect of unpaid
remuneration, for example sales commissions.

Accruals. These are expenses already incurred by the business, for which no invoice has yet been received, or
for which the date of payment has not yet arrived. An example of accrued charges is the cost of gas or
electricity used. If a business ends its accounting year on 31 December, but does not expect its next quarterly
gas bill until the end of January, there will be two months of accrued gas charges to record in the statement of
financial position as a liability.

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 Rs. 15000. The wholesaler may allow 20%
discount thereof to the retailer. This means the retailer will get it for Rs. 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 Rs.12000 only.

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)