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Basic Accounting Terms

This chapter covers

  • What is accounting ?
  • Objective of Accounting
  • Basic Accounting Terms

Accounting :


AccountingImage

It is the art of scientifically classifying, summarizing and recording the transactions of an enterprise and interpreting the results.


Objectives of Accounting :

The main objective of Accounting is to provide financial information to stakeholders. This financial information is normally given via financial statements, which are prepared on the basis of Generally Accepted Accounting Principles (GAAP). There are various accounting standards developed by professional accounting bodies all over the world. In India, these are governed by The Institute of Chartered Accountants of India, (ICAI).


The following objectives of accounting will explain the width of the application of this knowledge stream:


  • Systematically record transactions, sort and analyzing them, to disclose information needed by different stakeholders.

  • Prepare financial statements (To verify the amount of profit or loss made by the business i.e. to compare the income earned versus the expenses incurred and the net result thereof.)

  • Assessing financial position, and aid in decision making with financial data and information about the business.

  • A key role of accounting is to provide information and analysis for management decision and control.

For making decision at every level of management, information is crucial. Accounting gives the management the information regarding the financial position of the business, such as; profit and loss, cost and earnings, liabilities and assets, etc. That is why importance of accounting in business is very large.


Account :


An ‘Account’ is defined as a summarized record of transactions related to a person or a thing. E.g. when the business deals with customers and suppliers, each of the customers and supplier will be a separate account.

When a business transaction happens, one has to identify the ‘account’ that will be affected by it and then apply the rules to decide the accounting treatment.


Types of Accounts:


While doing business transactions (that may be large in number and complex in nature), one may come across numerous accounts that are affected. How does one decide about accounting treatment for each of them? If common rules are to be applied to similar type of accounts, there must be a way to classify the account on the basis of their common characteristics.


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Let us see what each type of account means.


(1) Personal Account :

The elements or accounts which represent persons and organisations.


  • Mrs. Vimla a/c - representing Mrs. Vimla a person.
  • M/s Bharat & Co a/c - representing M/s Bharat & Co, an organisation.
  • Capital a/c - representing the owner of the business, a person or organisation.
  • Bank a/c - representing Bank, an organisation.

(2) Real Accounts:

(The elements or accounts which represent tangible aspects.


  • Cash a/c - representing cash which is tangible.
  • Goods/Stock a/c - representing Stock which is tangible.
  • Furniture a/c - representing Furniture which is tangible.

These are accounts related to assets or properties or possessions. Depending on their physical existence or otherwise, they are further classified as follows:


  1. Tangible Real Account –

    Assets that have physical existence and can be seen, and touched. e.g. Machinery A/c, Stock A/c, Cash A/c, Vehicle A/c, and the like.


  2. Intangible Real Account –

    These represent possession of properties that have no physical existence but can be measured in terms of money and have value attached to them. E.g. Goodwill A/c, Trade mark A/c, Patents & Copy Rights A/c, Intellectual Property Rights A/c and the like.


(3) Nominal Account:

The elements or accounts which represent expenses, losses, incomes, gains.


  • Salaries a/c : representing expenditure on account of salaries, an expense.

  • Interest received a/c : representing income on account of interest, an income.

  • Loss on sale of Asset a/c : representing the loss incurred on sale of assets, a loss.

  • Profit on sale of Asset a/c : representing the profit made on sale of assets, a gain.


(These accounts are related to expenses or losses and incomes or gains. e.g. Salary and Wages A/c, Rent of Rates A/c, Travelling Expenses A/c, Commission received A/c, Loss by fire A/c etc.)


Debit :


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A debit is an accounting entry that either increases an asset or expense account, or decreases a liability or equity account. It is positioned to the left in an accounting entry.


• Whenever cash is received, debit Cash.


Debit1Image


Credit :


A credit is an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. It is positioned to the right in an accounting entry.


• Whenever cash is paid out, credit Cash.


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Transaction :


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A business activity which involves exchange of money or money’s worth between parties. Transaction could be a cash transaction or credit transaction.


  1. cash transaction :

    When the parties settle the transaction immediately by making payment in cash or by cheque, it is called a cash transaction.


  2. credit transaction :

    In credit transaction, the payment is settled at a future date as per agreement between the parties.


Goods/Services :


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Goods are normally structural and can be transferred in an instant while services are delivered over a period of time. Goods can be returned while a service once delivered cannot. Goods are not always tangible and may be virtual e.g. a book may be paper or electronic


Goods are items that are tangible, such as pens, salt, shoes, hats and folders and Services are activities provided by other people, such as doctors, software providers, lawn care workers, dentists, barbers, waiters, or online servers. According to economic theory, consumption of goods and services is assumed to provide utility (satisfaction) to the consumer or end-user, although businesses also consume goods and services in the course of producing other goods and services


Profit :


ProfitImage

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


Profit, in accounting, is an income distributed to the owner in a profitable market production process (business). Profit is a measure of profitability which is the owner’s major interest in income formation process of market production. There are several profit measures in common use.


Loss :


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The excess of expense over income is called loss. It could be calculated for each transaction or for business as a whole.


It refers to financial loss and damage suffered by a person such as can be seen only on a balance sheet rather than as physical injury to the person or destruction of property.


Examples of pure economic loss include the following:


  • Loss of income suffered by a family whose principal earner dies in an accident. The physical injury is caused to the deceased, not the family.

  • Loss of market value of a property owing to the inadequate specifications of foundations by an architect.

  • Loss of production suffered by an enterprise whose electricity supply is interrupted by a contractor excavating a public utility.


Assets :


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Asset is a resource owned by the business with the purpose of using it for generating future profits. Assets can be tangible and intangible.


  1. Tangible Assets :

    These are the Capital assets which have some physical existence. They can, therefore, be seen, touched and felt, e.g. Plant and Machinery, Furniture and Fittings, Land and Buildings, Books, Computers, Vehicles, etc.


  2. Intangible Assets :

    The capital assets which have no physical existence and whose value is limited by the rights and anticipated benefits that possession confers upon the owner are known as intangible Assets. They cannot be seen or felt although they help to generate revenue in future, e.g. Goodwill, Patents, Trade-marks, Copyrights, Brand Equity, Designs, Intellectual Property, etc.


Assets can also be classified into Current Assets and Non-Current Assets.


  1. Current Assets :

    An asset shall be classified as Current when it satisfies any of the following:

    • It is expected to be realized in, or is intended for sale or consumption in the Company’s normal Operating Cycle

    • It is held primarily for the purpose of being traded

    • It is due to be realized within 12 months after the Reporting Date

    • 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.


  2. Non-Current Assets :

    All other Assets shall be classified as Non-Current Assets. e.g. Machinery held for long term etc.


Liability :


LiabilityImage

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.


In simple words, A Liability is any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long period of time.


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 or non-current liabilities and Short Term or current liabilities.


  • Current Liabilities

    Current liabilities are a company's debts or obligations that are due within one year, appearing on the company's balance sheet and include short term debt, accounts payable, accrued liabilities and other debts. Essentially, these are bills that are due to creditors and suppliers within a short period of time.


  • Non-Current Liabilities

    All other Liabilities shall be classified as Non-Current Liabilities. E.g. Loan taken for 5 years, Debentures issued etc.


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