THEORY

MEANING & FUNCTIONS

y MEANING- Accounting is a process of

recording financial transactions, summarizing them & communicating the financial information to users, like creditors, investors, etc.

FUNCTIONSy 1. IDENTIFICATION- Economic events are identified & measured in terms of money.

FUNCTION cond.
y 2. RECORDING- Recording is the process of entering business transactions of financial character in the books of original entry, i.e. , in Journal. y 3. CLASSIFYING- Classification is the process of grouping transactions or entries of one nature at one place. The transactions recorded in Journal are classified & posted to the main book of accounts known as the LEDGER.

FUNCTIONS cond.
y 4. SUMMARISING- This involves presenting

the classified data in a manner which is understandable & useful to internal as well as external users of accounting statements. y 5. ANALYSING & INTERPRETATION- The final stage in the accounting process is analyzing & interpreting the financial data

FUNCTIONS cond.
so that parties concerned with business can make a meaningful judgment about the profitability of the business unit. y 6. COMMUNICATING- Finally, the accounting function involves communicating the financial data to the users.

USERS OF ACCOUNTING INFORMATION

y 1. OWNERS- Owners contribute capital in

the business & thus are exposed to maximum risk. Naturally, they are interested in knowing the profit earned or loss suffered by the business besides the safety of their capital. The financial statements give the information about profit or loss & financial position of the business.

cond.
y 2. MANAGEMENT- The management makes extensive

use of accounting information to arrive at informed decisions such as determination of selling price, cost control & reduction, etc. y 3.EMPLOYEES & WORKERS- Employees & workers are entitled to bonus at the year end, which is linked to the profit earned by an enterprise. Therefore, employees & workers are interested in financial statements.

cond.
y 4. BANKS & FINANCIAL INSTITUTIONSBanks & financial institutions are an essential part of any business as they provide loan to businesses. Naturally, they watch the performance of the business to ensure safety & recovery of the loan by analyzing the accounting information. y 5. INVESTORS- Investors do not have direct control over the business affairs. Therefore, they rely on accounting information available to them.

cond.
y 6. CREDITORS- Creditors are those parties who supply goods or services on credit. Before granting credit, creditors satisfy themselves about credit worthiness of the business through the help of financial statements. y 7. CONSUMERS- Consumers require accounting information for establishing good accounting control so that cost of production may be reduced with the resultant reduction of the prices of products they buy.

CHARACTERSTICS F ACCOUNTING INFORMATION

y 1. RELIABILITY- Accounting information

must be reliable. y 2. RELEVANCE- The accounting information should disclose all information after judging its relevance to the decisionmaking need of its users. y 3. UNDERSTANDABILITY- The information provided through the financial

cond.
Statements be presented in a manner that the users are able to understand in it the manner it should be. y 4.COMPARABILITY- Comparability means that the users should be able to compare the accounting information of an enterprise of the period either with that of other periods or with information of other enterprises.

BASIC ACCOUNTING TERMS

rights owned by a individual or business to which money value can be attached. Exdebtors, cash, furniture, machine, building, etc. Assets can be classified to be : y (a) FIXED ASSETS- Fixed assets are those assets which are purchased for the purpose of operating the business & not for resale.
y 1. ASSETS- Assets are properties or legal

cond.
Ex- land, building, machinery, furniture, etc. y (b) CURRENT ASSETS- Current assets are those assets which are kept for short-term with a purpose to convert them into cash or for resale. Ex- unsold goods, debtors, bank balance, etc. y (c) TANGIBLE ASSETS- Tangible assets are those assets which have physical existence, that is, they can be seen & touched. Ex- land, building, computer, etc.

Cond.
y (d) INTANGIBLE ASSETS- Intangible assets are those

assets which do not have any physical form, that is, they cannot be seen or touched. Ex- goodwill, trademarks, patents, etc. y (e) WASTING ASSETS- Wasting assets are those assets which are natural resources consumed during the process of use. Ex- mines, quarries, etc.

Cond.
y 2. LIABILITIES- Liabilities means the amount which

the business owes to outsiders. y LIABILITIES=ASSETS-CAPITAL Liabilities can be classified into : y (a) LONG-TERM LIABILITIES- These are those liabilities which are payable after a long term (after one year). Ex- long-term loans, debentures, etc.

Cond.
y (b) CURRENT LIABILITIES- These are liabilities

which are payable in near future (within a year). Excreditors, bills payable, bank overdraft, etc. y 3. CAPITAL- Capital means the amount which the proprietor has invested in the business & can claim from it. Capital ,means Owner s Equity. y CAPITAL=ASSETS-LIABILITIES

Cond.
y 4. EXPENSE- Expense is amount spent in order to

produce & sell the goods & services which produce the revenue. Ex- salaries, wages, rent, etc. y 5. INCOME- Income is the profit earned during a period of time. The difference between revenue & expense is called income. y INCOME=REVENUE-EXPENSE

Cond.
y 6. EXPENDITURE- Expenditure is the amount or liability incurred for the value received.

Expenditure can be classified as : y (a) CAPITAL EXPENDITURE- Capital expenditure is the expenditure incurred to acquire fixed assets or its improvement. It is shown on the asset side in the balance sheet. Ex- purchase of computer to conduct business. y (b) REVENUE EXPENDITURE- Revenue expenditure is the amount spent to purchase goods & services that are consumed during the accounting period. It is shown on the debit side of the profit & loss A/c.

Cond.
y 7. REVENUE- Revenue is an inflow of assets, which

results in an increase in the owner s equity. Ex- receipts from sale of goods, rent commission, etc. y 8. DEBTOR- A person who owes amount to the enterprise is called a debtor. The amount due is known as debt. y 9. CREDITOR- A person to whom an enterprise owes amount on account of credit purchase of goods or services is called a creditor.

Cond.
y 10. GOODS- They refers to the products in which an

enterprise is dealing. Ex- for a stationer, stationery is goods. y 11. COST- It is the amount of expenditure incurred on a specific article, product or service. y 12. GAIN- It is a profit that arises from transactions which are incidental to business such as sale of fixed assets at more than their book values.

Cond.
y 13. STOCK OR INVENTORY- Stock is the tangible

property held by an enterprise for the purpose of sale or using it in the production of goods or services to be rendered. Stock may bey (a) OPENING STOCK- It is the amount of stock at the beginning of the accounting period. y (b) CLOSING STOCK- It comprises of raw materials & finished goods in hand on the closing date.

Cond.
y 14. LOSS- A loss is an excess of expenses of a period

over its related revenues. y 15. PROFIT- It is the surplus of revenues of a business over its costs. Profit is categorized as : y (a) GROSS PROFIT- Gross profit is the difference between the sales revenue & services rendered over it direct cost. y (b) NET PROFIT- Net profit is the profit made

Cond.
after allowing for all expenses. y 16. DISCOUNT- When customers are allowed any type of reduction in the prices of goods by the business, it is called a discount. When some discount is allowed in the prices of goods on the basis of sales, it is called a TRADE DISCOUNT. But when debtors are allowed some discount in prices of goods for timely payment, it is called a CASH DISCOUNT.

Cond.
y 17. VOUCHER- Voucher is an evidence of a business

transaction. Ex- cash memo, invoice, bill, etc. y 18. TRANSACTION- The term transaction means a financial event entered by the parties & entered in the books of accounts. y 19. DRAWINGS- It is the amount of money or the value of goods which the proprietor takes for his domestic or personal use.

Cond.
y 20. BILLS RECEIVABLE- Bills receivable means a bill of

exchange accepted by a debtor the amount of which will be received on the specific date. y 21. BILLS PAYABLE- Bills payable means a bill of exchange, the amount of which will be payable on a specific date. y 22. DEPRECIATION- It is a fall in the value of an asset because of usage or with passage of time or accident.

Cond.
y 23. BAD DEBTS- It is the amount that has become

irrecoverable. It is debited to profit & loss A/c. y 24. INSOLVENT- Insolvent is a person or enterprise which is not in a position to pay its debts. y 25. BALANCE SHEET- It is a statement of the financial position of an individual or enterprise as at a given date.

Cond.
y 26. ENTITY- An entity means an economic unit which

performs economic activities. y 27. SOURCE DOCUMENT- A source document is a written document containing details thereof & prepared at the time of transaction.

ACCOUNTING PRINCIPLES
y 1. THE BUSINESS ENTITY PRINCIPLE- According to

the business entity principle, business is considered to be separate from its owners. Business transactions are recorded in the books of accounts from the business point of view & not owners. For ex- when owner introduces his capital, the cash account is debited & capital account is credited.

Cond.
y 2. THE MONEY MEASUREMENT PRINCIPLE-

According to this principle, transactions & events that can be measured in money terms are recorded in books of account of the enterprise. y 3. GOING CONCERN PRINCIPLE- According to the going concern principle it is assumed that business shall continue for an indefinite period & there is no intention to close the business or scale down it s operations significantly.

Cond.
y 4. THE ACCOUNTING PERIOD PRINCIPLE-

According to the accounting period principle, the life of an enterprise be broken into smaller periods so that its performance is measured at regular intervals. y 5. THE COST PRINCIPLE- According to the cost principle, the asset is recorded in the books of account at the price paid to acquire it & the cost is the basis for all subsequent

Cond.
accounting of the asset. For ex- an asset is purchased for 5,00,000 & if at the time of preparing the final accounts, even its market value is say, 4,00,000, yet, the asset shall be recorded at its purchase price: 5,00,000. y 6. THE DUAL ASPECT PRINCIPLE- According to the dual aspect principle, every transaction entered into by an enterprise has two aspects, a debit & a credit of equal amount.

Cond.
For ex- Rahul starts a business with a capital of Rs. 1,00,000. There are two aspects to the transaction. On one hand, the business has an asset of 1,00,000, while on the other hand, it has liability towards rahul of Rs. 1,00,000. y 7. THE REVENUE RECOGNITION PRINCIPLEAccording to this principle, revenue is considered to have been realized when a transaction been entered into & the

Cond.
obligation to receive the amount has been established. For ex- an enterprise sells goods in February 2009 & receives the amount in April 2009. Revenue of this sale should be recognized in February 2009, that is, when the goods are sold. y 8. THE MATCHING PRINCIPLE- According to the matching principle, cost incurred to earn the revenue should be recognized as expense

Cond.
in the period when revenue is recognized as earned. For ex- insurance paid is partly for the next year. The part relating to the next year should be shown as the expense in the next year & not this year. y 9. THE ACCRUAL PRINCIPLE- According to the accrual principle, a transaction is recorded at the time when it takes place & not when the settlement takes place. For ex- if ram sold

cond.
goods to raj on February 27, 2009 for Rs. 15,000 on credit of two months, the sale must be recorded on February 27, 2009 although the amount will be received on April 27, 2009. y 10. THE VERIFIABLE OBJECTIVE PRINCIPLE- The verifiable objective principle holds that accounting should be free from personal bias. Measurements that are based on verifiable evidence are regarded as objectives. It means

cond
all accounting transactions should be supported by business documents. These documents are cash memo, invoices, sales bills, etc.

BANK RECONCILATION STATEMENT

y A bank reconcilation statement is prepared on a

particular date to reconcile bank balance in cash book with the balance as per the pass book by showing reasons for differences between the two.

CAUSES OF DIFFERENCE B/W CASH BOOK & PASS BOOK BALANC

y 1. DIFFERENCE DUE TO TIMINGS- There is always a

time gap between recording a transaction in the books of accounts & their being recorded by the bank. For exa cheque issued is recorded in the books of accounts immediately but the bank will record when it is presented for payment. So, if bank reconcilation statement is prepared between the two dates, differences will exist.

Cond.
2. TRANSACTIONS RECORDED BY THE BANKSometimes transactions are recorded by the bank, which are not known to the account holder. The account holder comes to know about it after receiving the bank statement. Such transactions in the bank statement lead to a difference between the cash book & the bank statement balances. 3. ERRORS- Errors may be committed by the bank or the accountant, & these errors lead to

Cond.
difference between balances of cash book & bank statement. For ex- wrong balance may be carried forward by the accountant, a transaction may not have been recorded in the cash book or pass book. y 4. CHEQUES ISSUED BUT NOT YET PRESENTED FOR PAYMENT- When a cheque is issued for payment, an entry in cash book is recorded immediately. But the entry is

Cond.
recorded by the bank only when the cheque is presented for payment. There will, thus, be a gap of few days between the entry in the cash book & pass book. If BRS is prepared on the date between the issue of cheque & its presentation to the bank for payment, a difference will arise.

Cond.
y 5. CHEQUES PAID INTO THE BANK BUT NOT YET

CLEARED- Cheques sent to the bank are recorded in the bank column on the debit side of cash book. But bank credits the customer s account when they have received the payment from the other bank. Again, there will be gap of few days between deposit of the cheques & the credit given by the bank. Therefore, a difference will arise on a particular date in the bank as per the books & the bank.

Cond.
y 6. INTEREST CREDITED BY THE BANK BUT NOT

YET RECORDED IN THE CASH BOOK- If the bank allows interest to a customer, it credits the customer s account & his balance would increase. But the customer will make the corresponding entry in the cash book when he comes to know about this. Until then, the balance as per the pass book would be more than the cash book.

Cond.
y 7. BANK CHARGES & INTEREST CHARGED BY BANK

BUT NOT ENTERED IN THE CASH BOOK- Bank renders certain services to his customers for which it charges an amount known as bank charges. As soon as these charges are made, the bank debits the customer s account in its books & thus reduces the bank balance. But the customer comes to know about them only when he receives pass book & then he credits the bank

Cond.
account in his cash book. Until then, the balance as per the pass book would be less than that of the cash book. 8. INTEREST & DIVIDENDS COLLECTED BY THE BANK- Sometimes investments are left in the safe custody of the bank. The bank collects interest & dividends on the due dates & credits them to the customer s account. Naturally, the customer record it in their cash

Cond.
book either on receiving information from the bank or noticing it from their pass book. The entries in the cash book & the pass book may thus be on different dates. Until then, the balance as per the pass book would be more than the cash book.

Cond.
y 9. DIRECT PAYMENTS BY THE BANK- The bank may

be given standing instructions for certain payments such as for insurance premium. When the bank makes such payments, it immediately debits the customer s account. In this case also the customer comes to know of the payment only on pursuing the pass book. Entries in the pass book & the cash book will thus be on different dates.

Cond.
y 10. DIRECT PAYMENT INTO THE BANK BY A

CUSTOMER- If a payment is received by the bank directly, it will be recorded in the customer s account & also in the pass book. The account holder may come to know of the amount on a later date only when he pursues the pass book. Thus, the difference may arise between the balances in the cash book & pass book.

Cond.
y 11. DISHONOUR OF A BILL DISCOUNTED WITH

THE BANK- If the bank is not able to receive payment on promissory notes discounted by it, it will debit the customer s account together with any charges that it may have incurred. The customer will naturally record the entry only when he pursues the pass book. But till such entry is recorded , the balance shown by cash book & pass book will differ.

Cond.
y 12. BILLS COLLECTED BY THE BANK ON BEHALF

OF THE CUSTOMER If goods are sold, the documents may be sent through the bank. If the bank is able to collect the amount, it will credit the customer s account. The customer may make the entry only on receiving the pass book on the later date. Till then, the cash book & pass book balance will differ.

Cond.
y 13. ERRORS & OMISSIONS- Errors & omissions either

in the cash book or in the pass book would cause disagreement between the balance as per the cash book & the pass book. It may be possible that while recording the transaction in the cash book, a cheque of Rs. 1,000 deposited into the bank is recorded as Rs. 10,000. Such errors would lead to difference between cash book & pass book balances.

DEPRECIATION
y MEANING- Depreciation means fall in the value of an

asset because of usage or with efflux of time or due to obsolescence or accident. CHARACTERISTICSy 1. Depreciation is reduction in the book value of fixed assets. y 2. It reduces the book value of the asset but not its market value.

Cond.
y 3. The reduction in the book value of an asset is

permanent, gradual & of continuing nature. y 4. Depreciation is a continuous process because the book value is reduced either due to use or with the passage of time. y 5. It is not the process of valuation of asset, it is a process of allocation of cost of the asset to the period of its life. y 6. The term depreciation is used only for tangible fixed assets.

SOME IMPORTANT TERMS

y DEPLETION- The term depletion is used in respect of

the extraction of natural resources like quarries, mines, etc. y OBSOLESCENCE- Obsolescence refers to decrease in usefulness caused on account of the asset becoming out of date, old fashioned, etc. y AMORTIZATION- Amortization refers to the writing off the proportionate value of the intangibles such as goodwill, patents, etc.

OBJECTIVES OR NEED FOR PROVIDING DEPRECIATION

y 1. TO ASCERTAIN THE CORRECT PROFIT OR LOSS-

If depreciation is ignored, the loss that is occurring in respect of the fixed assets will be ignored. The loss will suddenly loom large when the asset becomes useless or valueless. Depreciation should, therefore, be debited to the P&L A/c before profit is ascertained. y 2. TO SHOW A FAIR & TRUE VIEW OF THE FINANCIAL POSITION- Depreciation if not

cond.
charged, would result in assets being stated at a higher value. As a result of this the balance sheet would not present a true & fair view of financial position. y 3. TO SHOW THE ASSET AT ITS PROPER VALUE- If depreciation is not allowed, the balance sheet would fail to show the proper value of the asset.

Cond.
y 4. TO RETAIN, OUT OF PROFITS, FUNDS FOR

REPLACEMENT- The amount debited in the P&L A/c are retained in the business. These are available for replacement of the asset when its life is over. Funds would not be collected for this purpose without accounting for depreciation. y 5. COMPLIANCE OF LEGAL PROVISIONS- It is necessary to charge depreciation to comply with the provisions of companies act & income tax act.

CAUSES OF DEPRECIATION
1. USE OF ASSET- Constant use of asset leads to its wear & tear & thus falls in value. 2. EFFLUX OF TIME- Some assets have a definite life period like lease, on the expiry of the life, the asset will cease to exist. 3. OBSOLESCENCE- If a better machine comes in the market, old machines may have to be scrapped even though they are capable of being used. It is a reduction in the usefulness

Cond.
of the asset. y 4. ACCIDENTS- Accidental loss may be permanent but is not continuing or gradual.

METHODS OF CHARGING DE RECIATION

y 1. STRAIGHT LINE METHOD OR FIXED y

y y y

INSTALLMENT OR ORIGINAL COST METHOD 2. DIMINISHING BALANCE METHOD OR WRITTEN-DOWN VALUE METHOD OR REDUCING INSTALLMENT METHOD 3. UNITS OF PRODUCTION METHOD 4. SINKING FUND METHOD 5. DEPLETION METHOD

COND.
y 6. DOUBLE DECLINING METHOD y 7. AMMUNITY METHOD y 8. SUM OF YEARS DIGIT S METHOD

STRAIGHT LINE METHOD

In this method following are noteworthy pointsy 1. Depreciation percentage is always calculated on the original cost of the asset. y 2. The amount of depreciation per annum will remain fixed every year. y 3. If we plot a graph of the amount of the depreciation per annum over a period of time, it will be in a straight line y 4. The depreciation is always charged on the closing date of books.

DIMINISHING BALANCE METHOD

y 1. The percentage of depreciation will always remain

fixed or constant y 2. The depreciation percentage every year will be calculated on the book value or written down value. y 3. The amount of depreciation per annum will keep on reducing every year. y 4. Depreciation is charged to accounts on closing date of books.