Introduction

Accounting is aptly called the language of business. This designation is applied to accounting because it is the method of communicating business information. The basic function of any language is to serve as a means of communication. Accounting duly serves this function. The task of learning to account is essentially the same as the task of learning a new language. But the acceleration of change in the business organization has contributed to increasing the complexities in this language. Like other languages, it is undergoing continuous change in an attempt to discover better means of communications. To enable the accounting language to convey the same meaning to all stakeholders, it should be made standard. To make it a standard language certain accounting principles, concepts and standards have been developed over a period of time. This lesson dwells upon the different dimensions of accounting, accounting concepts, accounting principles, and accounting standards.

Learning Objectives

1. Know the Evolution of Accounting

2. Understand the Definition of Accounting

3. Comprehend the Scope and Function of Accounting

4. Ascertain the Users of Accounting Information

5. Know the Specialized Accounting Fields

6. Understand the Accounting Concepts and Conventions

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Definition Of Accounting

Before attempting to define accounting, it may be made clear that there is no unanimity among accountants as to its precise definition. Anyhow let us examine three popular definitions on the subject:

Accounting has been defined by the American accounting association committee as:

“the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information”.

This may be considered as a good definition because of its focus on accounting as an aid to decision making.

The American institute of certified and public accountants committee on terminology defined accounting as:

“accounting is the art of recording, classifying and summarizing, in a significant manner and in terms of money, transactions, and events which are, in part at least, of a financial character and interpreting the results thereof”.

of all definitions available, this is the most acceptable one because it encompasses all the functions which the modern accounting system performs.

Another popular definition of accounting was given by American accounting principles the board in 1970, which defined it as:

“accounting is a service society. Its function is to provide quantitative information, primarily financial in nature, about economic entities that are useful in making the economic decision, in making reasoned choices among alternative courses of action”.

This is a very relevant definition in a present context of business units facing the situation of selecting the best among the various alternatives available. The special feature of this definition is that it has designated accounting as a service activity.

Introduction of Book‐Keeping and Accountancy

Human wants were limited in the past. Over a period of time, human wants started increasing and the resources available were utilized for satisfying human wants. In earlier times, the Barter system was followed. Goods were exchanged for goods. Gradually, the need was felt to have a common medium of exchange for goods and services and thus, the evolution of money took place. All the activities performed involved money. Business activities came into existence. It was very difficult for businessmen to remember each and every transaction of the business and therefore, recording all the transactions became necessary. This process of recording all the transactions in a systematic manner is known as Book‐Keeping.

Meaning of Book‐Keeping

Book‐Keeping is a systematic manner of recording transactions related to business in the books of accounts. In Book‐Keeping, transactions are recorded in the order of the dates. An Accountant is a person who records the transactions in the books of the business and is expected to show the financial results of business for every financial year. A financial year in India is followed from 1st April to 31st March. Book‐Keeping is an art as well as a science. It is the art of recording day to day business transactions in the books of accounts in a scientific and systematic manner.

Definitions:

J. R. Batliboi: Book‐Keeping is an art of recording business dealings in a set of books.

R.N Carter: Book‐Keeping is an art of recording in the books of accounts, all those business transactions that result in the transfer of money’s worth

Spicer and Pegler: Book‐Keeping is a systematic recording of all the transactions in a manner enabling the relationship of business with other persons to be clearly disclosed and the cumulative effect of transactions on the financial position of the business itself can be correctly ascertained

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Features of Book‐Keeping

i. To record business transactions.

ii. Records only monetary transactions.

iii. Transactions are recorded in a given set of Books of Accounts.

iv. Transactions recorded for a specific period are presented for future reference.

v. Records business transactions in a scientific manner.

Objectives of Book‐Keeping

i. Permanent, Date-wise and Account wise record of all the business transactions.

ii. To ascertain the Profit / Loss of the business during a specific period.

iii. Keep a record of the Capital Investment in the business.

iv. Business keeps a record of Total Assets and Liabilities.

v. It keeps a record of the amount a business owes to others and the amount receivable by the business from others.

vi. It facilitates the comparison of the financial performance of business with a previous year’s performance or with the performance of other businesses in the same line of business.

vii. It is useful to ascertain the Tax liabilities and meet the Legal Requirements of a business.

Importance of Book‐Keeping

i. Record: Book‐Keeping is recording transactions in a systematic manner. It may not be realistic for a businessman to remember all the transactions over a period of time. Thus Book‐Keeping ensures that the record of all the transactions is kept on a permanent basis.

ii. Financial Information: Book‐Keeping records the financial activities of a business. This financial record helps in generating financial information of the business regarding the Assets, Liabilities, Profit, Loss, Stock Investment etc.

iii. Decision Making: All the information provided by Book‐Keeping helps the company, business or businessman to make decisions for successful business operations.

iv. Controlling: Management uses the financial records of business to manage and control the business operations in a smooth manner. Such financial records are available from Book‐Keeping.

v. Evidence: Book‐Keeping records can be used as legal evidence in Courts as all the recorded transactions of a business are recorded from source documents which act as evidence in case of any disputes.

vi. Comparison: Record of transactions in the books of accounts helps businesses to compare their financial positions year after year and with other business units.

vii. Tax Liability: Book‐Keeping helps the businessman in ascertaining the amount payable for Sales Tax, Property Tax, Income Tax etc.

Utility of Book‐Keeping

Book‐Keeping is vital for the below parties:

i. Owner: Book‐Keeping helps to ascertain the financial information and position of the business at any time. Financial information includes Profits, Losses, Assets, Liabilities etc.

ii. Management: The various Management functions such as Planning, Organising, Directing and Controlling can be performed effectively and efficiently by the management based on the records and reports available through Book‐Keeping.

iii. Government: The various sources of information available through Book‐Keeping facilitate the Government and the Tax Authorities to ascertain the tax liabilities of the business.

iv. Investors: Investors are interested in the financial statements of business before investments are made. It provides them with assurance about the safety of their investments.

v. Customers: Customers are assured about the financial capacity of the business as well as the quality and quantity of goods supplied by the business, based on the information available through Book‐Keeping.

vi. Lenders: Book‐Keeping provides financial information to the lenders enabling them to judge the credit the worthiness of the business thus, ensuring uninterrupted supply of funds.

Branches of Accounting

There are different types of people/organizations interested in the accounting information of various business organizations. Considering, the different requirements of different people and organizations, three Branches of Accounting has been developed:

i. Financial Accounting: Financial Accounting is the process of identifying, recording, measuring, classifying, summarising, interpreting, analyzing and communicating the accounting transactions of business organizations. It is the original form of accounting. The main objective of Financial Accounting is to make the financial information of the business available to outsiders like Creditors, Customers, Banks, Financial Institutions, Investors etc. The purpose of Financial Accounting is to maintain systematic records for the ascertainment of the financial performance and the financial position of a business and communicate the same to the various interested parties. This information is presented in the form of Profit and Loss Account and Balance sheet which show the performance of the business during the specified period.

ii. Cost Accounting: Cost Accounting is a process to control the cost of the product. The purpose of this branch of accounting is to determine the cost, control the cost and to communicate the cost related information to the various departments in order to make decisions and take corrective actions.

iii. Management Accounting: Management Accounting is used by top management to make business decisions. It is essential for the top management to perform the various management functions. It covers various areas like Cost Accounting, Budgetary Control, Inventory Control, Statistical Methods, Internal Auditing etc. Management Accounting also facilitates the management in assessing the impact of the business decisions made and actions taken by them in the past.

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Accounting Terminologies

i. Business Transactions: Every transaction of a business, which deals with buying and selling of goods in exchange for money is called a Business Transaction. Every transaction should have a financial impact and it should be measurable in terms of money.

There are two main types of Transactions:

a. Monetary Transactions: The transactions which involve an exchange of money or money’s worth, directly or indirectly, are called Monetary Transactions. Only Monetary transactions are recorded in books of accounts. These can be further classified into two types :

1. Cash Transactions: Cash transactions are those transactions where the payment/receipt of cash occurs at the time of transaction only.

2. Credit Transactions: Credit Transactions are those transactions where the payment or receipt of cash takes place after a specified period of time.

b. Non‐Monetary Transactions: The transactions carried out without the involvement of money or money’s worth, directly or indirectly, are called Non-Monetary Transactions. These transactions are not recorded in the books of accounts.

c. Barter System: Barter System is when goods and services are exchanged against other goods and services.

d. Entry: Entry is the first record of a business transaction in the books of accounts. To pass an entry means to record a transaction in a proper form by using the correct technique in the books of accounts.

e. Narration: Narration is a short explanation of the business transaction for an entry. It starts with the word ‘Being’ and is written in brackets below the entry.

ii. Goods: Goods are commodities or articles bought or sold by a businessman with the motive to earn a profit. The businessman may manufacture the goods himself or he may purchase them for the purpose of sale.

iii. Profit / Loss:

a. Profit: The excess of Income over Expenses during an accounting year is known as ‘Profit’.

b. Loss: The excess of Expenses over Income during an accounting year is known as ‘Loss’.

c. Gross Profit: Gross profit is the excess of the Net Sales over the Cost of Goods Sold.

Net Sales is the revenue (income) received after deducting the goods returned by the customer out of the total goods sold. Cost of Goods Sold includes the direct expenses related to the manufacture or purchase of goods.

Net Sales = Cash Sales + Credit Sales - Sales Return

Gross Profit = Net Sales - Cost of Goods Sold

d. Operating Profit: The excess of Gross Profit over Operating Expenses is known as Operating Profit. Operating Profit is a result of conducting the Operational Activities of a business. Operational activities are the activities performed to generate revenue for the business. Operating Expenses are the expenses incurred for Administration of Office, Selling and Distribution of goods and the Financial Expenses of a business.

Operating Profit = Gross Profit - Operating Cost

Operating Cost = Administration and Office Expenses + Selling and Distribution Expenses + Financial Expenses

e. Non-Operating Profit: Non-Operating Profit is generated from activities which do not involve any production of goods or services. It is the profit arising out of the Non Operational activities of a business.

Non-Operating Profit = (Non-Operating Income) - (Non-Operating Expenses)

f. Normal Gain: When goods are manufactured they pass from various processes. Every process has a defined output. An output of one process becomes the input of another process. If the number of output increases during the normal course, it is called ‘Normal Gain’. Normal Gain is when the actual output is equal to the expected output. It happens under normal circumstances and does not affect the cost of production.

g. Abnormal Gain: During the production process, when the goods are transferred from one process to another, there is a possibility that the quantity may increase to much more than what is expected. Such an unexpected increase in the quantity is known as ‘Abnormal Gain’. The actual output in this situation is much higher than the expected output of production. Abnormal Gain may also arise when there is a reduction of wastage. When the actual wastage is lesser than the normal wastage, it is also termed as Abnormal Gain. Abnormal Gain is essentially a result of an increase in the efficiency of the production department.

h. Income: The revenue arising from the sale of goods or services is called Income. It also includes revenues from other sources, common to most businesses such as Interest on Investments, Dividend, Rent, Commission etc.

iv. Assets, Liabilities and Net Worth:

a. Assets: An Asset is any property owned by a business unit. Assets can be classified in three types:

1. Fixed Assets: Assets which are purchased for the purpose of long term use and are not usually sold until they are worn out are called Fixed Assets. They provide long term benefits to the Business.

2. Current Assets: Current Assets are the assets which remain in the business for a short period

of time (usually less than a year) and can be converted into cash easily.

3. Fictitious Assets: Fictitious Assets are intangible in nature. These assets cannot be seen or touched. They can only be felt. They do not have any physical form of existence but they can be valued in terms of money. They are imaginary assets and generally do not have any exchange value.

b. Liabilities: The amount payable by business to outsiders is known as Liability. It is the amount due from the business to various parties for the benefits received by the business unit.

1. Fixed Liabilities: Fixed Liabilities, also known as Long Term Liabilities, are funds made available to business units from various sources for long term use. They are the major source of funds for the business.

2. Current Liabilities: Liabilities which are payable in a short period of time (generally within a year) are called Current Liabilities. These are sources of short term finance for business units.

c. Net Worth / Owners Equity or Capital: Capital is the money invested by the proprietor of a firm to start a business. Additionally, the excess of the Assets over Liabilities is also known as ‘Capital’ or ‘Net Worth’ of a business. As per the business entity concept, business and its owner are separate entities.

Net worth = Owners Equity = Capital

Owner’s Equity = Total Equity (Assets) - Creditors Equity (Liabilities)

Net Worth = Capital + Reserves

Capital = Total Assets - Total Liabilities

Total Assets = Fixed Assets + Current Assets

v. Contingent Liabilities: Contingent Liability is a liability which may have to be paid at a future date, depending upon the happening or non happening of a certain event. It does not affect the financial position of a business and hence it is not recorded in the books of accounts until the event actually occurs. A contingent liability is stated as a footnote to the Balance sheet, simply for information.

vi. Capital and Drawings:

a. Capital: Total amount of funds invested by the proprietor in the business is called capital. In the accounting sense, the excess of Assets over Liabilities is called capital. Capital is a liability of the business as the amount is repayable to the owner of the business unit. Given below is the equation for the calculation of Capital:

Capital = Assets – Liabilities

b. Drawings: Any goods or amount withdrawn by the proprietor from the business for his personal use is called Drawings.

vii. Debtors and Creditors:

a. Debtors: A person who pays money to the business for goods and services purchased by him on credit is called a Debtor. A Debtor is a person who owes money to the business.

b. Creditors: A person to whom money is payable for goods and services purchased or received by the business is known as a Creditor. A creditor is a person to whom business owes money.

viii. Expenditure: The amount paid by a business to receive any services or purchase goods is called Expenditure. When a consideration is received against a payment, the amount paid is known as Expenditure.

a. Capital Expenditure: The amount paid to acquire an Asset or to increase the value of Fixed Assets is called Capital Expenditure. This type of expenditure is non‐recurring in nature and the benefits can be availed over a longer period of time. It increases the earning capacity of a business.

b. Revenue Expenditure: Revenue Expenditure is expenditure from which the benefit is received immediately or for a short term, generally less than one year. It is expenditure incurred on operating expenses/day to day expenses of a business which are recurring in nature. Such expenses do not increase the profit earning capacity of a business. Revenue expenditures appear on the debit side of the Trading Account or Profit and Loss Account.

c. Deferred Revenue Expenditure: Expenditure incurred which is revenue in nature and provides benefit for more than one year is called Deferred Revenue Expenditure. This expenditure is written off in Profit and Loss A/c over a period of time. The amount has written off is shown in the debit side of Profit and Loss Account and an amount which is not written off yet is shown in the

Balance sheet - Asset side.

ix. Cash Discount and Trade Discount: Discount is a concession on payment given by the seller to the buyer.

a. Cash Discount: Cash discount is an allowance or concession provided to customers for prompt payment of debt. It is deducted from the amount receivable or payable at the time of payment and is given for either spot payment or payment made within a specified time period. Cash discount is given on the price calculated after the deduction of Trade Discount. Cash Discount is a loss to seller and gain for the buyer and hence, it is always recorded in books of accounts.

b. Trade Discount: Trade Discount is an allowance or concession given to the buyer on the list price of goods at the time of sale. Trade discount is not recorded in books of accounts as it helps the retailer to sell the goods on printed price and yet make a profit.

x. Solvent and Insolvent:

a. Solvent: A Solvent person is someone who is financially sound and is in a position to pay off all his debts. The Assets of a Solvent person are equal to or more than his Liabilities.

b. Insolvent: An Insolvent person is someone who is not in a position to pay off his Total Debts from his Total Assets and who is not in a financially sound position. The Assets of an Insolvent person are less than his Liabilities.

xi. Accounting Year: In order to find out the financial position and performance of the Business, preparation of financial statements is essential. Financial statements are prepared for a period of 12 months. In earlier times, businessmen were allowed to prepare or close the accounts as per their traditional calendars. However, now, in India, as per the Income Tax rules, an accounting year should be of 12 months starting from 1st April to 31st March. A Businessman is required to prepare the Trading Account, Profit and Loss

Account and Balance sheet to ascertain the financial position of the business.

xii. Trading Concern and Non-Trading Concern:

a. Trading Concern: A business or a firm established to perform trading activities, with the objective of earning a profit is called a Trading Concern. A Trading Concern is also known as a Profit Making Organization or Commercial Organization.

b. Non Trading Concern: An organization which is established for rendering services to the society and does not operate with the objective of earning a profit is known as a Non-Trading Concern. A Non Trading Concern may be formed with the objective of promoting a useful object such as art, science, sports, culture, charity etc.

xiii. Goodwill: Reputation of the business in the market, valued in terms of money, is called Goodwill. It is an Intangible Asset. An Intangible asset is one which cannot be seen or touched. It can only be felt. Goodwill is the name established by the business in the market, measured in monetary terms. It adds value to the business in addition to the value of the Tangible Assets however, Goodwill does not have any physical existence. It is recorded on the Asset side of the Balance sheet.

The chart clearly presents the different types of information that might be useful to all sorts of individuals interested in the business enterprise. As seen from the chart, accounting supplies quantitative information. The special feature of accounting as a kind of quantitative information and as distinguished from other types of quantitative information is that it usually is expressed in monetary terms.

The types of accounting information may be classified into four categories:

(1) operating information, (2) financial accounting information (3) management accounting information and (4) cost accounting information.

Operating Information:

By operating information, we mean the information which is required to conduct the day-to-day activities. Examples of operating information are: the amount of wages paid and payable to employees, information about the stock of finished goods available for sale and each one’s cost and selling price, information about amounts owed to and owing by the business enterprise, information about the stock of raw materials, spare parts and accessories and so on. By far, the largest quantity of accounting information provides the raw data (input) for financial accounting, management accounting and cost accounting.

Financial Accounting:

Financial accounting information is intended both for owners and managers and also for the use of individuals and agencies external to the business. This accounting is concerned with the recording of transactions for a business enterprise and the periodic preparation of various reports from such records. The records may be for general purpose or for a special purpose. A detailed account of the function of financial accounting has been given earlier in this lesson.

Management Accounting:

Management accounting employs both historical and estimated data in assisting management in daily operations and in planning for future operations. It deals with specific problems that confront enterprise managers at various organizational levels. The management accountant is frequently concerned with identifying alternative courses of action and then helping to select the best one. For e.g. The accountant may help the finance manager in preparing plans for future financing or may help the sales manager in determining the selling price to be fixed on a new product by providing suitable data. Generally, management accounting information is used in three important management functions: (1) control (2) coordination and (3) planning. Marginal costing is an important technique of management accounting which provides multidimensional information that facilitates decision making.

Cost Accounting:

The industrial revolution in England posed a challenge to the development of accounting as a tool of industrial management. This necessitated the development of costing techniques as guides to management action. Cost accounting emphasizes the determination and control of costs. It is concerned primarily with the cost of manufacturing processes. In addition, one of the principal functions of cost accounting is to assemble and interpret cost data, both actual and prospective, for the use of management in controlling current operations and in planning for the future.

All of the activities described above are related to accounting and in all of them the focus is on providing accounting information to enable decisions to be made.

Groups Interested In Accounting Information

There are several groups of people who are interested in accounting information relating to the business enterprise. Following are some of them:

Shareholders:

Shareholders as owners are interested in knowing the profitability of the business transactions and the distribution of capital in the form of assets and liabilities. In fact, accounting developed several centuries ago to supply information to those who had invested their funds in business enterprise.

Management:

With the advent of joint stock company form of organization, the gap between ownership and management widened. In most cases, the shareholder's act merely as renders of capital and the management of the company passes into the hands of professional managers. The accounting disclosures greatly help them in knowing about what has happened and what should be done to improve the profitability and financial position of the enterprise.

Potential Investors:

An individual who is planning to make an investment in business would like to know about its profitability and financial position. An analysis of the financial statements would help him in this respect.

Creditors:

As creditors have extended credit to the company, they are much worried about the repaying capacity of the company. For this purpose, they require its financial statements, an analysis of which will tell about the solvency position of the company.

Government:

Any popular government has to keep a watch on big businesses regarding the manner in which they build business empires without regard to the interests of the community. Restricting monopolies is something that is common even in capitalist countries. For this, it is necessary that proper accounts are made available to the government. Also, accounting data are required for collection of sale-tax, income-tax, excise duty etc.

Employees:

Like creditors, employees are interested in the financial statements in view of various profit sharing and bonus schemes. Their interest may further increase when they hold shares of the companies in which they are employed.

Researchers:

Researchers are interested in interpreting the financial statements of the concern for a given objective.

Citizens:

Any citizen may be interested in the accounting records of business enterprises including public utilities and government companies as a voter and taxpayer.

9 Accounting Concepts

The important accounting concepts are discussed hereunder:

Business Entity Concept:

It is generally accepted that the moment a business enterprise is 17started it attains a separate entity as distinct from the persons who own it. In recording the transactions of a business, the important question is:

How do these transactions affect the business enterprise? The question as to how these transactions affect the proprietors is quite irrelevant. This concept is extremely useful in keeping business affairs strictly free from the effect of private affairs of the proprietors. In the absence of this concept, the private affairs and business affairs are mingled together in such a way that the true profit or loss of the business enterprise cannot be ascertained nor its financial position. To quote an example, if a proprietor has taken rs.5000/- from the business for paying house tax for his residence, the amount should be deducted from the capital contributed by him. Instead, if it is added to the other business expenses then the profit will be reduced by rs.5000/- and also his capital more by the same amount. This affects the results of the business and also its financial position. Not only this, since the profit is lowered, the consequential tax payment also will be less which is against the provisions of the income-tax act.

Going Concern Concept:

This concept assumes that the business enterprise will continue to operate for a fairly long period in the future. The significance of this concept is that the accountant while valuing the assets of the enterprise does not take into account their current resale values as there is no immediate expectation of selling it. Moreover, depreciation on fixed assets is charged on the basis of their expected life rather than on their market values. When there is conclusive evidence that the business enterprise has a limited life, the accounting procedures should be appropriate to the expected terminal date of the enterprise. In such cases, the financial statements could clearly disclose the limited life of the enterprise and should be prepared from the ‘quitting concern’ point of view rather than from a ‘going concern’ point of view.

Money Measurement Concept:

Accounting records only those transactions which can be expressed in monetary terms. This feature is well emphasized in the two definitions of accounting as given by the American Institute of certified public accountants and the American accounting principles board. The importance of this concept is that money provides a common denomination by means of which heterogeneous facts about a business enterprise can be expressed and measured in a much better way. For e.g. When it is stated that a business owns rs.1,00,000 cash, 500 tons of raw material, 10 machinery items, 3000 square meters of land and building etc., these amounts cannot be added together to produce a meaningful total of what the business owns. However, by expressing these items in monetary terms such as rs.1,00,000 cash, rs.5,00,000 worth raw materials, rs,10,00,000 worth machinery items, and rs.30,00,000 worth land and building – such addition is possible.

A serious limitation of this concept is that accounting does not take into account pertinent non-monetary items which may significantly affect the enterprise. For instance, accounting does not give information about the poor health of the chairman, serious misunderstanding between the production and sales manager etc., which have a serious bearing on the prospects of the enterprise. Another limitation of this concept is that money is expressed in terms of its value at the time a transaction is recorded in the accounts. Subsequent changes in the purchasing power of money are not taken into account.

Cost Concept:

This concept is yet another the fundamental concept of accounting which is closely related to the going-concern concept. As per this concept: (i) an asset is ordinarily entered in the accounting records at the price paid to acquire it i.e., at its cost and (ii) this cost is the basis for all subsequent accounting for the asset.

The implication of this concept is that the purchase of an asset is recorded in the books at the price actually paid for it irrespective of its market value. For e.g., If a business buys a building for rs.3,00,000, the asset would be recorded in the books as rs.3,00,000 even if it's market value at that time happens to be rs.4,00,000. However, this concept does not mean that the asset will always be shown at cost. This cost becomes the basis for all future accounting of the asset. It means that the asset may systematically be reduced in its value by changing depreciation. The significant advantage of this concept is that it brings in objectivity in the preparations and presentation of financial statements. But like the money measurement concept, this concept also does not take into account subsequent changes in the purchasing power of money due to inflationary pressures. This is the reason for the growing importance of inflation accounting.

Dual Aspect Concept (Double Entry System):

This concept is the core of accounting. According to this concept, every business transaction has a dual aspect. This concept is explained in detail below:

The properties owned by a business enterprise is referred to as assets and the rights or claims to the various parties against the assets are referred to as equities. The relationship between the two may be expressed in the form of an equation as follows:

Equities = Assets

Equities may be subdivided into two principal types: the rights of creditors and the rights of owners. The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called capital.

Expansion of the equation to give recognition to the two types of equities results in the following which is known as the accounting equation:

Liabilities + Capital = Assets

It is customary to place ‘liabilities’ before ‘capital’ because creditors have priority in the repayment of their claims as compared to that of owners. Sometimes greater emphasis is given to the residual claim of the owners by transferring liabilities to another side of the equation as:

Capital = Assets – Liabilities

All business transactions, however simple or complex they are, result in a change in the three basic elements of the equation. This is well explained with the help of the following series of examples:

(i) Mr. Prasad commenced business with a capital of Rs.3,000: the result of this transaction is that the business, being a separate entity, gets cash-asset of rs.30,000 and has to pay to.MR. Prasad rs.30,000, his capital. This the transaction can be expressed in the form of the equation as follows:

Capital = Assets

Prasad Cash

30,000 30,000

(ii) purchased furniture for rs.5,000: the effect of this transaction is that cash is reduced by rs.5,000 and a new asset viz. Furniture worth rs.5,000 comes in, thereby, rendering no change in the total assets of the business. The equation after this transaction will be:

Capital = Assets

Prasad Cash + Furniture

30,000 25,000 + 5,000

(iii) borrowed rs.20,000 from me. Gopal: as a result of this transaction both the sides of the equation increase by rs.20,000; cash balance is increased and a liability to Mr. Gopal is created. The equation will appear as follows:

Liabilities + Capital = Assets

Creditors + Prasad Cash + Furniture

20,000 30,000 45,000 5,000

(iv) purchased goods for cash rs.30,000: this transaction does not affect the liabilities side total nor the asset side total. Only the composition of the total assets changes i.e. Cash is reduced by rs.30,000 and a new asset viz. Stock worth rs.30,000 comes in. The equation after this transaction will be as follows:

Liabilities + Capital =Asset

Creditors Prasad Cash + Stock + Furniture

20,000 30,000 15,000 30,000 5,000

(v) goods worth rs.10,000 are sold on credit to Ganesh for rs.12,000. The result is that stock is reduced by rs.10,000 a new asset namely debtor (mr.ganesh) for rs.12,000 comes into the picture and the capital of Mr. Prasad increases by rs.2,000 as the profit on the sale of goods belongs to the owner. Now the accounting equation will look as under:

Liabilities + Capital = Asset

Creditors Prasad Cash + Debtors + Stock + Furniture

20,000 32,000 15,000 12,000 20,000 5,000

(vi) paid electricity charges rs.300: this transaction reduces both the cash balance and Mr. Prasad’s capital by rs.300. This is so because the expenditure reduces the business profit which in turn, reduces the equity. 21

The equation

The equation after this will be:

Liabilities + Capital =Assets

Creditors + Prasad Cash + Debtors + Stock + Furniture

20,000 31,700 14,700 12,000 20,000 5,000

Thus it may be seen that whatever is the nature of the transaction, the accounting equation always tallies and should tally. The system of recording transactions based on this concept is called double entry system.

Accounting Period Concept:

In accordance with the going concern concept, it is usually assumed that the life of a business is indefinitely long. But owners and other interested parties cannot wait until the business has been wound up for obtaining information about its results and financial position. For e.g. If for ten years no accounts have been prepared and if the business has been consistently incurring losses, there may not be any capital at all at the end of the tenth year which will be known only at that time. This would result in the compulsory winding up of the business. But, if at frequent intervals information are made available as to how things are going, then corrective measures may be suggested and remedial action may be taken. That is why Pacioli wrote as early as in 1494: ‘frequent accounting makes for only friendship’. This need leads to the accounting period concept.

According to this concept accounting measures, activities for a specified interval of time called the accounting period. For the purpose of reporting to various interested parties one year is the usual accounting period. Though Pacioli wrote that books should be closed each year especially in a partnership, it applies to all types of business organizations.

Periodic Matching Of Costs And Revenues:

This concept is based on the accounting period concept. It is widely accepted that the desire of making a profit is the most important motivation to keep the proprietors engaged in business activities. Hence a major share of attention of the accountant is being devoted towards evolving appropriate techniques of measuring profits. One such technique is the periodic matching of costs and revenues.

In order to ascertain the profits made by the business during a period, the accountant should match the revenues of the period with the costs of that period. By ‘matching’ we mean the appropriate association of related revenues and expenses pertaining to a particular accounting period. To put it in other words, profits made by a business in a particular accounting period can be ascertained only when the revenues earned during that period are compared with the expenses incurred for earning that revenue. The question as to when the payment was actually received or made is irrelevant. For e.g. In a business enterprise which adopts calendar year as accounting year, if rent for December 1989 was paid in January 1990, the rent so paid should be taken as the expenditure of the year 1989, revenues of that year should be matched with the costs incurred for earning that revenue including the rent for December 1989, though paid in January 1990. It is on account of this concept that adjustments are made for outstanding expenses, accrued incomes, prepaid expenses etc. While preparing financial statements at the end of the accounting period.

The system of accounting which follows this concept is called a mercantile system. In contrast to this, there is another system of accounting called a cash system of accounting where entries are made only when cash is received or paid, no entry is made when a payment or receipt is merely due.

Realization Concept:

Realization refers to inflows of cash or claims to cash like bills receivables, debtors etc. Arising from the sale of assets or rendering of services. According to the realization concept, revenues are usually recognized in the period in which goods were sold to customers or in which services were rendered. The sale is considered to be made at the point when the property in goods passes to the buyer and he becomes legally liable to pay. To illustrate this point, let us consider the case of a, a manufacturer who produces goods on receipt of orders. When an order is received from b, a starts the process of production and delivers the goods to b when the production is complete. B makes payment on receipt of goods. In this example, the sale will be presumed to have been made not at the time when goods are delivered to b. A second aspect of the realization concept is that the amount recognized as revenue is the amount that is reasonably certain to be realized. However, a lot of reasoning has to be applied to ascertain as to how certain ‘reasonably certain’ is … yet, one thing is clear, that is, the amount of revenue to be recorded may be less than the sales value of the goods sold and services rendered. For e.g. When goods are sold at a discount, revenue is recorded not at the list price but at the amount at which sale is made. Similarly, it is on account of this aspect of the concept that when sales are made on credit, though entry is made for the full amount of sales, then the estimated amount of bad debts is treated as an expense and the effect on net income is the same as if the revenue were reported as the number of sales minus the estimated amount of bad debts