Big picture
Every business, from a tea stall to a multinational company, needs to know three things: What do I own? What do I owe? Am I making a profit? Accounting answers these questions by recording, classifying and summarising financial transactions and communicating the results to the people who need them.
This chapter introduces the language of accounting. The basic terms defined here (asset, liability, capital, revenue, expense and so on) are used in every later chapter, so learn them with examples.
Learning goals
Define accounting and explain its process.
Explain accounting as a source of information and identify its users.
State the objectives, role, advantages and limitations of accounting.
Explain the qualitative characteristics of accounting information.
Explain the branches of accounting.
Define and give examples of the basic accounting terms.
Core ideas
1. Meaning of accounting
The American Accounting Association defines accounting as the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information.
The accounting process
Step | Meaning | Example |
|---|---|---|
Identifying | Deciding which transactions are financial in nature and should be recorded | Buying goods is recorded; a manager's resignation is not (it has no direct money value) |
Measuring | Expressing transactions in money (₹) | Goods bought for ₹50,000 |
Recording | Entering transactions in the books (journal) in chronological order | Writing the purchase in the journal on its date |
Classifying | Grouping transactions of similar nature in one place (ledger accounts) | All purchases in the Purchases Account |
Summarising | Preparing the trial balance and financial statements | Profit and Loss Account and Balance Sheet |
Analysing and interpreting | Understanding what the statements mean | Is profit rising? Can the firm pay its creditors? |
Communicating | Giving the information to users | Annual report to shareholders |
Book-keeping is the recording part: identifying, measuring, recording and classifying. Accounting goes further to summarise, analyse, interpret and communicate. Book-keeping is the base of accounting.
2. Users of accounting information
Internal users | Need information about |
|---|---|
Owners | Profitability and safety of capital |
Management | Planning, controlling and decision-making |
Employees and workers | Profit, for bonus and job security |
External users | Need information about |
|---|---|
Investors and potential investors | Return and safety of investment |
Lenders (banks and financial institutions) | Ability to repay loans with interest |
Creditors (suppliers) | Ability to pay on time |
Government and tax authorities | Tax liability and compliance with laws |
Customers | Continued supply and after-sales service |
Researchers and the public | The firm's contribution to the economy |
3. Objectives and role of accounting
Objectives
Maintaining systematic records of all business transactions.
Calculating profit or loss for a period (through the Profit and Loss Account).
Ascertaining the financial position on a date (through the Balance Sheet).
Providing information to users for decisions.
Protecting business assets by keeping records of what the business owns.
Role: accounting is the language of business. It provides information for decision-making, controls business activity, helps assess tax, supports claims in courts as evidence, and enables comparison between periods and between firms.
4. Qualitative characteristics of accounting information
Characteristic | Meaning |
|---|---|
Reliability | Information must be free from error and bias, verifiable, and faithfully represent what it claims to |
Relevance | Information must be available in time and must influence users' decisions |
Understandability | Information must be presented so that users can understand it |
Comparability | Information must allow comparison over time (same firm, different years) and across firms |
5. Branches of accounting
Branch | Purpose |
|---|---|
Financial accounting | Recording transactions and preparing financial statements to find profit and financial position |
Cost accounting | Ascertaining and controlling the cost of products and services |
Management accounting | Providing information to management for planning, decision-making and control |
Tax accounting | Calculating and complying with tax obligations (income tax, GST) |
6. Advantages and limitations of accounting
Advantages: it provides complete and systematic records; facilitates comparison; helps in decision-making; is accepted as evidence in courts; helps in the valuation of a business when it is sold; and helps in tax assessment.
Limitations
Records only monetary transactions: the skill of a manager or staff morale is not recorded.
Ignores price-level changes: assets are shown at historical cost, so the effect of inflation is not reflected.
Affected by personal judgement: choices such as the method of depreciation or the valuation of stock affect profit.
Possibility of window dressing: the accounts may be manipulated to show a better position.
Historical in nature: it records past events.
7. Basic accounting terms
Business and transactions
Term | Meaning | Example |
|---|---|---|
Entity | A business with a separate identity from its owner | Sharma Traders, separate from Mr Sharma |
Business transaction | An economic activity that changes the financial position of the business | Selling goods, paying rent |
Cash transaction | Payment is made immediately | Buying a table for cash |
Credit transaction | Payment is made later | Selling goods to Ravi on credit |
Voucher | Documentary evidence of a transaction | Cash memo, invoice, receipt |
Goods | Products the business buys and sells (or makes and sells) | For a furniture dealer, tables and chairs; for a stationery shop, pens and notebooks |
Capital and drawings
Capital: the amount invested by the owner in the business, in cash or kind. It is a liability of the business towards the owner (because of the business entity concept).
Drawings: cash or goods withdrawn by the owner for personal use. Drawings reduce capital. Example: the owner takes ₹5,000 from the business to pay their home electricity bill.
Liabilities are amounts the business owes to outsiders.
Non-current liabilities: payable after a long period (more than a year): long-term loans, debentures.
Current liabilities: payable within a year: creditors, bills payable, short-term loans, outstanding expenses.
Assets are economic resources owned by the business, expected to give future benefits.
Non-current assets: held for long-term use, not for sale. Tangible (can be touched: land, building, machinery, furniture) and intangible (cannot be touched: goodwill, patents, trademarks).
Current assets: held for a short period and convertible into cash within a year: cash, bank balance, stock, debtors, bills receivable, prepaid expenses.
Revenue, expense and profit
Term | Meaning | Example |
|---|---|---|
Revenue | Amount earned from the business's regular activities | Sales of goods, fees earned |
Expense | Cost incurred to earn revenue | Rent, salaries, electricity |
Expenditure | Spending of money or incurring a liability for some benefit; it can be revenue or capital | |
Revenue expenditure | Benefit is used up within the year | Wages, repairs, carriage on purchases |
Capital expenditure | Benefit lasts for more than a year | Purchase of machinery, building a shop |
Income | Increase in wealth; profit earned during a period | Net profit, interest received |
Profit | Excess of revenue over expenses | Revenue ₹5,00,000, expenses ₹3,50,000, profit ₹1,50,000 |
Gain | Profit from irregular, non-recurring events | Profit on sale of an old machine |
Loss | Excess of expenses over revenue; or a reduction in owner's capital from an event like theft or fire | Goods lost by fire |
Purchases, sales and stock
Purchases: goods bought for resale or for production. Buying furniture for office use is not "purchases" for a stationery shop; it is an asset.
Purchases return (return outward): goods returned to the supplier.
Sales: goods sold; sales return (return inward): goods returned by customers.
Stock (inventory): goods unsold on a date. Opening stock is at the start of the period; closing stock at the end.
Debtors and creditors
Debtors: persons who owe money to the business for goods sold or services given on credit. They are assets.
Creditors: persons to whom the business owes money for goods or services bought on credit. They are liabilities.
Discount
Type | Meaning | Recorded in books? |
|---|---|---|
Trade discount | A reduction in list price allowed at the time of sale, to encourage bulk buying | No; the transaction is recorded at the net price |
Cash discount | A reduction allowed for prompt payment | Yes; as discount allowed (expense) or discount received (income) |
Example. Goods with a list price of ₹10,000 are sold at 10% trade discount, and 2% cash discount is allowed for immediate payment. Invoice price = 10,000 − 1,000 = ₹9,000. Cash discount = 2% of 9,000 = ₹180. Cash received = ₹8,820. Sales are recorded at ₹9,000, and ₹180 is recorded as discount allowed.
A reliable approach to questions
For a "classify" question, decide whether the item is owned (asset), owed (liability), the owner's (capital or drawings), earned (revenue or gain) or spent (expense or loss).
For expenditure, ask how long the benefit lasts: more than a year means capital; within the year means revenue.
For discounts, record trade discount nowhere; record cash discount as a separate item.
For users, link each user to what they want to know.
Connections that matter
Theory base of accounting gives the concepts (such as business entity and money measurement) that explain these definitions.
Recording of transactions uses these terms in journal entries and the accounting equation.
Financial statements classify assets and liabilities into current and non-current.
Common mistakes
Treating book-keeping and accounting as the same. Book-keeping is only the recording stage.
Calling capital an asset of the business. It is a liability of the business towards the owner.
Recording trade discount in the books.
Treating all purchases of goods as "purchases". Goods bought for office use are assets, not purchases.
Calling repairs capital expenditure. Routine repairs are revenue expenditure.
Revision checklist
I can define accounting and describe the steps of the accounting process.
I can list internal and external users and what each needs.
I can explain the four qualitative characteristics.
I can explain the branches, advantages and limitations of accounting.
I can define and give examples of every basic term.
I can calculate trade and cash discount.