Basic Accounting Terms

Chapter 2: Basic Accounting Terms

Learning Objectives

• Understanding of accounting terms prescribed in the syllabus.

Accounting Terms

1. Entity

• A unit that performs economic activities.

• Can be a business entity (e.g., Reliance Industries Ltd.) or a non-business entity (e.g., Rotary Club).

• Business entity: An enterprise established to engage in business activities.

• Non-business entity: An entity set up for welfare, sports promotion, etc.

2. Business Transaction

• An exchange of money, goods, and/or services.

• A financial transaction or economic event that initiates the accounting process.

• It is a financial event expressed in money terms that changes the financial position of an enterprise.

• Example: Amrit sells goods worth $10,000$ to Gurman.

Characteristics of a Business Transaction:

1. Financial Value: Measured in money terms.

2. Evidence: Supported by a source document (e.g., Sales Invoice).

3. Change in Financial Position: Affects assets and liabilities.

4. Two-Fold Effect: Debit and credit.

Types of Transactions:

• Cash Transaction: Amount transacted immediately.

• Credit Transaction: Amount to be paid or received later.

• External Transaction: Between an enterprise and another party.

• Internal Transaction: Does not involve a second party (e.g., depreciation).

3. Account

• A record of transactions under a particular head (e.g., Sales, Salaries).

• Shows amounts of transactions and their effect.

4. Capital

• The owner's claim in the business.

• Amount invested by the proprietor or partners.

• Can be in the form of money or assets.

• In companies, capital contributors are shareholders.

• A liability of the firm towards the proprietor or partners, based on the "Business Entity Concept".

• Shows the owner's claim on business assets.

• Also known as Owner's Equity or Net Worth.

• Expressed as: $Capital = Assets - Outside Liabilities$

• Capital increases by net profit and additional capital, and decreases by net losses and withdrawals.

5. Drawings

• Amount, goods (at cost), or assets taken by the proprietor for personal use.

• Reduces the owner's investment (or capital).

• Debited to Drawings Account.

• Deducted from capital in the Balance Sheet.

6. Liabilities

• Amount owed by the entity to outsiders or the proprietor.

Types of Liabilities:

(a) Internal Liabilities:
- Liability towards owners or proprietor (capital).
(b) External Liabilities:
- Claims against the entity from outsiders.
- Arise from credit transactions or loans.
- Examples: amount due to creditors, bank overdraft, bills payable.

Classification of External Liabilities:

(i) Non-current Liability (Long-term Liability):
- Payable after more than 12 months from the end of the accounting period.
- Example: A loan payable in 5 yearly installments starting April 1, 2025, from a loan taken on October 1, 2024.
(ii) Current Liability (Short-term Liability):
- Payable within 12 months from the end of the accounting period.
- Example: A loan taken on September 1, 2024, payable by August 31, 2025.

Classification of Liabilities as per Schedule III of the Companies Act, 2013:

(i) Current Liabilities:
(a) Expected to be settled in the company's normal operating cycle.
(b) Held primarily for trading.
(c) Due to be settled within 12 months after the reporting date.
(d) No unconditional right to defer settlement for at least 12 months.
(ii) Non-current Liabilities:
- Liabilities that are not current liabilities.

• Operating Cycle: Time between asset acquisition for processing and conversion into cash. If not identifiable, it's taken as 12 months.

7. Assets

• Economic resources of the entity that will give future benefit.

• Properties (tangible and intangible) owned by the enterprise.

• Examples: land, building, machinery, stock, debtors, trademarks.

Characteristics of Assets:

1. Owned by the business.

2. Tangible (physical) or intangible form.

3. Measurable value in money terms.

Classification of Assets:

(i) Non-current Assets:
- Not meant for resale; held for investment or to facilitate business operations.
- Examples: Fixed assets, Non-current Investments, Long-term Loans.

—Fixed Assets:
- Held for long-term to carry out operations or increase earning capacity.

(a) Tangible Assets:
- Physical existence; can be seen and touched.
- Examples: land, building, machinery.
(b) Intangible Assets:
- No physical existence; cannot be seen or touched.
- Examples: patents, goodwill, trademarks.

(ii) Current Assets:
- Held for resale or conversion into cash within a short period (one year).
- Examples: goods purchased for resale, debtors.
(iii) Fictitious Assets:
- Neither tangible nor intangible.
- Expenses or losses not written off in the year incurred but over multiple accounting periods.
- Example: Deferred Revenue Expenditure like Advertisement Expenditure.

Classification of Assets as per Schedule III of the Companies Act, 2013:

(i) Current Assets:
(a) Expected to be realized or intended for sale or consumption in the company's normal operating cycle.
(b) Held primarily for trading.
(c) Expected to be realized within 12 months from the reporting date.
(d) Cash and Cash Equivalent (unless restricted).
(ii) Non-current Assets:
- Assets that are not current assets.

8. Receipts

• Categorized into revenue receipts and capital receipts.

(i) Revenue Receipts:
- Amount received from the sale of goods and/or rendering of services in the normal course of business.
- Example: Amount received from sale of goods or interest on fixed deposits.
(ii) Capital Receipts:
- Receipts that are not revenue receipts.
- Example: Capital contribution by owners, sale of fixed assets, loans.
- Increase liabilities or reduce assets and are shown in the Balance Sheet.

9. Expenditure

• Amount spent or liability incurred for purchasing assets, goods, or taking services.

(i) Capital Expenditure:
- Incurred to purchase fixed assets or improve existing assets to increase earning capacity.
- Gives benefit of enduring nature.
- Shown on the assets side of the Balance Sheet.
- Example: Purchasing machinery for $₹ 5,00,000$
(ii) Revenue Expenditure:
- Benefit is consumed or exhausted within the accounting period.
- Direct relationship with revenue or the accounting period.
- Transferred to the debit side of the Trading Account or Profit & Loss Account.
- Example: Paying staff a salary of $₹ 20,000$
(iii) Deferred Revenue Expenditure:
- Revenue expenditure written off to the Profit & Loss Account over multiple accounting periods.
- Benefit of the expenditure is available for more than one financial year.
- Example: Large advertising expenditure.

10. Expense

• Cost incurred for earning revenue.

• Value that has expired during the accounting period.

• Examples:

  • Cash payments like salaries and rent.

  • Writing off part of fixed assets (depreciation).

  • Amount written off from a current asset (bad debts).

  • Decline in asset value.

  • Cost of goods sold.

Types of Expenses:

(i) Prepaid Expense:
- Expense paid in advance, benefiting future years.
- Example: Insurance premium of $₹ 50,000$ paid for one year beginning October 1, 2024, with the financial year ending March 31, 2025. Prepaid expense is $₹ 25,000$ for the period April 1, 2025, to September 30, 2025.
(ii) Outstanding Expense:
- Expense incurred during the accounting year but not paid.
- Example: Rent of $₹ 10,000$ for March 2025 not yet paid.

11. Revenue

• Gross inflow of cash, receivables, or other consideration from the sale of goods, rendering of services, or use of enterprise resources.

• Amount received or receivable from operating activities.

• Examples: Receipts from the sale of goods, rent, commission, interest.

12. Income

• Profit earned during an accounting period.

• Excess of revenue over expenses.

• Broader term than 'profit'.

• For example, goods costing $₹ 15,000$ are sold for $₹ 21,000$. The company also earned interest of $₹ 2,000$ on fixed deposits. Thus,

• $Income = Revenue + Other Income - Expense$

• $Income = ₹ 21,000 + ₹ 2,000 - ₹ 15,000 = ₹ 8,000$

13. Profit

• Income earned from business operating activities (sale of goods and/or rendering of services).

• Profit = Revenue from Sale of Goods - Cost of Goods Sold

• For example, Revenue from Sale of Goods ($₹ 21,000$) - Cost of Goods Sold ($₹ 15,000$) = Profit ($₹ 6,000$).

Types of Profit:

(i) Gross Profit:
- Difference between revenue from sales and/or services rendered and its direct cost.
- Excess of revenue over direct expenses.
(ii) Net Profit:
- Excess of total revenue and other Income over total expenses.
- Profit after deducting total expenses from revenue and other Income.
- Calculated by deducting indirect expenses and non-operating expenses from Gross Profit plus Non-operating income.
- Net Profit increases capital, while Net Loss decreases it.

14. Gain

• Profit earned from transactions not being business transactions but incidental to them.

• Increase in owner's equity resulting from irregular or non-recurring transactions.

• Example: Gain on the sale of land or machinery.

15. Loss

• Excess of total expenses over total revenue and other Income.

• Decreases the owner's equity.

• Includes loss in operating activities and loss from non-recurring events.

• Example: Loss on the sale of fixed assets or cash lost in theft.

16. Purchases

• Purchase of raw materials for manufacturing goods and/or purchase of goods for resale.

• Includes both cash and credit purchases.

17. Purchases Return

• Goods returned to the seller due to defects, etc.

• Also known as Returns Outward.

18. Sales

• Sale of goods.

• Includes both cash and credit sales.

19. Sales Return

• Goods returned by the purchaser.

• Also known as Returns Inward.

20. Revenue from Operations

• Revenue earned from business operating activities.

• Net of Sales Return (Sales - Sales Return).

• Examples: Net Sale of Goods, services rendered, interest earned.

21. Goods

• Items of trade purchased or manufactured to be sold.

• Stock-in-Trade of an enterprise.

• For a home appliance dealer, TVs, fridges, and ACs are goods.

22. Stock/Inventory

23. Trade Receivables

• Amount receivable by the enterprise against goods sold and services rendered in the normal course of business.

(i) Debtor:

- Person or entity who owes amount to the enterprise against credit sales of goods and/ or services rendered or both.

(ii) Bill Receivable:

- Bill of Exchange accepted by a debtor, the amount of which will be received on the specified date.

24. Trade Payables

• Amount payable for purchase of goods and/or services or both taken in the ordinary course of business.

(i) Creditor:

- A person or an enterprise to whom an enterprise owes amount against credit purchases of goods and/or services taken or both.

(ii) Bill Payable:

- Bill of Exchange accepted by the person or enterprise, the amount of which will be payable on the specified date.

25. Cost

• Amount of expenditure incurred on or attributable to a specified article, product, or activity.

26. Voucher

• Evidence of a transaction having taken place.

(i) Source Voucher:

- Evidence of a business transaction such as a Cash Memo or Invoice.

(ii) Accounting Voucher:

- Prepared from the Source Vouchers indicating account heads debited and credited.

27. Discount

• Reduction in the price of goods or from the amount to be paid to a customer.

(i) Trade Discount:

- Reduction in prices by the seller when goods of a certain quantity are bought.

(ii) Cash Discount:

- Discount allowed for timely payment of the due amount.