Accounting Principles and Key Concepts

Introduction to Accounting

• The primary goal of every business is to make a profit.
• Businesses need to know their profits/losses, stock, liabilities, and amounts owed on a regular basis (daily, monthly, annually).
• To gain this information, businesses must keep systematic records of all transactions.

Meaning of Accounting

• Accounting involves identifying, recording, classifying, summarizing, interpreting, and communicating financial information to users for decision-making.
• AICPA definition: Accounting is the art of recording, classifying, and summarizing transactions and events of a financial nature in terms of money, and interpreting the results.
• Luca Pacioli is considered the father of accounting due to his contributions during the Renaissance period. He was the first to publish work on the double-entry bookkeeping system.

Functions of Accounting

1. Identifying:
   • Recognizing financial transactions from source documents (invoices, agreements, cash memos).
   • Measuring transactions in monetary terms.
2. Recording:
   • Maintaining a systematic record of transactions in chronological order.
   • Entries are made in the journal or subsidiary books.
3. Classifying:
   • Grouping similar transactions in one place (ledger accounts).
   • A trial balance is prepared to verify arithmetical accuracy.
4. Summarizing:
   • Using the trial balance to prepare the profit and loss account and balance sheet.
   • Information is presented in a manner useful to users.
5. Analysing:
   • Establishing relationships between items in the profit and loss account and the balance sheet.
   • Identifying financial strengths and weaknesses of the business.
   • Provides a basis for interpretation.
6. Interpreting:
   • Explaining the meaning and significance of the relationships established through analysis.
   • Providing useful insights for decision-making.
7. Communicating:
   • Relaying summarized, analyzed, and interpreted information to interested parties.

Accounting Cycle

The accounting cycle is a complete process of recording and processing financial transactions, from the transaction's occurrence to its presentation in financial statements and the closing of accounts. This cycle continues throughout the life of the business.

1. Transactions:
   • Identifying financial transactions and measuring them in monetary terms.
   • Transactions include debt payments, asset purchases, sales revenue, and expenses.
2. Journal Entries:
   • Recording transactions in the company’s journal in chronological order.
   • Debits and credits must always balance in these entries.
3. Posting to the General Ledger (GL):
   • Journal entries are posted to the general ledger.
   • Provides a summary of all transactions for individual accounts.
4. Trial Balance:
   • Calculating total balances for all accounts at the end of the accounting period (quarterly, monthly, or yearly).
5. Financial Statements:
   • Preparing the balance sheet, income statement, and cash flow statement using the correct balances.

Book-keeping, Accounting and Accountancy

• Book-keeping: Recording financial transactions in books of accounts.
  • Involves identifying, measuring, recording, and classifying transactions.
  • Routine and clerical, performed by staff with limited accounting knowledge.
• Accounting: A system for collecting and processing financial information.
  • Starts where bookkeeping ends.
  • Includes summarizing, analyzing, interpreting, and communicating financial data.
• Accountancy: Systematic knowledge of accounting principles and techniques.
  • Collection of accounting theory and practices.

Objectives of Accounting

1. Keep systematic record of business transactions:
   • Maintaining a complete record of all transactions according to specific rules.
   • Aids in preventing omissions and fraud.
   • Transactions are recorded in journals or subsidiary books and then posted to the ledger.
2. Calculate profit or loss:
   • Ascertaining net profit or loss from business transactions during a specific period.
   • Preparing the trading and profit & loss account at the end of each accounting period.
3. To ascertain the financial position of the business
   • Balance sheet is prepared to show assets, liabilities, and capital.
   • Provides a snapshot of the financial health of the business.
4. To provide information to various parties
   • Communicating accounting information to interested parties like owners, creditors, banks, and the government.

Sub-disciplines within Accounting

• Financial Accounting:
  • Maintaining systematic records of financial transactions.
  • Preparing and presenting financial reports to measure organizational success and financial soundness.
  • Determining profit/loss and financial position, and tracking cash flow.
• Cost Accounting:
  • Analyzing expenditures to determine the cost of products or services.
  • Aiding in cost control and providing costing information for management decisions.
• Management Accounting:
  • Utilizing information from financial and cost accounting to assist management.
  • Involved in budgeting, assessing profitability, pricing decisions, and capital expenditure decisions.

Accounting as an Art as Well as Science

• Accounting is a science because it follows a systematic path to understand an entity's economic status. It involves gaining knowledge through observation, study, practice, experiments, and investigation, similar to other sciences.
• Accounting is also an art as it involves the application of techniques and methods to present financial findings using universally accepted principles (GAAP). It requires the application of scientific methods to practical use.

Advantages of Accounting

• Protecting business assets
• Facilitates settlement of tax liabilities: Aids in settling taxes with accurate transaction records.
• Replaces memory: Provides necessary information without needing to remember transactions.
• Facilitates comparative study: Enables comparison of results between years, identifying factors causing changes.
• Facilitates loans: Provides performance data to support loan applications.
• Facilitates sale of business: Helps determine the proper purchase price based on maintained accounts.

Disadvantages of Accounting

• Ignores qualitative elements: Focuses on monetary aspects, overlooking staff quality, industrial relations, and public relations.
• May lead to window dressing: Can be manipulated to conceal vital facts and present a better financial position than reality.
• Based on historical costs: Uses historical costs, failing to account for inflation and price changes, skewing relevance.
• Not fully exact: Relies on estimates (depreciation, bad debts, market price of stock), impacting accuracy.

Types of Accounting Information

• Information relating to profit or surplus: The income statement (profit and loss account) provides information about profits earned or losses incurred during an accounting period.
• Information relating to financial position: The balance sheet provides information about the entity's financial position.
• Information about cash flow: The cash flow statement shows the inflow and outflow of cash during a specific period, aiding decisions on liabilities, dividends, and business expansion.

Basic Accounting Terms

• Capital: The amount invested by the owner in the business.
  • Also known as Owner’s Equity, Net Worth, or Net Assets.
  • $Assets = Liabilities + Capital$
• Drawings: Cash or goods withdrawn by the owner for personal use.
• Liabilities: Amounts owed by the firm to outsiders.
  • Example: Unpaid wages, creditors.
  • Internal Liabilities: Amounts owed to the proprietor or owners.
  • External Liabilities: Amounts owed to outsiders.
  • Non-current Liabilities: Payable after more than 1 year.
  • Current Liabilities: Payable within 1 year.
• Business Transaction: An economic activity that changes a business's financial position, expressible in monetary terms.
• Event: The result of a transaction.
  
  *Example: Ram purchased goods for $Rs. 2$ lacs and sold them for $Rs. 2.5$ lacs. Profit = $Rs. 50,000$. Transactions include purchasing and selling goods, while the event is the profit earned.
• Assets: Valuable resources owned by a business, acquired at a measurable money cost.
  • Example: Cash, Land, Furniture
  • Non-Current Assets: Used continuously in the business for producing goods and services; not for resale.
    • Tangible Assets: Have a physical existence (Cash, Computer).
    • Intangible Assets: Do not have a physical existence (Patents, Goodwill).
  • Current Assets: Meant for sale or conversion into cash within 1 year.
    • Example: Debtors, Stock, Bills Receivables.
  • Fictitious/Nominal Assets: Represent losses or expenses yet to be written off; neither tangible nor intangible.
    • Example: Debit balance of P&L, deferred revenue expenditure.
• Expenditure: Disbursement of cash, transfer of property, or incurring liability to acquire assets, goods, or services.
  • *Capital Expenditure: Incurred for acquiring or improving permanent assets not meant for resale; may add to the value of an existing asset; non-recurring outlay; increases earning capacity; shown in the balance sheet; provides benefit over several years.
  • *Revenue Expenditure: Routine expenditure in the normal course of business, including the cost of sales and maintenance of fixed assets; recurring outlay; maintains earning capacity; shown in the trading and profit & loss account; consumed within a single accounting year.
• Expense: Value that has expired during the accounting period, charged to the profit and loss account.
• Income: Profit earned during a period of time.
  • $Income = Revenue - Expense$
• Profit: Excess of revenue over costs.
• Gain: Profit of an irregular or non-recurrent nature.
  • *For example, profit on the sale of a fixed asset or investment.
• Loss: Excess of expenses over revenues, decreasing owner’s equity.
• Stock: Value of goods purchased for resale and lying unsold at the end of the accounting period.
• Inventory: A wider term including stock and raw materials, semi-finished goods, and finished goods.
• Bills Receivable: Bills of exchange drawn on debtors, receivable at a future date.
• Bills Payable: Bills of exchange accepted in favor of creditors, payable at a future date.
• Debtors: Persons or firms who owe money for goods sold or services rendered on credit.
• Creditors: Persons or firms to whom money is owed for goods purchased or services procured on credit.
• Bad Debts: Amount irrecoverable from a debtor, debited to P&L account as an expense.
• Insolvent: Unable to pay debts.
• Discount: Rebate or allowance given by the seller to the buyer.
  • *Trade Discount: Fixed percentage on the list price, not recorded in the books.
  • *Cash Discount: For prompt payment, always recorded in the books.

Accounting Principles

• Accounting Principles: Guidelines for recording and reporting accounting information.
  • Based on usefulness, objectivity, and feasibility.
• Generally Accepted Accounting Principles (GAAP): Basic accounting principles and guidelines providing the framework for detailed rules.
• Separate Business Entity Concept: Distinguishes between the business and its owner.
  • Transactions are recorded from the business's viewpoint, not the owner's.
• Money Measurement Concept: Records only transactions expressible in terms of money.
• Dual Aspect Concept: Records every transaction with two aspects (debit and credit).
• Going Concern Concept: Assumes the business will operate indefinitely.
• Accounting Period Concept: Divides the business's life into appropriate segments for financial reporting (usually a year).
• Historical Cost Concept: Records assets at their acquisition price.
• Matching Concept: Matches revenue with corresponding expenditure to show true profit.
• Accrual Concept: Records revenues when earned and expenses when incurred, not when cash is received or paid.
  
  *Difference between accounting concepts and conventions:
  
  *Accounting concepts refers to the rules of accounting which are to be followed, while recording business transactions and preparing final accounts. Accounting conventions implies the customs or practices that are widely accepted by the accounting bodies and are adopted by the firm to work as a guide in the preparation of final accounts.
• Materiality Convention: Items of small significance need not be given strict theoretical treatment.
• Conservatism Convention: Account for all anticipated expenses or losses, but do not record potential income or gains until actually earned/received.
• Consistency Convention: Use the same accounting policies and methods consistently unless there is a sound reason to change.
• Disclosure Convention: Financial statements should fairly disclose all material information.

Bases of Accounting

Accounting Equation

• The accounting equation states that a business’s assets are always equal to the total of its capital and liabilities.
• $Assets = Liabilities + Capital$

Rules of Debit and Credit

• All accounts have two sides: Debit (Dr.) on the left and Credit (Cr.) on the right.

Classification of accounts

• Personal accounts: Natural persons, artificial persons, representative persons
• Impersonal Accounts: Real (Tangible/Intangible), Nominal

Meaning of Journal

• The books in which transactions are recorded for the first time from a source document are called ‘Book of Original Entry’.
• Journal is one of the basic books of original entry in which transactions are originally recorded in a chronological order according to the principles of double entry system.
• The various columns of journal are explained in details below:-
  • Date: This column is used to write the date of the business transaction. Different date formats are used in different countries.
  • Particulars or Details Column: In this column the names of the two connected accounts are written in two consecutive lines - in the first line the name of account debited and in the second line the name of account credited.
  • Ledger Folio (L.F): In this column, the number of the ledger page is written to which the amount is posted.
  • Amount: The debit amount is written in the first "amount" column against the name of account debited and the