Basic Accounting Terms. Samir K Mahajan

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1 Basic Accounting Terms

2 Business Entity A business entity is a commercial (corporate or other) organisation that is formed in order to engage in business activities, usually for the sale of a product or a service. administered as per commercial law of the country. different forms such as sole trader, partnership, co-operatives, partnerships, private limited company, public limited company and so on. The motive of every business is profit.

3 Business Transactions An economic event that relates to a business entity is called business transaction. transactions Business are financial interactions between businesses and other entities involve transfer of money or goods or services between two persons or two accounts. e.g. purchase of goods, receipt of money, payment to a creditor, incurring expenses, etc. It can be a cash transaction or a credit transaction.

4 Business Transactions contd. Some business transactions are external that take place between the business enterprise and an outsider and. e.g. Sale of a product the customers Rendering services to the customers Purchase of materials from suppliers. Payment of monthly rent to the landlord And some others are internal that occurs entirely between the internal wings of an enterprise. e.g. supply of raw material or components by the stores department to the manufacturing department payment of wages to the employees

5 Features of Business Transactions Every business activity is not an accounting activity. Business activity are financial in nature and have documentary proof. money or money's worth of goods or services exchange of goods or services change in the financial position has dual aspects "receiving "(debit) and "giving "(credit ) of the benefit effect on assets, liabilities, capital, revenue and expenses Non-economic activities concerning emotions of love, patriotism, and respect do not find place in accounting.

6 Type of Business Transactions Transactions are of two types such as: cash and credit transactions. Cash Transaction is one where cash receipt or payment is involved in the transaction. For example, purchase of goods by cash immediately or by paying a price Credit Transaction is one where cash is not involved immediately but will be paid or received later. For example, purchase of goods on credit

7 Accounting Year Books of accounts are closed annually. There is no legal restriction about accounting year of the sole proprietor and partnership firm. They may adopt accounting year of their choice. It may be between two diwalis, or 1 st January to 31 st December of the same year or financial year.i.e. April 1 of any year to March 31 of next year. The only restriction is that it must contain twelve month. year. Companies must adopt financial

8 PROPRIETOR A person who owns a business is called its proprietor. He contributes capital to the business with the intention of earning profit. In accounting, business separate from its proprietor distinct identity i.e. existence other than the existence of its proprietor and other business units An accountant has to deal with the business entity and not with its proprietor

9 CAPITAL Capital is the amount (fund or any other form of resources ) invested by the proprietor/s in the business. This amount is increased by the amount of profits earned and the amount of additional capital introduced. It is decreased by the amount of losses incurred and the amounts withdrawn. For example, if Miss X starts business with Rs.5,00,000, her capital would be Rs.5,00,000. Or Mr Y may contribute a machines worth value 20 crores

10 Creditor and Debtor A creditor is a party, say A (e.g. person, organization, company, or government) that has a claim on the property or services of a second party (e.g. person, organization, company, or government). first party has provided some value (property or good or service or funds) to the second party under the assumption that the second party will return an equivalent value in some future date. second party is a debtor or borrower of the property, service or money. first party is the creditor which is the lender of property, service or money.

11 PAYABLES Payables is the total of sundry creditors and bills payables. Sundry creditors are sellers of goods on credit Bills Payables are the bills drawn by the certain seller (creditor) notes drawn by the buyer (firm ) to certain sellers to buyer (firm) or promissory Payables are shown on the liabilities of the balance sheet

12 RECEIVABLES Receivables is the total of sundry debtors and bills receivables. Sundry debtors are buyers of goods on credit (( buyers of goods on credit that have not paid yet to the firm) Bills receivables means bills drawn by the seller to certain purchasers/buyers. Receivables are shown on the assets side of balance sheet.

13 Goods Goods are commodities in which the business deals in Goods includes articles purchased for sale at profit or for use in the manufacture certain other goods as raw materials Furniture will be goods for firms dealing in furniture but it will be an assets for firm dealing stationaries.

14 Stock includes goods unsold on a particular date. Stock may be opening and closing stock Stock opening stock means goods unsold in the beginning of the accounting period. closing stock includes goods unsold at the end of the accounting period. For example, if 4,000 units Rs. 20 per unit remain unsold, the closing stock is Rs.80,000. This will be opening stock of the subsequent year. Stock can be classified as under: o Stock of raw materials o Stock of finished and semi-finished goods o Work in progress

15 ASSETS Assets are what firm owns. economic resources (properties or valuable things ) of an enterprise that can be usefully expressed in monetary terms. items of value used by the business in its operations. E.g. cash in hand, plant and machinery, furniture and fittings, bank balance, debtors, bills receivable, stock of goods, investments, Goodwill measured in money terms. is classified as fixed asset and current asset.

16 Assets contd. ASSETS OF A FIRM FIXED ASSETS CURRENT ASSETS

17 Fixed Assets Fixed Assets are assets held on a long-term basis, ASSETS contd. used for the normal operations of the business. not meant for business transaction rather are used to produce goods or service

18 Fixed assets includes o Lands, buildings o Machines and plants, o Furniture's, fixtures, fittings, o Investment in shares and debentures o Livestock ASSETS contd. Note: Fixed stock may be intangible (patient, copy rights, good will).

19 Current Assets ASSETS contd. Current Assets ( floating assets/circulating assets )are assets held on a short-term basis are expected to be realised in cash sold or consumed during normal operation of business. Are most liquid assets meaning that they are either in cash or going to be converted into cash. change their value constantly.

20 Current Assets ASSETS contd. Current assets include o Cash and bank balances o Stock of inventories of raw materials, finished and semi-finished goods o Debtors or accounts receivable or sundry debtors or book debt o Bill or note receivables o Prepaid expenses o Accrued income

21 It should be noted that certain assets which are popularly known as fixed may prove to be goods by virtue of their use. Such as: o Lands will be goods (land developer and property dealers). o Buildings (builders and property dealers). o Machines and plants (manufacturers and dealers of plants and machineries) o Furniture's, fixtures, fittings (furniture's dealers and furnishers ) o Shares and debentures (the dealers in securities ) ASSETS contd. It should be taken care that assets meant for regular purchase and sale are goods.

22 ASSETS contd. Tangible Assets: These assets are those having physical existence. It can be seen and touched. For example, plant & machinery, cash, etc. Intangible Assets: Intangible assets are those assets having no physical existence but their possession gives rise to some rights and benefits to the owner. It cannot be seen and touched. Goodwill, patents, trademarks are some of the examples. Liquid Assets: Liquid assets are those assets which can be converted into cash at short notice. E.g. cash in hand, cash at bank, debtors, bills receivables, etc.

23 Liabilities Liabilities are the obligations payable by the enterprise/business money or goods or services. in future in the form of Liabilities are what firm owes to others including owners. These denote the amounts which a business owes to owners and other parties, e.g., capital invested by business, loans from banks or other persons, creditors for goods supplied, bills payable, outstanding expenses, bank overdraft etc. Liabilities are and creditors claims against the assets of the business. Liabilities are measured in monetary terms

24 CLASSIFICATION OF LIABILITIES OF A FIRM IN TERMS OF CLAIM LIABILITY TO OWNERS (OWNERS' EQUITY /CLAIM) LIABILITY TO CREDITORS (CREDITORS' CLAIM/EQUITY) CONTINGET LIABILITES CREDITORS FOR GOODS CREDITORS FOR LOANS (LENDERS) LIABILITIY FOR EXPENSES

25 LIABILITIES OF A FIRM IN TERMS OF CLAIM contd. Liabilities to Owners /Shareholder s Funds / Owner s Equity/owner s net worth = Capital + surpluses (retained earnings) & reserves + interest in capital drawings expenses losses Liabilities to Creditors = Creditor's claim against business o Creditors for Goods = Suppliers of goods on credit to business = Sundry Creditors o Creditors for loans = Lenders (Banks, financial institutions or other parties) of Funds to Business o Creditors for Expenses = Outstanding salaries+ rents due + wages unpaid Contingent (Doubtful) Liabilities Contingent liabilities are not real liabilities future events will decide whether it is really a liability or not e.g. guarantees undertaken, cases pending in the law of court.

26 CLASSIFICATION OF LIABILITIES OF A FIRM IN TERMS OF IN DURATION OF TIME CLASSIFICATION OF LIABILITIES OF A FIRM IN DURATION OF TIME FIXED LIABILITIES/ LONG-TERM LIABILITIES CURRENT LIABILITIES/ SHORT-TERM LIABILITIES

27 LIABILITIES IN TERMS OF IN DURATION OF TIME Long-Term /Fixed Liabilities Long-Term liabilities are payable for a after a period of one year and for a long period of time. Long Term Liabilities includes o Owners capital o loans o Debentures/bonds o mortgages o Others

28 LIABILITIES IN TERMS OF IN DURATION OF TIME Short-Term /Current Liabilities Short-term Liabilities are payable within one year. Short-term liabilities change their values continuously. Short-term liabilities includes o Creditors/sundry creditors o bills payables (bill drawn by sellers of goods on credit,and accepted by the enterprise) o outstanding expenses Note: Account payables includes creditors/sundry creditors and bills payables

29 Purchases Purchases refers to the amount of goods bought by a business for resale or for use in the production. Purchase are intended to mean either purchase of finished goods for sale or purchase of raw materials for manufacture of the article, being sold by the business. Purchase of assets are not the purchase in accounting terminology as these assets are not meant for sale. Goods purchased for cash are called cash purchases. If it is purchased on credit, it is called as credit purchases. Total purchases include both cash and credit purchases

30 Purchase Return or Return outwards Purchase returns are the part of purchase of goods which are returned to the sellers by the business. This return may be due to unnecessary, excessive and defective supply of goods. It also may be result of violation of terms and conditions of the orders or agreements by the sellers. To find net purchases, purchases return is deducted from the total purchases.

31 EXPENSE Expense are the amount spent or cost incurred in order to produce and sell the goods and services(costs incurred by a business in the process of earning revenue). Generally, expenses are measured by the cost of assets consumed or services used during an accounting period. The usual items of expenses are: depreciation; payment of wages and salaries, interest, rent ; cost of heater, light and water; telephone bills, purchase of raw materials etc. Outstanding expenses: If expenses relates to the accounting period and remain unpaid they are called outstanding payment. Outstanding salaries, rent unpaid, wages due, repairs due but not paid are certain examples. As these expenses are still payables, these are liability of business. Pre-paid or unexpired expenses: Pre-paid expenses are expenses paid in advance. In certain cases, expenses relating to next accounting period may be paid during the current year. Pre-paid expenses forms part of assets of business.

32 EXPENDITURE Spending money or incurring a liability for some benefit, service or property received is called expenditure. Payment of rent, salary, purchase of goods, purchase of machinery, purchase of furniture, etc. are examples of expenditure. If the benefit of expenditure is exhausted within a year, it is treated as an expense (also called revenue expenditure). On the other hand, the benefit of an expenditure lasts for more than a year, it is treated as an asset (also called capital expenditure) such as purchase of machinery, furniture, etc.

33 SALES Sales are total revenues from goods (already bought or manufactured) or services sold or provided to customers by the business. In accounting sales means sale of goods and not sale of assets. Sales may be cash sales (sold for cash) or credit sales (sold and payment is not received at the time of sale). Total sales includes both cash and credit sales.

34 SALES RETURN OR RETURNS INWARD When goods are returned from the customers to the business, it is called sales return or returns inward. It may be due to due to defective quality or not as per the terms of sale. To find out net sales, sales return is deducted from total sales.

35 REVENUES Revenues are the amount the business earned by selling its products or providing services to customers, called sales revenue. Accrued revenues ( income )/ income due but not received: Accrued revenue are revenue earned during the current accounting year but yet to be received. These form part of assets. Income received in advance or unearned income: Income received in advance are the income received in current accounting year although this relates to the next year. These income form part of liability.

36 Profit, Income and Gain Profit: Excess of revenues of a period over its related expenses during an accounting year is profit. Profit increases the investment of the owners. Income: Income is positive change in the net worth of the enterprise from activities or other activities over a period of time. business Income is a wider term and includes profit too. Income is profit plus income from activities royalties, rent received, etc. (such as commission, interest, dividends, Gain: A profit that arises from events or transactions which are incidental to business such as sale of fixed assets, winning a court case, appreciation in the value of an asset

37 Loss : The excess of expenses of a period over its related revenues its termed as loss. It decreases in owner s equity. It also refers to money or money s worth lost (or cost incurred) without receiving any benefit in return, e.g., cash or goods lost by theft or a fire accident, etc. It also includes loss on sale of fixed assets. Drawings: Drawings is the amount of cash or value of goods withdrawn from the business by the proprietor for his personal use. It is deducted from the capital..

38 Discount: Discount is the deduction in the price of the goods sold. It is offered in two ways such as trade discount and cash discount. Trade discount are allowed on quantities of goods purchased as a percentage of list price. It is generally offered by manufactures to wholesalers and by whole sellers to retailers. Cash discount arises at the time of payment on the amount payable. After selling the goods on credit basis the debtors may be given certain deduction in amount due in case if they pay the amount within the stipulated period or earlier. Cash discount acts as an incentive that encourages prompt payment by the debtors.

39 Investment: The firm may invest in other firms share and equities and earn dividend and income. Insolvent: All business firms who have been suffering from losses for the last many years and are not even capable of meeting their liabilities out of their asset are financially unsound. Only court can declare the business firm as insolvent it is satisfied that the continuation of the firm will be against the public or creditors. Solvent: Solvent firms capable of meeting their liabilities out of their own resources. Solvent firms Solvent have sufficient funds and assets to meet proprietor s and creditor s claim.

40 Voucher: The documentary evidence in support of a transaction is known as voucher. For example, if we buy goods for cash, we get cash memo, if we buy on credit, we get an invoice; when we make a payment we get a receipt and so on. Voucher is a written document in support of a transaction. It is a proof that a particular transaction has taken place for the value stated in the voucher. It may be in the form of cash receipt or cash memo, invoice, bank pay-in-slip etc. Voucher is necessary to audit the accounts. Receipt: Receipt is an acknowledgement for cash received. It is issued to the party paying cash. Receipts form the basis for entries in cash book. Invoice/Bill: Invoice is a business document which is prepared when one sell goods to another on credit. The statement is prepared by the seller of goods. It contains the information relating to name and address of the seller and the buyer, the date of sale and the clear description of goods with quantity and price.

41 Entry: Any entry is a systematic record of business transaction. While passing entries, the principle 'every debit has got its corresponding credit is adopted. Different accounts are debited and credited in the entry with the same amount. Account: An account is a brief history of financial transactions of a particular person or item such as asset, capital, liabilities, expense or revenue named in the heading. An account has two sides called debit side and credit side.

42 Classification of Capital of Corporation (Public Limited Company) The company has to show the authorised, subscribed and paid up-capital under capital head. o Authorised capital/registered capital allowed (authorised) to issue. is the total of the share capital which a limited company is Capital Requirement (long run) = Rs. 1,00,000 Authorized Capital = Rs. 1,000,000 o Issued capital is the total of the share capital issued (allocated) to shareholders. This may be less or equal to the authorised capital. Current Requirement = Rs. 50,000 Issued Capital = Rs. 50,000 (5000 per share) o Subscribed capital is the portion of the issued capital, which has been subscribed by all the investors including the public. This may be less than or more than the issued capital. Subscribed capital= Rs. 40,000 (4000 Rs. 10 per share)

43 Capital /share capital : An Illustration Liabilities contd. o Called up capital is the total amount of subscribed capital for which the shareholders are required to pay. This may be less than the subscribed capital as the company may ask shareholders to pay by instalments. o If 4,0000 shares of Rs. 10 each have been subscribed by the public, and of which Rs. 5 per share has been called up. Called up capital= Rs. 20,000 o Paid up capital is the amount of share capital paid by the shareholders. This may be less than the called up capital as payments may be in instalments ("calls-in-arrears"). Some of the shareholders might have defaulted in paying the called up money. If some of the shareholders have defaulted in paying the called up money, say: Paid Up capital = Rs (2000 Rs 5 per share). o Reserve Capital : It is that part of uncalled capital of a company which can be called only in the event of its winding up Hence Reserve capital = Rs 20000

44 Surpluses: Surplus is the credit balance of the profit and loss account after providing for dividends, bonus, provision for taxation and general reserves etc. Balance of profit is carried forward in next year as retained earnings. Retained Earnings: When a company generates a profit, management has one of two choices: they can either pay it out to shareholders as a cash dividend, or retain the earnings, and reinvest them in the business. Retained earnings refers to the portion of net income/profit of a corporation that is retained by the corporation rather than distributing to shareholders or corporate investors or to vendors as part of continuing financial obligations as dividends. The business lists all retained earnings in the stockholder's equity portion of the balance sheet. A company may elect to utilize retained earnings in a number of ways, such as: o adding capital to the company's existing business investments and purchasing updated manufacturing equipment. o maintaining reserves for obsolescence of plant and machinery o building up a large cash reserve to help mitigate the effects of any risks, including downturns in consumer spending.

45 Bank Liabilities contd. Reserve Reserve : Reserve means a provision for a specific purpose. There are lots of unknown expenditures which can occur in current year or in future. To meet such type of expenses the business firm has to make the reserves. Reserves can be revenue reserve and capital reserve.

46 Reserve and surplus Revenue Reserve: Revenue Reserve arises out of retained earnings (are the reserves created out of revenue profit from trading activities. Examples of revenue reserves are General Reserve, Dividend Equalisation Reserve, Debenture Redemption Reserve. Revenue reserves are maintained To meet the financial position or improve (strengthen) overall financial status and health of an enterprise To settle any unknown future contingencies say inflation or deflation To increase the working capital To issue of bonus shares to shareholders To pay dividend to shareholders when profits are insufficient. to offset some specific future losses To meet litigation etc.

47 Reserve and surplus Capital Reserves: Capital reserve arises as a result of capital gains (arising from sale of equity share at a premium or resulting from upward revaluation of its assets to reflect their current market value after appreciation). Capital reserves are created by the accumulated capital surplus (not revenue surplus) of an organization. Allocating such sums to capital reserve means they are permanently invested such as future capital investment projects and will not be paid as dividends. Note: Share premium is the amount received by a company over and above the face value of its shares. This difference between the selling price and the face value of a share is known as share premium.

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